Daniel L. Molinaro - NOW, Inc. Robert R. Workman - NOW, Inc..

Ryan Cieslak - KeyBanc Capital Markets, Inc. Andrew E. Buscaglia - Credit Suisse Securities (USA) LLC (Broker) Sean C. Meakim - JPMorgan Securities LLC James West - Evercore Group LLC Vaibhav Vaishnav - Cowen & Co. LLC Charles Minervino - Susquehanna Financial Group LLLP Joseph D. Gibney - Capital One Securities, Inc..

Welcome to the NOW, Inc.'s Third Quarter Earnings Conference Call. My name is Jason and I will be your operator. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. I will now turn the call over to Senior Vice President and Chief Financial Officer, Dan Molinari. Mr. Molinari, you may begin..

Thank you, Jason. And welcome, everyone, to the NOW, Inc. third quarter 2016 earnings conference call. We appreciate you joining us this morning and thanks for your interest in NOW, Inc. With me this morning is Robert Workman, President and CEO of NOW, Inc. and Dave Cherechinsky, Corporate Controller and Chief Accounting Officer. NOW, Inc.

operates primarily under the DistributionNOW and Wilson Export brands and you'll hear us refer to DistributionNOW and DNOW, which our New York Stock Exchange ticker symbol throughout our conversations this morning.

Before we begin this discussion of NOW, Inc.'s financial results for the third quarter ended September 30, 2016, please note that some of the statements we make during this call may contain forecasts, projections and estimates including, but not limited to, comments about our outlook for the company's business.

These are forward-looking statements within the meaning of the U.S. Federal Securities laws based on limited information as of today, which is subject to change. They are subject to risks and uncertainties and actual results may differ materially. No one should assume that these forward-looking statements remain valid later in the year.

I refer you to the latest Forms 10-K and 10-Q that NOW, Inc. has on file with the U.S. Securities and Exchange Commission for a more detailed discussion of the major risk factors affecting our business.

Further information regarding these, as well as supplemental, financial and operating information may be found within our press release, on our investor relations website at ir.distributionnow.com or on our filings with the SEC.

In an effort to provide investors with additional information relative to our results as determined by GAAP, you'll note that we disclose various non-GAAP financial measures in our quarterly press release, including EBITDA excluding other costs, net loss excluding other costs and diluted loss per share excluding other costs.

Each excludes the impacts of certain other costs, and therefore, has not been calculated in accordance with GAAP. A reconciliation of each is included in our press release.

As of this morning, the Investor Relations section of our website contains a supplemental presentation covering our Q3 results and key takeaways, which should assist you in understanding our third quarter performance. A replay of today's call will be available on the site for the next 30 days.

It also should be noted that we plan to file our third quarter Form 10-Q later today and it will also be available on our website. Later on this call, I will discuss our financial performance and we will then answer your questions. But first, let me turn the call over to Robert..

Thanks, Dan. As you saw in our press release, we experienced our largest quarter growth since the third quarter of 2014. I never thought I could get excited about an average global rig count that is lower than peak by more than 55%.

But, for those of us with a large exposure to the upstream energy industry, the apparent bottoming of energy prices and activity levels were a much-welcomed event.

Ignoring the seasonal impact of breakup in Canada each year, the third quarter of 2016 marked the first time in eight quarters that we experienced increased average quarterly global rig counts. Rig count growth in the U.S. and Canada was able to offset revenue declines in other regions internationally.

Also in the quarter, WTI stabilized around $45 per barrel and Henry Hub natural gas prices improved to $2.88 per Btu. But, based on the recent pull back in oil and gas prices, we are still in choppy waters and not ready to characterize the bottom in the past tense, as the energy market remains uncertain as to the timing of a durable recovery.

The good news is that we have a great group of employees who are making the right decisions each day to help us navigate the ship in these uncharted waters. In the coming quarters, I know that our employees will continue to seize organic share growth and make adjustments to our business to match the market climate regardless of what comes our way.

One of those employees is a 43-year veteran with DNOW and I'd like to take a moment to recognize him before discussing the results for the quarter. Bill Harrington (05:10) joined our downstream business unit through the 2000 acquisition of Texas Mill Supply, called Wilson Supply at that time.

Over the years, Bill (05:19) has been instrumental, securing contracts with many customers, such as Bayer, Exxon Mobil, Phillips 66, Dow and others. He is currently responsible for our sales team in our South Texas region. He may not be listening today as he spends considerable time with his customers when he isn't with his grandkids and kids.

I would like to thank Bill for his many years of dedicated service to DNOW, and hope we experience his contributions for many years to come. Now, let's overview our results.

For the third quarter of 2016 we reported a net loss of $56 million or an adjusted net loss of $36 million, which is a modest sequential improvement of $8 million on revenue growth of $19 million.

This includes pre-tax charges of $1 million for severance-related expenses and $19 million for an after-tax charge for a valuation allowance recorded against the company's deferred tax assets.

Earnings per share for the quarter was a loss of $0.53 or a loss of $0.34 per share after adjusting for severance and a change in the company's deferred tax asset valuation allowance.

Revenue for average global operating rigs for Q3 2016 remained steady sequentially at $1.4 million with acquisitions and $1.3 million excluding acquisitions completed in the last year. Revenue changes were driven by a $47 million increase in the U.S. and Canada, partially offset by $28 million revenue decline in our International segment.

