DNOW Inc (DNOW) 2019 Q1 法說會逐字稿

Welcome to the first quarter 2019 earnings conference call. My name is Richard and I will be your operator for today's call. (Operator Instructions) Please note that this conference is being recorded.

I will now turn the call over to Senior Vice President and Chief Financial Officer, Dave Cherechinsky. Mr. Cherechinsky, you may begin.

Welcome to the NOW Inc. First Quarter 2019 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. 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 conversation this morning.

Before we begin this discussion on NOW Inc.'s financial results for the first quarter of 2019, 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.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 income, excluding other costs and diluted earnings 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 first quarter 2019 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 thanks everyone for joining us. Transitioning from the fourth quarter of 2018 to the first quarter of 2019 carried a degree of uncertainty, due to an environment where our customers were prudently revising CapEx plans for 2019 resulting from pressure from shareholders to hold CapEx spending within operating cash flow. Year-over-year CapEx projections by many of our E&P operator customers sets up an environment where most analysts are projecting activity declines in the high-single to low double-digit percentage range in the U.S. land market.

On our last earnings call, we guided that 1Q '19 revenue would have a sequential increase in the low to mid-single-digit range, banking on modest rebound in Canada and some market share gains in the Permian. Our full year 2019 guide was for flat year-over-year to low single-digit decline in revenue for 2019. Our 1Q '19 revenue came in at $785 million, up $21 million or 3% sequentially, within our guided range for the first quarter 2019. We delivered EBITDA excluding other costs of $31 million in the quarter and our gross margins improved 70 basis points year-over-year. Sequentially, gross margins declined 40 basis points, as the competitive environment we expected materialized.

One of the main contributors to sequential margin reduction is related to slowing U.S. land activity. In such an environment, price and margins are more contested. In addition to the macro U.S. land backdrop, commodity prices and supply and demand affecting commodities have changed from the previous inflationary environment we had over the last several quarters. Margins have been under pressure, as we guided, due to better product availability in the market during this industry pause. As we've noted, hot rolled coil pricing continues to decline, affecting welded pipe and the OCTG market is weakening, leaving more mill capacity on the market to produce line pipe. The result is downward pressure on price, as the market looks to turn higher cost inventory.

Global rig count averaged 2,262 rigs according to Baker Hughes, sequentially flat and a 2% year-over-year increase. Our annualized revenue per rig was $1.4 million for 1Q of 2019. U.S. average rig count was down sequentially 2% to 1,046 rigs, yet up year-over-year 8%. U.S. drilled but uncompleted wells or DUCs ended with 8,500 wells in March and averaged 8,471 for 1Q, up 6% sequentially. DUCs present future revenue opportunity for DNOW, should the wells be completed, which will drive tank battery construction and midstream gathering systems. WTI averaged $55 per barrel for the first quarter, trending up throughout the quarter.

We are maintaining adherence to our 4 strategic areas of delivering on margin discipline, maximizing our core operations, leveraging our acquisitions and having a tactical approach to capital allocation. With the ongoing successful execution of these strategies, we can deliver on the gains our shareholders expect and we made progress in those areas in the first quarter.

In the area of operations, we continued to optimize our footprint and inventory to capitalize on market opportunities as we scale the main market demand, where we had a few small location closures in the first quarter and maintained WSA under $140 million all while growing the top line.

We are maintaining our focus on supporting growth in areas of high activity by allocating resources to support our customers' operations, as we leverage operational efficiencies with our employees, processes and technology. Since the fourth quarter of 2018, we opened our newest regional distribution center in the Permian to more efficiently organize inventory across the area and to help further optimize inventory in the Permian. The Permian RDC investment solidifies our long-term commitment to customers in the Permian while providing operations with more flexibility on inventory planning, order fulfillment strategies for staging and bundling, as well as logistics solutions for our customers.

We continue to focus on opportunities to better tune our inventory across our network, to increase inventory turns and reduce our overall inventory investment. We further executed our human capital strategy in high and low activity areas to strengthen our position by prioritizing recruiting and training, holding recruiting events, relocating key personnel and providing a safe, positive work environment based on our core values of accountability, doing what it takes; caring about our coworkers, our customers and our communities.

Beyond just providing commodity products, we have been successfully delivering more value in the application of products and supply chain solutions that focus on industry applications, such as tank battery hook-ups, upgrades on existing batteries, pumping solutions for midstream crude, water and NGL pipelines, produced water disposal, gas measurement, LACTs, vapor recovery units and modular fabricated process and production equipment. We are meeting the demand for gathering systems and midstream projects comprised of pipe, high yield fittings and flanges, large diameter valves and actuation, closures, pump packages and fabricated equipment such as pig launcher and receiver modules. We're exploring economical ways to expand capacity where we have choke points, both organically and inorganically to grow in these areas.

We continue to manage product cost changes and inventory mix related to Section 232 impacting steel products, Section 301 impacting Chinese manufactured goods and components and dumping cases related to certain imported pipe, fittings and flanges through our strong relationships with suppliers. Cost changes are integrated into our pricing and quoting process when applicable. We are deploying technology to enhance our quote turnaround time, customer order process, fulfillment and delivery mechanisms.

Our cross selling from acquired companies continues to add value. The strong collaboration between U.S. energy centers, U.S. supply chain services and U.S. process solutions is resulting in pull-through sales, new customer introductions, increased market opportunities and further market penetration, as most evident in our U.S. process solutions gains.

