DNOW Inc (DNOW) 2018 Q2 法說會逐字稿

Good morning, and welcome to the Second Quarter Earnings Conference Call. My name is Michelle, and I will be your operator for today's conference. (Operator Instructions) I would now turn the call over to Senior Vice President and Chief Financial Officer, Dave Cherechinsky. Sir, you may begin.

Thank you, Michelle. And welcome to the NOW Inc. Second Quarter 2018 Earnings Conference Call. We appreciate you joining us this morning, and thank you for your interest in NOW Inc.

With me today is: Robert Workman, President and Chief Executive Officer of NOW Inc.; and 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 second quarter of 2018, 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 quarter or 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 earnings release, on our Investor Relations website at ir.distribution.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 income or loss, excluding other costs; and diluted earnings or 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 earnings 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 second quarter 2018 Form 10-Q today, and it will also be available on our website.

Now let me turn the call over to Robert.

Thanks, Dave, and good morning. I want to thank each of you for taking the time to join us today. At the mid-point of the year, we were pleased to you see the U.S. market continue its positive trend and rig count growth drilling in completions actively and facility gathering and transmission infrastructure projects. Our excitement grows as customers are realizing the value of our broad range of services. Our strengths come from our one-to-many customer support where we serve multiple customers from local branches with our core offerings. Additionally, our supply chain solutions deliver value through one-to-one where we specialize in managing key portions of our customer supply chain so they can focus on their core business, by working alongside their personnel, on their premises, sourcing goods and solutions from suppliers, managing their warehouses, minimizing product supply chain costs and risks, reducing their SG&A and eliminating duplicate of capital employed. A couple of value builds further from our bundled offerings, where we provide kitted solutions of modular, turnkey solutions for rotating equipment, valve actuation and process and production equipment designed to customer-specific applications. We finished the second quarter of 2018 with revenue of $777 million, up $126 million or 19% from the second quarter of 2017. We saw profitability across all 3 segments with significant growth in our U.S. operations, both sequentially and year-over-year. Our 19% year-over-year revenue growth outpaced advances in global average rig count, which was up 8% during that same period. The U.S. top line increased 25% and international increased 12% year-over-year, partially offset by Canadian decrease of 5%. And the U.S. energy centers made up 57%, U.S. supply chain services 29% and U.S. process solutions 14%, up second quarter 2018 U.S. revenue. In the second quarter, sales related to midstream activity represented the largest sequential percentage growth driven primarily by U.S. gathering and transmission projects. Gross margin percent was up 80 basis points sequentially to 20.2% as we benefited from a favorable inventory cost to replacement cost spread for pipe as well as commodity inflation and a continued focus on pushing price. Patience during the early quarters of the recovery paid off in the quarter, as we continued to capitalize on opportunities to sell products now at margin levels supporting our strategy. Warehousing, selling and administrative expenses were $139 million for the quarter. We continued to be diligent in controlling our expenses with a focus on cost and infrastructure rationalization while investing in areas of increasing activity. EBITDA excluding other costs was $29 million for 2Q, up $31 million year-over-year. As a result of our strong top line and gross margin growth, paired with excellent operational execution, GAAP net income was $14 million and diluted earnings per share was $0.12 or excluding other costs, net income was $10 million and earnings per share was $0.10. We have an optimistic outlook for the second half of 2018, as U.S. fundamentals hold and the breakup period in Canada is behind us. For the full year 2018, we are upgrading our forecast and expect revenue growth over 2017 to be in the high-teens percentage range if current market conditions persist.

For 3Q '18, on a year-over-year basis, from '17 we believe revenues should grow in the mid to high-teens range with incremental flow-through to EBITDA and the high-teens to low 20s percent range. Sequentially into 3Q '18, revenues could improve in the low to mid-single digits, with EBITDA results being flattish with the second quarter of 2018 levels off the back of a very strong pricing, expense minimization and flow-through quarter. However, we remain cautious due to the unknown downstream effects of trade policy changes, impacts of potential consolidation in the shale place, market and product pricing pressures, the effect of takeaway capacity constraints and uncertainties in the Permian, the ongoing offshore drought and general unease and year-over-year softening in Canada.