Consistent with previous quarters, pricing pressures experienced early in the downturn persist and competition remained fierce. Gross margin percent for the quarter remained basically flat compared to the prior quarter and was up 1.2% year-over-year.

Prices from the manufacturers for welded pipe rose in the quarter, as did resell prices by a similar amount. The opposite can be said for seamless pipe where sourcing costs remained relatively flat, but market prices continued to drop, indicating de-stocking continues with pipe distributors.

We tracked dumping suits on steel-related products and are making alternative plans should these cause a disruption or change of supply.

As we mentioned on the last call, Q2 2016 included a fringe benefit credit of $4 million and Q3 2016 included a full quarter of Power Service expenses, which restrained incremental flow through to EBITDA excluding other costs of 11% in the quarter.

Due to these items, we expected warehouse, selling and administrative, or WSA expenses, to increase sequentially by $5 million; however, continued expense reductions enabled us to maintain WSA expenses flat at $140 million. In the quarter, we reduced head count by 143 and our branch footprint by 12.

Simultaneously, we opened one artificial lift center and four onsite service centers for our Supply Chain Services customers. We've reduced non-acquisition head count by 1,964 or just over 36% during the two – last two years and have closed or consolidated about 110 branches and onsite locations.

These non-acquisition expense reductions have produced over $270 million of WSA expense reductions or a 38% reduction since the peak of Q4 2014. With expenses and gross margins relatively flat sequentially, we believe breakeven EBITDA remains at revenues of approximately $700 million.

We will continue our efforts to reduce breakeven revenues further by maximizing product margins and minimizing expenses where possible as we have more facility closures already completed and planned for Q4 2016. Diving deeper into the quarter, organic revenues in the U.S. with upstream and midstream customers grew sequentially by about $16 million.

We saw large customer account wins, some of whom increased their purchases sequentially by as much as 35%. Additionally, an increase in revenue was attributed to wins from continued construction of a customer's new facilities in the Northern Rockies and another customer's enhanced oil recovery pipeline.

We also experienced an increase in valve sales due to market share gains and a slight increase in project sales. All U.S. upstream areas showed growth with the exception of the Gulf of Mexico, with the largest improvements coming from the Marcellus, Utica, Mid-Continent and Permian areas.

Along with the declines in the offshore Gulf of Mexico, and with our ETC DAPL midstream project winding down, a more than 20% reduction of completions in Texas, as reported by the Texas Railroad Commission, were a major driver limiting revenue growth in the U.S. that lagged rig count increases.

Although rig counts began to improve in the quarter, facilities are (10:10) tank batteries, which are significant to upstream revenues, don't materialize until after the completion job ends. In U.S.

supply chain services, modest activity increases with OXY and Devon, along with the continued implementation with Hess, allowed for modest growth, while our downstream and industrial manufacturing businesses declined slightly.

A full quarter of our recent Power Service acquisition added a total of about $20 million of sequential incremental revenue in Q3 2016 in the U.S. Process Solutions group.

Considering these acquired sales, revenues in Process Solutions were relatively flat sequentially as growth in municipal projects and service work helped to offset large delayed projects with Crestwood in the Permian and Paradigm in the Bakken, as well as general softness in the DJ Basin and the Bakken.

In Canada, revenue growth of about $12 million was driven by recovery from seasonal breakup, the addition of our exclusive distributorship of the NOV Fiberspar-spooled fiberglass product line, a general increase with midstream customers and sales growth to drilling contractors in this Q.

Excluding acquisitions, revenues in our International segment are down approximately 75% since its peak, as non-acquisition operations in that segment are heavily oriented to the offshore drilling industry. Our U.S.

export sales, which is a large business within our International segment, is off almost 90% since peak as their largest customers are offshore drillers.

The continued stacking and scrapping of jack-ups, floaters, semi-submersibles and drillships in the offshore arena, trading surplus inventories that are being cannibalized at shore bases to support the working fleets, continues to negatively impact our offshore market in the Gulf Coast, North Sea, Latin America, West Africa and Asia-Pacific regions.

Looking at market activity moving forward, in the U.S., continued production declines in oil inventory draws, which are translating into increased rig counts and stabilizing energy prices, are increasing the appetite for some customers to complete a portion of their DUC inventory.

We're also experiencing modest activity increases in the major gas shale plays in Texas that haven't occurred for more than a half decade. These increases might be sufficient to offset continued softness in the Gulf of Mexico, the normal seasonal declines we experience due to holidays, fewer billing days and the winding down of budgets.

Anticipated increases with turnarounds downstream and slight activity improvements with operators should produce modest growth in our U.S. Supply Chain Services group, while softness in the overall industrial sector may put a governor on that.

This group should also begin delivering water alternating gas skids to OXY, as well as a recent order from Devon for several three-phase separators, all of which are being sourced from our Process Solutions group. We expect U.S.

Process Solutions to experience the bottom in its revenue stream in the next couple of quarters as the modular units they provide are relatively long lead time items, so the recovery in that business tends to lag that of our MRO business.

However, this group experienced an increase in purchase orders that should start materializing in the first half of 2017 and beyond. New orders include five large mainline pipeline stations for DCP in the Eagle Ford, which are scheduled to begin delivering mid-Q1 2017, and a large H2S scavenger package for ConocoPhillips in Alaska.

