Welcome to the third quarter earnings conference call. My name is Angela and I will be your operator for today's call. [Operator Instructions] I will now turn the call over to Senior Vice President and Chief Financial Officer, Dave Cherechinsky. Dave, you may begin.

Thank you, Angela. And welcome to the NOW Inc. Third 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. 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 third 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 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 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 third 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 everyone for taking the time to join us today. We're encouraged that our energy and industrial distributor value proposition is bearing fruit as the market is realizing the full scope of our products and services, kitted industry applications and supply chain offering DNOW delivers to our customers. We are uniquely positioned to help our customers reduce their total supply chain costs by offering a combination of models suited to each customer's requirements where we provide application know-how, material availability and quality products through our multi-channel engagement model. Our energy centers are strategically located with inventory to meet our customers' demand, demanding drilling and production schedules, as well as gathering and transmission projects while leveraging our global sourcing and replenishment infrastructure. Our supply chain services solution delivers value through a one-to-one integrated relationship partnering with the customer to drive efficiency, eliminate waste and minimize capital. Where we manage key portions of customers' supply chain, we often work alongside their personnel on their premises to source goods and solutions from suppliers, manage their warehouses and logistics, minimize product supply chain costs and risks, reduce their SG&A and eliminate duplicative capital employed. We see customer value expand with our bundled offerings where we provide kitted solutions of modular turnkey solutions for rotating equipment, valve actuation and process and production equipment from our process solutions group designed to meet customers' specific applications. We were pleased to see the U.S. market fundamentals hold firm in the third quarter with WTI averaging $70 per barrel; U.S. rig averaging 1,051, up 11% year-over-year. Our global revenue per rig for annualized third quarter remained at approximately $1.5 million per rig. We finished the third quarter of 2018 with revenue of $822 million, up $125 million, or 18%, year-over-year. U.S.…

Thanks, Robert. For the third quarter of 2018, we generated $822 million in revenue, up $125 million, or 18%, from the same period in 2017 and an increase of $45 million, or 6%, sequentially. This marks the highest revenue level since early 2015, the onset of the prolonged downturn. In the quarter, gross margins reached 20.4%, our highest post-spin level. Gross margins are up 100 basis points from the third quarter of 2017 and up sequentially from 20.2% This better-than-expected sequential improvement was driven by success in our initiatives to push price in a growing market, improve margins on peripheral products like fitting and flanges, an off-shoot to improved steel pricing offset by expected pipe pricing stabilization in pipe margin contraction like we expected and pricing gains in Canada coupled with the solid revenue gains in the period in that segment. While we believe there's room for gross margin gains over time, expanding when commodity inflation occurs and our market expands further, we expect the gross margin percent to fluctuate in the short term. Warehousing, selling and administrative expenses, or WSA, was $142 million. We've been intentional about reducing these costs relative to each additional revenue dollar earned and have reduced WSA as a percent of revenue from a high of 28% during the downturn to 17% today. And we are working to drive efficiencies and improve these numbers further. We are serious about adapting our footprint to a constantly evolving 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 year-over-year, when considering the locations closed in the last year, the revenue generated in those locations approximated $20 million more in 3Q '17 than in 3Q '18. While we did retain a portion of…

Thanks, Dave. Let's wrap up with the outlook for the fourth quarter of 2018. Our outlook is tied to global rig, drilling and completion expenditures, infrastructure and pipeline buildout and downstream projects particularly in North America. Oil prices and U.S. storage levels will continue to be primary catalysts for determining both land and offshore rig activity as well as all of the other end markets required to transport and process product after it is extracted from the formation. Our approach continues to be to advance our strategic goals and manage DNOW based on current and projected market conditions. We remain cautious due to seasonal budget exhaustion, holidays and reduced billing days in the fourth quarter of 2018 that could be amplified by a temporary slowdown in the Permian and Canada related to takeaway constraints and widening WCS-WTI differentials, which could extend into early to mid-2019 when planned pipeline projects are completed. Some customers have already achieved production targets for this year in certain basins and there is also the pending vote on Colorado Initiative 97, which, if passed, could impact our activity in the DJ Basin in 2019. Even though activity in North America land has rebounded from the depths of the market collapse that began in late 2014 yet still remained about half off prior peak, we have yet to experience a recovery in the offshore market. While there are some promising signs that the offshore market has bottomed and may recover soon, I believe we are still at least a year away before deepwater activity begins to materialize in our top line. However, the jackup market is tightening, day rates are rising and contracts are being awarded. Recently, we were selected as the supply chain partner for a drilling contractor for new build load-outs for the rigs currently…

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Nathan Jones from Stifel. Please go ahead.

