DNOW Inc (DNOW) 2014 Q3 法說會逐字稿

Welcome to the DistributionNOW earnings conference call.

(Operator Instructions)

I would like to turn the call over to Mr. Daniel Molinaro, Senior Vice President and Chief Financial Officer. Mr. Molinaro, you may begin.

Thank you. Welcome, everyone, to the NOW Inc. to the third-quarter 2014 earnings conference call. We appreciate you joining us this morning. 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 will hear us refer to DistributionNOW and DNOW, which is our New York Stock Exchange ticker symbol, throughout our conversations this morning.

Before we begin this discussion on NOW Inc. financial results for the third quarter ended September 30, 2014, 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 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 and 10-Q that NOW Inc. has on file with the 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 website at www.distributionnow.com or in our filings with the SEC.

A replay of today's call will be available on the site for the next 30 days. It also should be noted that tomorrow, we plan to file our third-quarter 2014 Form 10-Q.

Later on this call we will answer your questions. I will discuss our financial performance a bit later, but first let me turn the call over to Robert.

Thanks, Dan. Welcome to DistributionNow's Q3 2014 earnings conference call.

Today, we reported revenues for the third quarter of 2014 of $1.07 billion and EBITDA of $53 million or 5% of sales. We are excited about our sequential 12% organic top line growth and thrilled about growth in the US of 13%, where the market activity only increased 2.8%. Of particular note is the fact that none of the growth was aided by acquisitions. The majority of the sequential growth came from the users and branches that transitioned from their heritage ERP system to our new platform.

When comparing revenue to market changes from Q1 2014 to Q3 2014 in the US, ignoring the disruptions that occurred in Q2 2014, the US growth was in line with recount changes.

We experienced a nice recovery in Canada, 38% top line growth in the third quarter, as well. We believe we would have performed even better if not for the fact that our Canadian operations moved to the new ERP platform late in Q2 2014 as compared to US operations, which moved in April. Also, our central distribution center in Edmonton was unexpectedly interrupted for the extended period of time due to connectivity issues in the warehouse.

After four consecutive strong quarters in our international segment, we had a soft period, as fewer large projects materialized. This segment is [chopping], as a large portion of the business is project-oriented and we have enjoyed some large customer orders in Kuwait, Iraq, Azerbaijan, Indonesia, and Kazakhstan over the last 12 months that did not repeat in the quarter.

Consistent with Q2 2014, our project line pipe group continued to experience unusually high competitive pressures and produced sequential revenue growth with consistent margins, Although we had a strong recovery in the quarter related to reduced spend and ERP disruptions, coupled with improved user proficiency with the new ERP system, as we have communicated, we still have improvements to make in Q4 2014 to restore the company to normal operations.

Outside of changes in customer or market activity, the continued recover from spend and ERP disruptions in Q4 2014 could partially offset the normal seasonal declines we typically experience in this quarter. Some of the benefits we have already begun to realize from the rollout of the new ERP system that will continue as we move forward, are managers having real-time detailed financial information for their businesses, allowing them to make more informed decisions. Essentially, all branches now have visibility and access to our distribution centers and other branch inventories, and improvement to our quotation system which allow employees to respond to customers more efficiently is being implemented.

Enhanced material search, which is a major improvement to the original search tool for quoting was just completed. Financial consolidation software that has been implemented will aid us as we begin integrating new acquisitions. Our Houston pipe yard move is now complete and fully operational. The HR system that manages human capital, benefits, payroll, expenses, et cetera, is now up to speed, and lastly, supplier integration software is now implemented and we will be onboarding hundreds of our vendors over the coming months.

Moving forward, we still have challenges in other areas, such as a backlog of B2B customer integrations, cash applications, collections, et cetera; and have project teams addressing those as we speak. While our business hasn't yet experienced any notable change in activity as a result of lower commodity prices, our healthy balance sheet and our experienced management team and employees help position our Company well to respond to any changes in market conditions.

Looking at market activity moving forward in the US, we believe there are several exciting things happening in this quarter that we believe could possibly offset current challenges such as normal Q4 seasonal declines, reduced oil prices, customers completing projects, and CapEx [hits] before year end, increased project bidding, permitting issues in California, and a slowdown in the natural gas series of the Rockies.