In addition to these projects, we've also received orders and encouraging feedback from customers outside of their core areas of the DJ Basin and Bakken shale play. We're also in the early stages of implementing an onsite materials management solution for Process Solutions in Casper that should be completed in the first half of 2017.

This initiative will increase profitability on modular packages, improve supply chain processes, lower overall costs and increase competitiveness. In Canada, we're expecting continued revenue growth as many of our contract customers are planning increases in wells drilled through Q4 2016 and into 2017.

In addition to an increased drilling program, we are working with a contract customer to prepare for a large oil sands turnaround project that will begin this quarter and continue into next year.

While we plan to support another contract customer in the Saskatchewan Bakken with their planned growth in wells drilled, we've also been given feedback from them that some of our first quotes for modularized tank battery solutions looks promising.

Turning to our International segment, the end of Wheatstone and Gladstone projects in Australia were a major contributor to revenue declines.

However, what should provide a partial recovery outside of North America in Q4 2016 are recent awards with Chevron TCO in Kazakhstan; wins in Latin America with Ocean Rig, Odebrecht and Dolphin; a seasonal spike in Russia and the CIS; and valving and electrical product shipments to Kuwait for the onshore Jurassic gas project.

We are currently finalizing an agreement with Schlumberger to extend our exclusive distribution rights for the REDA HPS pumps and certain related parts to 15 states to include key new regions such as Louisiana, the Permian and Eagle Ford.

This, along with our previously-executed global enterprise distributor program with Schlumberger, for its Cameron engineered and distributed valve product lines, further strengthens our relationship with this world-renowned brand.

We believe the expansion of our REDA agreement, combined with our current distribution agreements with National Oilwell Varco and Flowserve for their pump lines, will enable DistributionNOW to provide unparalleled pump product coverage, salt water disposals and water flood projects in all of the major shale plays throughout the Central U.S., especially in the Permian where activity has increased the most.

Internally, we continue to invest in technology that will enable organic growth within all of our geographies and product lines.

In addition to the millions of electronic transactions and associated revenues that we currently enjoy with our customers and suppliers, both through B2B and through our online catalog, we have recently developed and rolled out apps that not only allow customers to place orders on their smartphones from their customized product baskets, but also enables them to use their personal devices to scan materials from our production workover trailers and consigned RigPACs.

We've also implemented vending with upstream customers, complete with RFID portals to automate the deployment of goods and electronically communicate usage data. We are currently in the development stages for technology that will allow customers to snap pictures of pipe inventory and it will immediately tally the inventory count.

We're always looking for innovative ways to make it easier for customers to do business with us and bring efficiency to the supply chain, as we have many more projects currently on the drawing board.

Moving to capital allocation, in the quarter, we were able to generate cash flow from operations of $31 million, bringing the total to $186 million year-to-date, and $588 million since the downturn began in Q4 2014.

Continued cash generation enabled us to move sequentially from a net debt position of $44 million to a net debt position of only $14 million in the quarter. We generated cash sequentially by reducing net inventory and receivables by $57 million and $15 million, respectively, by bringing inventory turns to 3.3 from 2.8 times, and DSOs to 59 from 64.

We also continued to have minimal capital expenditure needs of $1 million in the quarter. These improvements to our balance sheet have reduced working capital as a percent of revenue, excluding cash, from 33% to 29% sequentially.

Our goal is to continue making improvements to our working capital as a percent of revenue, with the ultimate goal of reaching at least 25%.

Additionally, we're making strides on integrating acquisitions into Process Solutions and leveraging the DNOW organization to aid the team in growing organic share at a greater pace than they could achieve as standalone entities.

That said, we continue to have a healthy balance sheet and will use that asset to grow organically or inorganically to increase our competitive advantages.

Considering our cash balance, line of credit, recent ability to use our equity due to the lapsing of restrictions previously imposed by our Tax Matters Agreement, and the future cash benefit we will receive from the use of our deferred tax assets, including net operating losses, our balance sheet is available to support all forms of growth we are pursuing.

We're excited about what we have achieved in this market downturn, the opportunities our organization and financial position afford us, and the future we will create for the DistributionNOW family. Now, I'll turn the call over to Dan to review the financials..

Thanks, Robert. When we were spun off into a separate publicly traded company, I had great confidence in this company, its seasoned management team and our future. Despite these two years in a challenging market, I am as confident as ever in DNOW.

I continue to be proud of the efforts of our dedicated workforce as we created a standalone world-class provider of products and solutions to energy and industrial markets. I am grateful for the hard work and perseverance of the DNOW family. They make me proud.

We will continue to concentrate on the needs of our customers, while focusing on producing long-term value for our stakeholders. Robert discussed our business, and I'll say more about our financials. NOW, Inc. reported a net loss of $56 million or $0.53 per fully diluted share on a U.S.

GAAP basis for the third quarter of 2016 on $520 million in revenues. This compares with the net loss of $44 million, or $0.40 per fully diluted share on $501 million of revenue in the second quarter of 2016.

When looking at the year-ago quarter, we had a net loss of $224 million or $2.09 per fully diluted share on a revenue of $753 million for the third quarter of 2015. It should be remembered that the third quarter of 2015 included $255 million of non-cash charges associated with goodwill impairment.