Our solid second quarter performance was the result of our hard work as they executed against our strategy to maximize core operations, drive margin expansion, leverage our acquisitions and approach capital allocation with discipline. With the continued execution of these efforts, we can deliver the gains our shareholders expect and we made excellent progress on all 4 areas in the second quarter.

In the area of operations, we continued to optimize our footprint and inventory to capitalize on market opportunities. We closed 5 branches in the quarter and added personnel inventory to areas of high activity, including a new valve actuation location in the Permian. We continued to execute our human capital strategy in the Permian and other growing areas to strengthen our position and gain market share, prioritizing training and recruiting, relocating key managers and making further progress on margin expansion.

In addition to capitalizing on the strong oil play market environment with tank battery hookups, upgrades on existing batteries, line pipe, and actuated valves for gathering systems, we're also enhancing operating margins by leveraging an improved quoting process that enables us to process a higher volume of quotations across markets. We continue to manage product cost changes related to section 232, section 301 and dumping cases on steel products through our strong relationships with suppliers. Cost changes are integrated into our pricing and quoting processes as applicable. We have been focusing on improving efficiencies in operations, utilizing technology to enhance our quote turnaround time and customer order process as well as bringing some art and science, defining the market price. We're seeing cross-selling our products from acquired companies materialize. For example, Odessa Pumps is selling LACT units and Power Service is selling air-operated double dye frame pumps. A strong collaboration between U.S. energy centers, U.S. supply chain services, and process solutions is resulting in pull-through sales, new customer [wins], increased market opportunities and further penetration.

Our investment in (inaudible) inventory and standardized production packages is yielding benefit. As market lead times grow for rotating, process and production equipment, we are able to meet demand through collaborative inventory planning and product standardization practices with our customer.

For example, we captured opportunities in the water market, both with produced water disposal and reuse in shale plays as well as crude line gathering and transportation systems. We continue to approach capital allocation with discipline. To that end, we slightly reduced inventory and improved terms to 1x in Q2, while DSOs improved to 50 (inaudible)

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WTI pricing in the current range is a positive trend for our global energy centers for the U.S. operations. Drilled but uncompleted wells or DUCs, according to EIA, ended June with a count of 7,943 wells, and averaged 7,745 for 2Q '18. [Documents] work continues to increase and we see that as a future opportunity for DNOW to participate in that market for surface production equipment, pumps and PVF, whenever the wells are completed.

According to EIA, completions increased 17% on average from 1Q '18 to 2Q '18, plateauing in the last 2 months of the second quarter, averaging 1,235 wells. Based on these market indicators and the resulting midstream projects required to move product to its final destination, we believe DNOW is well-positioned to take advantage of the strong market.

Turning to our segments, U.S. revenues were $600 million, up $119 million or 25% year-over-year. Sequentially, U.S. revenues were up $38 million or 7%. An improvement in rig count, focus on tightly managing expenses and selling lower cost inventory at current market prices produced strong incremental flow-throughs. Strength in the Permian from increased rig count and well completions as well as midstream projects in the Mid-Continent, Northeast and Western oil plays led to strong U.S. growth and helped drive gains in excess of rig expansion growth.

Looking at the specific operations within the U.S., our 3 U.S. businesses experienced growth year-over-year as a result of increased rig count, continued well completions and midstream projects.

The Permian remains the most active in the areas of the Delaware and Midland basins and the business is strengthening in the Bakken, Northern Rockies, Eagle Ford, DJ Basin and the Northeast.

Pipe and actuated valve activity remains strong as the midstream market in the shale plays continues to build out infrastructure to support increased production volumes and we expect that to continue. We've experienced a shift in customers, wanting more domestic line pipe versus import and we added new customers in Arkansas and the Rockies. We continued to witness, product availability becoming more difficult for many producers, especially those that were more reliant on import mills and (inaudible) good domestic sources. We have both, shifting as required to maintain our service to our customers. Due to increased volume, many domestic manufacturers are not taking on new distributors, but continue to supply their existing partners.

Looking ahead, assuming that rig count and commodity price trends continue, there are no major supply disruptions, unforeseen events or inclement weather, we see continued positive trend for our U.S. energy center's revenue. While the Permian activity will likely be steady, we are watching takeaway capacity constraints as we work with our customers to plan accordingly. If there is a pullback in the Permian, we believe producers will redirect capital to other basins, where we are well-positioned to service their needs.