Turning to our segments, U.S. revenues were $600 million, up $21 million or 4% sequentially, in line with expectations as the U.S. rebounded from the holidays. U.S. energy centers contributed 52%, U.S. supply chain services 31% and U.S. process solutions 17% of first quarter 2019 U.S. revenue. The Permian continues to be the most active in areas of the Delaware and Midland basins, with growth also in the Eagle Ford, Bakken and Rockies. Midstream projects were active in the Permian, Eagle Ford and Northeast, and were a large contributor to our sequential top line growth.

U.S. energy centers revenue was $314 million, an increase of 2% sequentially. The improved position we highlighted last quarter in the Permian contributed to delivering top line growth for our U.S. energy centers, all while rig counts declined, as we provided a range of valves and maintenance products, followed by new tank battery builds and expansion batteries. Our broad range of products and services combined with our application expertise, provided not only pipe, valves, fittings and flanges, but also instrumentation, electrical, safety and production equipment.

The Delaware Basin continues to be a very active area with a number of our customers, as we supply core MRO and pipe, valve and fittings products to drilling contractors, oil and gas operators and midstream customers. Rig count within the Delaware grew over the quarter with our core customers showing signs of continued robust activity. In South Texas, we were successful in providing PVF for midstream customers for gathering and pipeline projects, as well as processing facilities that have been under construction to help takeaway capacity from the Permian to the Gulf Coast downstream market.

In the Northeast, our midstream launcher and receiver program for a major midstream customer continues to bear fruit, as we provide pre-packed, staged and delivery of customized PVF kits which increases our customer's supply chain efficiency and streamlines their order process. Our employees' collaboration with multiple parties, including fabricators, ensure material is forecasted, kitted, quality documents are validated and order fill rates meet agreed upon predetermined targets.

The Mid-Continent area saw sequential rig count decline for the quarter, approximating 17%. Our line pipe business softened during the quarter, as we continued to see falling pipe replacement cost and some seasonality weakness. We delivered pipe to oil and gas operators for gathering projects and major midstream customers to support their pipeline expansion projects.

As for U.S. supply chain services, revenue was up 2% sequentially. Activity continued with our main SCS energy customers in the Permian Delaware basin, SCOOP-STACK, Eagle Ford, and Bakken plays. PVF facility revenue was lighter in the quarter, with one of our major operators correlated to design modifications made on newbuild facilities.

In the Bakken, poor weather contributed to low activity, resulting in limited customer work days during the quarter. U.S. supply chain services operator customers' orders were related to steel line pipe, valves, flow-back kits, production equipment and electrical products. In an effort to continually add value as a supply chain partner, we secured orders for water alternating gas or WAG units for the Permian. Regarding downstream and industrial activity, we executed on project and turnaround business involving PVF, mill tool and safety products for major refineries and chemical manufacturing facilities.

For U.S. process solutions, we saw sequentially $11 million improvement or 13%. The Permian remained the most active region for U.S. process solutions, with the Bakken, Rockies and Eagle Ford area all experiencing increased activity. In the quarter, our strategy to grow market share for our fabricated process and production equipment business continues, as we received orders for a variety of units, including but not limited to, LACTs, motor control centers or MCCs, heater treaters, vapor recovery towers and water injection and pipeline pump packages that were shipped to North Dakota, Texas, Wyoming, Montana and Colorado areas. Customers range from small to large independent E&P operators, as well as midstream companies which represented our largest growth customer segment sequentially for U.S. process solutions.

Our strategy to provide engineered pump packaged solutions targeted to the water management industry continues to be strong. For water applications, customers range from small oil and gas operators to midstream firms to standalone water management companies. Furthermore, I am pleased with our market penetration within the midstream pipeline booster market as a result of shipping pump packages for crude, NGL and light-end fluids movement for gathering lines.

Working with our strategic vendors to plan and provide kitted pump solutions offers a unique value proposition to our midstream customers from pump packages, process and production equipment, as well as actuated valves from our U.S. process solutions group.

Turning to our Canadian operations, revenue decreased $2 million or 2% sequentially. The market continues to contract due to production curtailment instituted by the Alberta government to offset rising crude inventory levels and an attempt to narrow the price gap between Western Canadian Select and WTI oil. Macro challenges remain, as takeaway constraints persists, while political and economic challenges impact the oil and gas industry and our business in Canada.

Canadian rig count averaged 186, a year-over-year reduction of 87 rigs or 32%. Well spuds were 2,179, down 566 or 21%, with only 132 operators, down 47 or 26% year-over-year. To summarize Canada for the first quarter, in what is normally our strongest quarter of the year, we actually saw a sequential revenue decline, as we had fewer rigs, fewer operators and lower levels of spudding; translating to lower DNOW revenue.

Finally, the international segment reported first quarter revenues of $99 million, up $2 million or 2% sequentially. International rig count averaged 1,030, up 2% sequentially and up 6% year-over-year. Gains were led by offshore activity in Asia, the U.K., and West Africa. Jack-up rig loadouts for newbuilds continued to during the quarter in Asia. DNOW provides many of the OEM and MRO consumables used during drilling operations of an offshore rig, where we also provide an inventory replenishment model from a nearby shore base in close proximity to where the rig has been deployed.

Middle East land activity remained steady, as we provide PVF and MRO consumable products locally to drilling contractors and NOC and IOC oil and gas operators. Our U.K. McLean Electrical group has been successful in securing and shipping electrical products tied to project activity in the Middle East and former CIS.

