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Edited Transcript of DNOW earnings conference call or presentation 3-May-17 1:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 NOW Inc Earnings Call

Houston May 5, 2017 (Thomson StreetEvents) -- Edited Transcript of NOW Inc earnings conference call or presentation Wednesday, May 3, 2017 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Daniel L. Molinaro

NOW Inc. - CFO and SVP

* David A. Cherechinsky

NOW Inc. - CAO, VP and Corporate Controller

* Robert R. Workman

NOW Inc. - CEO, President and Director

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Conference Call Participants

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* Andrew Edward Buscaglia

Crédit Suisse AG, Research Division - Senior Analyst

* Charles Matthew Duncan

Stephens Inc., Research Division - MD

* Charles P. Minervino

Susquehanna Financial Group, LLLP, Research Division - Senior Analyst

* David John Manthey

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Sean Christopher Meakim

JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst

* Vaibhav D. Vaishnav

Cowen and Company, LLC, Research Division - VP

* Walter Scott Liptak

Seaport Global Securities LLC, Research Division - MD of Diversified Industrials and Senior Industrials Analyst

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Presentation

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Operator [1]

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Welcome to the First Quarter Earnings Conference Call. My name is Sylvia, and I'll be your operator for today's call. (Operator Instructions) I'll now turn the call over to Senior Vice President and Chief Financial Officer, Dan Molinaro. Mr. Molinaro, you may begin.

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Daniel L. Molinaro, NOW Inc. - CFO and SVP [2]

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Thank you, Sylvia, and welcome, everyone, to the NOW Inc. First Quarter 2017 Earnings Conference Call. We appreciate you joining us this morning, and thanks for your interest in NOW Inc. With me this morning is Robert Workman, President and CEO of NOW Inc.; and Dave Cherechinsky, Corporate Controller and Chief Accounting 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 throughout our conversations this morning. Before we begin this discussion on NOW Inc.'s financial results for the first quarter ended March 31, 2017, please note that some of the statements we make during this call may contain forecasts, projections and estimates, including, but not limited to, comments about our outlook for the company's business. These are forward-looking statements within the meaning of the U.S. federal securities laws based on limited information as of today, which is subject to change. They are subject to risks and uncertainties, and actual results may differ materially. No one should assume that these forward-looking statements remain valid later in the 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 regarding these as well as supplemental, financial and operating information may be found within our press release on our Investor Relations website 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 GAAP, you'll note that we disclose various non-GAAP financial measures in our quarterly press release, including EBITDA excluding other costs, net loss excluding other costs and diluted loss per share excluding other costs. Each excludes the impact of certain other costs and, therefore, has not been calculated in accordance with GAAP. A reconciliation of each is included in our press release. As of this morning, the Investor Relations section of our website contains a presentation covering our Q1 results and key takeaways, which should assist you in understanding our first quarter performance. A replay of today's call will be available on the site for the next 30 days. It also should be noted that we plan to file our first quarter 2017 Form 10-Q later today, and it will also be available on our website.

Later on this call, I will discuss our financial performance, and we will then answer your questions. But first, let me turn the call over to Robert.

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Robert R. Workman, NOW Inc. - CEO, President and Director [3]

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Thanks, Dan. Solid sequential revenue growth in Q1 2017 of $93 million was driven by rig count improvements from late Q3 and early Q4 of 2016, bolstered by recent contract awards. Due to seasonal breakup in Canada, we expected to reach breakeven EBITDA in the latter half of 2017. However, it appears that U.S. growth could be enough to offset Canadian breakup, and we could reach those revenue levels sooner than we anticipated. For this reason, we might reach breakeven EBITDA, excluding other costs, in Q2 of 2017 if normal seasonal declines in Canada aren't more pronounced than years past and product margin gains hold up.

Looking at the quarter, Q1 2017 represents the third consecutive quarter of top line improvements, driven primarily by the recovery in North America. Canada and the international segments are profitable in the period. All of our balance sheet metrics are tracking as planned. We have more cash than debt, again, and we're nearing an important psychological segue into EBITDA profitability.

Revenue per rig for the quarter, both with and without acquisitions, completed in the prior year, remain in line with quarterly measurements during the last 2 years. Our performance on a sequential revenue per rig basis indicates continued share gains, resulting from a revenue to rig count lag of several months that is dependent on the number of wells on a given pad, as we wait for the construction of facilities or tank batteries.

