In general, spinoffs have outperformed the S&P 500 in their first few years of trading. There are two recent articles on GuruFocus providing information on spinoffs and their outperformance:
Not all spin-offs are setup to succeed. You do not want to end up with companies like Patriot Coal or Orchard Supply Hardware that are doomed for bankruptcy. In Ross’ article, he gives four characteristics to look for: Management Moves, Insider Buying, Stock-Based Compensation, and Debt Level.
Now Inc (DNOW) is a recent spinoff from National Oilwell Varco (NOV), and it meets most of the criteria for being successful. The company is an industry-leading provider of pipe, valves and valve automation, fitting, mill and industrial supplies, tools, safety products, and artificial list systems to the upstream, midstream, and downstream and industrial markets. It also provides supply chain management solutions to energy and industrial manufacturing companies around the world.
Let’s take a look at how it has the characteristics to be a successful spinoff:
The parent company, National Oilwell Varco, has been an industry leader for years. The stock is up 481 percent over the past ten years. Earnings have increased at an annual rate of 24.50 percent over the same time period. The stock has also been one of the top net buys of the investing gurus in the latest quarter. The person who has led NOV during those years has joined Now Inc as the Chairman of the Board. Pete Miller was the Chairman at NOV since 2005 and its CEO since 2001. The rest of the executive management comes from high ranking positions within NOV. The management of NOV, especially their Chairman and CEO, would not leave to join Now Inc if they did not think that the company would succeed. Pete Miller leaving NOV to lead Now Inc is the type of move that would equate to Eddie Lampert leaving Sears Holdings to lead Land’s End. It’s a big deal.
Peter Lynch in his book “One Up On Wall Street” says, “A month or two after the spinoff is completed, you can check to see if there is heavy insider buying among the new officers and directors. This will confirm that they, too, believe in the company’s prospects.” There has been no insider buying for Now Inc, but it has only been trading for a month. Although there has been no insider buying, there has not been any selling either.
Employees of the new company have received stock options and restricted stock that generally have a vesting period of three years. In addition, certain members of senior management were granted performance share awards with potential payouts between zero to 22,247 shares. That’s a huge payday if they meet their performance goals, so it gives senior management plenty of incentive to succeed. Rather than being short-term, the performance goals are based on a three-year period. The performance metrics are dependent on two independent parts, total shareholder return and internal return on capital.
Now Inc was spun off with $175 million in cash and zero debt. That is a great sign for the company. The previous bankruptcy examples I mentioned were spinoffs with large amounts of debt. Peabody Energy spun off Patriot Coal with an unsustainable pension liability and Sears Holdings loaded up Orchard Supply with $405 million in debt after collecting a $450 million dividend from them right before spinning them off. Now Inc has almost no chance of any financial problems with its clean balance sheet of no debt and pension liability.
We can see that Now Inc has the foundation to be a successful spinoff, but what is the plan from here? In a recent investor presentation, it lists its strategy for growth as:
- Energy Branches: Organic Growth
- Increase presence in non-conventional energy plays
- Continue market share gain in the U.S. and Canada
- Further expansion to and within new markets outside the U.S. and Canada
- Supply Chain Services: Growth through Capital Allocation
- Further penetrate downstream & industrial
- Expand product lines such as valves / actuation, safety services and electrical
- Rapidly grow market share with manufacturing customers
- Future Opportunities
- Broaden scope and reach of industrial offering: Industrial MRO, OEM supply, New product lines, New end markets
- Equipment rentals
The parts distributing market for the oil and gas industry is highly fragmented with Now Inc controlling 19 percent of the market. Its largest competitor is MRC Global with 24 percent of the market share. Nearly half of the market is made up of mainly small, local/regional players. Now Inc has the scale and the expertise to attract more of the market. A big opportunity for growth is acquisitions. MRC Global has been making acquisitions, but has a large amount of debt that could slow down its inorganic growth. The debt is still manageable with an interest coverage ratio of 5.14, but Now Inc has no debt and is looking to expand.
The future opportunity that is most interesting to me is the idea of equipment rentals. United Rentals (URI) is the number one player in the industry and has a market cap of $10.11 billion. The market cap of Now Inc is only 3.82 billion. Although United Rental has the highest market share, it is only 12 percent of the total market. The next two competitors have less than half of United Rental’s market share at 5 percent each for HERC and Sunbelt. That means that 78 percent of the market is highly fragmented with plenty of opportunity to gain market share. Plus, the rental industry is expected to grow at an 8.8 percent compounded growth rate. Heavy equipment rentals also have much higher operating margins that are 4 to 5 times higher than the distribution business. The downside to the rental business is the large capital expenditures that are needed. Now Inc typically has very low capital expenditures with a goal of only $10-$20 million for maintenance capex.
When valuing Now Inc, we can look at its closest competitor for a comparison. MRC Global is currently trading with a P/E ratio of 22.80. Using the most recent data, Now Inc’s P/E is at 26.28. The difference between the two companies is that MRC’s earnings have declined by nearly half compared to the first quarter of last year while Now Inc’s earnings are shown as flat. Both companies are expected to grow at 20 percent rates in 2015 according to the average analyst estimates. With a full year earnings expectation of $1.53 per share in 2014 for Now Inc., it needs to grow at a rate of 16.49 percent to justify its current price. With a clean balance sheet, available capital for acquisitions, a solid reputation, and a strong management with long-term performance incentives, Now Inc has the potential to grow at a faster rate than 16.49 percent. At a 20 percent growth rate, the stock is valued at $43.56 using the GuruFocus DCF Calculator with 2014’s expected earnings. The stock is trading at $35.29 today, June 25, 2014, making it undervalued. So far the stock is up about 26 percent since it started trading last month on May 20.
Ahead of the spinoff, the investing gurus have been buying up shares of National Oilwell Varco. It was one of the top net buys of all the gurus for the first quarter of 2014. It is currently held by 30 gurus we are following, including Warren Buffett, David Einhorn, Ken Fisher, and Tom Gayner. There have not been any reported sales of the stock, yet. You can monitor the guru trades for Now Inc at GuruFocus.