Before moving on to discuss the outlook for the second quarter and the rest of 2019, I'll turn the call over to Dave to review the financials.

Thanks, Robert. For the first quarter of 2019, we generated $785 million in revenue, up $21 million or 3% from the same period in 2018. Sequentially, revenue also improved $21 million or 3%. First quarter 2019 revenues landed in the range we guided to in our fourth quarter and full year 2018 earnings call. Whereas oil prices then were declining in the fourth quarter, beginning October at $75 and ending the year at $45, they now have improved into the low $60 range.

In the first quarter, gross margins were 20.1%, down from the 20.5% level we experienced in the fourth quarter, but up 70 basis points from 19.4% a year ago. The sequential decline was primarily driven by product margin pressure, product mix and a resumption of inventory charges which were lower than usual in the fourth quarter of 2018. Conversely, the uptick in gross margin percent compared to the first quarter of 2018 can be attributed to an improved pricing position this year and more selective pricing on project quotes compared to this period last year. We expect gross margins to be choppy in the near term, as the market reacts to reduced activity levels and commodity price volatility.

As we have discussed, we believe there is room for gross margin gains over time, expanding generally in inflationary conditions when oil and steel pipe inflation occurs and our market resumes in a growth trajectory. Warehousing, selling and administrative expenses or WS&A, was $135 million, unchanged from the fourth quarter of 2018. In the first quarter, we made progress resolving a long-standing receivables issues with a third party, resulting in the $3 million net favorable effect on WS&A and operating profit, paired with continued cost savings from various initiatives throughout the organization. We expect WS&A to approximate $140 million or lower per quarter at the activity levels in our guidance and we'll continue to take additional measures in step with changing market conditions.

In addition, we have been systematically analyzing our supply chain footprint, namely improving how effectively our network of distribution centers, branches, customer on-sites and stocked trailers work together; how cost effective they are, how well they support the customer strategies and how adaptable our network is to the nomadic opportunities the industry provides, given the commodity price volatility, market dynamics and evolving customer requirements. This view helps us shape the profile we need to grow the business and mitigate working capital and operating costs further. As you know, we have been diligent about fine-tuning our model to improve the financial performance of the business. As such, when considering the locations consolidated or closed in 2018 and the first quarter of 2019, revenue generated in those locations approximated $12 million more in 1Q '18 than in 1Q '19. While we did retain some of this revenue by servicing activity from other locations, we were able to move resources to fund growth elsewhere. This remains a mantra for DNOW, grow the business while demanding improved operating efficiencies and working capital philosophy.

While many positive things are happening across DNOW, one area we've seen notable gains is in our downstream industrial group. This group has implemented a high (inaudible) regimen by focusing on higher margin opportunities and product lines and meaningfully improving operating efficiencies, while turning their working capital even faster. All employees of DNOW, in addition to our shareholders, have benefited from the focus and hard work of this team.

Operating profit was $22 million or 2.9% of revenue, an improvement of $16 million year-over-year. Net income for the first quarter was $18 million or $0.16 per diluted share, an improvement of $0.14 when compared to the corresponding period of 2018.

On a non-GAAP basis, EBITDA excluding other costs was $31 million or 3.9% of revenue for the first quarter of 2019, an improvement of $15 million versus the first quarter of 2018. Net income excluding other costs was $13 million or $0.12 per diluted share. Other costs after tax for the quarter included the benefit of approximately $5 million from changes in our valuation allowance recorded against the company's deferred tax assets, offset by less than $1 million in severance expenses after tax in the period.

Our effective tax rate as reported for GAAP purposes was 6.5% for the first quarter of 2019, compared to 24.1% a year ago. The change in the effective tax rate when compared to the corresponding period in 2018 was primarily driven by increases in pre-tax income in 2019. Cash totaled $87 million at March 31, with $76 million located outside the U.S., approximately 60% of which is in Canada and the U.K. Historically it's been our practice and intention to reinvest earnings of our foreign subsidiaries. In light of the significant changes made by the Tax Cuts and Jobs Act, we previously discussed we are no longer permanently reinvested with regard to our pre-2018 Canada and U.K. earnings. We now are able to repatriate excess cash from both Canada and the U.K. to the U.S., providing additional treasury flexibility, including repayment of amounts borrowed under our credit facility. During the first quarter of 2019, we repatriated 20 million from our Canadian operations.

Moving to our segments, U.S. revenues were $600 million, a 7% improvement from the first quarter of last year on an increase in U.S. rig activity. Canadian revenues were $86 million, down 16% year-over-year. Calling out the negative impact of foreign exchange in Canada, the revenue decline would have been 11%, amid a 32% decline in Canadian rig count. And internationally, revenues were $99 million in the first quarter of 2019, essentially flat with a year ago. After excluding the negative impact of foreign exchange, international revenue would have increased 3% from 1Q '18 to 1Q '19.

Moving on to operating profit, the U.S. generated operating profit of $19 million or 3.2% of revenue, an improvement of $16 million when compared to the corresponding period of 2018, primarily due to revenue increases and improved pricing. Canada operating profit was $2 million or down $2 million when compared to the corresponding period of 2018, as a result of the revenue decline mentioned earlier. International operating profit was $2 million or up $2 million when compared to 1Q '18, driven by reduced bad debt charges.