Well thanks. I've just got a question on the -- both Dave and Robert, you made comments that your maybe gross margin could be a little choppy here over the next couple quarters. Can you talk about what drives that? What are the inputs that have the potential to put a little bit of choppiness into that gross margin number?

Well, if you remember from our last call, we actually guided third quarter gross margins down. So we expected a little bit of a dip in the third quarter, but we were pleasantly surprised by many things that happened. In Canada, we saw a gross margin improvement, for example, and they represented more than half of the growth in the period. We saw pipe margins go down in the third quarter, as that pricing there has stabilized and inventory costs have come closer to replacement cost and pricing there. So that was kind of an offset. But we saw margins in our fittings and flanges product category improve. So it's just kind of a -- I consider it more of a gravity question on we've had such nice gross margin progression. In 2016 we had 16.4% gross margins. Today, we have 20.4%. I just expect a little bit of correction. We're going into a seasonal decline, as Robert mentioned, so I think we'll see our competitors being a little more scrappy in the area. So I think there will be some downward progression there. But as the market continues to expand, as we see commodity prices expand, as we expect because we've seen many years of deflation, I think we'll still see an improvement in gross margins. But we generally see ups and downs there, but the trajectory is still positive.

Okay. So maybe down a little bit in the fourth quarter because you've got seasonally lower volume. But there's nothing really underlying this that should concern us. It's just maybe a little bit of choppiness, but over time you're still seeing some opportunities to expand those further.

Yes, and I think the main drag for the fourth quarter is simply reduced revenue opportunities in the market so our competitors get a little more aggressive on pricing.

A follow-up question here on process solutions. I think you said that that business was up 38% year-on-year. I know, Robert, when we were on the road, you were talking about potentially gaining some more traction down in the Permian and basins near that. Of that expansion, it's 38% there, can you kind of give us a little color on what is just market expansion versus you taking some of those businesses and expanding them to places that they haven't been before and the traction that you're gaining there on the turnkey tank battery solutions?

Yes. So just one little correction. I think I stated it was 34% year-over-year. Just not that it's that big of a deal. But so this business, process solutions, is really 2 of our big acquisitions, Odessa Pumps and Power Service. And they're currently running revenue right now at their 2014 peak at half the rig count. So clearly we're making traction on expanding the product and service offering from that business into other plays that they didn't participate in before. That's the only way you can achieve the same revenue at 1100 rigs that you were having at over 2000 rigs. And the good news is we're not anywhere near max-ing out our ability to continue to penetrate other markets. So that group just takes a little while to get everybody trained. You've got the combination of all the Odessa Pump service people, who understand rotating equipment, and you combine -- you get them trained and get them teamed up with the Power Service people and you start making some pretty good traction. We're pretty excited about where that's headed so far and where it's going to go in the future. We have gotten some orders from customers that typically DNOW as a company hasn't traded with in the past, which is really good news because there's pull-through available there for our other business units. And we have received several orders for complete turnkey tank batteries. So we're excited about what we've achieved so far, but we're even more excited about what it might look like on the other side of the year.

Okay. I've just got one more. You guys have some pretty good visibility into certain of your large customers through the supply chain services business. Without talking specifically about any one customer, do you have any kind of indication of spending plans for 2019? Just any broad ranges of what you think spending might be up with some of those customers domestically? Any kind of color you can give us there on your current outlook to 2019?

Well, our customers that we're -- we have, with those 4 big operators, we're in their project teams, their engineering departments, their procurement departments. So you would think we could get some information that you wouldn't normally get from your regular, everyday customers in our branches, but they're really good at making sure we don't get insider information. So we really don't have much visibility into what the budgets are going to be for next year. As hard as we try to get some inkling of an idea, we have been unsuccessful in getting any kind of feedback. So no, I wish I could tell you something, but there's really nothing that I know on my end of the equation to share with you.

Our next question is from David Manthey from Baird.

So I was wondering about the DUCs. This obviously represents a future opportunity for you. But is there any reason that the 8,000 you see today couldn't become 10,000 or 20,000 over time? And the question is just; is this a cyclical thing or is it becoming structural? And if you could just help me understand. Is there anything technical or a reason why that couldn't go to that level?