Some of those positive developments are that we are experiencing activity increases in the Utica, Marcellus, Bakken, Permian, Northeast Eagle Ford and Woodbine. Also, due to customer demand, we have added several near branches in the Permian. We anticipate continued ramp-ups of projects with ConocoPhillips in the core Eagle Ford area. The expansion of our artificial lift centers that has been occurring over the past several quarters is bearing fruit; and lastly an additional drilling contractor is adopting our onsite supply chain solution called rig pack, which should increase our share of purchase from their company.

Moving on to our line pipe group, going forward, pricing continues to be very competitive. However, lead times have begun to increase for both domestic and international mills, which, going forward, could relieve some of the pressures. We will continue to maintain our relatively low inventories of line pipe, until we see some type of pricing recovery in the market.

Even though drilling activity was up in Canada Q3 2014, over the same quarter last year, well count was relatively flat, yet down most of the quarter. As well, one third of the year-over-year revenue decline in Canada is attributable to an unfavorable foreign exchange. However, the Canadian Bakken, Duvernay, Montigny, Cardium, and Viking Shell plays all continue to be active.

While in the current quarter we don't expect our international segment to make a rebound back to Q2 2014 levels due to seasonal declines and market conditions in Europe, and a lack of projects in Asia, we should experience a modest sequential recovery in Q4 2014 due to increases in MRO and OEM exports destined for the CIS in Saudi Arabia; artificial lift activity in Australia; protective personal equipment, or PPE, sales in the CIS; coated pipe and valve projects for Chevron's Wafrah Field in Kuwait; PPE and line pipe projects for BP in Basra, Iraq; valve and PPE projects for Exxon Mobil in Western Iraq.

Moving beyond the top line, we still believe that we can begin showing consistent improvement in EBITDA margins the first part of 2015, and that we will reach our goal of 8% within about a year afterwards in the current market environment. Between corporate project expense reductions, efficiencies gained in operations by eliminating multiple ERP systems, reduced cost of goods by leveraging our combined spend, access to the DCs and pipe yards for all branches for inventory replenishment, and improved base margins driven by our incentive plan, the three-point improvement can be achieved at current or improved revenue levels.

Q3 2014 marked the completion of the corporate SG&A buildout for functions such as legal, tax, external reporting, collections, audit, insurance, Board of Directors expenses, et cetera, required to support DistributionNOW as a standalone company. Additionally, due to less leverage with reduced head count, and demographic differences in DNOW as a standalone company, employee benefit costs increased $3 million over prior quarters -- increased costs that we did not pass on to our employees.

Moving forward, I would fully expect our SG&A level to begin stabilizing over the coming quarters. From the high in June of 138 contingent workers and consultants working projects related to spend and the ERP implementation, we are now only marginally down to 123 on staff that are completing projects that will be finished by early next year. Also, the acquisitions of Wilson Supply and CE Franklin 2012, and in addition to the 14 new energy branches we have opened globally, we have consolidated 79 and repurposed 8 more branches to be focused on either drilling contractors or oil and gas operators. We have 14 branches in the US and Canada that are candidates for that same rationalization over the coming quarters at current market levels.

We believe working capital, now at an unacceptable 34% as a percentage of revenue, is at peak as spend and ERP rollout in Q2 2014 have increased our DSOs by about 20 days, and inventory turns have temporarily decreased as well. In the coming quarters, we believe inventory turns will return to historical performance, as we are experiencing a steady increase of branch usage of the distribution centers, which will in turn instill confidence in the field and result in decreased inventory at the branches.

We are near completion of several projects in accounts receivable and cash application group that will enable us reduce DSO by more than 15 days and back to historical levels. Our goal is to reduce working capital as a percentage of revenue by 10% next year.

During the quarter, we consumed around $70 million of cash. The increase of over $130 million in accounts receivable, due in large part to the increase in revenues, was offset by other improvements on the balance sheet. On our last call, we announced that we had executed four LOIs related to acquisitions that represented just over $100 million of aggregate revenue. In Q4, we completed two acquisitions that represent a small portion of the $100 million revenue potential, and hope to close two more by late Q4 2014 or early Q1 2015. Additionally, we have executed new LOIs since our last call that have an aggregated revenue potential of just over $50 million.

Our M&A pipeline is full. Our opportunities to deploy capital look promising, and we are continuing to increase the velocity of our M&A efforts. There are many opportunities, both small and large, in the US and abroad, and we will continue to be selective and strategic in what we go after and how we value them.