Further emphasizing this point is that we have held revenue per rig constant, while the drilled but uncompleted well count, or DUCs, continues to grow in the Permian, Eagle Ford and Haynesville shale plays further delaying tank battery construction. And over 110 offshore rigs have been scrapped, permanently removing very large customers from the market and flooding shore bases with considerably large inventories, which are resupplying the offshore working fleet. Illustrating this point even further is the fact that our U.S. energy center business grew by 26% sequentially. The driver behind our U.S. energy center revenue growth was the increase of approximately 33 land rigs per month several months ago. However, the revenue per rig calculation uses the approximately 55 rigs that were added in the each month of Q1 2017, which have yet to fully translate into our most meaningful revenues related to pipe, valves, fittings and MRO supply sales into the tank battery construction process. Some examples of share gains enabling this type of performance are: securing 2 large operator customers in our U.S. supply chain services group that were substantially sourcing products from our competitors beforehand; the recovery of pipe, valve and fitting sales into the Rocky Mountain region that many distributors, including ourselves, lost several years ago, when our operator customers migrated to our current DNOW U.S. process solutions modular tank battery offerings; the expansion of our U.S. process solutions group to new shale plays beyond the Rocky Mountain region by leveraging our substantial rotating equipment infrastructure and our U.S. supply chain services customer partnerships, which has resulted in U.S. profit solutions quoting activity in the Permian, which rivals levels last experienced in 2014; the bundling of our energy center pipe, valves and fittings product offering with sales of modular units by our U.S. process solutions group to operator customers that currently source those products from our competitors; and continued expansion of critical supplier partnerships with companies such as Schlumberger for their Reda pumps and Cameron engineered valve product lines, Flowserve ANSI centrifugal pumps, multiple products under Rotork Controls and most recently, the exclusive Kimray distributorship for control valves in the Eastern hemisphere. Of course, this growth, which we are also experiencing in other regions, such as Canada, is driven by the performance of the exceptional team of folks we have out on the front lines. One such person is [B. V. Buras], who celebrated his 44th year with DistributionNOW just a few weeks ago. [BV] joined DNOW in Harvey, Louisiana and outside of a few special projects, has spent his entire career with us, working up and down the Gulf Coast. [BV's] current role is regional manager leading employees spanning several branches along the Gulf of Mexico. When he isn't at work or with his wife, kids and grandkids, he can be found floating around somewhere in a pirogue with a fishing pole in his hands. I have many stories about my travels with BV that date back to the early 1990s, but one in particular stands out above the rest. During the Macondo incident, Pete Miller and I were traveling with BV visiting locations and employees that were stationed across the Gulf to manage procurement and logistics for BP. During our travels, we noticed that he seemed to be a bit confused having to turn around several times. As you can imagine, once Pete realized that BV couldn't find one of the branches under his responsibility, the harassing began. Now to be fair to BV , we encountered several bridges that were closed or under repair so he was forced to find alternative routes. However, after spending the full day locked up in a car with Pete and me, BV could not get us to the airport and out of Louisiana fast enough after the trip was concluded. All kidding aside, BV and his team did an amazing job of managing through that crisis. During that period, they proved to our customers that we have the best team in the business. I'd like to thank BV and our amazing team of employees for not only how they recently navigated through the worst downturn of our carriers, but also for how they're maximizing opportunities to grow our business during this recovery.

Diving deeper into the quarter, for the first quarter of 2017, we reported a net loss of $23 million compared to a net loss of $71 million in the fourth quarter of 2016. Adjusted first quarter net loss of $16 million excludes a $7 million after-tax charge for a valuation allowance recorded against the company's deferred tax assets. Earnings per share for the quarter was a loss of $0.21 or a loss of $0.15 per share after adjusting for the change in the company's deferred tax asset valuation allowance. A sequential organic revenue improvement of $93 million was driven by growth in all 3 of our geographic segments. Flow-through to EBITDA, excluding other costs, of 24% is consistent with our range of expectations during the early quarters of a recovery. On the product margin front, we continue to roll out and fine-tune our processing software. We experienced a modest improvement in pricing in Q1, which is attributable to both improving market conditions and contributions from our pricing initiatives. Our focus on inventory efficiencies and pricing advanced our gross margin position by 170 basis points in the quarter. We expect improving gross margins in the coming quarters as freight and inventory efficiencies continue and discounted product costs materialize as we resume purchasing and continue to push price in this recovery. With the rising rig count, OCTG demand at the pipe mills is very strong, resulting in land pipe constraints and subsequent increased pipe pricing.

Sequentially, domestic and foreign quarter average line pipe prices moved up by 16% and 23%, respectively, in Q1 2017 as reported by Pipe Logix but are still not back to the 2014 pre-downturn levels. The pipe mills are working to add people and shifts to increase output. Valve lead times continue to extend due to demand from newly permitted pipe lines and production well hook-ups, with lead times ranging from 4 to 44 weeks depending on the manufacturer and type of valve. Political uncertainty surrounds the market due to trade suits, possible border tax adjustments, melting and manufacturing requirements and the pending further definitions of the Made in America initiatives. Simply put, steel is made here only if it is melted here.

Regarding revenue in the quarter, the largest single customer growth in our U.S. energy center business came from a recent contract win with a customer very active in the Bakken and Delaware basins more than doubling their purchases from DNOW sequentially. Outside of this new win, most of the U.S. major liquid shale plays all experienced robust growth with the Permian, Eagle Ford and SCOOP/STACK out in front. In terms of our midstream business, the Marcellus led the pack with increased customer growth as mild winter conditions allowed for more project activity. Land pipe projects also generated robust growth with midstream and gas utility customers across several regions. Areas of softness in the U.S. were continued declines in the offshore Gulf of Mexico and weather disruptions in the Rocky Mountain region. In U.S. supply chain services, double-digit growth in our downstream and industrial markets driven by turnarounds finally occurring were offset by declines with our operator customers. Since we performed most procurement and logistics activities for supply chain services customers, we experienced lumpy revenues for capital projects that aren't common for our energy center business. Due to the completion of budgets last year and being in the planning phase for 2017 capital projects during Q1, sequential nonrecurrence of large project offset gains from our downstream and industrial groups. Growth of 21% in our U.S. process solutions group was led by some large midstream mainline pipeline units and numerous orders for our broad modular solution tank battery product offering and pumping solutions. It is exciting to see our efforts to expand U.S. process solutions materialize in new basins, as many of these orders were destined for the Eagle Ford, SCOOP/STACK, Delaware and Midland plays for first-time process solution customers. Our international group has also experienced some success as we are beginning to export leased automatic custody transfer units or LACT units from our U.S. process solutions group to Nigeria. We have also expanded valve actuation efforts to include modification and repair services and opened a new operation in the Rocky Mountains. This actuation expansion has produced such success that we are now implementing another site in the Marcellus and have one planned for the Permian. In Canada, needless to say, we were very pleased with revenue growth of over 30%. While this growth was largely across the board in all geographies and with the majority of our customers, noticeable increases with composite pipe, engineered valves and actuation for midstream customers, pumping solutions and artificial lift products led the way. Internationally, the Middle East and North Africa specifically from Kuwait and Egypt was strong in Q1, while Asia Pacific, Australia and Russia softened. Europe and the North Sea remained difficult with low offshore rig counts, short-term contracts and spending cuts. Latin America is far from a recovery, but we did note some signs of life in Colombia and Mexico.

