Logo of jester cap with thought bubble.

Image source: The Motley Fool.

NOW Inc  (NYSE:DNOW)
Q3 2018 Earnings Conference Call
Nov. 01, 2018, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to the Third Quarter Earnings Conference Call. My name is Angela and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions)

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

David Cherechinsky -- Senior Vice President and Chief Financial Officer

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 US 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 US 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 US 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.

Robert R. Workman -- President and Chief Executive Officer

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 by 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 our customer's 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 sludging costs and risks, reduce their SG&A, and eliminate duplicated 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 customer's specific applications. We were pleased to see the US market fundamentals hold firm in the third quarter with WTI averaging $70 per barrel; US rig count averaging 1,051, up 11% year-over-year.

Our global revenue per rig for the 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. US revenue was up 25% year-over-year outpacing US rig count growth. Our international revenue segment was up 4% while Canadian revenue was down 3% on a year-over-year basis. Gross margins were up 100 basis points year-over-year and 20 basis points sequentially as we continued to experience product pricing inflation and the effect of sections 232, 301, and tariffs impacting the price and availability of imports. While we still believe we can achieve modest improvements in gross margin percent in general as the topline grows, the path could be uneven and we fully expect choppiness with that metric.

Our warehousing, selling and administrative expenses of $142 million shows a focus on rationalizing our costs and was in line with our guidance. We continue to leverage our existing infrastructure as demonstrated by adding $125 million in revenue year-over-year while only adding $1 million of expenses. Year-over-year EBITDA, excluding other costs for metals, were 22%. As a result of our strong topline growth and gross margin improvement paired with excellent operational execution, GAAP diluted earnings per share improved to $0.18 or excluding other costs, diluted earnings per share improved to $0.15. US drilled but uncompleted wells or DUCs averaged 8,186 wells for the third quarter were up 32% year-over-year and 9% sequentially. DUCs present a future revenue opportunity for DNOW when the wells are completed and drop tank battery construction.

US completions increased 6% sequentially and about 20% year-over-year to 1,264 for the third quarter. In the third quarter, sales related to E&P and midstream activity led sequential revenue gains driven primarily by our operations in the US. Our solid third quarter performance was a result of our employees' execution of our strategy to maximize our core operations, drive margin expansion, leverage previous acquisitions, and approach capital allocation with discipline. With the continuing execution of these efforts, we can deliver the gains our shareholders expect and we made excellent progress on all four areas in the third quarter and year-to-date. In the area of operations, we continue to optimize our footprint and inventory to capitalize on market opportunities. We closed five locations in the quarter and added personnel and inventory to areas of high activity while reducing overall inventory investment and improving our turns.

In fact for a business that typically runs countercyclical in that we normally generate cash as revenues decline and use cash to fund working capital as the topline grows, we were actually free cash flow positive during the last two quarters having generated $23 million of cash from operations in 3Q enabled by improvement in inventory efficiency. We continue to execute our human capital strategy in the Permian and other high activity, low unemployment areas to strengthen our position and gain market share by prioritizing recruiting, training, relocating personnel, and providing a safe positive work environment based on our core values of accountability, doing what it takes, and caring about our co-workers, our customers, and our communities. In addition to capitalizing on the strong oil play market environment with tank battery hookups, upgrades on existing batteries, line pipe, and actuated valves for gathering systems; we also are enhancing operating margins by leveraging an improved quoting process that enables us to process a higher volume of quotations across the market.

We continue to manage product cost changes and inventory mix related to Section 232 impacting certain steel products, Section 301 impacting Chinese manufactured goods and components, and dumping cases related to certain imported pipe fittings and flanges through our strong relationships with suppliers. Cost changes are integrated into our pricing and quoting process when applicable. We continue to focus on improving efficiencies in operations, utilizing technology to enhance our quote turnaround time and customer order process. Our cross selling of products from acquired companies continues to materialize. The strong collaboration in the US between energy centers, supply chain services, and process solutions is resulting in pull-through sales, new customer introductions, increased market opportunities, and further market penetration. US Energy Centers made up 53%, US Supply Chain Services 31%, and US Process Solutions 16% of third quarter 2018 US revenue.