Before I turn the call over to Dan to review the financials, I would like to thank our employees for all their contributions towards this remarkable recovery, which is even more impressive given all the disruptions they have experienced. They are truly our greatest asset.

Dan?

Thanks, Robert.

These continue to be interesting times at DistributionNow, and the third quarter marks the full first full quarter as a standalone public entity after being spun off from National OilWell Varco at the end May of this year. We are proud of our history with NOV and will continue to act as a distributor of certain NOV products, and will supply products and solutions to NOV. At DNOW we are excited about our future as a standalone company and increasing value to all of our stakeholders. And I join Robert in thanking our dedicated employees as they continue to handle the spinoff, the implementation of a new ERP system, and the integration of two significant transactions, Wilson and CE Franklin.

Robert discussed our business, and I will touch on our financials. Now, we generated earnings of $32 million or $0.30 per fully diluted share in this third quarter ended September 30, 2014 on $1.07 billion in revenue. This compares with net income of $27 million or $0.25 per fully diluted share on $952 million of revenue in the second quarter of this year, and compares to net income of $39 million or $0.36 per fully diluted share on revenue of $1.1 billion for the third quarter of 2013. It should be noted that an earnings comparison with the prior year could give the wrong impression, as 2013 did not reflect the full cost of running an independent publicly traded company.

Gross margins were 19.9% in the third quarter of 2014 compared with 20.3% in the second quarter of 2014 and 18.5% in the year-ago quarter. For the nine months of 2014, gross margins were 19.8% compared with 18.4% for the similar period last year.

EBITDA for the third quarter of 2014 was $53 million or 5.0% of sales. This compares with 5.1% in Q2 of this year and 5.8% in the comparable quarter last year.

We are pleased with the 12% sequential revenue growth, as we completed a quarter which saw us make progress with implementation of a new and improved ERP system, continue the integration of Wilson and CE Franklin, as well as finalized details relative to the spinoff. Once completed, it will position DistributionNOW as a powerful provider of products and solutions to the energy and industrial sectors worldwide.

Revenues for the nine months of 2014 were $3.1 billion, generating $100 million net income or $0.93 per fully diluted share. This compares with revenue in the similar period of 2013 of $3.25 billion, which produced $113 million net income or $1.05 per fully diluted share. Once again, earnings comparison with 2013 are not comparable.

Looking at operating results for our geographic segments, revenue in the United States was $748 million in the quarter ending September 30, 2014, up 13% sequentially and up 2% compared with the year-ago quarter. The increase in sequential US revenues is primarily attributable to improved systems that option and increased supply chain services activity along with an improved market. Operating profit in the US for the third quarter 2014 was 3.7% compared with 4.9% for the year ago quarter, reflecting the higher incremental cost of operating as an independent publicly traded company. For the 9 months of 2014, US revenue totaled $2.1 billion, down 3% from the similar period of 2013.

In Canada, third quarter revenue rose 38% sequentially to $173 million as we partially recovered from seasonal breakup. Revenue was down 9% from Q3 2013 and Canada revenue of $489 million for the first 9 months of 2014 was down 15% versus the same period in 2013. A decrease from prior year periods was due in part to a disruption at the Edmonton Central Distribution Center and its warehouse management software. The decline of the Canadian dollar relative to the US dollar also adversely impacted revenue. Canadian operating profit for the 3 months ending September 30, 2014, was 8.1% compared with 6.8% last year due to product mix and lower operating costs.

International revenue was $149 million in the third quarter, down 10% from the second quarter. Compared with the third quarter of 2013, international revenue was down 22% due to large nonrecurring export and [VAL] projects. International operating profit for the third quarter 2014 was 5.4% compared with 7.4% last year, reflecting fewer project sales. International revenue was $496 million for the 9 months of 2014, up slightly over the first 9 months of 2013. We continue to be optimistic about our international opportunities.

Revenue channels for the third quarter show 82% through our energy branches -- or stores, as many of us know them -- which includes our pipe group as well; and 18% through our supply chain locations, which reflects a slight increase in supply chain revenue.