Looking at market activity moving forward, oil prices have been inconsistent at best moving above and below $50 per barrel for quite some time now. I believe those choppy waters will continue, driven by oil and gas storage levels and OPEC actions until such time that the under investment in offshore development for the last 3 years and beyond begins to produce meaningful offshore production declines. I anticipate that once those offshore declines begin, deepwater projects that take 3 to 5 years to bring online will commence and oil prices will be strong during that period of time and possibly beyond. Fortunately, for DistributionNOW in the interim, even if North America land rig counts flatten for some period of time, our revenue should continue to grow due to the several month lag of tank battery construction related to rig count improvements, the large DUC inventory of over 5,000 wells that still needs to be completed and processed, and the expansion of our U.S. process solutions offering to shale plays outside of the Rocky Mountain region.

In the U.S., upstream activity increases in Q1 2017 should drive further growth in Q2. For our U.S. energy center business, I anticipate similar sequential growth in revenue dollars to what we experienced in Q1 2017. Some factors that could limit growth include continued DUC conditions and lack of inventory availability. At the beginning of this recovery, we had excess inventory in our system that aided the growth we experienced last quarter. We began placing stock orders strategically for long lead time items, but if we experience shipment delays, it may impede anticipated growth. In U.S. supply chain services, we could see double-digit growth as capital projects with operators restart, the rollout with Marathon begins to ramp up considerably, 2 new branches to support OXY activities in Delaware come online and modest improvements in downstream and industrial segments improve the trajectory of those businesses. Based on increased orders and modular solutions currently being fabricated in our shops, U.S. process solutions should also post strong growth. Unfortunately, in Canada, normal seasonal breakup is well underway, so we would anticipate a 25% to 30% revenue contraction in that geographic segment depending on the severity and longevity of the [free style cycle]. Continued growth in the Middle East, a seasonal increase in Russia and the CIS and anticipated projects in Australia may be sufficient to hold revenues firm sequentially in our international segment. However, softness in offshore markets in the North Sea, Latin America and Asia and continued scrapping of deepwater rigs may offset stability and successes elsewhere. Moving to capital allocation in the quarter. We moved from generating cash over the last 7 quarters to adding work -- the working capital needed to support growth. Cash flow used in operations was $21 million plus we used $1 million for capital expenditures, yet we still finished the quarter with net cash of $20 million. Sequentially, days sales outstanding remain flat at 60 while inventory turns improved from 3.7 to 4.2 days. Improvements to our balance sheet have reduced working capital as a percent of revenue, excluding cash, from 24% to 21% sequentially. This level is well below our stated goal of 25% and probably represents the appropriate level of working capital as a percent of revenue required to support our business moving forward even though we still expect to make improvements to days sales outstanding and inventory turns. Regarding capital allocation, let me assure you that while organic growth is the main consumer in a recovery, we are still very active in pursuing capital deployment towards M&A. We're looking at product lines that we can add to our existing businesses to complement them, further differentiate us from competitors, fill a geographic gap and offer higher value-added solutions to our customers. While we have several targets in our pipeline, the levers that we cannot control include the surrounding market, the availability of cash and financing to our middle-market competitors along with our willingness to pay more for the same opportunity and finally, the seller's expectations coming out of a down cycle. There are numerous potential deals in the harbor from the Middle East to Texas, and while we're evaluating them, conducting due diligence and negotiating them, as has been the case with our post-spin acquisitions, a small percentage we review make it across the finish line. And as many of you know, who have been on the seller side or the acquirer side, no transaction is easy. DNOW has stated to our long-term shareholders that it is better for us to remain patient for the right deal than to overpay for a deal, rush through a transaction or misunderstand the risk and liabilities associated with it. We will keep on hunting for the right deals to be struck at the right time, in the right place and for the right price. Until then, we will keep pushing forward in returning this business to profitability. So with that, let me turn the call over to Dan.

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Daniel L. Molinaro, NOW Inc. - CFO and SVP [4]

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Thanks, Robert. We are enthused about the rapid land drilling rig recovery that we are experiencing and are hopeful for its stability and sustainability, which give us confidence for the future. I appreciate the efforts of our dedicated workforce, and I'm convinced we have the top people in the industry. I'm proud to be part of this wonderful team, and I'm grateful for the hard work and perseverance of the DNOW family. Thanks for all you do. We will continue to concentrate on the needs of our customers, while focusing on producing long-term value for our stakeholders. Robert discussed our business, and I'll say more about our financials.

NOW Inc. reported a net loss of $23 million or $0.21 per fully diluted share on a U.S.-GAAP basis for the first quarter of 2017 on $631 million in revenue. This compares with a net loss of $71 million or $0.66 per fully diluted share on $538 million in revenue in the fourth quarter of 2016. When looking at the year-ago quarter, we had a net loss of $63 million or $0.59 per fully diluted share on revenue of $548 million for the first quarter of 2016. The first quarter 2017 results included $7 million of after-tax charges for valuation allowances recorded against our deferred tax assets. After adjusting for these charges, our first quarter loss was $16 million or $0.15 per share, both non-GAAP measures. Gross margin rose to 18.1% in Q1 compared with 16.4% in Q4 2016 and 15.9% in the year-ago quarter. The company generated an operating loss of $21 million in the first quarter of this year compared with a loss of $47 million in Q4 and an operating loss of $65 million in the year-ago quarter. Fourth quarter EBITDA, excluding other costs, a non-GAAP measure, was a loss of $9 million, sequentially improving by $22 million.