The Permian continues to be the most active in areas of the Delaware and Midland Basins along with modest growth in the Bakken, Northern Rockies, Eagle Ford, and DJ Basin. Turning to our segments. US revenues were $630 million, up $124 million or 25% year-over-year. An improvement in rig count, product margin gains, and a focus on managing expenses produced strong incremental flow-throughs. Increased rig count, well completions and gathering, processing, and transmission projects led to strong US growth and helped drive gains more than rig expansion growth year-over-year. Steel, fiber glass, and line pipe demand was strong as the gathering and midstream market in the shale plays continued to build up infrastructure to support increased production volumes. We are starting to see some effects and uncertainty in the market of pipe supply due to Section 232 and tariff quotas, decreasing hot roll coal prices, and some budget exhaustion.

As mentioned last quarter and to reaffirm this quarter, we continue to witness product availability becoming more difficult for many distributors, especially those that were more reliant on import mills and did not have good domestic sources. We are well positioned through our domestic and international sourcing relationships to provide for the current demand. Due to increased volume, many domestic manufacturers are not taking on new distributors, but continue to supply their existing partners. We have several supply agreements with gas utility and midstream customers that help us hedge against near-term price declines in pipe as well as support our baseline inventory holdings. US Supply Chain was up 30% year-over-year.

Revenue was primarily driven from activity with our integrated customers in the Permian, SCOOP, STACK, Eagle Ford, and the Bakken plays. US Supply Chain customers saw growth with steel line pipe, poly pipe, vessel fabrication, valves, and electrical sales while the downstream business experienced increased sales from upgrades and turnarounds in the refining sector. We continue to invest in areas where our customers' activity is expanding. We opened a new 20 acre pipe and tubing yard to support our supply chain customers in the Delaware play, which will also be used to forward stage capital projects. For US Process Solutions, we saw 34% year-over-year revenue growth. Our strategy to grow market share for our fabricated process and production equipment business in the Permian is paying dividends as we receive orders from large and small independent E&Ps leveraging our Odessa Pumps, supply chain services, and energy centers relationships.

Collaborative planning with our midstream customers presented us the opportunity to invest specific inventory in crude oil pump packages to meet customer demand for gathering and midstream projects. Furthermore, for the produced water market, we're stocking saltwater disposal pump packages designed for produced water disposal and reuse application in the shale plays allowing our customers the ability to keep production targets by moving produced water to more distant disposal areas. The Permian remained the most active region for US Process Solutions with the Bakken and Powder River Basin experiencing increased activity over the quarter. Turning to our Canadian operations, revenue was down 3% year-over-year at $93 million. Sequentially, revenue was up 24% as the market exited the seasonal breakup period. The Cardium, Duvernay, Montney, and Southern Saskatchewan Bakken plays showed high activity in the quarter while the oil sands markets remained steady.

The Canadian market remains challenging due to widening differentials, midstream takeaway limitations, and political uncertainties. Finally, the International segment reported revenues of $99 million. This segment is up 4% year-over-year. Gains were led in Iraq, Kazakhstan, and CIS from E&P majors as well as the North Sea market. In Latin America, activity in Brazil, Mexico, and Colombia gained strength with drilling in the Magdalena Valley. Australia remained steady with the majority of the activity coming from the coal seam gas market where we provide artificial assistance, drilling products, and valves. We're excited about the results. Our teams continue to produce in what has been a very unique, challenging, and uneven recovery that has required a ramp-up in investments to support growth in certain areas along with further expense and working capital rationalization and others. We will continue down the path of aligning our business around the market dynamics and generating improved returns for our shareholders.

Before moving on to discuss the outlook for 4Q and beyond, I'll turn the call over to Dave to review the financials.

David Cherechinsky -- Senior Vice President and Chief Financial Officer

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 fittings and flanges, and offshoot to improve steel pricing offset by expected pipe pricing stabilization and 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 new 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 this revenue by servicing those customers from other locations, we were able to redeploy and reinvest inventory in more lucrative areas and the expense savings generated helped us fund growth elsewhere. We expect WSA to be in the low-to-mid $140-s million in the fourth quarter, unchanged from our guidance last quarter. Operating profit was $26 million or 3.2% of revenue compared to an operating loss of $6 million or negative 0.9% of revenue in 3Q '17. Net income for the third quarter was $20 million or $0.18 per diluted share, an improvement of $0.26 when compared to the corresponding period of 2017. Our effective tax rate for the three months ended September 30, 2018 as calculated for US GAAP purposes was 11.7%. As our profitability increases and when we are no longer subject to a valuation allowance in the US, we expect our effective tax rate to be in the mid to upper 20% range.