Looking at our income statement, operating and warehousing costs were $108 million for the 3 months ended September 30, 2014. This compares with $105 million in Q2, 2014, and $104 million for the similar period of 2013. These costs include branch and distribution center expenses. SG&A expense was $55 million in Q3 2014 compared with $45 million in Q2 2014 and $39 million for the year-ago quarter. The increases related to the net incremental cost in connection with operating as an independent company -- these costs include health care and outside services costs, information technology, global insurance, public company fees, and other charges.

The effective tax rate for the third quarter of 2014 was 34.7%, and we expect the expected tax rate to be close to the US federal statutory rate of 35% for the full year.

Turning to the balance sheet, NOW Inc. had working capital of $1.45 billion at September 30, 2014, which included accounts receivable of $906 million, inventory of $905 million, and cash totaling $156 million. Cash declined $70 million during the quarter, due primarily to higher accounts receivable resulting from increased revenue as well as DSOs remaining at unsatisfactory levels. Approximately 3/4 of our cash is located outside the US.

Capital expenditures during Q3 were $14 million, bringing our 9-month spending to $32 million, the majority being spent on integration- related. Pretax free cash flow for the 9 months of 2014 was $136 million. Our current days sales outstanding are in the mid-70s, reflecting short-term effects of our systems implementation on collections. We plan to get our DSOs closer to the 60-day range soon. Inventory turns were 3.8 times, also impacted by the ERP project, but we believe we will return to at least 4 turns soon.

Days payable outstanding are now running in the upper 40s. Working capital of 34% of sales -- it had been running around 30%, with our objective of getting to a 25% rate. The single ERP system will be an effective tool to accomplish these improvements, thus freeing up additional cash.

We continue to be debt free, having not tapped into our unsecured $750 million revolving credit facility. When you consider our cash position and the $250 million accordion provision of our five-year credit facility, we have in excess of $1 billion as we consider growth opportunities for DNOW.

Looking ahead to the fourth quarter, we will finalize clean-up items relating to the implementation of peripheral systems tied into our new ERP system, while focusing on integrating our recent acquisitions into the DNOW family as well as continuing to focus on our customers.

Looking to 2015 and beyond, we have confidence in our strategy, in our employees, and in our future as we position NOW Inc. to continue to serve the energy and industry markets with quality products and services. We are an organization with an experienced management team, a strong financial position, and we believe the spinoff creates new opportunities for us and our shareholders.

With that, let's open it up to questions.

Thank you.

(Operator Instructions)

The first question is from Matt Duncan from Stephens.

Good morning, guys. Nice progress in the quarter.

Morning.

First thing I got -- first thing I got from the interruption or disruption to revenue in the quarter from the SEP install I said it was $40 million to $70 million. Any thoughts on this quarter?

I would say in the US it was very low, probably in perspectively. In Canada, we did experience some disruption up there, but I would imagine it's less than $20 million in Canada for the third quarter.

And I guess that begs the question, even if it's $20 million your sales are down year over year. Can you elaborate on what caused the decline when rig counted is up?

Yes. We are very happy about the third quarter sales in Canada but there were offsets, some which Robert has touched on. We intentionally reduced our focus on some of the lower margin pipe categories.

Right.

CE Franklin in Canada sold more and more invested in the SOG business and we wind that down somewhat. That influenced those numbers. Wet weather in the Canadian prairie impacted that. We have a very strong presence in that part of Canada. We have seen unfavorable foreign exchange and we talked about the DC issues which have been solved which impacted the numbers as well.

Okay.

Matt, I would say, Matt, while we are happy with the performance on the top line for Q3, we're still not fully recovered. It's hard to measure us against prior quarters, prior years on revenue at this point when we are clearing stating that our recovery from Q2 chaos is not over yet.

That's fair, Robert. On the line pipe side, how much were your project based line pipe sales down year over year to get a gauge of what that impact was?

For the business?

Yes.

Fire line pipe group in the states, which is probably what you are talking about, project group that sells in mid-stream market, their down currently this quarter just like they were last quarter by 50%. So, that is tens of millions of dollars of line pipe.

Okay. So, I guess, that's the real reason that the US revenues aren't up more than they are and that makes complete sense given the competitive dynamic in the marketplace. Robert, moving on.

Go ahead.

Let's talk about this drop in oil prices and how it may impact you guys. It sounds like through today it has not. I'm curious, as you guys talk to your customers about your plans for the future, do you have a feel for what their CapEx budget plans are for next year given how much oil is down and if we do end up seeing rig counts go down because of this drop in oil prices, can you grow against that next year?