U.S. supply chain was up 20% year-over-year, but down 5% sequentially. Permian was primarily driven from activity with our integrated customers in the Bakken. Our downstream, industrial and mill tool businesses ramped up a new large-scale refining customer and added new aerospace and energy products manufacturing customers.

U.S. supply chain customers saw positive growth in measurement, transmitter and electrical cells as well as rotating, process and (inaudible) such as meter (inaudible), fire tubes and separators. We rolled out a fuel based, just in time, inventory model to (inaudible) customer that will generate new revenue going forward. For U.S. process solutions, we saw a 37% year-over-year revenue growth and 6% sequentially. We continue to see strong growth from customers in the Permian Basin for our fabricated equipment and packaged products. We began selling LACT units for a new large independent E&P customer in the Permian.

The Permian remained the most active region for U.S. process solutions with the Eagle Ford also experiencing increased activity. As oil prices remain at current levels or rise, this should lead to an increase in well completions which bodes well for the U.S. process solutions business.

Turning to our Canadian operations, revenue was down 5% year-over-year at $75 million. Sequentially, revenue was down 26%, the decrease resulting from seasonal breakup, a condition where heavy equipment is not able to access drilling sites. The midstream sector and unconventional energy sector were positive, stemming from a busy turnaround season (inaudible) and increased share gains from major operators.

Finally, the international segment reported revenues of [$102 million], this segment is up 12% year-over-year (inaudible) percent sequentially. Gains were led in China, Indonesia, and the CIS from TCO and BP Azerbaijan. The business climate in the North Sea is improving, noting an increase in activity in the U.K. continental shelf and Norwegian and Dutch sectors. In Mexico, numerous pipeline projects have been added and assigned to EPCs, presenting some optimism for an upstream market. We are well-positioned in the (inaudible) segment to take advantage of an offshore recovery when it materializes, as we maintained our infrastructure through this prolonged offshore drought.

As mentioned last quarter, and I'll reiterate this quarter, assuming that current business drivers and commodity prices maintain their upward or stable trends, and if there are no major supply disruptions or unforeseen events, we are optimistic about distributions now as long-term prospects.

With that, I'll turn the call over to Dave to review the financials.

Thanks, Robert. In the second quarter of 2018, we generated $777 million in revenue, up $126 million or 19% from the same period in 2017 and an increase of $13 million or 2% sequentially. This marks the highest revenue levels since the first quarter of 2015, the onset of the prolonged downturn. In the quarter, gross margins reached 20.2%, the highest level since the fourth quarter of 2014, up from 19% in the same period of 2017 and up sequentially from 19.4%. This significant jump was driven primarily by pricing gains from pipe, a portion of which is the result of a favorable spread between inventory cost and replacement cost, which fueled premium product margins and a boost to gross margins. While we believe there is still room for gross margin gains over time, bending favorably when commodity inflation continues and our market expands further, we expect the gross margin percent to fluctuate in the short term. Warehousing, selling and administrative expenses or WS&A was $139 million. This is low (inaudible) than in the second quarter of 2016, which then, on a run-rate basis, we added [$1.1 million] in revenue to our business. In other words, about the same level of expense for a business now $1.1 billion larger annually. We are serious about adapting our footprint to a constantly changing market. Our employees are focused on the customer, growing the business and improving bottom line results. For some color on the effects of expense rationalization, when viewing the locations closed in the last year, the revenue generated in those now closed locations totaled around $28 million in 2Q '17 and $3 million in 2Q '18. Our revenue (inaudible) [$25 million] in those discrete locations. While we did retain a portion of this revenue by servicing those customers in the locations, the benefit derived included being able to redeploy and reinvest inventory in more lucrative areas, and the expense savings generated helped us fund growth elsewhere. We expect WS&A to go to mid-140s per quarter for the remainder of the year. Operating profit was $18 million, or [2.3%] [improved] compared to an operating loss or -- of $14 million, or negative 2.2% of revenue in 2Q '17. Net income for the second quarter was $14 million or $0.12 per diluted share, an improvement of $0.28 when compared to the corresponding period of 2017. Our effective tax rate for the 3 months ended June 30, 2018, as (inaudible) for U.S. GAAP purposes was 6.1%. As our profitability increases and when we are no longer (inaudible) to a valuation allowance in the U.S., we expect our tax rate to be in the mid to upper 20% range. On a non-GAAP basis, EBITDA excluding other cost was $29 million or 3.7% of revenue for the second quarter of 2018. Net income excluding other cost was $10 million or $0.10 per diluted share. Other cost after-tax for the quarter included approximately $1 million charges related to severance and accelerated debt issuance costs offset by a $5 million benefit from changes in valuation allowances recorded against the company's deferred tax assets. In 2Q '18, we continued to evaluate the provisions of the Tax Cuts and Jobs Act as well as all interpretive guidance issued to date. We have not completed accounting for all the effects of this new law but have recorded provisional amounts which we believe represent a reasonable estimate of the accounting implications of the tax act. Moving to our segments, U.S. revenues grew to $600 million, a 25% improvement from the second quarter of last year, well above the build in U.S. rig activity. Canadian revenues were $75 million, down 5% year-over-year, due to a decline in Canadian market activity. And internationally, revenues were $102 million in the second quarter of 2018, up $11 million from a year ago driven by increased customer projects and foreign-exchange. Moving onto operating profit, the U.S. generated operating profit of $16 million or 2.7% of revenue, an improvement of $32 million when compared to the corresponding period of 2017, primarily due to significant revenue increases coupled with product margin gains and lower operating expenses.