The third quarter 2016 results included $1 million in pre-tax severance charges and $19 million for after-tax charges for evaluation allowance recorded against our deferred tax assets. After adjusting for these items, our third quarter loss was $36 million, or $0.34 per share, both non-GAAP measures.

Gross margin was 16.7% in Q3, up slightly over the 16.6% in Q2, and improved over the year-ago margin which was 15.5%, but included inventory cost adjustments. The company generated an operating loss of $53 million in Q3 compared with the loss of $57 million in Q2.

Third quarter EBITDA excluding other costs, a non-GAAP measure, was a loss of $40 million. Looking at operating results for our three geographic segments, revenue in the United States was $372 million in the quarter ended September 30, 2016, up 10% over Q2. Third quarter revenue in the U.S.

was down 25% from the year-ago quarter, with the decline being less than the 45% fall in the year-ago U.S. rig count as acquisition revenue improved our position. Renewed customer spending certainly contributed to these year-over-year revenue declines. Third quarter operating loss in the U.S.

was $46 million compared with a $44 million loss in the second quarter of 2016. In Canada, third quarter revenue increased 22% sequentially to $67 million, but down 29% from Q3 2015, which is less than the 37% decline the year-ago rig count in Canada. Declines in the Canadian rig count and well completions, as well as the strengthening of the U.S.

dollar, contributed to lower year-to-date revenue in 2016. For the three months ended September 30, 2016, Canada's operating loss was $2 million compared with the loss of $8 million in Q2 and compared with operating profit of $2 million in the year-ago quarter. Market activity in Canada remained sluggish.

International operations generated third quarter revenue of $81 million, which was down 26% from the second quarter of 2016, and down 50% from the year-ago quarter.

Additional revenue provided by acquisitions was offset by decreased international rig activity, reduced customer spending as they use their own inventory, and the completion of certain major projects.

International operating loss for the third quarter of 2016 was $5 million, similar to Q2, and compares with an operating profit of $1 million in the year-ago quarter. You'll recall that last quarter, we moved from two to three revenue channels in the U.S., adding Process Solutions to our existing Energy Centers and Supply Chain Services.

For Q3, revenue channels in the U.S. show Energy Centers at 52%, U.S. Supply Chain at 33%, and U.S. Process Solutions at 15%. For your modeling, I'll give you Q1 and Q2. In Q1, we had 54% U.S. Energy Centers, 37% U.S. Supply Chain Services, and 9% U.S. Process Solutions. That was 54%, 37% and 9%. In Q2, U.S. Energy Centers were 53%, U.S.

Supply Chain Services were 36%, with U.S. Process Solutions at 11%. Again, that's 53%, 36% and 11% for Q2. Continuing on our income statement, warehousing, selling and administrative expenses were $140 million in Q3, unchanged from Q2 and down $13 million from Q3 2015. We continue to show progress with our cost-cutting initiatives.

It should be remembered that we've acquired 12 companies adding to these costs. These costs include branch distribution center expenses as well as corporate costs. The effective tax rate for Q3 2016 was essentially 0%, as we're not allowed to record a tax benefit on our losses in the U.S. due to our deferred tax asset valuation allowance position.

There was a mix of tax benefit and tax expense in our jurisdictions outside the U.S. which largely offset each other. I expect Q4 to also be close to 0%. Turning to the balance sheet, NOW, Inc. had $601 million of working capital excluding cash at September 30, 2016 which was 29% of Q3 annualized sales. We still strive to get at least 25% again.

Accounts receivable improved another $15 million in Q3, ending the quarter at $339 million. We reduced AR more than $515 (26:51) million in the past two years despite adding AR from our acquisitions.

We continue to be challenged by bankruptcies in our energy space with some 180 North American oil companies and service providers filing for bankruptcy since early 2015. Access to capital remains a problem for many in our industry with energy companies defaulting billions of dollars of debt, but fortunately, not a problem for us.

Our current day sales outstanding were 59 days, down from 64 days in Q2, and an improvement over the 80 plus days last year. And I'm pleased with this progress as we continue to work on improving these results. Inventory was $532 million at the end of Q3, a reduction of $57 million in Q3.

We have slowed the inventory replenishment process and have reduced inventory more than $400 million since the start of last year despite increased inventory from our acquisition. Inventory turns were 3.3 times, which is an improvement over the last few quarters as we move towards 4 turns (28:06) again. Days payable outstanding were 41 days.

Cash totaled $131 million at September 30, 2016 with $109 million located outside the U.S., almost half of this being in Canada. We ended the quarter with $145 million borrowed on our credit facility, down $35 million in Q3. Our borrowing cost on this debt averages less than 3%. So, at September 30, 2016, we had a net debt position of only $14 million.

Capital expenditures during Q3 was approximately $1 million which we have averaged each quarter of this year. Free cash flow for the third quarter was $30 million and totaled $183 million for the nine months of this year. Our worldwide market continues to be challenging in 2016, but there are signs that better times may be ahead.

In the meantime, we'll continue to focus on serving our customers as we manage costs, and concentrate on synergy gains from our acquisitions. We have confidence in our strategy, in our employees, and in our future, as we position NOW, Inc.

to strengthen our value proposition as we continue to serve the energy and industrial markets with quality products and solutions. We're an organization with an experienced management team, strong financial resources, and we are prepared for whatever the future brings. With that, Jason, let's open it up to questions..

Thank you. And our first question comes from Matt Duncan from Stephens, Inc..