Matt, so, if you asked me six months ago would oil be at $80 right now, I would have told you were insane, and I would have been wrong. If I forecast what customers will do in Q1 and Q2 next year, I would be wrong again. I can only tell you what they are saying right now. If you look at the land rig contractors out there, they are building rigs as I speak. I saw an announcement as early as this morning, where one of the largest players in one of the largest shale plays said that they don't plan to grow rig count next year because of $80 an oil but they don't plan to decline activity. We've managed through many cycles.

As of today -- today is my birthday, thank you very much -- I have been in this Company half my life. I have been through many many cycles. The guys on my team have been here a lot longer than I have, 1970s and 1980s. We've been through many cycles. We will manage through those cycles.

Look at 2009 which was the worst downturn I have every experience and we managed very well through that cycle and continued to produced profit. We had a lot of cash in a downturn. Our business is in a high barrier entry business. Downturn isn't necessarily bad thing when it comes to competition.

We are really actively wanting to deploy capital for M&A. That's the best time to do it. This Company was built in down turns, not up turns.

Last thing, then I will hop back in the queue. As I look at your EBITDA margin goal to get to a kind of 8% EBITDA margin by early 2015 on a quarterly basis, can you walk us through how you get there. I am looking at the SG&Anumber this quarter and it's a little on the high side.

I'm curious how much nonrecurring cost might be in there as a result of the SAP install. And as that goes away, as the consultants leave on a quarterly basis, how much will that bring out of your current run rate on SG&A costs because if it stays at this level with revenue at this level you would need about 22% gross margin to get to that 8% EBITDA margin. Help us think through how that will look and what is going on in the SG&A line.

The consultants we have in house today, Robert said more than 100 of them, they are focused on many projects. They will mature and be completed the next several quarters. If we got down to the level we think we will get down to in the next year, those costs should be reduced about $10 million a year just from that effort.

Getting back to our previously produced EBITDA margins requires an improvement in base margin. We are seeing indicators in the business that it is starting to take hold from the incentive plan. The hardest part of recovering from Q2, you can't fix the P&L if you can't get the revenue. Our amazing employees fixed that problem or show they can completely fix that problem it in the coming quarter.

Hard part is done, the rest of it is managing the back office. We know how too do that. With this current environment with the base margin dollars coming in, all we have to do is make sure that we don't eat too much of them to get to the bottom line and we will pull it off.

Thank you. Our next question is from Vaibhav Vaishnav from Bank of America.

How are you doing?

Good morning.

Good. Seems like the EBITDA margins target of 8% that we were thinking by late 2015 have been pushed back by maybe mid- to late 2016. First of all, is that my correct interpretation? I couldn't hear you exactly what you said, Robert, when you were talking about it.

We said we should start a progression of improved EBITDA margins starting the beginning of next year and it would take about a year to reach our goal at current market activities and current revenue levels. That still puts us in the same time frame we have always been discussing.

Okay. And does that -- if we think about the 75-barrel of WTI, is that 8% still achievable in those oil price levels?

The only reason that -- oil price doesn't drive our revenue stream. Customers reaction to oil price drives our revenue stream. It depends what the customers do.

Let's assume it goes to $75 a barrel. The only that happens is that current activity stays flat and doesn't grow like most oil companies are forecasting, then our revenue stream would be consistent. The only pressure we see from $75 oil and we are seeing it today based on $80 oil, this that customers tends increase the amount of project business they do rather than placing orders on our MRO contract. That puts a little bit of pressure on base margins but oil price doesn't drive the revenue. Customers reaction to oil price does.

Fair enough. Thinking about M&A you spoke about four LOI then two additional LOIs that you are working on. Can you talk about the deals sizes that you have in the pipeline coming from the perspective that you can interior deploy about a billion dollars of capital, but are there enough big deal sizes out there that you can deploy or it would be a combination of a bunch of smaller deals?

No, so far it's been a bunch of smaller deals. Depends how you define smaller. There has been some that we passed on this year that would have required dipping into the line of credit. There are some or multiple ones in the pipeline that would require dipping into the line of credit.

The question really is about evaluations. Typically we don't win out when it's a process. Some of the big ones we are working on right now aren't a process.