On a non-GAAP basis, EBITDA, excluding other costs, was $33 million or 4% of revenue for the third quarter of 2018. Net income excluding other costs was $17 million or $0.15 per diluted share. Other costs after tax for the quarter included a benefit of approximately $3 million from changes in our valuation allowance recorded against the company's deferred tax assets. In 3Q '18 we continued to evaluate the provisions of the Tax Cuts and Jobs Act as well as all interpreted guidance issued to date. We have not completed accounting for all the effects of this new law, but have recorded provisional amounts, which we believe represent a reasonable estimate of the accounting implications of the Tax Act. Moving to our segments. US revenues grew to $630 million, a 25% improvement from the third quarter of last year, well above the build in US rig activity. Canadian revenues were $93 million, down 3% year-over-year due to an unfavorable foreign exchange rate impact.

And internationally, revenues were $99 million in the third quarter of 2018, up $4 million from a year ago driven by increased customer projects with an offset from foreign exchange. Moving on to operating profit. The US generated operating profit of $21 million or 3.3% of revenue, an improvement of $31 million when compared to the corresponding period of 2017 primarily due to significant revenue increases coupled with product margin gains. Canada operating profit was $5 million, an increase of $1 million when compared to the corresponding period of 2017 due to improved product margins. International operating profit was nil or flat when compared to 3Q '17. Turning to the balance sheet. Cash totaled $91 million at September 30, 2018. We ended the quarter with $170 million borrowed under our revolving credit facility and a net debt position of $79 million when considering total company cash.

At September 30, 2018, our total liquidity from our credit facility availability plus cash on hand was $494 million. Our debt-to-cap was 12% at September 30 or 6% when considered on a net debt basis and we had $403 million in availability on our credit facility. Interest on the debt approximates 5% and we expect the fed to push short-term rates incrementally higher as they attempt to fend off inflation. Working capital, excluding cash as a percent of revenue, was approximately 22%; the lowest level since the beginning of 2017. Accounts receivables were $559 million at the end of the third quarter, up $64 million sequentially as our DSOs moved to 62 days. Third quarter inventory levels were $599 million. Churn rates improved again sequentially to 4.4 times in 3Q, the highest level since being a stand-alone public company.

Accounts payables were $356 million at the end of the third quarter with days payables outstanding at 50 days. Cash flows provided by operations was $23 million for the third quarter with capital expenditures of approximately $2 million resulting in 21 -- $21 million free cash flow in the quarter. Our challenge going forward is to further improve working capital velocity by collecting accounts receivable faster and building on our notable inventory turn progress while maximizing profitability.

And now, I will turn the call back to Robert.

Robert R. Workman -- President and Chief Executive Officer

Thanks, Dave. Let's wrap up with the outlook for the fourth quarter of 2018. Our outlook is tied to global rig count, drilling and completion expenditures, infrastructure and pipeline buildup in downstream projects particularly in North America. Oil prices and US storage levels will continue to be primary catalysts for determining both land and offshore rig activity as well as all the other end markets required to transport in-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 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 remain about half of 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 topline. However, the jack-up 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 newbuild load-outs for their rigs currently in a shipyard in Asia.

This award allows our customer to focus on rig readiness while DNOW focuses on our core competencies and managing the supply chain to fill up the belly of these drilling units with critical spares and consumable inventory before they depart for their final destination to begin operations. While this project is specific to the load-outs of several jack-ups over the next few quarters, it is a promising sign that better things may be to come offshore globally in 2019 and beyond. For the full-year 2018, we reiterate our guidance and expect full-year 2018 revenue growth over 2017 to be in the high teens percentage range. For 4Q '18, we would anticipate normal seasonal impacts related to holidays and budget exhaustion, which equated to more than a 4% sequential decline last year. Coupled with our strong performance in 3Q, softening oil prices, and the transitory takeaway issues occurring in two of our largest areas, Canada and the Permian; 4Q '18 could result in an additional 1% to 2% sequential revenue decline on top of normal seasonality.