Hey, good morning guys. This is Will (30:18) on the call for Matt..

Hi, Will (30:19)..

Hey. I want to start with the midstream piece of the business and what you're seeing and hearing from customers there.

How would you characterize the tone of those conversations regarding the outlook into 2017? And what would you say the pickup in the 3Q from the 2Q was largely driven by in midstream markets?.

These midstream projects are very lumpy, because they're project-oriented. For example, we've been working on ETC's DAPL project now for many, many quarters. I was actually with a large midstream customer probably three weeks ago, and they've got several projects in the queue that they plan to start in Q1. So, I think you're going to find a mixed bag.

I think you're going to find some midstream firms that are going to slow down and others are going to pick up. But, we actually had a pickup with midstream in Canada in the quarter..

Okay. That helps. And, Robert, you touched on the pricing environment in the remarks.

I'm wondering if you've seen, or feeling a bottom, or firming in the pricing environment while activity was picking up? And how you're thinking about price, now looking forward versus what you saw in the 3Q?.

Our margins are driven really in two major buckets. One is our contract customers, and so the branches can affect those margins. And so, we negotiate and constantly look to remove either concessions we've made in the past, or push pricing there. We haven't had much traction yet, because we're in the lull of the bottom.

And then, the other big piece of our business is really margins that are managed by the branches. So, we may have a contract customer that buys from us every day and they may send us a spreadsheet full of materials to bid.

And so, the branches at that point don't have to live by the contracts, they basically price at what they think the market will accept. And so, they're going to continue to push margins naturally at all of the branches, because that would only improve their incentive program, which is driven by EBITDA margins.

But so far, we haven't seen any of that stick. But, I would expect if activity continues to improve that eventually, that would start gaining tractions as price availability and service levels take precedent over price differences..

Okay. And then, last thing for me.

I'm wondering how you guys are thinking about M&A and what you're appetite right now is there, as we've seen a pickup in the upstream activity? Trying to get an idea of the working capital reinvestment you'll need if trends continue to work higher, or even substantially improve, how that working capital investment might offset your acquisition activities through the recovery?.

Yeah. So, we have plenty of room, just in our line of credit and cash, not to mention other forms, to fund both the recovery and do acquisitions. I mean, whatever you're modeling for rig count recovery, which could get you quickly to our revenue line, we continue work our way down to 25% of revenue for working capital.

And so, that would kind of give you an idea of how much additional cash we'd need to fund inventory and receivables, but it won't be nearly the amount of cash and credit line we have available right now currently. So, we're still interested in M&A. We're still working it like we always have.

We just currently have a tremendous amount of our resources focused on the organic opportunities that exists by getting the synergies out of the acquisitions that are now in the process team..

Great. Thanks a lot, Robert..

Thank you. And our next question comes from Ryan Cieslak from KeyBanc Capital Markets..

Hey. Good morning, guys..

Hey, Ryan..

Hey, Ryan..

I guess, first off, Robert, I'd just be curious to know when you look at the quarter and the way it played out, maybe relative to your expectations, was there one particular month that was weaker or better than the others? And just maybe some directional sense of how the quarter ended relative to maybe how it started..

Well, in a flattish market, which we've not been in in a long time, but in a flattish market, Q3 is usually our strongest quarter. And Q2 is usually our weakest due to the breakup in Canada. And then, Q4 and Q1 look generally similar to each other. And as normal, the third month of the quarter was our strongest month. So, that was not unexpected.

That generally happens in our business, the revenue grows per month through the quarter. So, it was stronger than we expected it to be, because most of the offset that was a surprise for us was simply the winding down of projects internationally..

Okay. And then, it seems like there's some puts and takes going into the fourth quarter, still a choppy market and, certainly, international side of things has been weak.

Maybe just directionally, how we should think about the type of sequential pattern in sales going into the fourth quarter for you guys, if it's going to be what you generally see or is there a better way of just thinking about that trend on the top line going from the third to the fourth quarter?.

Well, in the three geographic segments, we expect International to recover, maybe not to the Q2 levels, but definitely a strong recovery in International. Canada will continue to grow based on what we're hearing from our customers on their drilling program.

And in the U.S., with rig counts continuing to increase, my hope would be – and we won't know, but our hope would be that, that could offset fewer billing days, holiday impact, Thanksgiving and Christmas, and our customers always start winding down budgets later in Q4. So, I think if we ended up with a flat U.S.

revenue stream, that would be pretty exciting..

Okay. Great. Then, I'm sorry if I missed this. Did you guys provide just some direction of where we should think about operating expenses or WSA into the fourth quarter? I know you guys have given some guidance on that in the past. I'm sorry if I missed it, but just any color around that would be great..

Yeah. We're not going to sit on our hands and wait on the market to come back. So, we're going to continue the same expense cutting in Q4 that we did in Q3 that we did in Q2. So, based on our past performance, I would expect we could reduce expenses further in the $3 million to $5 million range for WSA.

That being said, if you see rig count start going up 30 a week for the rest of the quarter, that would definitely – those increases would probably offset those targeted reductions, but based on modest activity improvement like we've experienced so far, I would expect we could reduce expenses again by $3 million to $5 million..

Okay. And then, this is my last question on – sort of dovetailing off of that is, you've done some significant cost-cutting here since the peak in certainly a market that remains very uncertain and choppy.