Turning to the balance sheet, cash totaled $87 million at March 31, and we ended the quarter with $124 million borrowed under our revolving credit facility and a net debt position of $37 million when considering total company cash. At March 31, 2019, our total liquidity from our credit facility availability plus cash on hand was $531 million. Our debt to capital ratio was 9% at March 31, or 3% when considered on a net debt basis. Working capital excluding cash as a percent of revenue for the first quarter of 2019 was 22%.

Accounts receivable were $513 million at the end of the first quarter, up $31 million sequentially on higher sales, yielding 60 day DSOs. First quarter inventory levels were $634 million and inventory turn rates remained steady at 4.0 turns. Accounts payable were $339 million at the end of the first quarter with days payable outstanding at 49 days.

Net cash used in operating activities was $20 million for the first quarter, with negligible capital expenditures. This quarter we adopted FASB's new standard for accounting for leases which requires us to move operating leases onto the balance sheet. You will see these added assets and liabilities included in our financial statements in the quarter with the impact of adopting this standard on our income statement and cash flow being immaterial. We are a working capital intensive business. Our employees are focused on providing value-added products and supply chain solutions by out-delivering and out-servicing the competition while finding ways to meaningfully speed up collections and reduce purchase quantities and safety stock values and aspiration-enabled in the static atmosphere, so that we can generate higher levels of free cash flow in 2019.

And now I'll turn the call back to Robert.

Thanks, Dave. Let's wrap up with the outlook for the second quarter and the rest of 2019. Looking forward in the U.S., WTI is trending above its 4Q '18 average, as U.S. rig count has declined off its December peak. U.S. completions have risen from December, while the average DUC inventory continues to build. The most recent report from the EIA showed a modest net DUC reduction in March. Even if rig counts decline modestly or remain flattish, and if customer budgets shift more towards completions to draw down more on DUC inventory; this could benefit our U.S. process solutions business from modular and rotating production measurement and process equipment. This would also benefit our U.S. supply chain services and U.S. energy centers demand for pipe, valves and fittings, especially as it applies to midstream projects that would be required to get oil, gas and water to their final destinations.

Our outlook for the U.S. energy centers remains positive, with high activity areas such as the Permian, Eagle Ford, Rockies and Bakken; leading softer areas such as the Mid-Continent and Northeast. Two of our larger U.S. supply chain services operator customers announced they plan to reduce CapEx spend approximately 10% this year, one stated by the midpoint of 2019, and the other on a year-over-year basis. This will put downward pressure on our U.S. supply chain services revenue for the remainder of the year.

In Canada, where political turmoil and takeaway issues persist for which there aren't any solutions in sight, the rest of 2019 will be challenging and we expect declines there. Canada will experience breakup as the free-style cycle has historically reduced our Canadian revenues by approximately 25% sequentially. Alberta's recent election results and investment in transportation by rail provides some optimism for the rest of the year. However, we are cautious about our Canadian operations due to all of the uncertainty.

Looking ahead internationally, we are eager to see more jack-up and floater tenders materializing; continued increase in offshore activity in Europe, Brazil and Mexico; an uptick in land-based activity in Australia and budgetary quoting activity tied to some LNG projects. Beyond this, we have some bright spots with a specific offshore drilling contractor in Asia and other projects in the Middle East which could enable growth in our international business. Recent and planned FID approvals and offshore rig contract announcements indicate that the worldwide offshore markets are poised for long-term recovery and that could produce more than just marginal top line improvements for our international segment in 2020 and beyond, as customers work through inventories and move from exploratory to development activities.

Given these scenarios and recognizing the opaque view we have into customers' second half 2019 budgetary plans, we reaffirm our guidance for the full year to be flat revenues to a low single-digit decline and expect 2Q '19 revenue to be flat to low single-digit decline from 1Q '19. We will continue to focus on maximizing gross margins in the choppy but stabilizing price environment. We will work to improve our working capital turns and generate positive free cash flow.

Before I move on to recognize one of our dedicated employees, I'd like summarize the progress we made in the execution of our strategy. We continue to focus on margin discipline, identifying opportunities for enhancement in areas related to our quotation process, as well as pricing, improving our operational efficiencies, optimizing our inventory and our sourcing strategy in response to import tariffs on steel products and leveraging our previous acquisitions through enhanced cross-selling of products in bundled product and service offerings.

We are adjusting our footprint in our supply chain, focusing on our central and regional distribution center's inventory strategy, optimizing our human capital, leveraging technology to enhance our replenishment settings and partnering with our preferred suppliers to grow market share. We approach capital allocation with discipline while leveraging our inventory investment, managing our working capital as a percent of sales with an increase in revenue, and maintaining a healthy balance sheet, which provides optionality in the event that one of the many companies we'd like to add to our differentiated product and service offering becomes viable.

With the further successful execution of our strategy, we expect continued improvement towards generating free cash flow, paying down our already low level of debt and creating greater shareholder value. With that, let me recognize one of our employees whose daily hard work and dedication enabled us to deliver on our promises.

44 years ago, [Ed Merit] started his career as a warehouseman for the oil well division of U.S. Steel in Houston, Texas. In less than a year, Ed was promoted to storeman, and in 1981 Ed moved to the purchasing area as a buyer associate, followed by a move to the front lines as a sales service representative in 1987. After spending several years in sales leadership roles, in 1998 Ed became an MRO coordinator and eventually moved to customer contracts for the distributions services group at National Oilwell. Today, Ed works as a pricing coordinator, where he works closely with sales, operations and material sourcing to help drive value for our customers.