Looking at operating results for our 3 reportable geographic segments. Revenue in The United States was $439 million in the quarter ended March 31, 2017, up 16% over Q4 2016. The first quarter revenue in the U.S. was up 23% over the year-ago quarter. Year-over-year improvements in the U.S. rig count, coupled with incremental revenue gains from acquisitions, contributed to these revenue improvements. Revenue channels in the U.S. for Q1 were 53% U.S. energy, 31% U.S. supply chain, and 16% U.S. process solution. First quarter operating loss in the U.S. was $26 million compared with the $43 million loss in the fourth quarter of 2016 and a $59 million loss in the year-ago quarter. The year-over-year improvement was primarily driven by increased volume, coupled with lower inventory charges and lower employee-related expenses. In Canada, first quarter revenue increased 32% sequentially to $96 million and up 52% over Q1 2016 due essentially to increased Canadian rig activity.

For the 3 months ended March 31, 2017, Canada's operating profit was $3 million, up $5 million sequentially and improved $9 million over the year-ago quarter, reflecting increased rig activity. International operations generated first quarter revenue of $96 million, which was up 12% over the fourth quarter of 2016, but down 25% from the year-ago quarter. Softening in the overall international market, coupled with the completion of a large project in Q1 2016, contributed to this year-over-year decline. International operating income for the first quarter of 2017 was $2 million representing a $4 million sequential improvement and a $2 million -- and $2 million over the year-ago quarter. Despite the year-over-year revenue decline, operating profit improved, primarily due to reduced bad debt charges paired with realized cost-savings.

Continuing on our income statement. Warehouse, selling and administrative expenses remained at $135 million in Q1, similar to Q4 2016 and down $17 million from first quarter 2016. The decline from the year-ago quarter reflects our continuing cost-cutting initiatives and a reduction in accounts receivable charges, partially offset by adding operating expenses associated with acquisitions. These costs include branch, distribution center and regional expenses as well as corporate costs. Our effective tax rate for the first quarter of 2017 was 1.8%. The rate continues to be impacted by a valuation allowance recorded against our deferred tax assets in the U.S., Canada and other foreign jurisdictions, as well as lower tax rates on income earned in foreign jurisdictions, offset by certain nondeductible expenses.

Turning to the balance sheet. NOW Inc. had $524 million working capital, excluding cash, at March 31, 2017, which was 21% of annualized sales, as we continue to improve this ratio. For the first time in 2 years, our working capital increased during Q1 and we anticipate continuing working capital demand to support rising revenue. Accounts receivable increased $58 million in Q1 to $412 million, reflecting our increasing revenue. We are in the early phases of a recovery and the pace of bankruptcies in our energy space is easing, but there are still some remaining concerns, especially internationally. So we must continue to be diligent as we extend credit. Banks have begun to loosen purse strings, once again increasing their exposure to the energy industry. Our current days sales outstanding remained at 60 days. While I'm pleased with our progress over the past year or so, there's more that we can do.

Inventory was $491 million at the end of the first quarter of this year, up $8 million in Q1. With signs of an improving market, the lead times extending for certain items, we expect inventory levels to continue to rise. Inventory turns were 4.2x, an improvement over the last few quarters. Days payable outstanding were 54 days. Cash totaled $102 million at March 31, 2017, with $87 million located outside the U.S., almost 40% of that being in Canada. Having this cash overseas could facilitate financing of an international acquisition. We ended the quarter with $82 million borrowed under our credit facility, and we are in a net cash position of $20 million. Our borrowing cost on the debt is slightly above 3%. Capital expenditures during Q1 were approximately $1 million, our quarterly average for the past 5 quarters. Showing the effects of improving business conditions and the need to support the organic revenue growth, free cash flow for the first quarter was a negative $22 million. Our worldwide market continues to be challenging, but the worst may be over with improving activity. In the meantime, we will continue to focus on serving our customers as we manage costs and concentrate on integration gains from our acquisitions. We have confidence in our strategy, in our employees and in our future as we position NOW Inc. to serve the energy and industrial markets with quality products and solutions. We are an organization with exceptional leaders, solid financial resources, and we'll continue to respond to the needs of our customers. With that, Sylvia, let's open it up to questions, please.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And the first question comes from Andrew Buscaglia from Crédit Suisse.

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Andrew Edward Buscaglia, Crédit Suisse AG, Research Division - Senior Analyst [2]

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Congrats on a good quarter there. Can you just touch on your incrementals in the quarter? They're definitely -- definitely strong at 24%. I think you guys alluded to them being in that range last quarter. So now that you got -- we're a quarter into the year, what's your confidence in terms of the sustainability of that strong incremental going forward for the rest of the year? I know your long-term range is 15% to 20%, but just kind of want to hear your thoughts now.