Robert, how are you thinking about the business going into next year in terms of maybe some additional cost opportunities or what you need to see to really feel comfortable that you guys have cut enough from a cost perspective?.

Well, I'm excited every quarter, because we manage – the cost cutting actually happens in our operations and these are the branch managers that are doing the best they can to try to improve their profitability. And so, they've already gone above and beyond with respect to what I thought they could accomplish in the expense reduction efforts.

So, if the market stays consistent going forward as it has been in the last few months, I would expect costs to continue to come down. If we have some top of robust recovery, then that would be a whole other scenario..

Our next question comes from Andrew Buscaglia from Credit Suisse..

Hey, Andrew..

Hey, guys.

How are you?.

We're good.

How about you?.

Good. Can you give us an update just after you had that great Analyst Day on Power Service? I think I missed what it contributed in the quarter. And then, if you could comment into Q4 just for modeling purposes, what you expect.

I know seasonally, there is typically a slow down, but can you just give us some color there?.

Yeah, we acquired Power Service in Q2, and they contributed $7 million of revenue in that quarter. And then, they contributed an additional $20 in Q3, so that would be $27 million of revenue that they had in Q3. Now, that business is longer lead time.

So, these orders that we're receiving lately that are quite exciting, some of these pumps have some 12-week, and 18-week, and 24-week deliveries and things of that nature. So, it'll take a while for that to materialize. Unlike our Energy Center business, which is pretty close to the tip of the spear.

So, I would think that our process team revenues will continue to soften into Q4 and possibly Q1 until those longer lead time items start materializing into our revenue stream..

Okay. And then – okay. So, then after Q1, we should model somewhat of a material pickup for that specific..

I guess that depends on how you would define the word material, but yeah, you would defiantly model a pickup in that business beyond there..

All right.

And then, could you just give us an update on DUC inventory, anything changed in the quarter over the last three months?.

Well, there is all sorts of people that date out there that conflicts with each other, but we did notice a nice little pickup, mainly in the North East and in the Bakken with respect to customers completing DUC inventory. Now, it's a far cry from the number that's actually out there.

I think you get anywhere from 4,000 DUCs to 5,000 DUCs out there on people that try to keep up with it. And so, we didn't have that kind of recovery. But, we did see dozens and dozens of wells that have been capped, get completed. So, that was an exciting little kind of turnaround finally..

All right. That's it for me. Thanks, guys..

Thank you..

Our next question comes from Sean Meakim from JPMorgan..

Hi, Sean..

Hi, Sean..

Morning. So, we often reference the rig count as a good proxy for your business and we have the natural lag between drilling and completions, that makes sense. We saw some of that in the quarter. But, we did lag the rig count by a good bit. And now, I think, if I understood correctly, we're talking about a flattish top line in the U.S. for 4Q., U.S.

land rig count up about 13% quarter-to-date.

Seasonality towards an year-end is understood, but I guess how do we think about the business eventually catching up to what we've seen in terms of rig count off the bottom here?.

Well, the only reason we use rig count as an indicator for our revenue stream is simply because it's the only – it's the least inaccurate data point we can find.

If there was solid completions data out there that didn't vary widely between firms, we would switch to measuring our revenue on a completion basis, because the vast majority of our upstream revenue is with the actual completion of the tank battery, not necessarily the consumables that the drilling rig consumes while they're drilling.

But it's the only thing we have to measure against unless you have a data source that's accurate and reliable. So, generally, you're going to spend, I don't know how many days you're going to spend drilling a six-well or eight-well pad, and we're going to be selling to the drilling contractor while that's going on.

And then, we're going to sell very little to the frack crew, maybe some safety gear and some tools, but not anything worth measuring, and that takes a month or two. And then, they do the tank battery. So, there is definitely a lag between our revenue stream and rig count movements.

It's probably one of the more closely tied businesses to rig count movements, but there's still definitely a lag there..

And so, that's all well understood.

If you think about – can you give us maybe a little more detail just on this quarter, how your drilling business – your drilling-related business did perhaps relative to the overall?.

It definitely improved as a percent of total revenue, starting about mid-last quarter. It's up several percentage points of total revenue..

Okay.

And then, just thinking about the relationship between revenue and working capital as you kind of make your way through the turn, your expectation that the working capital build will lag the revenue ramp, and that's how you get to your efficiency targets? Or is there some risk as we go another quarter here where we've generated more cash, we've liquidated more inventory, we actually have to build more cash – sorry, build more working capital early in order to catch up? Just curious about that interplay..

Yeah. I would expect, Sean, that the progression you've seen from the point of spin all the way to now where we've been working our working capital down, that you're going to see that ratio continue to improve. Now, will we have to buy some A items that are high turn items to replenish those in the branches? Sure, we will.

But, I would think DSOs and inventory turns will continue to improve..

Okay. Fair enough. Thanks..

Thank you..

Our next question comes from James West from Evercore ISI..

Hey, James..

Hey. Good morning, guys.

Robert, so kind of following-up on Sean's question there about rig count growth and understanding the lags, but how good is rig count now as a proxy for your drilling-related or completions-related businesses? I mean, it seems to me like it would be more tied to, kind of, I guess the completions side, or the number of completions done per quarter.

Because, there was, I mean, a pretty significant disconnect between the rig count in both the U.S. and Canada, and your growth in both those regions in this quarter. And I understand we may see a pickup later on, but given your guidance, it sounds like the lag is much longer than I would have expected..