Canada operating profits was $1 million, a decline of $1 million when compared to the corresponding period of 2017 due to lower activity this year versus last. International operating profit was $1 million, an increase of $1 million when compared to 2Q '17, driven by the increase in revenue.

Turning to the balance sheet. Cash totaled $91 million at June 30, 2018, with $76 million located outside the U.S., about 2/3 of that being in Canada and the U.K. We ended the quarter with $195 million borrowed under our revolving credit facility, and net debt position of $104 million, when considering (inaudible) cash.

At June 30, 2018, total liquidity from our credit facility availability and cash on hand was $423 million. Our debt to cap was [14%] at June 30, or 8% when considered on a net debt basis. And we had $332 million in availability on our credit facility. Interest on the debt approximates 4% and we expect the Fed to continue to push short-term rates incrementally higher as they attempt to fend off inflation. Working capital, excluding cash as a percent of revenue was approximately 23%. Accounts receivables were $495 million at the end of the second quarter, down $1 million sequentially as our DSOs improved to 58 days. Second quarter inventory levels were $604 million. Churn rates improved sequentially to 4.1 in 2Q, inventory is down sequentially for the first time since 4Q 2016.

Accounts payables were $315 million at the end of the second quarter with DPOs at 46 days. Cash flows from -- provided by operations was $5 million for the second quarter with capital expenditures of approximately $2 million, resulting in $3 million free cash flow in the quarter.

We tend to consume cash as we grow the business and generate cash in the contraction. Our challenge going forward is to further improve working capital velocity by collecting accounts receivables faster and turning inventory more quickly while operating earnings improve.

With that, I'll turn the call back to Robert.

Thanks, Dave. Let's wrap up with the outlook for the second half of 2018. Our outlook is tied to global rig count and drilling and complete (inaudible) measures, particularly in North America. Oil prices and U.S. oil storage levels will continue to be the primary catalyst for determining U.S. rig activity. Our approach continues to be to advance our strategic goals and manage DNOW based on current and projected market condition. Before I move on to recognize one of our dedicated employees, I'd like to summarize the progress we've made in the execution of our strategy. We're adjusting our footprint in line with customer demand and optimizing our human capital-inspired relationships.

We executed on margin enhancement initiatives by improving our quotation and pricing processes, leveraging and optimizing our inventory and driving intracompany collaboration. We leveraged acquisitions through enhanced cross-selling and we approached capital allocation with discipline, improving inventory turns and continuing to engage acquisition targets that will help us deliver on our near and long-term objectives.

With the further successful execution of our strategy, we fully expect continued improvement towards generating greater shareholder value. With that, let me recognize one of our -- the employees whose daily hard work and dedication enable us to deliver on our promises.