It's hard to forecast how it will turn out. We're oportunistic. If the market slows down or if some of these companies fear the market will slow down, valuations typically get a lot more reasonable. So, I can't commit to any amount done next year, we could spend a billion, we could spend zero. We will spend it wisely and invest in our shareholders.

Sounds like in the lower activity it becomes easier to do acquisition from valuation at least.

If you look back on the history, we do most of the acquisitions in a down market.

Last question, if I may, last quarter you guys gave guidance around revenues of mid to single digits for the third quarter. Can we get a similar guidance for the fourth quarter? You did speak about US Canada and international. Any specific guidance?

Yes, I think you will see recovery on the top line in both international and the Canadian segments. Canada always performs well in Q4 and Q1 typically unless some crazy event occurs.

International was down on an abnormal basis due to the way projects align. I mentioned on the call that I think they will modestly recover. Those two segments will recover. The question is about the US

Assuming that activity stays flat. I don't need activity to be up, the US will recover some more based on getting over the hump of those interruptions in Q2 because we didn't fully recover yet. The question is whether or not those improvements will offset normal declines. Because Q4 is usually never the strongest quarter. It's usually Q3.

I think recovery from all this chaos could possibly offset seasonal declines that we always experience in the quarter. Best case scenario we could be looking at maybe a Q4 that looks a lot like Q3 with small bottom line improvement.

Okay. That's all for me. Thank you, sir.

Thank you. Our next question is from David Manthey from Robert W. Baird.

Thank you. Robert you may have just answered the question. I just want to get baseline here. In terms of the -- you mentioned that ERP and integration benefits could offset typical seasonality in the fourth quarter. My question was, is that revenues or EBITDA or both and then sort of looking at that normal seasonality, how would you define that from third quarter to fourth quarter historically, because we don't have a lot of historical data?

You have historical data now because you have Q1, Q2 and Q3 from last year. Simple math will get you Q4 from last year. Generally in a situation where we are not going through this integration work and ERP and spinning, Q3 is the strongest. Q2 is our softest due to the break up in Canada and Q3 and Q4 fall somewhere in between.

I think that this recovery in the US continues from Q2 disruptions and definitely in Canada. They have two months less of recovery time than the US did. I think you will see both top line possibly matching Q3 maybe. That would be the goal or our hope. Bottom line, we have definitely got more expense in this business in Q3 then we will going forward. So bottom line needs to improve as well.

Okay, thank you. Using Canada as an example, you mentioned you are deemphasizing some low margin line pipe business there. What I'm wondering is, you have a margin improvement goal that is very clear. Your goal is to outgrow -- I think you said you could outgrow a flat market by 300 to 500 basis points.

I'm wondering in a flattish market can you both grow and improve EBITDA in this industry? Will it support that. If those are mutually exclusive, which would you choose?

I will always choose -- if I had to choose between one of the two, which I won't do because I think we can do both, I would obviously choose cash in hand and not revenue with no cash because revenue hasn't ever paid a bill ever. We will grow our revenue with nice flow throughs as we get past the chaotic period of 2, 3 and 4 which I have talked about many times. You can expect any kind of incremental revenue growth we have in our business to make it to our bottom line and improve EBITDA margins. It's always going to be seasonal.

For example, next year when we go through breakup, we don't over react and start shuddering branches and things of that nature. We hold on to our core assets and our core employees because we know it's coming. We know it will end. That will affect profitability clearly, but generally, we expect to improve revenue and EBITDA margins consistently going forward. If we find a market that turns the other direction that we didn't anticipate, we will act accordingly and manage expenses in line with our revenue.

Great, thank you.

Thank you. Our next question is from Walter Liptak from Global Hunter Securities.

Hello, Walter.

Hi, thanks, good morning. I want to ask this question on the overhead expenses again and understanding the magnitude of how much they might go down. In warehousing we are looking for sequential lower number in the fourth quarter?

If revenues are flat I wouldn't see warehousing costs go down in the fourth quarter. For SG&A, you know, that is going to depend on -- one of the big cost increases we had in the quarter was health care. That could persist. But it's not going to be next quarter where those costs are extracted from the business. That's our project over the next several quarters is to get more efficient.