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David A. Cherechinsky, NOW Inc. - CAO, VP and Corporate Controller [3]

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Andrew, this is Dave. Our long-term incrementals is more of a 10% to 15% range. Over the last 3 quarters, we've seen flow-throughs in the 25% average range. So we've been pretty successful in that regard. The main drivers for gross margin -- were gross margin appreciation in the quarter. We had our highest gross margin since Q1 '15. So we saw product pricing begin to improve, which drove a little more than 1/3 of the benefit, and we've seen a much more fluid movement in our inventory, which as demand increases, you'll see less obsolescence charges due to our scrapping requirements, that kind of thing. So real nice increase in gross margin. Cost containment was solid in the quarter. And into the second quarter, we think the flow-throughs won't be as strong. We have Canada breakup, which will be a big contra-effect on revenues in the period. But our challenge is to get into those premium flow-throughs we talked about in the last few calls, which would be in the low 20s. But we don't expect that in the second quarter, but we expect to get back to that after that period.

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Andrew Edward Buscaglia, Crédit Suisse AG, Research Division - Senior Analyst [4]

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Okay. Got it. And on that margin comment. I mean, it sounds like you got some pricing this quarter. You talked about mills pushing up pricing some. Can you talk about more about that going forward? It sounds like that only gets better, that should only juice those gross margins. Is that correct?

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David A. Cherechinsky, NOW Inc. - CAO, VP and Corporate Controller [5]

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Yes, I think, we'll see pricing continue to improve as long as the market's as robust as it is. We saw price increases basically across most product lines, particularly in pipe as we expected. So we're seeing pipe shortages and higher demand for pipe, actual increases in pipe that are sticking in the market and we're benefiting from that in the short term as our lower cost of inventory is moved out. So we do expect price appreciation that will be kind of lumpy, but still the trajectory will be positive.

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Andrew Edward Buscaglia, Crédit Suisse AG, Research Division - Senior Analyst [6]

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Okay. And then just one last one on your breakeven. It sounds like there's some confidence in that occurring next quarter. Just talk about -- you kind of hedged it with assuming Canada -- assuming normal seasonality or things are a little bit better than normal. Just walk through as to how you are thinking about breakeven for next quarter?

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David A. Cherechinsky, NOW Inc. - CAO, VP and Corporate Controller [7]

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I think we feel pretty confident about breakeven in the second quarter. We have a real strong market in Canada, in particular, which will be headwind, the headwind which we talked about, but in the U.S., week after week, rigs are being added. Our order logs are increasing and we're seeing revenue gains higher than we expected. A big component of getting to breakeven like we talked about in the last 2 quarters has been price. We saw some of that, but frankly, the market -- our revenues grew faster than we expected and it takes a little bit of time for the mentality from a downturn psychology to shift to a strong growing market. So once we see our people and our competitors embrace the possibilities of the price, then we'll see that breakeven and profitability come more naturally.

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Operator [8]

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Our following question comes from Vaibhav Vaishnav from Cowen & Company.

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Vaibhav D. Vaishnav, Cowen and Company, LLC, Research Division - VP [9]

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First of all, just wanted to clarify. So what I understood from Dave's comment was as opposed to 24% incrementals in first quarter that you guys saw, we should be thinking low 20s in 2Q? Is that fair?

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David A. Cherechinsky, NOW Inc. - CAO, VP and Corporate Controller [10]

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I don't know about that. Like we've said and I'd like to reiterate, our flow-through is in the 10% to 15% range, right? But now the market is growing, we do in the early parts of recovery, expect the low 20s. Now we're going to see contraction in Canada, for the moment, our most profitable unit. We saw real strong revenue surge in Canada in the first quarter, and there's going to be a big reel in, in the second quarter. So we don't necessarily know how to gauge that. Same with price. So those are kind of caveats to getting there. But we do believe it's possible and we're going to do everything we can to get to that number. And we're pretty highly confident about the second quarter breakeven.

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Vaibhav D. Vaishnav, Cowen and Company, LLC, Research Division - VP [11]

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Okay. And if I heard correctly, the guidance for U.S. revenue, Dan, you gave was the dollar amount increase would be similar. Did I get it right?

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Daniel L. Molinaro, NOW Inc. - CFO and SVP [12]

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Yes, you did. We would expect the actual dollar amount that we enjoyed from Q4 to Q1 to possibly repeat in Q2 in the U.S.

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Vaibhav D. Vaishnav, Cowen and Company, LLC, Research Division - VP [13]

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That would imply like U.S. revenue growth of 14% versus 16% you saw in first quarter and if I look at the rig count, it grew -- what -- 16% in third quarter, 20 plus in fourth quarter and first quarter, it's almost 27%. So the rate of growth has been increasing in the U.S. rig count. Just wanted to understand how should we reconcile that rig count growth that we have seen versus the guidance that revenue growth could actually decline in 2Q for the U.S.?

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Robert R. Workman, NOW Inc. - CEO, President and Director [14]

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Well, the issue around revenue growth compared to the rig count growth is pretty straightforward. So you had probably what 75% of the working horsepower fleet for doing frac job sitting in a yard somewhere. And so 25% of that fleet has been supporting the active rig counts in Q3, Q4. Now -- and most of those are working for cash breakeven. So now what you're seeing -- what you saw in 2015 and '16 were people intentionally creating DUCs. Right? They were drilling the wells and capping them and not fracking them to cut back on their CapEx. Now you are seeing the growth -- the DUC count grow not intentional because now they are in negotiations with their service providers about how much of a price increase they have to agree to, to convince the company that does the frac job to spend the money to reactivate their fleets, hire their employees, train their employees and put the frac fleet to work, which drives tank battery hook-up. So our caveat on that one simply is we need the frac crews to be able to keep up with rigs and they can't do that yet and that's evidenced in the growing DUC count.

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Vaibhav D. Vaishnav, Cowen and Company, LLC, Research Division - VP [15]

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Okay. So basically, DUCs is -- okay, just to offset. Can you help us think about in first quarter in the U.S., how much upstream revenues increased versus downstream?