Mary (inaudible) began her career with Wilson Supply in 1974 as a clerk in warehouse operations, in what most Wilson employees called, "The White House", a building that was painted white before our new warehouse house was built in the 1980s on (inaudible) Street close to downtown Houston.

Mary subsequently moved through roles in purchasing, credit and billings. Today Mary manages mill test reports or as many refer to them, (inaudible) for DNOWs' customers. The management of (inaudible) a job that has grown exponentially as more and more customers want (inaudible) from the materials they are buying.

Mary is always asking people how they're doing and how their family is doing. She regularly walks laps around our 450,000 square-foot La Port distribution center at 7 a.m. each morning before her day starts. People who know Mary know her as a very caring person, who frequently brings people gifts for no reason other than her kindness. She has remained steady and loyal over (inaudible) through the many ownership changes from Wilson Supply to (inaudible) to Slumber J to NOV and ultimately to DNOW. Over the past 44 years of service, there hasn't been anyone more supportive of all the changes we've endured than Mary. Thanks for all you do for DNOW, Mary.

Now we turn it over to Michelle so we can start taking your questions.

(Operator Instructions) The first question in the queue, sir, comes from Walter Liptak with Seaport Global.

You have a lot of the good things going on. But I wanted to start off with one of the comments that I think Dave made about the gross margin in the second half and I think you mentioned that the gross margin's going to be a little bit lower, did I hear that right? And maybe just a little bit of color around why that might be the case?

Yes, I think what we were alluding there Walt is, gross margins were very strong in the second quarter due to many things. We're pushing price, we've got commodity inflation, there's product availability issues, but one of the components of the gains we saw in the second quarter was simply the difference in our inventory costs versus replacement cost as market prices change. That gap, we believe, will continue to narrow in these, what we call it premium margins, will ease a little bit. So (inaudible) gross margin and we've talked about this on the last (inaudible) calls. We're focused on pursing higher-margin transactions and we're using technology to help us (inaudible) incrementally higher price on the next transaction. Plus we're still seeing general inflation and commodity move forward. So that premium piece, we believe will (inaudible) shrink a little bit. So we expect some movement up and down with gross margins, and after a big jump like this, we think it might ease a little bit in the short-term, but bend favorably over time.

Okay. Fair enough. Let me ask you a question about the high producing basin like the Permian. Are you continuing to see better pricing there? Or is that -- as the takeaway capacity gets constrained? Or is pricing getting more difficult in the Permian?

I would say we're saying broad price appreciation across the world in our product lines. And I assume we're seeing the same thing in the Permian. So I think that -- whether that continues is another matter. Takeaway capacity issues and activity in the Permian can alter that. I would tell you, the Permian is probably our most competitive play in the world, and pricing is a -- obviously a big part of the decision for each transaction our customers make. So that's just a battle we have to fight. But we don't -- I think we expect the activity to stay strong and for a migration of sorts to happen to the other plays. There are going to be puts and takes on gross margin and more importantly, on the (inaudible) as the customers' activity strengthens.

Okay. That sounds great. Just another one on the reallocation of resources. Really impressive with the example that you gave of the $27 million of closed operations down to $3 million. So the question is, with the reallocation, when do we start seeing benefits? How do the benefits of that reallocation show up? Like is it people and inventory that you're investing in? And does that show up in growth rate or margins? How do we gauge the benefits from the reallocation or resources?

That's a good question, Walt. I think we're seeing the benefits. If you look at the flow-throughs, gross margin flow-throughs, operating margin flow-throughs that we've demonstrated each quarter, we're seeing the benefits of finding locations where the contribution margin for each customer or transaction is better than the last transaction. That's why we're moving out of some locations, shrinking the size of some locations and that's showing up in our flow-throughs in our cost to service those customers. I mean our WS&A, the expense as a percent of revenue has dropped 8 quarters in a row. We expect that percentage to continue to improve as we grow the business. So I think it's showing up. I mean, I think it's -- I think what we were trying to say is, we had foregone some revenues to improve the return on investment our shareholders have in DNOW and it's paying off.

And the next question in the queue comes from Steve Barker [Barger] with KeyBanc Capital Markets.

You said tight pipeline capacity could maybe shift capital to other basins. Can you talk about where you are in terms of customer relationships and acceptance in those basins, just in terms of keeping up momentum in the tank battery business?