One of Ed's claims to fame within close circles of our drilling customer community was winning a branding completion for our customer vendor managed inventory solution for land-based rigs or as our drilling contractor customers and employees know it today as RigPAC. Over the span of 44 years, it would be natural to have a few nicknames thrown at you to see what sticks. For Ed, two words rise to the top as his coworkers, colleagues and customers refer to him as Steady Eddy, a nickname that capture Ed's pride in his work, his commitment and attention to detail. Ed has had a life-long passion for horticulture and tends to his own orchard at his home in Magnolia, just north of Houston. If you are looking to win a content or find yourself in a chair wanting to be a millionaire and need to phone a friend who can name any tree, plant or flower, give Steady Eddy a call. Ed, thanks for your 44 years of service, your customer focus and for doing it the right way.

Now let me turn the call over to Richard to start taking your questions.

(Operator Instructions) And our first question comes from David Manthey from Baird.

Hey, Dave, a quick question for you. Last quarter you had some bad debt recoveries that offset WS&A and you said that it would have been 140-plus if not for those. And this quarter you have these lower bad debt charges, which I assume are lower accruals to a reserve account. The question is, is that a one-time adjustment or should we expect a sustainably lower accrual there? And I guess bottom line, is $135 million more representative going forward or the 140 level?

So in answering your first question, we had a $3 million net gain with a third party, which is something we've been working on for probably 6 years. So that benefit, you won't see that in future quarters. So while we posted WS&A at $135 million, it's easily $138 million. We are seeing more efficiencies, lower medical costs this year in the business. So we're hoping to bring that number down. I talked about in my comments. We expect WS&A to be $140 million or lower. Right now it's looking like it's going to be in that 138-140 range and we like to leave a little cushion there in case things percolate and things and the market gets stronger. But that's kind of where we're at.

Okay, so the $4 million is more a representation of something that you've recaptured as opposed to a sustainably lower accrual based on better experience?

Exactly, Dave.

Our next question on the line comes from James West from Evercore ISI.

So Robert, I think part of your business, the offshore part of your business has been -- well, to use it bluntly, decimated during the downturn here. I believe it went from a -- and these are rough ballpark numbers -- from probably a $250 million a year business to maybe $75 million at the bottom. But with offshore rigs going back to work now, I would think that they need to restock, that they probably are understocked on equipment-- spares, et cetera. So I think that would be a pretty big opportunity for you guys. How do you see that unfold? I know you just did a big whirlwind tour and met with many of the offshore operators during that tour. So what are they saying and how do you see that opportunity going forward?

Yes, so the number you suggested as far as our peak was a full-year number and it's dropped off quite considerably through all the rig stackings that have been going on. So the reason I don't expect much recovery in that market for us until 2020-ish is because as you know, there's about 30 or 40 more at least offshore rigs to be scrapped. And they will scrap them as they're putting other rigs to work. You know how that works. And so then they'll put that inventory to shore base and they'll start feeding the rigs that are either getting constructed or out there working. So for us, it's such a huge lag before it affects us, especially when we just went through an offshore decline like the one that's never happened before, like the one we just went through where there's so much spare inventory out there, they'll be burning through their own capital for quite some time. So while it will grow, I think our offshore revenue with both oil and gas companies and drillers bottomed in 2Q of last year. It's improving modestly and sometimes it's double-digit growth. But don't forget. It's coming off a really low base.

Okay, fair enough. And then as you think about the U.S. land market this year, the independents are going to be holding the line within budget, which is down a little bit year-over-year. Private is likely to respond to the oil price moves that we've had. And then you have these two major oil companies announce very ambitious plans. And so how does your customer mix stack up against that planning cycle and that budget cycle? And do you have -- could you be conservative, I guess, in your kind of forecasting for U.S. land if in fact the major oil companies do what they say they're going to do?

Well, the difference between the major oil companies and what I'd say is the medium to small independents is the major oil companies typically partner pretty strongly with a supply chain provider. And some of those majors are some of our largest customers. So it could benefit us if the right major is the one that goes to work. The part that gives me some concern is our biggest customers are supply chain oil and gas companies. And most of those, if you listen to their earnings calls so far this season, are toeing the line on their budgets. I mean one of them reported earlier this week and he must have said 10 times on the call, we are living within our cash flow. We're living within our cash flow. Our CapEx budget won't go up. I don't care where oil goes, we're not going to increase our CapEx budget. So there's so many dynamics involved in that that it's really hard at this point to figure out. Because even some of our big customers that have reported so far have announced they overspent budgets in 1Q and then said, but we won't overspend this year, which leads me to believe that their spend for the next several quarters is going to be lower than 1Q.

So if you've got the answer to what our customers are going to spend in the second half of this year, I've got a plane ticket for you to come and entertain us.

Our next question on the line comes from Marc Bianchi from Cowen.

I guess I'm curious to talk a little bit more about the gross margin commentary that you have here. You guys have been saying for a few quarters choppy and it has this quarter. I'm just curious, what do you think is the range when you say choppy as we look out over the next couple quarters? And how do you see this OCTG weakness that you alluded to kind of impacting that as we roll through the next couple?