We have a lot of projects underway that are related to spin and ERP rollout. We just barely started rolling off some of that stuff. It still exists and still here. It won't all come out in Q4. I said all along in every conversation I've ever had, Q2, Q3 and Q4 will all be noisey related to the spend in ERP and we will begin showing steady improvement Q1 of next year. That doesn't mean you won't see improvement in Q4 but you won't see the type of change in our business that you would expect of us going forward.

Okay. Got it. Right, so maybe it's flat or down slightly in the fourth quarter and then the timing of some of these costs rolling out, is that the first half of 2015 or further than that?

The current project underway that have been going on since Q3, some of them will finish in Q1 and some in Q2. That's generally when you will see the stuff happen. I don't know of any of them that go beyond Q2.

Got it. Thank you.

Thank you. The next question is from Jeff Hammond from KeyBanc Capital Markets.

Hey, Geoff.

High, guys, this is James filling in for Jeff. How is it going.

You are disguised as Jeff.

Yes. I have a question on line pipe pricing, what are you seeing in the environment? There has been some rumblings about a lift in pricing over a possibility of an ITC filing for anti dumping. What are you seeing with respect to that?

The only thing we have seen so far that would give us hope for improved inflation or improved pricing is lead time. So, any time that you have a short lead time at the mills almost any broker that doesn't have much in inventory can be as competitive as any of the big guys that have a lot of money in inventory. That's really a big pressure point on pricing. We haven't seen anything change other than lead times starting to stretch out.

As far as that anti dumping case line pipe, I think it's in Korea and Turkey, it's impossible to forecast how that's going to turn out. It involves the unforecastable, the government. If it happens, it happens. If it doesn't, it doesn't.

You mentioned pretty significant decline in your US midstream project work and obviously you guys deemphasizing this lower price margin product. But what percent of it is business that you guys aren't intentionally moving away from. There has to be some percentage of that.

I do want to clarify something. It's not -- we did do some deemphasizing in LCTG in Canada. We are generally not intentionally deemphasizing pipe its just the competitive nature and the pricing in the market right now are at levels that we are interested in.

There is a pretty sustained level of non-inflation for pipe pricing and there was a period deflation, too. That hasn't crept up yet. Like Robert said, the longer lead times might spark some increased pricing and then we want -- our guys, we consider line pipe a core product line of ours. Our guys are focused on growing that business. We want to be smart about how we invest our inventory and what kind of returns we require from that investment.

Got it. If I could switch gears quickly. Regarding the SG&A expense, I know $55 million versus $39 million last year, what percentage of -- what portion of the $14 million is -- will be retained versus other one time ERP related items. What can we sort of model in 2015 and 2016.

Well, I think most of those costs, except for the $2.5 million or so I cited for the additional temporary costs for fixing systems, making peripheral IT investments, et cetera, most of those costs are the new costs to run the business. But about $2.5 million a quarter or $10 million a year like estimated would come out as we wind down the remnant projects.

If we did that, that would be consistent what we said all along which is the $45 million incremental corporate costs.

Yes. Because the $2 million annual that Dave talked about, that's probably the right answer, $2 million to $3 million a quarter opportunities to get some cost out of it. A lot of this stuff with the corporate, we mentioned last quarter we could have another $4 million this quarter and that's what it looked like. Then the benefit thing that Robert mentioned earlier, the cost of benefits when you have a company our size, those are our costs. We will manage those. Those are our costs on a go forward basis.

Sounds like nothing changed. Thanks a lot. Appreciate it.

Thank you. The next question is from Flavio Campos from Credit Suisse.

Hi, thank you for taking my question. I wanted to switch gears a little bit to the gross margins. It talks a lot about SG&A. You have showed good improvement over 2013. Sequentially a small decline. What is the driver of that, if it's mix or -- since it's being realized since Q1?

In Q2, with the huge revenue reduction we had when we went through the chaos, we mentioned on the call that we had done an extensive analysis to determine if we lost customers or what we had lost that drove the revenue down in Q2. And our conclusion was that we kept our base business, but lost a lot of projects because of adoption of the new system. We weren't getting quotes back, customers on time.

Material search wasn't working the way it should. We missed out on our normal fair share of those project bids. We said on the call, if we recover that portion of our business in Q3 it would impact margins somewhat because the project bids are at lower margins than our daily MRO sales. That's what happened in the quarter.