Yes, so far we have not seen anything occur in the Permian outside of rumors about -- that you hear from everybody, I think on almost every earnings release so far this season. But our activity is still strong. We get the benefit of the fact that in our supply chain services, we are embedded with 4 of at least 3 of the largest operators in the Permian and so we have to plan with our engineering departments, we plan with our project managing teams, our raw materials. So we get an early indication, if they're shifting capital to other basins and we're not seeing that either. So I'm not saying it's not going to happen, but so far there's been no indication of it. But I do believe that our operator customers [whether] they are the supply chain customers or just our regular general branch customers, cut back on CapEx in the Permian and then did it somewhere else, because they still have commitments they have to make to their shareholders. So we fully expect if we do see some slowdown in the Permian, which again we've not see any indication of yet, that you would see capital shift to the Eagle Ford, to the SCOOP Stack to the DJ and Niobrara basin. And what do you know? We're in all those places too. So I'm not expecting any topline hit to our business in the U.S., it just may shift from one basin to another.

And in terms of the modular tank battery business specifically, how is the acceptance of that going? You gave us an update last quarter about being able to sell some specific parts of units? Any update there?

Yes, I was just up there a couple weeks ago. And if you'd been there 2 years ago, to the facility up in Casper and you walked through all those buildings or all those modules (inaudible) fabricated, you would have seen most -- the majority of those skids with either (inaudible) buildings on them because they were going to the Rockies. And so you have to protect it from weather. I was up there last week and I had a hard time finding skids with buildings on them. So that means they're all headed south. So we're having really, really good success in the SCOOP Stack Permian and Eagle Ford from that offering. And I expect that to continue.

That's great. One more for me. Really great to hear that you're being selective on finding those higher-margin transactions. When you talk about technology driving that process, is that the quoting system that you're referring to? And does that contribute to just margin through price? Or does it help with share gains as well?

Well, we're using different technologies for both of those, okay? So we have some technology we've implemented here recently around -- lots of times in this business, especially, when it's busy like it is, first quote back wins. I mean our customers are just trying to get the inquiry off their desk and move on. So there's an advantage to getting a quote back to the customer quickly. So that's helping. The system we've got now that helps us fill out most of the quote up front and then we just handle the one-off items later. And on top of that, we've implemented some technology in our SAP system about a year and half ago, I think, that per branch, whether you're in Williston, North Dakota or you're in Casper, Wyoming, or you're in Waston, Pennsylvania, or Cuero, Texas. It looks at your region and it looks at the stuff that you've quoted for projects and it looks at the prices you've been able to win orders at and suggests what the price should be, not only based on your highest margin transactions previously, but also inputs that we put in the system here at our corporate office that update the price of steel to suggest what the replacement costs are going to be so you don't quote based on your moving average cost, you quote based on replacement cost. So all of that's helping.

And it's always hard to tell about share in an up-cycle, but do you feel like you're able to take some share from the smaller guys in those various regions.

Yes, no doubt about it, I mean -- any metric that you want to come up [to measure us] against -- there's no other explanation.

The next question in the queue comes from Adam Farley with Stifel.

Yes, first question is on tariffs. You guys don't seem to have any problem matching price right now. When do you think the tariffs will become an issue? And then also on sourcing I know you have a lot of relationships with domestic suppliers, but do you see any impact right now? Are you guys pre-buying any inventory to get ahead of this? Just any color there?

Adam, I think what we're seeing is -- so there's a lot of tariff activity going on and the U.S. manufacturers are matching those tariffs. I think the U.S. manufacturers are smartly taking advantage of that, they're raising their prices. So that inflation is happening. So whether tariff news changes in the coming months, we don't see it affecting us much different in terms of imports except for a less need of product availability. So they are [quotas] which limit Korean imports and things like that but we see that being favorable. We -- as far as inventory buying, we're trying to make sure we have the right inventory through the cycle and our turns are still, are (inaudible), they could be a little higher. So we still have extra inventory to accommodate the build in the short-term. What you don't want to be stuck with is some of these tariffs being relieved and imports coming back in and then you're left with a situation where your inventory is over [cost] So we're just trying to manage that very tightly.

Okay. That's really helpful. And just shifting gears to offshore upstream. The presentation called out some signs of increase in activity in Norway. But at the same time, you also mentioned offshore drought, I know it's been a challenge for a very long time. Just any additional color there. Where -- when do you think we'll get that kind of moving? Is that just higher oil prices, tighter capacity on-shore? Just anything there would be helpful.

Yes, I don't think there's a question about the fact that an offshore recovery is coming. You can't cut your expenditures each year from -- down by $500 billion to $750 billion on offshore, which is 1/3 of the world's (inaudible) and think that that's not going to impact (inaudible) whole storage and production negatively, which it already is, by the way. That's already turned the corner. So the issue is the fact that it can take a little while once it comes back to affect the operations because the industry, the offshore industry has scrapped what, 150 offshore rigs or something of that nature? I don't know the exact number, but it's way up there. All of that inventory ends up in a shore base. And that inventory in the shore base supplies the existing fleet. So it's really hit our offshore revenue stream considerably. So I'm not counting on revenue recovery in the offshore sector for us in any meaningful way until late '19, early '20. Now the good news is, we've reallocated our resources towards all of our land opportunities and we're seeing growth every single quarter. It's nothing massive, but it's keeping the business in a profitable sphere, so that we can hold onto our infrastructure in places like (inaudible), in (inaudible), and Singapore, and Aberdeen, in (inaudible), places that -- where offshore is supported so that [when offshore] does come back we should have some infrastructure and (inaudible) in place to attack that market without much incremental investment.

And the next question in the queue comes from David Manthey with Baird.

The first question for you, Dave. Can you disaggregate the factors that drove the gross margin change? You talked about the price cost inventory situation, but can you then talk about any other factors, is there a mix or price increases, other volume benefits?

Yes, in terms of mix, our product line that grew the most as a percent of revenue was pipe. So we're seeing product inflation there and a bigger volume of tonnage of pipe being moved as well. So that had a heavy weight on the growth in terms of gross margin percent sequentially. So that was a big driver of it. But all the things we've talked about from using technology to find the right incrementally higher strike price to seeking higher-margin transactions, walking away from the 2%, 3%, 4% PVC line pipe transactions, all of that conspires to get the kind of gross margin gains we saw. But 1/3 to 1/2 of the gains were probably due to pipe. So the pipe inflation. Inflation is generally helping us grow gross margin. We do expect some volatility like we talked about though.

So the difference between the cost of your inventory and the market price, that factor alone, did you say that was maybe 1/3 to 1/2 of the year-to-year improvement?

It's hard to tell. I believe it was -- it could have been a 1/3. It's hard to calculate because in an inflationary environment, there's always going to be that spread as prices [edge up]. So just measuring that spread is harder to do. But it could have been 1/3, but it's hard to say.

Okay. All right. And then as it relates to longer-term trends. When you look at the current mix of business and growth trends, do you feel that the gross margin can sustainably exceed prior peak levels over the long-term?

I think as long as we're in a strong global economy like we're in and we see general inflation, commodity inflation and our market growing, I think gross margins can continue to go up with kind of a stair-step approach. They will moderate.

And, Dave, I would just add to that, don't forget that in this downturn on the 12 acquisitions we've made, some of those have historically higher gross margins than the rest of our business (inaudible) grow. That's also going to pull gross margins up.

And the next question in the queue comes from Ryan with Northcoast Research.

I just wanted to quickly ask you guys about the dynamic on the price cost side of things, Dave, as it relates to that benefit. You're assuming that we continue to see the type of inflation we're seeing on steel and pipe, I mean, the expectation should be that, that dynamic could continue in back half. I understand maybe being a little bit cagey with regards to how that might play out. But if we continue to see that inflation, we should expect that dynamic to continue to be a benefit for you guys, correct?

Well, as long as we see commodity inflation, I think we'll be able to realize improved profit margins generally. But you have to keep in mind we just went through a long downturn. Our pipe, in particular, was written down in lockstep with the movement in commodity prices, so we're burning off that inventory. It's gone. That premium we talked about, that's going to diminish. So we'll still benefit from commodity inflation. But that inventory cost -- cost differential will narrow and that will be a headwind to gross margins.

Okay, right. So then if 1/3 to a 1/2 is from pipe inflation, you think about the other components, you guys have talked about the improved quoting procedures and functions there. Is that something that you still feel like is in the early innings or is that something that you expect to continue to have some incremental benefit as the rest of the year plays out?

Our operations, our incentive to push margins, it increases their take-home pay every quarter. So I fully expect that to continue indefinitely, pushing price. Now we've come from a low of the 16% gross margin range to now at a level that's similar to 2014 level, but I don't believe that were finished. I mean, I believe there's more margin percent to be gained, both in (inaudible) business, the branches and supply chain as well as in our solutions group where margins are definitely healthy and accretive to gross margin percent in the rest of the business.

Okay, great. And then my last question on process solutions, really nice growth there this quarter. I think -- if you could sort of dissect that a little bit in terms of how much of that are you starting to see with the traction at TSI and the modular [tank] solutions coming through or is a lot of that still sort of in the pipeline and could benefit the growth rate even more here going forward?

So it's not just the power service acquisition. Odessa Pumps is hitting on all cylinders right now as well. Their core area for Odessa Pumps is the Permian and the Eagle Ford and SCOOP Stack and Mid-Continent. So you can imagine how busy they are right now fabricating water injection pump skids, water transfer skids, all sorts of fluid rotating equipment packages. As well as that army of people at Odessa Pumps in those areas that are now pulling (inaudible) from power service down into the Texas (inaudible). And so all of that coupled together is generating quite a bit of success as far as penetration in the new basins. Michelle?

And the next question in the queue comes from Sean Meakim with J.P. Morgan.

So could you maybe just give us a little more sense of the revenue contribution from midstream. This certainly has been on the smaller side. And just -- and within that something about what the product mix in midstream looks like compared to the overall. Just trying to better size that opportunity?

Well, our midstream market continues to grow, especially as we're expanding our valve and valve actuation capacity. We originally, not too long ago, 2 or 3 years ago, we had one valve, valve actuation instrumentation shop. Now we have, just in the U.S. alone, we have at least 4 or 5 of them. We have them up in Canada, we've got them in Singapore, you've seen the one in the Middle East, so we're investing heavily in our midstream product line, especially the higher value product line, which is valves, valve actuation and so forth. So we (inaudible) midstream based on pure mainstream customers, there's nothing we do. You can pull our port and SAP and it'll show you how much we sold to (inaudible) transfer or whoever you want to pull up. We don't [measure] the other part of midstream, which is, I wouldn't say, Chesapeake or Chevron or somebody who is going to do a gas gathering systemic. Well it's billed to the same account that we bill to when they bill the tank battery. So we only measure the pure tank -- trunk lines that go between plays. We don't keep up with -- we really see no benefit in putting a lot of effort in SG&A and time and money into trying to measure how much goes into a gathering line in the middle of the Permian Basin field. So our midstream market is strong for us. It's always been core of our business. We've been in the midstream market since I started here in 1991. So -- and it was a big part of Wilson Supply business. So it's strong, it's growing. We're doing well in Canada and -- in that market as well.

Okay. Fair enough. So thinking about the leverage off of WS&A. Do you think by 2019 you can get back to where that's 13% to 15% of sales. Just thinking about some of the puts and takes there around hiring difficulty, wage inflation on the one side but then also additional cost-cutting measures and of course, the push on gross margin, which has been a big part of the discussion today. Just curious how you think about that -- what that can look like on WS&A as a percentage of sales next year?

13% to 15%. So we ultimately to get down (inaudible) range and lower. That's going to be a function of [revenue]. So it's hard to gauge what's going to happen in 2017, we haven't really spent too much time thinking about revenues and gross margins and cost of service to business. But that's going to be (inaudible). We want a business that's agile, that's scalable in a market that grows or shrinks and we know that's kind of where we need to be. But we don't have a number or a guess for what 2019 would look like.

Okay, but long-term that's where you see things in terms of optimally where you'd like the business to be?

That's right.

Ladies and gentlemen, we've reached the end of our time for the question and answer session. I will now turn the call over to Robert Workman, CEO and President for closing statements.

Thank you all for your interest in DistributionNOW and we'll look forward to talking about our 3Q results in a few months. Thank you.

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