Well, if you'd asked me a year or 2 ago, could we get to 8,000, my answer would have been no. So I would have gotten that one wrong. Really right now, most of the activity is in the Permian and they have -- customers have two choices; wait for the pipelines to be completed and pay X dollars per barrel to get the product to market or take it by train or truck and give away a lot of the spread that you would normally make through a pipeline. So they're basically just using their formations as storage until the pipelines arrive. So I literally am 100% convinced that customers aren't paying a drilling rig to drill a well and don't plan to produce that well. That is not happening. So these 8,100 or whatever the number is, I forget exactly, DUCs that are out there, they're going to get completed and then start producing whenever the issues resolve themselves and customers can find an economically feasible way to get that to the final destination.

Okay, thank you. And as it relates to your current capabilities and ability to cross-sell solutions, coming out of the spin, acquisitions were a big part of the story here, which kind of dissipated with the downturn. And I'm wondering; at this point, do the lines between acquisition target health and price expectations, are those starting to intersect at a more attractive level today that make acquisitions more likely for you or no?

Actually, the downturn is when, for us, when we had the most success doing acquisitions. We did, it was shortly after we went public that the downturn showed up and we did I think 12 deals during that suppressed period. What we're finding recently up until last quarter or so that we just can't get aligned with the target company around what an appropriate value would be. However, our pipeline right now is as robust as it's ever been so I wouldn't count out in this kind of period of uncertainty we're going through with takeaway issues and oil now that is $65, the target companies won't get a little more reasonable on what they think the value is of their business.

Thank you. Our next question is from Steve Barger with KeyBanc. Please go ahead.

Good morning guys. This is Ryan Mills on for Steve. Congrats on the quarter.

Thank you.

Yes. Just wanted to start with tariffs. Can you give some detail around your COGS exposure to China and steps you're taking to manage the impacts as well as the tone from customers when you have conversations on pricing?

Well, in terms of tariffs specifically and in China in particular, I think like our pipe content from China is probably near zero at the moment because of tariffs and we've simply shifted most of our sourcing from import pipe manufacturers to domestic and domestic manufacturers have followed suit and effectively have matched the tariff prices smartly. So, they've been able to improve their margins that way. Now how we manage that in terms of conversations with customers, our customers see what's happening in the market. These are commodities that are traded very openly and they could see what's happening with pricing. So while we have some contracts that limit when we can push through price increases and that kind of stuff, we negotiate with customers in those cases otherwise we have contracts that are pretty fluid. Our product costs ultimately get reflected in higher product cost as we see inflation. So, that's obviously a negotiation with some key customers otherwise our contracts protect us generally.

Okay. And then solid incremental flow through in the quarter and year-to-date and I know you said 4Q's going to be seasonally lower, but I'm looking out to 2019 and thinking about tough comps. So I'm just curious can you maintain these high teens to low 20% incrementals in let's say a high single-digit, low double-digit growth environment?

Well, I would say that it depends on the rate of growth. We've had, we've had premium flow throughs for the last few years. 2016 to 2017 we had flow throughs of excess 30%, I think nine months 2018 to 2017 we're above 20%. Those are premium flow throughs. Now we've been very intentional about pushing price and we've talked pretty exhaustively about that, but it depends. If we see modest growth, I think the opportunity for improved gross margins becomes limited. If we see more strident growth, I think the opportunities are strong. But I think it's a matter of the rate of growth that's going to drive that result.

And I would add to that, it also depends where the growth happens. We have, our international arena has been at basically breakeven or little bit better for a while because it's waiting for the market to come back. And we in that infrastructure can handle a lot more revenue with a lot, without a lot more expense. So, it really depends on where the growth occurs.

Okay. Then one last question for me. Balance sheet remains strong, free cash flow remains positive. So I just want to ask about the M&A pipeline. Are you exploring more deals? And what areas are you focusing in on?

We're still focused on the same areas we've always said. So in the States, we're really honed in on things that would augment our process solutions group. And then outside of North America, we're pretty much interested in any acquisitions that strengthen our competitive position in any of our businesses. So we're looking at valve actuation businesses. We're looking at more pump distributors. We're looking at everything that would fit well within our process solutions group.

Our next question is from Walter Liptak from Seaport Global. Please go ahead.