Okay, so we've talked about gross margins declining for about 3 quarters now. And they held strong through the end of the fourth quarter and we had record gross margins of 20.5%. So this was a decline we had anticipated for some time. But somehow we were able to maintain growth in gross margin several quarters in a row. I think we had 4 quarters in a row over 20%. What that range is, I don't think we're really sure. I mean I think we did 20.1% in this quarter. It's going to vary in these coming quarters. But we don't expect major drops in gross margin. I think it feels like pricing may have stabilized. But that's going to depend on what happens in the market. If we see things slowing down, there will downward pressure on gross margins. If things start to -- if we start to percolate in the second half, we'll see some lift there. That's generally kind of how it's going to behave. But getting specific about the number, it's really hard to tell.

And regarding the question you asked about OCTG, we don't really distribute OCTG. But when the mills are rolling steel, they prefer to make OCTG over everything else. Because that's where they make most of their profits. So whenever they're really busy making tubing and casing, it's really hard to get a slot in the plant for us to get line pipe for replenishment orders. And they charge a premium for that pipe, because we're convincing them to stop rolling, where they make most of their profit. When it slows down and the OCTG is not filling up the mill, then they're more open to rolling line pipe and they're also more open to cutting better pricing arrangements with their suppliers, because they need the volume. So that's really how the OCTG affects all of our line pipe.

So Robert, to clarify on that, your point is that if OCTG prices are down there becomes more capacity for line pipe, which could perhaps help your gross margin. Is that really the point you guys are trying to make here?

No, what it does is it creates a deflationary period for line pipe. Because our moving average cost in our system for line pipe would be higher than what replacement cost is.

Yes, okay. And then just really a follow-up, you guys have been focused on the working capital wind-down here and really executing on that as best you can. We noticed in the proxy you guys increased the weighting of that metric in the annual comp, which I think inventors will applaud. But could you kind of talk about what the targets are there and how you see that unfolding over the balance of the year?

Okay, so working capital, right now it's 22%. We've had that a bit lower than that. We want to go lower. Aspirationally we've talked about this. We'd like to get down to 20%. Now we're in a period where customers are trying to live with budget. Everyone is trying to maximize cash retention. So our DSOs suffered a little bit in the quarter. Customers are holding onto cash. The real opportunity in addition to working closer with our customers to get paid faster, is to turn our inventory better. We're a little encouraged by -- although we had a use of cash in the first quarter of $20 million, it's better than the use of cash last year, which was $31 million in the first quarter. So we want kind of the quarters to behave similarly in 2019, like they did in '18, and we believe we can turn our working capital faster and get to more free cash flow in 2019 than 2018. But that's kind of our target and that's what we're shooting for. We're in kind of a sideways environment and it's harder to get there in this space.

Our next question on the line comes from Steve Barger from KeyBanc Capital Markets.

So I hear you on customers wanting to stay within budget or cash flow. But don't you view that as an opportunity to some degree, as a lot of your offerings are focused on lowering cost or just making operations more efficient? And how have you pushed the company to respond to the environment?

The long answer to your first question is yes. The answer to your second question is you're seeing some of that materialize in our business right now. So the two groups that would mainly be able to impact that for customers would be either the process group or the supply chain group. And supply chain group, you'd basically have to win a customer and that would be a big event. It wouldn't be just incremental. The process group is growing for that reason. So that's one of the big drivers, because we can start pre-modularizing the entire tank battery while the drilling is going on. And so while the drilling is going on and then the frack job is going on, we actually could have finished the entire tank battery and then it's all modular. And so when the frack crew leaves the well site, we can show up with our stuff, our kit, drop it down. It takes minimal time to plug all the stuff together. So where a normal tank battery might take 45 or 60 or longer days -- it depends on how many wells are on the pad -- we can have all of our modules on site plumbed in and producing and cleaning gas, oil and water and measuring it, and put it in pipelines in 3 days, 5 days, 7 days. So it's cheaper for the customer, because believe it or not, the modules that are made in our ASME shops and all of our ISO shops are higher quality. The net-net cost is lower, just straight up what it costs to fabricate it, because you don't have a bunch of crews on site with torches and welders and grinders. And customers get cash flow quicker, because instead of waiting 60 to 90 days to get cash flow, they get cash flow in short order. So that is one of the reasons why we're selling this kit right now to customers who have typically not been our customers, because they see the value.

Yeah, I mean and we talked about this before. It seems like that solution just should sell itself. So what is the pushback, if any, that you get when you're out offering that to new customers?

It's something that most customers haven't experience before. In fact, most customers say to us, they're like, I wouldn't even know you could do this stuff. So we have to sell them on that. Then you've got to get them into the shops and then they have to send their quality people into go through our shops and make sure we meet their quality standards. But literally most customers didn't know it existed. And that was usually the pushback that we got. But right now we're seeing kind of an acceleration of that. Our biggest issue right now is if you think about these solutions, you might have one shop that's fabricating all the skids. And then those feed other shops. Like the skid shop will feed the LACT unit ship. It will feed the oil, gas and water separator shop. It will feed the multiplex water injection pump package shop. So everybody is waiting on their skids to go to their shops, so they can finish the work. Another one of our shops that feeds all the other shops is our vessel shop and that's where we make the ASME vessels that are used for all sorts of stuff. All across, they're on LACT units. They're on the water injection pump packages. They're part of the gas, oil, water separators. They're at the heater treaters. All that stuff is waiting on a vessel to come to their shop, so they can complete their package. That's my choke point right now. So that's what I mentioned on the call. We're trying to find inorganic or organic ways to solve that choke point quickly.