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Robert R. Workman, NOW Inc. - CEO, President and Director [16]

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Well, our downstream business grew almost double-digit-ish percent and -- but that whole unit stayed flat quarter-to-quarter pretty much and the reason for that is with OXY, Devon, Hess and Marathon, which are the 3 big operators we have in our supply chain services group, different than the U.S. energy centers. For supply chain services customers, we do all their procurement and logistics management for large capital projects. And that's really, really dependent upon their budgets. And so they wind down their budgets at the end of the year and try to use up their budget. So if you look at supply chain services revenue in Q4, it was a nice growth. And in Q1, it's typically their planning period. So we had a contraction in capital projects with those 4 large operators. So those 4 operators basically offset all of our growth in our downstream, industrial and shop floor manufacturing supply chain businesses.

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Vaibhav D. Vaishnav, Cowen and Company, LLC, Research Division - VP [17]

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Okay. I mean, that would imply the upstream revenues actually grew faster than the overall U.S. revenues. Last question, if I may. International revenues, given they're lumpy, can you help us think about them in 2Q? It should be -- how should we think about those?

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Robert R. Workman, NOW Inc. - CEO, President and Director [18]

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Yes. We're having some really exciting successes in the Middle East, North Africa on some new partnerships that are all land-centric. My concern is the growth that we will experience in that -- in Q2 for international will be offset by further continued declines in the offshore market. And so until we can solve this offshore decline problem, it's going to be really tough for the U.S. -- the international land segment to keep pace with the declines offshore. So we're kind of hoping for a flat quarter.

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Operator [19]

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Our next question comes from Chuck Minervino from Susquehanna.

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Charles P. Minervino, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [20]

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Just another follow-up there on the international side. Nice strong growth in 1Q. It looks like you guys at least started to trend here. You bottomed maybe in the third quarter and maybe even flattening out a little bit in 2Q, but do you think we've kind of set a new baseline here in this mid-90s revenue level? And then also, the operating profit positive this quarter, first time in a number of quarters that that's gone positive. Is that something you think you can sustain for the remainder of the year as well?

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Robert R. Workman, NOW Inc. - CEO, President and Director [21]

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Yes, so let me put a little caveat on that one . If offshore would stop declining, our international segment would continue to grow. We have a lot of really exciting things going on, on land. I mean, really exciting stuff. And so the problem is as it grows and the offshore declines, it's been kind of washing each other out except for the fourth quarter. And the reason for that was Q3 had some unusual items in it. So as long as offshore is declining, I would expect probably flat revenue. When offshore stops declining, it's going to grow.

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Charles P. Minervino, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [22]

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And is the proxy there going to be offshore active rig count? Or is there -- or is it noncold-stacked fleets? What would you kind of highlight as the thing to watch there?

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Robert R. Workman, NOW Inc. - CEO, President and Director [23]

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Yes. So if you can imagine an offshore rig, whether it's a jack-up or semisubmersible or drill ship spends a lot of money with us for consumables to run those rigs than a land rig. So it's meaningful when one of those gets scrapped. So yes, the rig count needs to stop declining offshore and almost more importantly, even though they're going to continue to do it, we need to see those rigs stop being scrapped and sent to Blowtorch beach in Turkey because when they do that, they take $10 million, $20 million or $30 million of inventory off these rigs before they ship it across to the eastern hemisphere, move it to the shore base like (inaudible) or Aberdeen or Singapore or Ciudad del Carmen, and in that $10 million to $20 million to $30 million loss of inventory, supports my current customers that are still drilling in the offshore arena. So the scrapping actually hurts me worse than the decline in rig count.

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Charles P. Minervino, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [24]

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Got it. And just one last one on that. I mean, are you able to help us understand how big is offshore within international at this point in time? I mean, is it getting it to the point where it's going to start to get small enough where that headwind can offset the tailwind over the land?

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Robert R. Workman, NOW Inc. - CEO, President and Director [25]

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Yes, I would say back in 2014 before all of this offshore decline occurred, half of our international segment was offshore-oriented. And only about 10% of our U.S. business in the Gulf of Mexico was offshore-oriented and very little in Canada because we only really do offshore in Nova Scotia and Newfoundland area, and so there's not that much activity. Today, the percent of those -- of each of those buckets that's offshore-oriented has probably been cut by 3/4.

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Operator [26]

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Our next question comes from Matt Duncan from Stephens.

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Charles Matthew Duncan, Stephens Inc., Research Division - MD [27]

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So first thing, just on tank battery construction and process solutions business and sort of what's going on there with power service. Can you talk about sort of share of wallet in tank battery construction, and how you are seeing that changing due to that power service acquisition? How much is that adding to revenue that you're able to go sell a more complete package there?

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Robert R. Workman, NOW Inc. - CEO, President and Director [28]

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We are in the very, very early days. We didn't [bought] Power Service that long ago, and so we've coupled them with Odessa Pumps because Odessa Pumps has an army of people in the Eagle Ford, in the Permian, in the SCOOP/STACK, in the Delaware, in the Midland. I mean, that's their bread and butter, has always been their bread and butter and they know rotating equipment, unlike our branches who have to be everything to everybody. The Odessa Pumps people, they know this type of stuff. So what our effort now is to get them all trained, which we've pretty much completed and start tackling opportunities in the other place, where Power Service originally did not participate. So Power Service might have grown -- grew from what -- $30 million in 2003 when they sort of developed on this model to like $230 million or $270 million in 2014 in the Rocky Mountain region predominantly. So that kind of tells you what the opportunity set is for all of the other plays. And I would say we're in early, early days. I mean, it's going to be easy to grow substantially as a percentage basis in those other plays because we're so small to start with.