This is Steve Friedberg filling in for Walt. Looking at the EBITDA as a percentage of sales, and I see you guys are at 4% kind of this early in the recovery, energy recovery. Is there a new normal of or I guess new baseline for once the energy cycle returns or fully returns? Is there, I guess, new level? Do you think you guys can get to, or at least get back to, 8% again?

Yes. I still live in the same place that I've been since late '14, early '15 when we went on the road. I mean, in fact, I believe that our 8% target when we're at the peak of the cycle is just as achievable today as it's ever been. We've got some businesses that are part of the company now that would definitely help us achieve that goal that weren't here back in '14 and '15. So I think it's still that, there's always going to be extreme peaks and extreme busts that we really don't forecast what the bottom and top of the margins could be, but in a regular cycle of business, which any time you use the word regular in the oil and gas industry it's almost like an oxymoron, but in regular cycles, I still think it's in that 3% to 8% range.

Okay, great. And then one more quick one. I think, or looking at the receivables, it jumped pretty high in the quarter. Are you guys having any trouble with customers paying on time?

Well, no. So in the quarter we had the biggest, the longest month of the 3-month period was August. And we had a very large billing month in August. And that's the main driver for collections not happening until early October in the month of October. So I expect a correction to DSOs more like what we produced in Q2. But if you look at our days to pay per customer, it's a little bit different metric than DSOs, it's pretty consistent. It's just a timing issue. We had a very large billing month in August, a long business month, and we'll be collecting those bills in October. So I think we're going to self-correct in the fourth quarter.

Our next question is from Sean Meakim with JP Morgan. Please go ahead.

So Robert, I want to maybe talk a little bit more about the Permian. You noted that you're taking share. It sounds like process solutions is kind of finding its legs there. You mentioned the major integrated customer you picked up as well. Are you seeing any changes in terms of customer desire for turnkey type of solutions? We've seen some other product lines here or some lateral service and equipment providers where maybe there is a little more desire for that when the solution seems to make sense to the customer. Any shifts in how customers are perceiving that? Is that helping you? How would you help us kind of frame that out?

Yes, it's a progression. So when we first bought Power Service, and if you recall, we bought them after we'd acquired Odessa Pumps, and our goal was to use the infrastructure of Odessa Pumps in the Eagle Ford and the Delaware and the Midland and the SCOOP and the STACK and the Mid-Con to accelerate their ability to get product into those basins. Because before, they were mainly in the Niobrara, Northern Colorado to the Bakken in North Dakota. That was kind of their backyard. That's where most of their revenue was. Customers started giving us -- putting their toe in the water. And one customer would order 20 LACT units, and one customer would order 22 oil and gas water separators with a gas measurement system, and one customer would order 15 water injection pump packages. And so they would go to a particular product and see; can we make delivery? Is the quality going to be there? [Indiscernible] And as we've earned our stripes with these customers, now they're ordering 2 or 3 or 4 pieces. And now we have some customers are ordering the whole kit. So I would hope on this call next Q4 we're talking about how customers are generally just ordering the entire tank battery. I doubt that we'll be that successful, but if we have the same progression the next 4 and 8 quarters that we had the last 8 quarters, it's going to be a great story to tell.

That's really helpful. And good to see all that progress there. Maybe -- I don't think we've talked much about the midstream. Could you give us a sense of how things are trending there? Obviously there's a lot of activity particularly around the Permian as folks are trying to expand takeaway capacity. It's not necessarily been a big part of your business as far as on a mix basis, but it's certainly a pretty strong opportunity set. What are lead times looking like? What's -- I mean thinking about the difference between MRO type of work versus new projects. Can you help us kind of frame out that part of the opportunity set?

Yes. Midstream actually is a big piece of business for us. We just report it along with our upstream business as one unit. Probably the biggest driver of our revenue improvement in 3Q was our midstream market. And it wasn't just with the big midstream firms that do the trunk lines. It was a lot with gas gathering and NGL processing and gas plants and all that midstream work that goes in the field itself. So we were pleasantly surprised how well it improved. And yes, lead times are growing. Pipe lead times are longer. Valve lead times are longer. So we're trying to get ahead of all that by ordering inventory. Some of these valves -- in fact, not just some of them -- a lot of these valves are running 30, 35, 40week delivery. So we have to get ahead of that if we want to take share. And so we've been doing that.