We forecasted a reduction in gross margins in our last call given what we hoped for was a recovery in project sales that did materialize. Over time, like you cited year over year, we are seeing nice improvements in gross margins due to better utilization of our central distribution in Edmonton, Houston, the UK and in the Middle East. That is helping us limit our forwardly deployed inventory source from suppliers where we get a better cost and grow margins.

Our folks -- our employees are bonused on higher EBITDA margins at the branches. They are encouraged to look for opportunities to grow margins and that helps fuel some of the -- very strong growth margin performance we have seen over the last couple of years.

Perfect. That's very helpful. On that same vein if you look at international business a second, that decline in margin, we would expect that gross margin in the business would be a little bit up because of the project reduction. Is that declined mostly because of lower operating leverage, the top line reduction?

Actually, project business in the US and Canada typically is at lower margins than our base business. That is not necessarily the case outside of US and Canada where we have specialty facilities that are quoting large valve projects and things of that nature where we are carrying inventory overseas where we command a higher margin to cover the additional risk of having inventory sitting in places where we can't get it out.

For example, I can put a bunch of material in the Bakken. If it doesn't turn I can just move it to Eagle Ford and my risk is pretty low. If I move a bunch of inventory to Indonesia and it doesn't turn, that same option doesn't exist so we command higher margins both on projects and our MRO sales and international arena.

Perfect. Very helpful. If I can sneak a last one in real quick. Can you talk about the downstream business how that is doing and if that guides a little bit more of the MRO side and if that's part of the upside in the US especially on the supply chain side?

Sure. I think most people know that talked to me, our downstream segment was actually built under Wilson Supply back in the 1990s when there was acquisitions made of key players in that market. They didn't receive their fair share of love and capital for most of the 2000 time frame when they were owned by other companies.

We have been in a rebuilding mode with that business ever since we acquired Wilson. They got a capital injection that they haven't witnessed for over a decade. We are showing steady improvement in that business. They are growing revenue on EBITDA margins but we have a long way to go.

Perfect. Thank you for taking my questions, guys. Good progress in the quarter.

Thank you.

Our next question is from Matt Duncan from Stephens.

Hey, guys.

Matt.

Dan, I think you gave the break out between energy branches and supply chain for the 3Q of this year. Do you have it for 3Q of last year?

I don't think we do, Matt. I think we did it on annual basis. We didn't break it out by the quarters.

Actually I do have it. I don't have the math. You may want to calculate it. It was 933 for energy branches last year, and total revenue was 1,113 so I have the numbers without the %. I bet it's close to the 87 -- 83 and seven --

Looks like its 84 and 16.

84 and 16 for a year ago Matt and 82 and 18 now.

Nothing materially changing there. On international, Robert, can you talk about what the backlog of projects looks like there. You mentioned you do expect it to increase some in the fourth quarter. Looking out to next year, I think previously you expected international sales to be a double digit grower for you. Is that still a safe assumption or has anything changed in the market?

I don't know if it will always be always double digit, Matt, but it will be at a clip well above market changes. A huge market that is untapped. There is no major player in that market necessarily. If you were to measure up the total revenue potential and all the players that exist. It's easy to grow revenue in that space, well in excess of market.

We don't measure backlog. I think backlog in a distribution business is crazy. We do have projects that are underway that give us confidence. We will see a recovery in Q4. We don't see anything yet that tells us we have disappointments coming next year at this point. But you can't see that far out in the distribution business.

Understood. Back to the line pipe trade case, to think how that might impact you guys, I guess it's been filed. We will probably know more on the first step as we get a ruling in a few weeks on whether or not it moves forward.

To help us understand what it does to your revenues potentially if we do start to see price increases, how much of your sales at this point, given the drop you have seen in project line pipe is coming from the sale of line pipe? I know historically it was closer to 20% but you have obviously seen a little but of a decline in the project driven side because of the competitive dynamics. Roughly, what percentage of revenue right now is line pipe?

Matt, it's not much less than 20 because we had really good increases in the energy branches in line pipe where we make much better margins. They more than offset the decline in our central project line pipe group. Probably 18%, 19%. We made up for a lot of it in the branches.

Thank you. We have no further questions at this time. I will turn the call over to Robert Workman for final remarks.

Thank you, everybody, for your interest. We look forward to talking to you about our Q4 results and we will see you then.

Thanks.

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