Yeah. Our revenue per rig – per global operating rig for the quarter was pretty much flat with Q2, but I do agree that there is definitely a lag between rig count increases and our revenue stream. I mean, because if you think about it, they could spend, what, a month drilling the wells on a pad.

And then, they're going to spend one to two months doing the completion job. And then, the biggest revenue stream for us, upstream, by far, as it related to activity, is the tank battery. So, the biggest part of our revenue related to the rig count increases we've had over the last two months, three months is yet to materialize..

Right, okay.

But, aren't you involved in as the rigs are staffed and stood back up? Aren't you involved in kind of getting all the ancillary equipment or the supply chain going again, so you would see kind of a concurrent improvement? I understand it's a small revenue piece, but there would be some concurrent improvement as well?.

There is no doubt that we experience revenue growth with the drilling contractors, even before they start drilling..

Right..

I mean, they've got replenished inventory on these rigs before they even move them out to the well site. But, as a percent of the total upstream revenue we have, it's not going to move the needle. I mean, it's great revenue, we love our drilling contractor customers.

But, at the end of the day, our operator customers, by far, carry the weight when it comes to our revenue stream..

Okay, okay. Fair enough. And then, on the ....

James, I want to add something. If you look at our rig count, like Robert said, it's still our best, but inaccurate proxy for what revenue should do.

If you look at our revenues from the first quarter, our rig count from the first quarter in Canada, which I think is a better comparative period given the breakup, our revenues are up versus a much smaller rig markets, down 26% in Canada versus the first quarter and our sales are up.

If you look at the same in the U.S., rig count from the first quarter is down 14%, but our revenues are up, or flat, even after pulling out Power Service. So, there is not a perfect quarter-to-quarter correlation, but over time, I think it's still a good barometer..

Okay. But Dan, that's helpful. And then, another follow-up from me on the balance sheet. The balance sheet obviously in good shape right now, but you're going to have to rebuild your inventories probably significantly as the recovery takes hold.

So, if we envision a scenario where activity, maybe not rig count given the efficiencies on the rig side, but activities – completions activity gets back to 2013, maybe early 2014 type level, how much incremental inventory are you going to need to the balance sheet to be able to service your customer base in North America?.

Well, as a general rule of thumb, you should expect our inventory turns to work their way to 4 times and you should expect our DSOs to be in the mid-50s and you should expect our working capital spending revenue to be around 25% million.

So, if we add $1 billion of revenue, we need $250 million of cash to fund our balance sheet and we've got -- we could do that several times over..

Right. Okay. Okay. Got it. Thanks, guys..

Thank you..

Thank you. Our next question comes from Vebs Vaishnav from Cowen & Company..

Good morning, gentlemen..

Hey, Vebs..

Hey.

How are you doing?.

Good..

Thanks for taking my question. I guess it has been asked in various forms. I'm going to try from a different angle.

How would you characterize your drilling versus completions revenue share within the U.S.?.

Our revenue share?.

Yeah.

Like how much comes from drilling with the completions?.

I don't have that number in front of me, Vebs, but I mean, our drilling revenues must be of our U.S., of our Upstream business got to be 10%, 8%, some number. I mean, I can pull it out and publish it, but it's not – I mean, it's definitely insignificant for the operators. Operators might be half of it..

Okay, okay. So, let's say if we were to say U.S. D&C spending is up 15% to 20% in fourth quarter.

You are implying that despite spending being up 15% to 20%, you would still have flat revenues in fourth quarter?.

So we're talking about the U.S. as a whole right now. We're going to have some declines in the process group for the reasons I mentioned earlier about – it's a bigger lag for long lead time, and we're going to have an impact of fewer billing days. Billing days are a big deal in this business, and we're going to have holiday impact.

And we're going to have winding down of budgets. And a lot of customers, if you ever get Pete aside and he'll talk to back in his H&P days, they send the crews home at Thanksgiving and Christmas, unless there is a really strong reason not to.

So, all of that stuff combined, hopefully, will be offset by the activity improvements we have in the non-holiday season periods of the quarter..

Okay, okay. And could you help us just think about like how much of your U.S.

business comes from Gulf of Mexico?.

Back in 2014, before the slowdown, I think it was maybe 11%, 12%. I remember running the numbers a long time ago. It's somewhere in that range and now it's got to be 5% or less..

Okay. Okay. And there was a comment that you made basically saying considering your credit facilities and the lapsing of restrictions previously imposed by taxpayer on issuing more equity, you would use all forms of growth.

Was that comment related to like a preemptive thing or was it in consideration for a deal?.

No, no, no. There's several forms of currency we have to do M&A, and I was just highlighting some of the ones that folks don't always know about, which is obviously our DTA is going to be cash avoidance in the future.

And most folks don't know that we've been under a Tax Matters Agreement for two years where we had no access to our equity if the right deal came up where equity would make sense. So, I'm just kind of updating the callers or listeners on – we have more than one form. We've got cash. We've got a line of credit that's barely tapped into.

So, we have plenty of powder in many forms to not only fund a recovery, we could fund a recovery of a couple billion more dollars of revenue and still have room. So, just making sure everyone knows that it's not an either/or for us. It's an all the above.