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Charles Matthew Duncan, Stephens Inc., Research Division - MD [29]

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How much did they add to revenue on a year-over-year basis in the quarter, Robert?

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Robert R. Workman, NOW Inc. - CEO, President and Director [30]

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Who -- Power Service?

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Charles Matthew Duncan, Stephens Inc., Research Division - MD [31]

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Yes.

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Robert R. Workman, NOW Inc. - CEO, President and Director [32]

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We don't -- we're not disclosing an acquisition revenue.

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Charles Matthew Duncan, Stephens Inc., Research Division - MD [33]

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Okay. I mean, wasn't that the only year-over-year acquisition, just trying to get a sense for how much M&A added in total, but we maybe get on that later. On the pricing front, how much -- how much is the impact from pricing specifically on gross margin versus some of the other items like better freight recovery and all the other benefits you're getting as the business start to grow again? Just trying to get a feel for how much price is actually helping right now. And then dovetailing on to that, how much of that benefit is from the pricing actions that you guys are taking sort of internally versus what's going on in the market?

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David A. Cherechinsky, NOW Inc. - CAO, VP and Corporate Controller [34]

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Okay. As far as what's driving the gross margin improvements, our price is less than half of that, closer to 1/3. And we're seeing on a wide product category basis -- we're seeing our pricing margins grow in almost all those categories. So I attribute -- how much is attributable to us intentionally pushing price, the pricing software, the market, I don't think we know that. What I could say is our pipe margins are growing the most. So I'd attribute most of that to the market and on our larger pipe orders, we have our experts get involved in those transactions. So a portion will be attributable to we know the market, we know how to price the goods. Inventory is the lifeblood of the distributor. We had a lot of write-downs and a lot of liquidation efforts in the downturn. Now we're starting to see the fruits of a very solid inventory position and we're seeing less inventory write-downs, less scrapping requirements and that kind of thing. So that's actually another half of the gross margin gains. We do expect price lift in the coming quarters as well.

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Charles Matthew Duncan, Stephens Inc., Research Division - MD [35]

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All right. And then last thing, just on inventory. It sounds like you're starting to have to place orders of some of this longer lead times stuff and the inventory is probably going to continue to go up. Just any thoughts on what the pace of that inventory growth is going to look like through the year as you start to get some of these products you're ordering that do have those longer lead times start to come into inventory? So how do we need to think about inventory growth?

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David A. Cherechinsky, NOW Inc. - CAO, VP and Corporate Controller [36]

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Well, it's hard to say. It's going to be a function of sales, of course, which we expect to increase. But I still expect our inventory turn rates will increase and like Robert said earlier on the call, our working capital as a percent of revenue less cash would be in that lower 20s range. So while we will be adding inventory probably quarter-on-quarter throughout the year, those term rates should be flat or better throughout the year. We're still going to be very scrutinous about investment in inventory given where we are in $45, $55 oil range. So number will go up but it will improve in terms of utility.

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Operator [37]

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Our next question comes from David Manthey from Robert W. Baird.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [38]

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First off, when the rig count accelerates dramatically like it has recently because of the lag in your business, the denominator gets overstated relative to the numerator. And if I just compare first quarter revenues to fourth quarter rig count, just fun with numbers, the ratio is somewhere in the $1.4 million to $1.5 million range. As the trajectory of rig count growth starts to level out, assuming it will at some point here, does it not follow that your all-in revenues per rig should normalize at a higher level than you're seeing today?

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Robert R. Workman, NOW Inc. - CEO, President and Director [39]

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That is correct, Dave.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [40]

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Okay. Good. And then second, the expanded relationships with Marathon and Hess, where are you in the ramp up of those 2 expanded customer relationships? And do they have the potential to ultimately become as large as, say, OXY and Devon are for you today?

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Robert R. Workman, NOW Inc. - CEO, President and Director [41]

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The answer to that question is, yes, they have the potential and they -- unless something surprises me, they will be as big as those 2 accounts or close to. We are probably 2/3, 3/4 away through the implementation with Hess. And we are in early, early days with Marathon, early days.

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David John Manthey, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [42]

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Right. Okay. And then final question on -- back to the revenue side. If -- you hear the adage that 1,000 U.S. rigs is the new 2,000. If you use that as a base, maybe the global rig count gets into the low 2,000s over the next few years. And I don't know if you buy into that or not. But second, if you use something in the $1.3 million revenues per rig, that would get you to about the $3 billion level. I know in the past, Robert, you've expressed comfort with the fact that you can get to 7%-plus EBITDA at $4 billion in revenues. I'm just wondering if you can help me understand those 2 variables and what is -- what is the path as you see it to $4 billion in revenues for the company today? I mean, which -- is it both of those? Is it one more than the other of those 2 metrics?

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Robert R. Workman, NOW Inc. - CEO, President and Director [43]

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Yes. So like you said earlier or commented earlier, our revenue per rig, once the recount flattens out, will grow. And so that will get you to a bigger number than using $1.3 million. And we have tremendous opportunity to grow our process solutions group organically. I mean, well beyond market changes because, I mean, that whole offering was simply centered in 1 play. So as we expand to the other locations, we're going to continue to grow that revenue even at 1,000 rigs. So I think with 1,000 rigs, we're going to flat on it 1,000, you're going to see our business grow quarter-over-quarter-over-quarter for quite some time.

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Operator [44]

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Our next question comes from Sean Meakim from JPMorgan.

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Sean Christopher Meakim, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [45]

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So Robert, your comments on Power Service being at an early stage in all these basins, obviously, that's very fair. But -- so based on the energy branch growth rate in the quarter versus U.S. overall, it seems like Power Services may be a drag on growth. And I think, again, given the lag in that business, that's not a surprise. Based on your comments, it sounds like you'd expect to see some catch-up of that growth in 2Q. I guess I'm just trying to think about with the business as it is today and that growth trajectory, what's the potential margin contribution for Power Service as you kind of ramp up to a full run rate in terms of just that lag effect kind of wearing off?

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Robert R. Workman, NOW Inc. - CEO, President and Director [46]

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Well, the process solutions group, which is Odessa Pumps and power service predominantly, they grew what -- by $13 million on $57 million in the quarter. So they grew nicely in the quarter, but don't forget their lag is even longer than the energy branch lag because we have to design the equipment and we have to fabricate and shop. And so the lead time is a little longer for that. In fact, some of these big projects, like these big mainland pipeline skids we sold in Q1 to a midstream firm in the Eagle Ford, those pumps have a 36-week delivery. So we're dealing with that kind of thing that we don't deal with the energy branches. Regarding the 16% growth or whatever the number was, 17%, whatever, I forget the ratio. That was held back by supply chain services for those reasons I mentioned earlier around capital projects with the 4 big operators because the process solutions group and the energy centers grew nicely. And I would expect supply chain to get back into the groove now that we're going into the capital projects period, which will be Q2, Q3 and Q4.

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Sean Christopher Meakim, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [47]

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Right, I guess, the meat of my question was more around acknowledging the lag and then saying on a margin contribution basis, what's the potential there given that we assume that the margins are nicely accretive, especially as you get to a higher run rate?

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Robert R. Workman, NOW Inc. - CEO, President and Director [48]

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Yes, so in 2014, and I believe EBITDA margins in that unit, which mainly, again, is Odessa Pumps and process solutions can get back to where they were at 2014 levels with our volume growth. They were both low-double digit EBITDA.

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Sean Christopher Meakim, JP Morgan Chase & Co, Research Division - Senior Equity Research Analyst [49]

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Right. Okay. That's helpful. And then, just it will be great to get a little bit of sizing the potential of the Kimray agreement that you guys signed. It's been pretty interesting. Would like to get a sense for where the real opportunity is to leverage your footprint to help them grow that business.

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Robert R. Workman, NOW Inc. - CEO, President and Director [50]

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Yes. So it's a privately owned firm. We -- all the distributors in the energy space in Canada and the U.S., probably every single branch you could walk into with DNOW or my competitors, you're going to find this product on the shelf. They've never really tackled the eastern hemisphere. So we agreed to partner up and try to displace their competitors in the other hemisphere with their products. So it's going to be more difficult than simply signing for example, the Cameron engineered valve line. We knew pretty much it was going to shift to us and one of the competitor, this particular product line, we have to go take share from other manufacturers. So this will be slow going.

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Operator [51]

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And our final question comes from Walter Liptak from Seaport Global.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD of Diversified Industrials and Senior Industrials Analyst [52]

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I wanted to ask about the cadence during the quarter and especially, if you can talk a little bit about April, the price of oil has been volatile and has come down below $50. Do you see any change in tone from your customers? Are they reacting to that? Or how are they -- what are they thinking about with projects?

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Robert R. Workman, NOW Inc. - CEO, President and Director [53]

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So far we are hearing nothing that would change their outlook for activity in 2017. In fact, we get a little more insight to that with our supply chain services operator customers because we have to plan with them to support those activities, and they're still all planning to add rigs. Now could they change their mind? Of course. But so far all the indications we're getting is that no one's planning to pull back.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD of Diversified Industrials and Senior Industrials Analyst [54]

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Okay. That's great. And then just to maybe get a little bit more clarity around pricing. Maybe some of your higher margin products, pumps, valves and things, are you seeing price increases from the suppliers? Are you able to pass those along?

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Robert R. Workman, NOW Inc. - CEO, President and Director [55]

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No. So far, we're not seeing our manufacturing providers pushing pricing, but I fully expect it to happen. It's really the only thing affecting us right now from a cost perspective. We love inflation. That's a great thing in a distribution business. And we're having inflation with anything that's heavy steel-oriented. So you think of valve, it'd be heavy steel oriented but it's really not because when you break it down into patents and labor and machining and steel, steel becomes a small component. So where we're seeing inflation right now is pretty much PFF -- pipe, fittings and flanges -- which is a big part of our spend, but that's the only place we're seeing inflation so far.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD of Diversified Industrials and Senior Industrials Analyst [56]

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Okay. With that said, are you seeing the mix of more ERW or the seamless type just go around?

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Robert R. Workman, NOW Inc. - CEO, President and Director [57]

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It's staying pretty consistent. It moves around 5 points here and 5 points there, but generally around half of our pipe is ERW and around half of our pipe is seamless.

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Walter Scott Liptak, Seaport Global Securities LLC, Research Division - MD of Diversified Industrials and Senior Industrials Analyst [58]

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Great. Okay. And that's where inventory levels sound like they have to go up. Do you think you'll be able to continue to get margin on it?

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Robert R. Workman, NOW Inc. - CEO, President and Director [59]

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I do, because -- generally because we're going to be going into an inflationary period. So by the time material arrives from the mills to our yards, it's probably going to have another price increase by then.

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Operator [60]

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

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Robert R. Workman, NOW Inc. - CEO, President and Director [61]

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Thanks, everyone, for your interest in DistributionNOW. And we look forward to speaking to you in August regarding our Q2 performance.

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Operator [62]

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