We expect third quarter to fourth quarter EBITDA decremental flow-throughs to be seasonally unfavorable relative to the higher than usual incrementals we have generated over the last several quarters. We expect solid full-year EBITDA to revenue incrementals to be in the high teens percentage range. We're encouraged by rig counts currently holding steady and growing inventory of drilled but uncompleted wells, which bode well for growth in our business in 2019. Customers should begin announcing their budgets in the coming months so we should be able to provide more color regarding our expectations for 2019 during our next earnings call in February. Before I move on to recognize one of our dedicated employees, I'd like to summarize the progress we made in the execution of our strategy. We are adjusting our footprint in line with customer demand and optimizing our human capital and supplier relationships.

We executed our margin enhancement initiatives by improving our quotation process as well as pricing discipline, optimizing our inventory, and leveraging acquisitions through the enhanced cross-selling. We approached capital allocation with discipline, improving inventory turns and lowered working capital as a percentage of sales. With further successful execution of our strategy, we fully expect continued improvement toward generating greater shareholder value. With that, let me recognize one of the employee whose daily hard work and dedication enable us to deliver on our promises. On December 1st, 1974 a young man showed up for his first day at work at Oilwell Supply outfitted in a suit and a tie ready to begin his career as a sales trainee. Within a few minutes, Chuck Wilson was sent home by his manager to change into a pair of jeans and boots to work in the warehouse for the next two years. The hands-on approach he learned early in his career has guided Chuck throughout his almost 44 years of service at DNOW.

Chuck along with his wife Darlene, two children, and two grandchildren have ridden many of the ups and downs of the oil and gas industry. In 1976 Chuck moved to Harvey, Louisiana to work in a manufacturing service center followed by a move to a city sales position in New Orleans. In 1982 he became General Manager followed by a Regional Sales Manager position in South Texas. Chuck found his calling and settled down in Houston as a sales executive calling on global drilling contractors and E&P companies for the last 15-plus years. For those of you who know Chuck, he can quite linguistically gifted and at most times long winded, but those are some of the more sociable traits that have made him a successful sales executive throughout his career at DNOW. As one of his colleagues recently stated after returning from a customer event, if you're looking for our CEO or Chief Entertainment Officer, Chuck is located down the hallway. Chuck, thanks for your service and long-term commitment to DNOW.

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

Questions and Answers:

Operator

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.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Good morning, everyone.

Robert R. Workman -- President and Chief Executive Officer

Hey, Nathan. How are you doing?

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Well, thanks. I just got a question on both Dave and Robert, you made comments that you thought 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?

David Cherechinsky -- Senior Vice President and Chief Financial Officer

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 gross margin improvement. For example, (inaudible) 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 -- 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 little more scrappy in the period so I think there'll 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.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Okay. So it may be 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 this further.

David Cherechinsky -- Senior Vice President and Chief Financial Officer

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.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

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 that'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 getting there on the turnkey tank battery solutions?

Robert R. Workman -- President and Chief Executive Officer

Yes. So, just one little correction. I think I stated it was 34% year-over-year, just not that big of a deal. But -- so this business Process Solutions is really two 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 1,100 rigs that you were having at over 2,000 rigs. And the good news is we're not anywhere near maxing out our ability to continue to penetrate other markets. So, that group just takes a little while to get everybody trained. You got the combination of all the Odessa Pumps 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 -- of the year.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Okay. I've just 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?

Robert R. Workman -- President and Chief Executive Officer

Well, our customers that were -- we have with those four big operators, we're in their project teams, their engineering department, their procurement department. 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. Now I wish I can tell you something, but there's really nothing that I know on my end of the equation to share with you.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Okay. Fair enough. I'll pass it on. Thanks very much.

David Cherechinsky -- Senior Vice President and Chief Financial Officer

Thanks, Nathan.

Operator

Our next question is from David Manthey from Baird. Please go ahead.

Robert R. Workman -- President and Chief Executive Officer

Hey, Dave.

David J. Manthey -- Robert W. Baird & Co. Inc. -- Analyst

Hey, good morning, guys. Hi, Robert. 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 just help me understand is there anything technical or a reason why that couldn't go to that level?

Robert R. Workman -- President and Chief Executive Officer

Well, if you'd asked me a year or two 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 -- I'm 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 issue has resolve themself and customers can find an economically feasible way to get that to the final destination.

David J. Manthey -- Robert W. Baird & Co. Inc. -- Analyst

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 of -- 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?

Robert R. Workman -- President and Chief Executive Officer

After 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.

David J. Manthey -- Robert W. Baird & Co. Inc. -- Analyst

Okay. Thanks a lot, Robert.