So it's fair to say that midstream has probably been accretive growth to the overall upstream energy branch business?

Absolutely. I mean and a lot of our midstream sales will go to an oil and gas operator who's doing their own midstream work. So like, for example, our supply chain group, you know the 4 clients that are in that bucket, and a lot of those guys did midstream work in 3Q that benefitted us.

Got it. Now, I think that's really helpful. And since I'm kind of late in the call, maybe I'll sneak one more in. And thinking about offshore. So it's been a big drag on the business for several years. And one of the larger offshore drillers now is hosting a call opposite yours and everyone is getting pretty excited about activity, at least rigs going back to work. You're expecting the day rate. Rigs go back to work, that's generally good for your business. Maybe could you tell us how you see inventories among that customer base? Do you have a good visibility into how much they destocked the last couple years? And therefore as rigs start to get back up and running things may go back the other way on a restocking type of cycle. How does that look for you?

Yes. I would separate the conversation into deepwater versus the shallow water jackup market. Shallow water jackup market started to recover before deepwater. And we're starting to see some nuggets of gold in that market. So that will help our international operations and our export group. Deepwater, there's a lot of positive stuff being said by everybody, whether it's Noble, ENSCO, Transocean, whoever. The problem is I think they will all tell you, every one of those CEOs, and I know you know them, that they probably still have more rigs to scrap, which won't be -- won't bode well for people who are trying to sell them product. So that's why I say that we're probably a year away from getting deepwater semis and drill ships to impact our top line, even though most of those folks are telling you that they're putting rigs back to work in 1Q and 2Q, which is good because they'll start burning through these inventories. And it could -- it highly likely could end up being that they get through any duplicative inventory some time in '19 because -- just because they scrapped a drill ship and put their OEM spares in the shore base doesn't mean those OEM spares can go to another drill ship because they may have different top drives, different mud pumps, different draw works. So we'll get benefit there too. I'm just, I'm in the glass-half-full -- or half-empty boat right now when most of my guys are in the glass-half-full boat. So I'd rather be pleasantly surprised to the upside than get all excited and find out it's not going to materialize.

Our next question is from Blake Hirschman with Stephens.

Just real quick, kind of wanted to circle back to the DUCs. So the way it kind of sounds like you expect this to play out is that operators probably move some rigs out of the Permian in the near term, but that you would expect those to return to the Permian at a time when additional pipeline capacity comes online, which, at this point, is kind of sounding like the second half of '19.

Well, kind of what's happening so far -- in this industry, my information is only as good as today because it will change tomorrow. But what's happening so far in the Permian is operators aren't necessarily laying down rigs per se. They're still drilling wells. So they're creating inventory in the ground, waiting on the pipelines. So what they're doing is they're postponing completing that well, fracturing the formation to get the oil and gas and water out of the ground, until the pipelines are there. So what I would suggest is going to happen is that once the takeaway issues are resolved and there's ample opportunity to economically get product to market, customers -- or operators -- are really going to focus a big part of their budget on the completion work so that they can take advantage of all this inventory they have in the ground for wells that are already drilled, which will be a really good event for our business because that positively affects our supply chain group, our energy centers and our process solutions group. Because once the oil and water gas come out of the ground, you've got to separate that stuff and you've got to treat it and you've got to measure it and you've got to pump it in the pipeline. And that's our wheelhouse right there. So I'm pretty pumped up that they're still drilling wells because they're not drilling them for practice; they're planning to produce them. And when they start producing them, it's going to be good for us.

Got it. All right, that's helpful. And then just one more, I guess, on the tariffs and with the strains on sourcing and the quotas that are out there, I assume you're probably in a much better position to deal with that than the smaller peers that you have out there. So would you kind of expect this to result in some share gains maybe above market growth due to the more scope and kind of having less issues than the competition?

Yes, I think there's a lot of things that benefit the large distributors versus the smaller players. I mean not only having all these sources, I mean our sources are all over the world including the states, but in order to, when you have a situation where all these tariffs are hitting and these sections are hitting and that drags out lead times, you have to have the balance sheet from which to make some pretty big commitments to have product available for the customer. And if your small independent competitors don't, which there's a thousand of them out there, then you're going to take share in that scenario as well and I think that's already happening. I don't think it's going to happen, I think it's already happening.

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'd like to again thank everybody for calling in and your interest in DNOW and look forward to talking to you about our full-year results in February. Thank you.

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