And are you making progress on that front? Have you found a way to open up some capacity there?

I think so. Yes, I believe we have a solution that it will happen in short order.

And just holding the product pricing conversation constant, if you're successful in selling these value-added solutions, isn't that positive for gross margin over time in itself?

It is. There's no question about that it would be positive for gross margin over time. The one thing that works against us is the huge behemoth that's called energy centers that takes a lot of positive to move that ship upward.

Right. Right, and I think I missed this. But you made some comments about one specific downstream team that was really outperforming on inventory turns or margin. Any more detail on that and is that something whatever they're doing that you can spread across the platform?

Yes, well I do think we're doing that across the platform. But the leadership there has been particularly focused on improving their business in a meaningful way. And we've seen real positive results there. That's stuff is happening across the organization. But when we looked at the year-over-year most improved, that was one of the areas where that happened.

Okay, and just one last one from me. Alberta announced that railcar deal in late February. I think they expect to start shipments in July. Do the customers up there believe that's happening at that pace? And what's the real benefit to you when those trains start transporting oil?

Well, the issue with Canada, from an operator perspective, an oil and gas company perspective; is they just need to know that something is going to solve the problem. So even if somebody announced, okay, if BC agreed with Alberta, yes, you can build that pipeline to go to our coast; even if that pipeline would take a year and a half to 2 years to build, just knowing it's going to get done would spur activity. So if there's evidence that shows up that the rail solution is actually going to solve some of the problem, I think you would see increased activity. But don't forget. Shipping oil by rail is a lot more expensive than shipping it by pipeline. So the differential between what the oil and gas operator earns after paying to get that product all the way to the Gulf Coast is still not inspiring. It's just a lot better than where we are today.

Right. Still being better than being stranded.

Exactly.

Our next question on the line comes from Vebs Vaishnav from Howard Weil.

I just want to make sure I heard correctly the response to I think Marc's question about gross margins. Did Dave mean gross margins are going to be down sequentially? I just didn't want to put words in your mouth. I want to make sure I caught it correctly though.

No. I don't know that to be the case. What I said is we had said for some time we expected -- we saw our gross margins grow quarter after quarter. We saw records in the fourth quarter. We expected declines 2 quarters ago. And they occurred in the first quarter. What happens from here, we're not sure.

And Vebs, the reason why it's hard to forecast that is we're not dealing with some simple way to forecast margins. We do millions and millions and millions of transactions, like left and right. And so all of that has to settle out, so we can see where the margins are headed. So it's a really difficult thing to predict.

Yes, I don't think the variability is going to be wide. But it's going to vary. And we might -- so, I'll just leave it at that. I think it's going to be a little choppy, as we've been forecasting for some time.

I mean if it was down a little bit in this quarter or flat or up a little bit, none of those would surprise me.

Got it, okay. Just year-over-year, if I think about like the international piece of the business, everybody has been talking about mid-to-high single digits international growth. Is that a good ballpark to think about overall 2019?

No, not for us. So if you think about the process you go through when international activity picks up, so once an oil and gas company agrees that they're going to hire a drill ship and they're going to go out and drill some exploratory wells, and then determine later if they're going to go to development; the people that get that revenue first are the drillers and the people that build the subsea equipment and things of that nature. It doesn't materialize in my P&L until that development work is done. Yes, I'll sell the rig some stuff. But what I really need is to go into development. When the oil and gas company -- and there's more than 1 rig out there, start buying a product from us; MRO products and things of that nature, pipe valves and fittings. And so that's why I said -- I think I've been saying 3 years in a row, I didn't expect a material improvement in our international segment until 2020 or beyond.

Okay, and just thinking about Canada, obviously down 16% year-over-year, but there was some FX-related issues. Is a 10% to 15% down year-over-year Canada a good ballpark?

Yes, it probably is. It probably is. I mean we were down 11% in the first quarter if you take out the FX effect. So in U.S. dollars it could be in that range.

Okay, and just last question from me on tank battery. I think like you guys had announced like a 1-kit (inaudible) order lasts quarter. Just any uptake? Any more orders for the full tank?

Yes, so that particular customer was the first one that gave us a shot at delivering what I just reviewed earlier with James West and his question -- or not James, with the others, Barger on his question. So we delivered that complete turnkey battery. They wanted to test us. They really liked it and they've ordered several more since then. So I'm hoping as other customers find out that this is working for this particular customer that it will begin to become a more and more accepted solution, as opposed to the way we've done it for the last 50 years.

Our next question on the line comes from Nathan Jones from Stifel.

This is Adam Farley on for Nathan.

Is he down in Australia vacationing?

It's a busy morning for us. Hey, just turning back to U.S. process solutions, you guys called out pretty strong deliveries of produced water packages and some of the future drivers in this like midstream water space. So I was wondering if maybe you could like size that opportunity or at least provide some color on a high level, is this midstream water gaining more importance on the E&P capital spend?

Well, it is. And it's not just the E&P folks. There's some midstream companies that are in it and some pure water companies. Now the kinds of pump packages we sell into that market are generally some of the lower revenue packages. Because they're just ANSI centrifugal pumps generally. Where the exciting piece is and we've already got some orders lately from some large midstream companies, is once you get all that water to one spot which uses these small lower-cost packages, once you've treated this water you either have to recycle it which still uses more of these low-cost pump packages, or you've got to reinject it back down in the formation. And that's where the big pump packages come in. So we were successful last quarter in getting a nice order for a large midstream company that will take -- I don't know -- 5-6 quarters to deliver the whole thing. So there's some pretty positive stuff happening in that space. In fact, the supplier of these big high-pressure expensive pumps is one of our partners and they actually mentioned the order on their earnings call.