We're just currently focused on getting the synergy and organic benefit out of some acquisitions of recent and making sure we don't divert those resources onto other areas of our business and miss out on basically free revenue growth..

Probably, the key thing there, Robert, is the equity side with the Tax Matters Agreement, too, because now that opens up currency, as you said, all forms of currency. So, we can kind of run the business as we need to..

Okay. And last question, if I may. Just if you can update us on like the Power Services M&A or the acquisition, how was the progress on leveraging that piece of the business, just putting it on your broader U.S.

scale?.

Putting on a what scale?.

Just much broader U.S. – like, earlier it was more in the Rockies versus....

Yeah. Believe it or not, their peak obviously was late 2014, early 2015, obviously, because their lead times are longer. So, they didn't feel the downturn at the beginning of it. And their quote log right now for that business, for the modular solutions, is greater now than it was back then. So, there's a lot of exciting things happening.

They constantly send me emails about projects they win, up in the Marcellus and Utica, or down in the Eagle Ford or up in Alaska that they would have never even known about if they hadn't been part of the DNOW organization.

And on top of that, you now combine it with the Odessa Pumps teams, you've got the entire Odessa Pumps army out there trained and generating these opportunities as well. So, I'm excited about it. I mean, I'm extremely excited about it..

Our next question comes from Chuck Minervino from Susquehanna..

Hi. Good morning..

Hey, Chuck.

How are you?.

Hi, Chuck..

Good. Good. Hey. Just a couple of questions, I guess first in the International business, I think you said that you think that that's going to recover in 4Q.

Do you think that we've now seen the bottom in 3Q with that International business or is that more of a kind of – I know you have some cross-currents there with offshore still kind of in decline and you've got some new projects starting, but, do you think we've seen the bottom now in 3Q as we kind of look out into 2017?.

If you separate our business internationally into offshore-centric and not-offshore-centric, the onshore work both coming from MacLean, which is that acquisition we made, who have been knocking it out of the park – I mean, I don't want to detract from their success.

They had a lull, because of the winding down of two LNG projects, but compared to their past performance, they are killing it. And so, groups like that and our teams in the Middle East that are focused on projects in Kuwait and some shipments into Iraq and some other areas, they've been making up for some of the offshore decline.

And so, that particular segment is going to continue to do well.

The part I don't know, and I don't know anybody out there that does know, is what's Q4 and Q1 and Q2 and Q3 look like for the floater fleet? Are they going to stack another 30 rigs? Are they going to stack another 10 rigs? Are they going to get busy again? You hear a mixed bag of what's going to go on with offshore projects.

I've heard positive things from Schlumberger and others this quarter about FID projects and I've heard negatives from others. So, the offshore is the wildcard for me for our International segment, because if it's a big enough decline, the great things happening elsewhere might not be able to mask it..

Are you able to help us with how big offshore now is as a piece of the International business?.

Well, I think, when I looked at it last, which was, I don't know, a few quarters ago, it was about half of our International segment. And I'm sure that's moving every quarter left and left and left, because obviously as revenues decline in that segment, they grow elsewhere ,the ratio is going to switch..

Okay. And you might've touched on it earlier, but just kind of looking at the U.S. business. I think in the past couple of quarters, you guys have talked a little bit about maybe like 15% or 20% incremental margins in that business as the revenue grows and it looks like the incrementals are actually negative this quarter.

Can you just help us understand maybe what's going on there? I know there are some acquisitions that have worked in there as well, but how to maybe think about incrementals as U.S.

begins to recover more materially?.

Well, the incrementals in the quarter were clearly affected by non-recurring benefit and then the full quarter loaded full of Power Service expenses. If you saw a nice ramp in revenue in the U.S.

and we didn't have any one-off kind of scenarios like the ones I just described, then you would expect, at least in the first few quarters of a recovery, a robust recovery, you would expect high teens or low-20%s in flow-through..

So, I guess is this just more of a matter of timing before we start seeing that?.

Yeah. I mean, I think Q3 would have looked a lot different without those two things I just mentioned. So, those kinds of events mask the operational flow-throughs that we've experienced in the quarter. So, if that stuff kind of stays constant and we have considerable revenue growth in the U.S.

segment in the coming quarters, you're going to see flow-throughs that are clearly in the mid to high-teens or low-20s%..

Got it. Thank you..

You're welcome..

Thank you. Our next question comes from Joe Gibney from Capital One..

Hi, Joe..

Thanks. Good morning, guys. Covered most of the ground. Really I just wanted to touch on a smaller piece of your business, some perspective on downstream perhaps, maybe tone of conversation with the customers regarding outlook for possible increase in turnaround work.

I know it can be lumpy on the project side too, but just some perspective there, I'd appreciate it..

Well, Joe, I have been hearing that turnarounds are one quarter away now, but it feels like two years. I've gotten to point now when they come to my office to talk about turnaround activity in the coming quarter, I stick my fingers in my ear, because I'm just tired of hearing one thing and it materializing differently. But they're pretty excited.

I mean, they're telling me right now that they think Q4 is going to be a good turnaround quarter, and we'll see if that ends up being true, but they're pretty upbeat on turnaround this quarter and into Q1..

Into Q1..

Thank you. That will end our question-and-answer session. I will now turn the call back to President and CEO, Robert Workman, for closing statements..

I'd like to thank everyone for your interest in DistributionNOW, and we look forward to talking to you in February..

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect..