DNOW Inc (DNOW) 2017 Q3 法說會逐字稿

Welcome to the third quarter earnings 201 earnings conference call. My name is Paulette, and I will be your operator for today's call. (Operator Instructions)

I will now turn the call over to Chief Accounting Officer, Dave Cherechinsky. You may begin.

Thank you, Paulette, and welcome, everyone, to the NOW Inc. Third Quarter 2017 Earnings Conference Call. We appreciate you joining us this morning, and thank you for your interest in NOW Inc. With me today are Robert Workman, President and Chief Executive Officer of NOW Inc.; and Dan Molinaro, Senior Vice President and Chief Financial Officer. NOW Inc. operates primarily under the DistributionNOW and Wilson Export brands, and you'll hear us refer to DistributionNOW and DNOW, which is our New York Stock Exchange ticker symbol during our conversations this morning.

Before we begin this discussion on NOW Inc.'s financial results for the third quarter ended September 30, 2017, 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 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 in our filings with the SEC. In an effort to provide investors with additional information relative to our results as determined by U.S. GAAP, you'll note that we also disclose various non-GAAP financial measures, including EBITDA, excluding other costs, net loss, excluding other costs, and diluted loss per share, excluding other costs. Each excludes the impact of certain other costs and therefore, has not been calculated in accordance with GAAP. A reconciliation of each of these non-GAAP financial measures to its most comparable GAAP financial measure is included in our press release.

As of this morning, the Investor Relations section of our website contains a presentation covering our results and key takeaways for the quarter. A replay of today's call will be available on the site for the next 30 days. We plan to file our third quarter 2017 Form 10-Q today, and it will also be available on our website. Later on this call, Dan will discuss our financial performance, and we will then answer your questions.

But first, let me turn the call over to Robert.

Thanks, Dave. Before we get started today, I'd like to thank a moment to thank our long-term leader, mentor, and more importantly our friend for the 21 years of guidance he has provided to DistributionNOW. Pete Miller made an immeasurable positive impact not only on our company, but more significantly on the lives and careers of the entire DistributionNOW family.

It is hard for me to envision the halls of our offices without Pete, especially since I have worked directly for him for the last 16 years. One thing is for sure, I don't think Pete realizes that he has retired because I met up with him recently one afternoon and had you been a patron of the restaurant that day, you'd realize there hasn't been any change to our mentoring relationship. While he is no longer Executive Chairman, I look forward to continuing our longstanding relationship and seeking his counsel.

We all love and miss you, Pete, already, and we hope you enjoy your well-earned and deserved time in Telluride with Peggy.

Before I get back to the DNOW results, I'd like to extend our thoughts and prayers to all those who were impacted by the recent natural disasters, including hurricanes and the California fires. It is our DNOW DNA to help others in times of need and I want to thank DNOW's resilient employees who responded to our customers, employees, and community needs in times of crisis.

Despite being based in Houston with nearly 2 dozen facilities in the areas affected by Hurricane Harvey, our facility sustained minimal damage. Regrettably, many members of the DNOW family were impacted and are still displaced from their damage homes. The countless acts of heroism and selflessness, such as using personal boats in rescue operations were very inspirational.

Moving back to DNOW, for the third quarter of 2017, we improved our bottom line results from a net loss excluding other costs of $36 million a year ago and $11 million in 2Q to a net loss excluding other costs of $3 million. This is on an expected sequential revenue increase of $46 million or 7% in line with a 7% increase in rigs. The third quarter GAAP net loss of $9 million includes pretax charges of less than $1 million for severance and $5 million for an after tax charge for a valuation allowance recorded against the company's deferred tax assets.

GAAP loss per share for the quarter was $0.08 or a loss per share of $0.03 excluding other costs. Gross margin percent improved nicely and along with improvements in warehousing, selling, and administrative costs, which were down as a percent of revenue, drove strong sequential EBITDA incrementals of 15%, which have now averaged a very strong 24% since the 2Q 2016 bottom.

3Q 2017 marked our first positive EBITDA excluding other cost quarter since the downturn began. U.S. revenues were up 5% sequentially while rig counts grew 6%. Lower sequential revenue in the U.S. from industrial manufacturers reduced downstream activity and delayed line pipe projects due to Harvey drove a $10 million revenue decline, muting the U.S. revenue expansion.

Sequential operating profit incrementals in the U.S. of 24% were generated as operating losses narrowed $6 million on $25 million in revenue gains.

Now, let me give you some background on our key business drivers and how they may impact our near and long-term growth potential. Revenue per rig for the quarter remained in line with quarterly measurements over the last few years. While rig counts are up 126% from the May 2016 trough, rig counts are still down 53% from the 2014 peak.

Fortunately, for DNOW, we believe our U.S. drilled but uncompleted wells, or DUC's backlog, provides a growth driver for us in future quarters as DUC inventories are completed. Even though service companies have been deploying idled horsepower and plan to continue doing so into 2018, there still isn't sufficient equipment and experienced crews available to keep up with the current rig count as evidenced by the accumulation of DUCs.

Given requirements for planning and scheduling completion jobs, there will always be DUCs. DUCs have surged in recent years, causing the ratio of DUCs to completions to increase. In 2014, the average was 2.6 to 1 and in 2015, it was 5.5 to 1. It ballooned to 8.9 to 1 in 2016 and has moderated in our favor but still at historically high levels of 7.3 to 1 in 2017.

So while DUC levels continue to grow, presenting a growing future opportunity for DNOW, completions or the process of making a well ready for production, are now trending up as well, providing an immediate opportunity for increased DNOW U.S. sales as tank batteries get constructed weeks or months after the completion.

Current EI estimates show U.S. DUC counts at the end of September totaling 7,270, up 9% sequentially for the quarter. EIA estimates show U.S. completions in September were 1,029, up 12% sequentially for the quarter. U.S. rigs according to Baker Hughes, while dropping most of the quarter, were up 6% sequentially from 2Q. Rig counts are a good proxy for DNOW revenues over time and newly available EIA completions data may serve as a supplementary barometer of customer activity in the U.S.

Looking at the key takeaways presentation on the IR portion of our website, you'll see a chart showing volatility with the DUCs to completions ratio, which should provide an opportunity for DNOW in future quarters as the ratio comes back into balance.

Diving deeper into the quarter, let me walk you through our business and segment performance in various markets. Fluctuating oil prices and confidence of sustainability of the commodity price contains to hamper large projects in our U.S. energy center business. The market continues to be very conservative with a tremendous amount of ongoing bidding. Growth in the Permian remains bottlenecked by the difficulty of bringing on additional experienced talent,

We were able to produce strong growth in our midstream projects group even with the lack of experienced completion crews, which continue to slow well completions and facility builds. In the wake of Hurricane Harvey, [pot mills] and [coaters] had to either shut down or delay production in shipments due to flooding, which also pushed back future deliveries.

In U.S. supply chain services, upstream revenue grew as the implementation of 3 Marathon sites in North Dakota, South Texas, and Oklahoma, as well as 2 large oxy sites were finalized. In U.S. process solutions, we substantially overcame the human capital bottlenecks we experienced in 2Q and received several new orders including an order for more than 50 crude oil pump packages for western refining.

For the last 2 years, our largest Permian customers for U.S. process solutions have been purchasing multiplex pumps for each disposal well they drill and for the big spring gateway pipeline system. In the quarter, revenue with these customers was down due to project timing, however revenue grew in 3Q 2017 in U.S. process solution driven by a diversification beyond our anchor customers.

[Janitor] revenues again were strong, growing $17 million or by 22% aided by a strengthening Canadian dollar and emergence from seasonal breakup. Canadian sequential OP grew from $2 million to $4 million on strong revenue gains.

Aiding our growth in Canada was increased upstream activity in the Montney and Bakken plays and a new oil sand MRO agreement. Our composite pop division in Canada more than doubled in volume as the impact of breakups subsided and roadways were open for transporting joints of fiberglass pot and spools of fiber spar.

Contractual activities with [Pembina] and [Apopline], an important new customer, are near completion, which should enhance our future position. We opened a new total valve solutions branch in Saskatchewan with particular focus on Cameron engineered valves that may contribute to our Canadian performance going forward.

International revenues recovered by $4 million as projects resumed. Deliveries increased into Kazakhstan's future growth project and overall activity in the Middle East and Europe improved. Even though sequential revenues grew internationally, operating margins were flat as project sales at better than average product margins declined in 3Q.

Significant year-over-year 3Q operating profit gains resulted from a 17% increase in international sales, while rig counts grew just by 1% generating 36% operating profit flow throughs during that period. Global revenues overall were up 34% year-over-year, near the 37% growth in rigs. Looking at the impact on our suppliers, outside of the pot mills and logistics carriers, Hurricane Harvey had little effect and our logistics carriers were back to normal within a week to ten days after the storm.

Lead times for midstream valves remain long as distributor inventories and manufacturers have not yet caught up with demand. We continue to place forward valve orders and our inventory for midstream valves is improving. Line pipe swap process continued to rise for the eleventh straight month as reported by Pipe Logix.

Dumping suits continue as 2 new suits were filed on stainless phalanges and forced steel fittings recently. Conclusions were finalized in carbon phalanges, which resulted in prices going back to where they were before the downturn started in 2014. We have primary and alternate manufacturers, which enables us to make proper adjustments, so our supply chain is not interrupted due to these suits, but these suits can cause prices to rise.

Looking at market activity moving forward, our fourth quarter is seasonally slower than 3Q due to customer vacations, holidays, and fewer business days, as well as the exhaustion of customer CapEx budgets. Both of these tend to be headwinds against sequential fourth quarter expansion.

As well, many customers are commenting that they are experiencing delays currently across the industry for surface equipment. We believe a few factors this quarter may help soften those sequential challenges for DNOW but the vast majority of the time, seasonality prevails.

These factors include increased tank battery construction, modest growth internationally, and in U.S. process solutions, and continued implementation with Marathon's Delaware operation in U.S. supply chain services. Yesterday, we announced that we cemented an agreement with Forum Energy Technologies regarding their global tubing coiled line pipe products. We've been working hand in hand with Forum for many quarters, jointly communicating the benefits of this product to customers as compared to traditional joint pipe, and training our sales and operational staff on how to add this arrow to their quiver.

Based on the success of our combined efforts to date, DNOW and Forum solidified our relationship in a formal agreement and will continue jointly penetrating the market with coiled line pipe. This is another great example of how DNOW partnering with a Tier 1 brand and product line to ensure that our customers have access to the best and most innovative products and solutions across the energy value chain.

Like we said from the beginning of the downturn, we want to be where our customers need us when the market comes back. Given that this recovery has been an uneven one, where feast or famine themes predominate across the U.S., we are facing a challenge where resources in one area are scarce and in other areas too plentiful.

As such, we've introduced a beta business model concept for one of our U.S. Energy Center regions to allow for maximum customer reach at the least possible cost of service from a warehousing, selling, and administrative and capital employed perspectives. Depending on results of this pilot, this could enable growth in maximum share and better bottom line results.

We continue to focus on generating growth in our pipe valve product lines and creating an increase in our ecommerce customer integrations. U.S. Energy Centers are still experiencing strong bidding in the marketplace, putting a strain on existing resources. Completions are expected to increase and we could see strong infrastructure build and pipeline work out of the Permian and in South Texas.

We have a plan in place to attract additional talent to the Permian but the holiday season this year will probably produce light activity. The newly implemented sites in U.S. supply chain services will continue to produce sustained revenue and additional opportunity such as the new site we're implementing with Marathon in Carlsbad, New Mexico. Additional growth will come from orders taken in 2Q and 3Q for large capital projects, which U.S. supply chain services will begin billing in 4Q.

We provided bids to 2 long-term customers for 38 multipurpose oil, water, and gas combination LACT units and 55 oil LACT units, for which U.S. process solutions should receive purchase orders in 4Q 201y for future delivery. Also in U.S. process solutions during 4Q, our total valve solutions facility in the Rocky Mountains secured 2 projects for 2 separate customers, one in the DJ Basin and one in the Bakken.

One project scope includes 37 fully automated valve packages with pneumatic actuation and the other encompassed 35 actuators and controls packages that will ship in either late 4Q or early 1Q.

While the Canada market tends to expand seasonally in the fourth quarter, early fourth quarter rig downturn suggests the usual seasonal lift might be subdued. Gains in the midstream arena could make for better than expected results given this headwind. We're anticipating continued growth in our composite pipe division in Canada as we have recently quoted a half dozen projects in high quantities and unusually large diameters that as secured would generate additional revenues in future quarters.

We have also recently submitted proposals to 2 large Canadian operators from whom we are receiving very positive feedback and if secured would have a very favorable impact on our future performance. Our project bid pipeline from operators and EPCs continues to increase throughout the international segment as customers revalidate pricing of budgetary quotes provided earlier this year to firm up budgets for 2018.

We've also seen drillers, such as Borr Drilling, getting more bullish about a recovery in the jack up market with their acquisitions of several drilling assets to expand their fleet. When activity with offshore customers eventually improves, we will be prepared to support them, thus intentionally retaining our bases in Singapore, Australia, the North Sea, Gulf of Mexico, and Brazil during this down cycle.

Moving to capital allocation, working capital as a percent of revenue was with and without cash 26% and 23% respectively. This was driven by increased inventory in anticipation of further growth and for long lead-time items, which have begun to arrive, and increased receivables, as sales have expanded.

Inventory turns are near target levels buoyed by improvements in Canada and international with a decline in the U.S. as the noted long lead-time items began to arrive. In terms of deal activity, we looked at fewer but larger deals in the third quarter than in 2Q. Some of these have been deals that we've been waiting to come out of the gate for several years and finally had the opportunity to review. But upon digging further into them, it further solidified our already agreed upon strategy to focus on providing higher value add products and solutions to our customers and not diversifying outside of our core.

Additionally, we had good conversations with some private equity firms about certain assets that would be attractive to our portfolio should the prospect become available and we believe that in some cases that could be in the next year or so. As always, for us, being fiscally conservative in allocating capital, the question will be whether or not we want to bridge the bid ask spread but we have a solid balance sheet to avail when needed.

Our strategy continues to be growing organically in our Energy Center Business and growing through acquisitions in our U.S. supply chain services and U.S. Process Solutions businesses. Leveraging our scale, the higher value add product lines across our segments. As noted, while our 4Q tends to be weaker, we see some positive signs and are working on international initiatives we believe can soften those seasonal factors.

And as mentioned earlier, as DUC levels continue to grow, this presents a growing future opportunity for DNOW. Before I turn it over to Dan to run us through the detailed financials, I'd like to take a moment to recognize someone else on the DNOW team, Doug Pennington, who works in our materials management group in Houston as a material recovery manager and has been with the company for 44 years. Doug started with J&L Supply in Wichita Falls in 1973 as a beginner [store man] and that is where he and Sandra, his wife of 41 years, met and married on April Fool's Day.

If someone wanted to do a case study on the impact of mergers and acquisitions on employees, I'd highly recommend they contact Doug. Doug's M&A experience started when LTV merged J&L Supply with Continental / INSCO, which was then purchased by SCF Partners, who then sold the supply division to Wilson Supply, which was acquired by Smith International before they were acquired by Schlumberger who subsequently sold Wilson Supply to [National Avargo] and then was spun off into a publicly traded company called DistributionNOW.

When Doug isn't spending time with his wife and his 3 sons, all of whom have served or currently serve in the military, he's usually in his garage working on computers or shooting sporting clays. I'd like to thank Doug for his many years of loyal service and ask that he gets inventory turns up by a full point before our next earnings call. And now, I'll turn it over to Dan.

Thanks, Robert. We are approaching a return to profitability and it wouldn't be possible without our dedicated workforce and I remain convinced that we have the top people in the industry. I am proud to be part of this wonderful team and am grateful for the hard work, integrity, and perseverance of the DNOW family. Thanks for all you do.

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 $9 million or $0.08 per fully diluted share on a U.S. GAAP basis for the third quarter of 2017 on $697 million in revenue. This compares with a net loss of $17 million or $0.16 per fully diluted share on $651 million of revenue in the second quarter of 2017. When looking at the year-ago quarter, we had a net loss of $56 million or $0.53 per fully diluted share on revenue of $520 million for the third quarter of 2016. The third quarter 2017 results included $5 million of after-tax charges for valuation allowances recorded against our deferred tax assets, and less than $1 million of pretax severance charges.

After adjusting for these other costs, our third quarter loss was $3 million or $0.03 per share, both non-GAAP measures. We are encouraged by gross margin rising to 19.4% in 3Q compared with 19% in 2Q 2017 and compared with 16.7% in the year-ago quarter. The company generated an operating loss of $6 million in the third quarter of this year versus a $14 million loss in the previous quarter, and an operating loss of $53 million in the year-ago quarter.

Third quarter EBITDA, excluding other costs, a non-GAAP measure, was $5 million, sequentially improving by $7 million, and our first positive EBITDA since the first quarter of 2015. EBITDA sequential flow through of 15% in the third quarter of 2017. Looking at operating results for our 3 reportable geographic segments. Revenue in the United States was $506 million in the quarter ended September 30, 2017, up 5% sequentially and up 36% over the year-ago quarter. Year-over-year improvement in the U.S. rig count contributed to these revenue improvements. Revenue channels in the U.S. for 3Q were 55% U.S. Energy, 30% U.S. Supply Chain, and 15% U.S. process solutions.

Third quarter operating loss in the U.S. was $10 million compared with a $16 million loss in the second quarter of 2017 and a $46 million operating loss in the year-ago quarter. The narrowing of the U.S. operating loss was primarily driven by increased volume and improved product margins. In Canada, third quarter revenue rose 22% sequentially to $96 million and was up 43% 3Q 2016 due essentially to increased Canadian rig activity.

For the 3 months ended September 30, 2017, Canada's operating profit was $4 million, up $2 million sequentially and improved $6 million over the year-ago quarter, reflecting increased rig activity and lower inventory charges. International operations generated third quarter revenue of $95 million, which was up 4% in the second quarter of 2017 and up 17% from the year-ago quarter. A resumption in electrical projects in Europe and increased customer penetration throughout the Middle East contributed to these revenue improvements.

International's operating profit was breakeven for the third quarter of 2017, the same as the prior quarter, and a $5 million improvement over the year-ago quarter. Operating profit improved over the year ago quarter due to increased volume.

Continuing on our income statement. Warehousing, selling and administrative expenses was $141 million in the third quarter, up $3 million sequentially and up $1 million from 3Q 2016, as we grow our supply chain services and process solutions business. These costs include branch, distribution center and regional expenses as well as corporate costs.

Our effective tax rate for the third quarter of 2017 was a negative 1.6%, and for the 9 months ending September 30, 2017, was 0.6%. Compared to the U.S. statutory rate of 35%, the rate continues to be impacted by recurring items, including lower tax rates on income earned in foreign jurisdictions that is permanently reinvested, offset by certain nondeductible expenses, state income taxes, and the change in a valuation allowance recorded against our deferred tax assets in the U.S., Canada and other foreign jurisdictions.

The change in valuation allowance is the most significant factor, and brings our effective tax rate to the low single digits, approaching 0. You will recall that we must record a valuation allowance against our deferred tax assets when for GAAP purposes, it is more likely than not that some portion or all of our deferred tax assets will not be realized. As we continue to return to profitability, we can adjust the valuation allowance, thus reducing GAAP income tax expenses in the future periods.

Excluding the impact of our valuation allowance, as well as a favorable return to provision adjustment impacting our valuation allowance, our third quarter effective tax rate would have approximated 35%. We expect our fourth quarter GAAP effective tax rate to remain in the low single digits.

Turning to the balance sheet. NOW Inc. had $628 million of working capital, excluding cash, at September 30, 2017, which was 23% of annualized sales, essentially the same as the previous quarter, and remained below our 25% target. Accounts receivable increased $48 million sequentially to $466 million, reflecting increased revenue. The pace of bankruptcies in our energy space is easing, and companies have emerged from bankruptcy but there are still some remaining concerns. Some companies were to keep their heads above water in 2016, but now that commodity prices have not completely recovered, may still need to do something whether it's in court or out of court restructuring. Banks are looking more favorably on the energy it but upcoming debt maturities could be a concern. So we must continue to be diligent as we extend credit.

Our current days sales outstanding was 61 days. We made progress but there was still more to do. Inventory was $562 million at the end of the third quarter of this year, up $33 million over 2Q as we respond to increased activity. With signs of an improving market, and continued replacement orders for long lead-time items, including pipe and valve, inventory levels may rise but we will carefully manage the process. Inventory turns remained at our targeted 4.0x in 3Q. Days payable outstanding were 50 days.

Cash totaled $99 million at September 30, 2017, with $83 million located outside the U.S., more than 1/3 of that being in Canada. Having this cash overseas could facilitate financing of an international acquisition if the opportunity develops. We ended the quarter with $163 million borrowed under our revolving credit facility, and we're in a net debt position of $64 million when considering total company cash. Our debt-to-cap was approximately 12% at quarter's end and we had $441 million in availability.

Our borrowing cost on the debt approximates 4% as the Fed pushed short-term rates incrementally higher. Our credit facility matures in April of 2019. Capital expenditures were $2 million in the third quarter of this year, and only $3 million for this year so far, showing the effects of improving business conditions and the need to support organic revenue growth, free cash flow used for the third quarter was $35 million.

Our worldwide market continues to be challenging, as we remain tied to the global rig count and drilling and completions expenditures. We will continue to focus on serving our customers as we rationalize expenses, concentrate on integration gains from our acquisitions, and seek to maximize new opportunities. We have confidence in our strategy, in our employees, and in our future as we position NOW Inc. to serve the energy and industrial markets with quality products and solutions. We are an organization with exceptional leaders, outstanding employees, solid financial resources, and we'll continue to respond to the needs of our customers.

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

(Operator Instructions) Your first question comes from line of Matt Duncan from Stephens.

First question and Robert, you alluded to Harvey, but I don't know that I heard a clear impact. Was it a net negative or a net positive and if so, how much?

Well, it would be a net negative and it's going to be a few million dollars in just revenue for us but it's almost impossible to calculate how our customers were impacted from the hurricane and how that effected their purchases from us. So I really can't quantify.

You talked a lot about the puts and takes looking at the sequential move in sales 3Q to 4Q. I know typically it would be down sequentially from a seasonal standpoint but also sounds like you've gotten rid of the bottleneck at process solutions and if completions do go up, you would think we'll see some improvement in your tank battery revenue.

So all things considered, what's the most reasonable way to think about the sequential change in your sales here?

It's really going to boil down to the areas that should improve slightly in the quarter, like our U.S. SES with Marathon in Carlsbad, like you mentioned, our process solutions sales, Canada, and international, if they're going to be able to offset or at least soften the seasonal decline we will absolutely experience in our biggest business, which is our Energy Center business.

So the vast majority of the time, 80% to 90% of the time, even in a growing market, Q4 seasonality is impossible to overcome. So I'm looking at a flattish quarter at best.

It sounds like you guys are running a beta test on a way to improve profitability further and we look at what's going on with rig count. It started to trend a little bit lower, but now, we've got oil prices moving higher so maybe that reverses. But who knows. So let's assume flattish revenue and obviously, we both know it won't turn out that way but what I'm getting at is what are you guys doing to drive profitability higher? It was very nice to see the return to EBITDA positive this quarter. I know that's a focus for the company. How much do you think you can drive EBITDA up if we assume sort of a flat revenue environment? How much room is there to continue taking cost out and improve profitability in the company over the long-term?

Well, it's not going to be just taking cost out. We have several regions that are not booming like the Permian, or the Niobrara, or the Marcellus, or the Bakken. And so in those areas, we're attempting to pilot a redesign of our fulfillment model, which would take cost out. So we've done that already. We're just measuring right now to see if it affected revenue, how it affected expenses and so that's something that if successful we could take to many other regions that are not experiencing the recovery.

Our branches, based on their incentive plan each quarter, continue to push price. You've seen it 3 quarters in a row now so that's another avenue to improve profitability in a flat market and then lastly, like you mentioned, our process solutions group, which is Odessa Pumps and Power Service combined have typically better margins.

So as they're successful in penetrating markets where they've historically not participated those additional incremental share gains at better than average margins will improve EBITDA.

And our next question comes from Andrew Buscaglia from Credit Suisse.

I think you mentioned in the call and in the past couple of calls sort of an interesting backlog building and a lot of potential projects or potential work coming online, especially in 2018. So can you talk us through high level? I would think the way you guys are managing costs, as some of these things really pick up, how you would expect those incrementals to flow through in 2018 and any unusual ramps quarter-to-quarter?

For the longest time in this business, I've been in this business now for 20 something years, we've usually experienced 10% to 15% incremental decremental to EBITDA based on revenue changes. So far in this recovery, we had 15% in Q3, which is the top end of our normal experience, but on average it's over 20% so far.

So I still live in a space of I like being surprised that they're better than their experience says. So we internally expect 10% to 15% and just get excited when it goes beyond that.

We should probably just use history as our base case for now and then be surprised I guess.

I would suggest that and the reason I say that is we all expected gross margins to improve as the market strengthened but nobody in this room on this end of the call expected it to do what it's done so far. So that is a total surprise.

Then just curious on the comment on the private equity conversations you guys have had, can you give us a little more color on that? Because that's been interesting and something that's been a little bit quiet as of late.

There's several companies out there that have a component of their business that are interesting to us but have other components that we're not interested in and so we've never been successful in convincing those firms to talk about a partial acquisition.

And as of late, those conversations are a little more successful than they have been in the past and that's generally what I'm talking about.

Our next questions comes from Steve Barger from KeyBanc Capital.

This is Ryan on for Steve. I just wanted to talk about oil price has been improving slightly. Does that change your thought on rig count and DUC completions going forward at all?

I look at rig count and oil prices separate from the completion piece. My personal belief, and I'm telling you, I will be wrong because no one ever forecasts this stuff right, but I think we're going to be range bound in rig count and oil prices until offshore declines start meaningfully happening because we've underspent offshore development by trillions probably in 2015, 2016, and 2016 and these are all 3 to 5 year projects.

So the resilience of offshore production that we've seen through this downturn was really projects started in 2012, 2013, and 2014 but those projects didn't happen the 3 years post that period and so that's eventually going to turn into offshore declines.

And then when offshore declines happen then you're going to see an imbalance in supply and demand, and then I think the Shell participants will just take advantage of improved oil price while the large integrated oils, the Shells, and the Totals, and the Chevrons, and the rest scramble to start FID studies and try to get offshore production back underway and that takes 3 to 5 years.

So my belief is that when offshore is starting (inaudible) start, we're going to have a good 3 to 5 year run of nice oil prices that will drive a lot of land activity while offshore players scramble to try to solve the problem.

Regarding completions, we've had a lot of oil companies that have released their earnings in the last 3 weeks and at this 50 to 60 range, they all comment about how they want to get their DUCs completed and their biggest issue is not a desire or willingness. It's getting the crews and getting the equipment. So if they follow through on those comments then you would see a nice impact to our U.S. business even if rig count stays range bound for a little while.

Could you talk about the customer traction you're getting as you bring the modular tank battery offering into new basins? And can you talk about which basins you're seeing the most improvement in?

We're seeing some exciting things with respect to penetrating that market but we might have gone from having our toe in the water to having one ankle in the water. So it's exciting to see it happening because it never happened before but there's a tremendous amount of runway left on growing that business into other basins.

We signed a deal just recently for South Texas for most of the equipment that would go into tank battery that lasts through 2020 with a large operator. So those kinds of things are exciting. We're selling a bunch of gas measurement and LACT units into the Delaware and the Midland Basin we've never sold before. That's exciting.

So we're seeing fruits of the labor but we're nowhere near declaring victory in that area.

My last question, just going back to gross margins, real nice performance there. Can you talk about any internal initiatives you guys are taking to drive that performance?

It's happening in a couple areas. One is our incentive plan drives it. The branches are rewarded at the branch level, not across the corporation but at their specific branch based on EBITDA margins and EBITDA margins, one of the easiest way to improve them is to push pricing. So that's producing some of the result you're seeing. And then the acquisitions we've made are typically higher margin businesses and so as they grow, then margin so goes with it.

And then you heard me mention earlier, we're doing some beta tests that could impact in a positive way, WSA expenses, and that would also help.

Our next question comes from Joe Gibney from Capital One.

Question on supply chain. So how did your upstream portion of that supply chain business trend quarter-over-quarter? I think last quarter you indicated it was up over 20%. Did we see similar good results this quarter as well? I know the industrial downstream piece dragged. Just trying to get a sense of how the U.S. upstream piece of that supply chain business worked?

It grew because we're simply implementing new customers so it definitely outgrew activity but I don't think it was 20%. I think probably high teens in that particular segment.

The people gap, Robert you referenced it, human capital bottlenecks. Curious from 2 perspectives. One, it sounds like you corrected some of it in process and project management, maybe ASME welders. It sounds like you corrected some of that. But obviously, in the Permian it's an issue across the board not just for you guys. Just curious what you're trying to do to address that and where the skill gaps are specifically as it pertains to DNOW and the Permian that you're trying to fill or having a hard time closing the gap on. Appreciate it.

I'm from Crane, which is 30 miles south of Odessa and I think it's the best place on earth. I don't know why people don't want to move there. So we're obviously -- any position that would go into our branches that we're having issues with, especially the skilled positions. So it's not the drivers. It's not the folks that you could find available. It's people that actually know product, that understand how to use the ERP systems and things of that nature. So we're having job fairs in other areas trying to recruit people in. We're using moving incentives to try to get them to move to the Permian. We are holding training for other employees that want to expand their skillset and then move them into that area.

We're trying everything we can possibly come up with to increase our talent in the Permian just to keep up with the demand with respect to the activity.

As it pertains to process -- excuse me, in terms of the people gap, ASME welder side, project management side, do you see alto of those issues that sort of in 2Q seem to have corrected a little bit?

Yes, we've made a lot of progress there and I would say we corrected substantially all of that issue. Now, we're just working through the delays that lacking those positions caused and trying to get those through the system so that we can -- we have our stock floors are full right now because of this -- for this reason. So we're trying to get those projects out the door so we can start taking on more work.

Our next question comes from Sean Meakim from JPMorgan.

Maybe to stay in the Permian a little bit, just curious if you've got any line of sight to more penetration for the full prefab units in the Permian. You highlighted I think just now some customer wins on some discrete products but how about full power service offering? How is that uptake looking in the Permian?

It's starting to take hold. I had a little internal challenge between the 3 U.S. businesses, U.S. process, U.S. SES, Process Solutions, and Energy Centers around who was going to be successful first and the group that I thought had the least change of wining the internal challenge won, and it was the Energy Centers. So they got our first customer to accept in a full turnkey headed out to the Midland Basin and we've had customers as recently as today that have toured that stuff and then they're now in Casper meeting with engineers because they're interested in testing the model as well. So we're starting to see some traction.

What would you point to as the -- is it the people bottleneck? Is it just sales cycle? Is it the mix of on average fewer high well pads in the Permian than where the business came from originally? Anything you can point to, to say here's some of the initial hurdles that maybe had led to a longer sales cycle than maybe what you anticipated when we first entered the Permian.

Well, it's an adoption challenge just like our supply chain services business is hard for people to adopt to because it's a completely different way of doing things. There's a lot of people involved at an operator's office when it comes to determining, and acquiring, and designing the tank battery. And if you remember back in the day, if you followed NOV when they were trying to turnkey the drill ship, that was a hard adoption sale because customers liked buying from 32 vendors, designing the top side for drill ship themselves, didn't want to give up control, they'd done it that way for 30 years. That kind of thing is what we're facing up against.

And so where we've really been successful is when our contacts in, say, the Bakken where they penetrated that market over time are getting transferred to the Permian and they're going into these customers' offices going, you guys need to really consider this. Here's all the benefits from it. So that's kind of where we're getting our most juice right now is actually customers selling it to their own internal office.

That all makes sense. On the quarter itself, you guys called out downstream as being weaker and then U.S. I think I was a little surprised by that. I think we would have thought that your customers in that part of the market would be more inclined to get more work done as they had some capacity offline. Could you give us a little more detail on what drove that relative to your expectations?

So on our last call, we said we might reach $700 million in the quarter and we're only $3 million short of it and the reason that we thought even 90 days ago it would be around 700 million of revenue was simply because the original plans for the completion companies was to get most of their spreads out in Q2 and Q3 and that just keep getting delayed either because they had to wait on long lead time items to refurb the equipment or they were having a real issue hiring qualified crews to run that equipment.

And when that started showing up in their notes, and their comments, and their calls, we started reassessing how fast this activity with the completions in the DUCs was actually going to impact our revenue. So that's why we readjusted in Q2, 90 days ago, about what we expected for Q3.

On the downstream side though, just curious what drove some of the weakness in the quarter.

I'm sorry, I thought you were talking about the U.S. in general. So the downstream piece was softer in Q3 than Q2 and that's mainly because finally, for the first time ever for us, for our customers, we had a good turnaround season in Q2.

Got it. So more just a tough comp on the prior quarter.

Turnarounds are coming. We've been saying that for, what, 3 years now and it finally showed up in Q1 and Q2 of this year.

Our next question comes from Vaibhav Vaishnav from Cowen and Company.

M&A, if you think about M&A, last quarter, you guys had mentioned doing a deal with manufacturers or service companies doing some kind of swap. Can you provide some color and any progress on that front?

Like with any acquisitions or at least with all the ones I experienced at my prior life at NOV, you buy a company and you get 4, 5, or 6 businesses in that company and 3 or 4 of them are what you really wanted and 1 or 2 of them is not. So we have some suppliers that we trade with heavily that have made some acquisitions in the past 12 or 24, 36 months where they acquired some things that aren't core to what they do.

So there's been conversations around whether or not they would want to peel that off and have us acquire or give that to us to take that over. So that's what I meant. I didn't describe it very good on the last call. So we learned that lesson. And we also have, in distribution, some things that we've gotten through acquisitions, even prior to being DNOW, when we were at NOV, that really don't fit what you would normally expect to see from us. They aren't big. Their performance wouldn't move the needle but they're things that our suppliers are interested in.

So that's really what I was talking about.

I apologize for asking this question but I get this question asked almost all the time now. On the market share, how do you guys track market share and are you losing any market share you see or anything that you can provide any color on that? That would be great.

There's no doubt that we're gaining share. That's a definite. I could give you 12 examples of that. It's hard to measure how much of the market we get because there's only 2 big players in the public space that do this but there are a bunch of independent private people who don't report their revenue externally and some of those are hundreds and hundreds of millions of dollars of revenue. So it's really almost impossible to get a good picture of what the total market is. We end up using third parties who just put out what they think the market is and we know that's not true. But it's almost impossible to measure because there's only -- as opposed to other industries where you have 10 or 12 public companies that make up most of the market, here you've got 2 that make up half the market or whatever the number is and we can't measure the rest.

You mentioned delayed line pipe revenues in the press release. Could you talk about how much is that and if that would be realized in 4Q?

It's part of that $10 million that I mentioned on the call and it probably shares a quarter of that amount and the problem with that is that will get shipped in Q4 but then things that are supposed to ship in Q4 are getting pushed to Q1 for the same reason. Everything is getting delayed because these coaters have to coat all this pipe and they were shut down. So everything got pushed.

We have no further questions at this time. I will now turn the call over to Robert Workman, CEO and President, for closing comments.

I think everyone for their interest in DistributionNOW. We look forward to seeing investors at the Baird's Conference in Chicago, Stephens Conference in New York, December NDR with Evercore ISI, and as well as other upcoming conferences and NDRs throughout the remainder of the quarter. Thank you.

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