That's good to hear, and then just turning to M&A, maybe you just give an update on the space, valuations, where you guys are at and how's your pipeline, what geographies. Any color there would be great.

Yes, so you know it's now moved from a seller's market to a buyer's market, obviously. That's why almost all of our deals are usually done in a questionable period of market activity. And the inbounds are definitely higher than they were the last 18 months. And we've always got deals that we're looking at that we're constantly negotiating. But we just haven't closed any, because we're not willing to -- we're trying to be conservative with how we value these businesses. So we never could get over the [bid-spread]. Things look a little bit better right now. So we hope something will translate into success in that arena. And the good news is we have a super clean balance sheet. So we won't have any concerns around leverage or anything like that.

And is that -- are there certain geographies that you're looking at or maybe add something to -- like a bolt-on to U.S. process solutions or any ideas there?

Yes, so our stated strategy around M&A is for anything that we need to do in Canada or the U.S. for our energy center business or our U.S. supply chain service business is going to be organic, generally, unless some deal comes along that we just can't turn down. So they can have access to the balance sheet as they come up with great ways to grow their business organically and we will fund that for them. If we do anything else in the U.S., it will more than likely be U.S. process solutions. And then outside of the U.S. and Canada, we're kind of open to anything that we do that's core, whether it's process equipment, supply chain investment or in the energy center branch. Because we're in some 20-some odd countries that have all their own corporate offices, because you have to have them in all these countries. So you have all this overhead. And so if you can acquire companies that are part of our core service and product offering and tuck them up under that corporate office, you can get some pretty nice flow-throughs on that stuff. So generally that's kind of our planned approach to capital allocation, as it applies to acquisitions.

Our next question comes from Sean Meakim from JP Morgan.

I was hoping we could get some more detail around the midstream. It seems like it's becoming a little more prominent in your messaging to the market. To what extent did some of your working capital build relate to what's going to be probably a pretty busy construction season in 2Q and 3Q? And then long term, how do you think about -- and I recognize that and we've talked about this in the past that to some degree you may not as explicitly distinguish up versus midstream. But how do we think about the long-term potential of that end market in terms of projects in the next couple years versus long-term maintenance and more steady work?

Yes, so we've always been in the market, obviously. But we've experienced as of late, which was part of the original plan, is we now have access to things that we didn't before that are part of the entire project. So for example, I'm talking about our process solutions group. We never had LACT units before. That's what measure oil when it goes in the pipeline. We never had the gas measurement systems. We never had the vapor recovery units. All this stuff that a midstream customer who used to go to us or our competitor to get all the pipe, valves and fittings. Then they would go to another supplier to get all the equipment that goes in, like the pig launcher, receivers and things like that. Now if we can get up front the actual equipment that they're going to use on these pipelines, we can typically cross sell all of the material that's needed to construct or put this material into the pipeline. So we're seeing a lot of success on cross-selling between U.S. supply chain services and U.S. energy centers by them coordinating with our U.S. process group to bring in a bigger package and offering the end user a better economical opportunity to bundle the whole thing. So that's why we're seeing some success in our midstream market greater than normal. And that also includes the fact that when we got process solutions. Before, we didn't have the ability to a valve modification and things like that. We had to outsource that work. Now we're doing that all in-house. So we're getting nice valve and valve actuation orders, because we have the ability to turn down a ring joint into a race face or whatever, as opposed to waiting on valve deliveries of 38 and 40 and 45 weeks. So all that stuff coupled together and the teams working together it's what's kind of spurred this nice growth for our midstream customers. And literally, we have all sorts of businesses. We've got all sorts of markets, whether that's downstream or midstream or upstream, or artificial lift, or electrical or whatever. I really expected 1Q to be down where you guys forecasted it. Because we had a decline in completions in 4Q. And you know there's a lag and so I expected the completion decline in 4Q to translate into revenue declines in 1Q, fully expected it. What happened is that actually happened. Revenue tied to completions went down. Our midstream growth offset it.

Very interesting, yes. It makes a lot of sense. And then I guess it would be good to get an update in terms of where we are on your inventory. We've had tariffs coming in last year. We had some inflation running through the system. At various points that was a net benefit for the distributors. So where do we stand today in terms of where your inventory sits versus where spot is across high business or kind of key sensitive product lines? It would be great to give a sense of where we stand on that end and the look forward.

Well, what I would say in terms of inventory, Sean, is obviously the period of strong inflation -- we went through a period of deflation for a couple years and then finally we saw a nice pop for several quarters, mostly driven by steel, punctuated by pipe. That period is over. We're starting to see some pullback in pricing on welded pipe in particular and seamless pipe otherwise, where replacement cost is close to our inventory cost and in some cases lower. So that's kind of leading the downward movement in margins for us in the first quarter. So we're trying to manage our inventory to mitigate the effects of that change in pipe costs. But I think that will stabilize once we burn off that inventory.

Ladies and gentlemen, we have 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.

I appreciate everyone's interest in our earnings call and the discussion about the business and look forward to talking to you in about 3 months regarding our 2Q performance. Thanks.

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