Robert R. Workman -- President and Chief Executive Officer

You're welcome.

Operator

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

Robert R. Workman -- President and Chief Executive Officer

Hi Steve.

Ryan Mills -- Keybanc Capital Markets Inc. -- Analyst

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

Robert R. Workman -- President and Chief Executive Officer

Thank you.

Ryan Mills -- Keybanc Capital Markets Inc. -- Analyst

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?

Robert R. Workman -- President and Chief Executive Officer

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

Operator

So, that's obviously a negotiation with some key customers otherwise our contracts protect us generally.

Ryan Mills -- Keybanc Capital Markets Inc. -- Analyst

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?

David Cherechinsky -- Senior Vice President and Chief Financial Officer

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.

Robert R. Workman -- President and Chief Executive Officer

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.

Ryan Mills -- Keybanc Capital Markets Inc. -- Analyst

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?

Robert R. Workman -- President and Chief Executive Officer

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. 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 pipe distributors, we're looking at everything that would fit well within our Process Solutions group.

Ryan Mills -- Keybanc Capital Markets Inc. -- Analyst

Thanks for taking my questions and congrats again on the quarter.

Robert R. Workman -- President and Chief Executive Officer

Thank you.

David Cherechinsky -- Senior Vice President and Chief Financial Officer

Thanks, Steve.

Operator

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

Robert R. Workman -- President and Chief Executive Officer

Hey, Walt.

Steve Friedberg -- Seaport Global Securities LLC -- Analyst

Hi. This is Steve Friedberg filling in for Walt.

Robert R. Workman -- President and Chief Executive Officer

Hello Steve.

Steve Friedberg -- Seaport Global Securities LLC -- Analyst

Hey, guys. Nice quarter.

Robert R. Workman -- President and Chief Executive Officer

Thank you.

Steve Friedberg -- Seaport Global Securities LLC -- Analyst

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 a new level? Do you think you guys can get to or at least get back to 8% again?

Robert R. Workman -- President and Chief Executive Officer

Yes. I'm still 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 in -- I believe that our 8% target when we were at the peak of the cycle is just as achievable today as it's as ever been. We've got some businesses that are a 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 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 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 the 3% to 8% range.

Steve Friedberg -- Seaport Global Securities LLC -- Analyst

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

David Cherechinsky -- Senior Vice President and Chief Financial Officer

Well, no. So in the quarter we had the biggest -- the longest month of the three-month period was August and we had a very large billing month in August and that's the main driver for collections not happening till 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.

Steve Friedberg -- Seaport Global Securities LLC -- Analyst

Okay. Thanks.

Robert R. Workman -- President and Chief Executive Officer

Thank you.

David Cherechinsky -- Senior Vice President and Chief Financial Officer

Thank you.

Operator

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

Robert R. Workman -- President and Chief Executive Officer

Hey, Sean.

Sean C. Meakim -- JPMorgan -- Analyst

Hey, good morning.

Robert R. Workman -- President and Chief Executive Officer

Good morning.

Sean C. Meakim -- JPMorgan -- Analyst

So Robert, I want to maybe talk a little more about the Permian. You noted that you're taking share, sounds like Process Solutions is kind of finding its legs there. You mentioned that 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 with 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 shift in how customers are perceiving that? Is that helping you? How would you help us kind of frame that out?

Robert R. Workman -- President and Chief Executive Officer

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 MidCon 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 -- put their toe in the water and one customer would order 20 light (ph) 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 that would go to a particular product and see can we make delivery, is the quality going to be there, la da da da da. And as we earned our stripes with these customers, now they're ordering two or three or four pieces and now we have some customers 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 will be that successful, but if we have the same progression next four and eight quarters that we had the last eight quarters, it's going to be a great story to tell.

Sean C. Meakim -- JPMorgan -- Analyst

That's really helpful and (inaudible) 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 a sort of a pretty strong opportunity set. What are lead times looking like? What's -- 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?

Robert R. Workman -- President and Chief Executive Officer

Midstream actually is a big piece of business for us. We just report it along with our upstream business as one unit. Part of 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 of 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 of by ordering inventory. Some of these valves, in fact not just some of them, a lot of these valves are running 30, 35, 40-week delivery. So, we have to get ahead of that if we want to take share and so we've been doing that.

Sean C. Meakim -- JPMorgan -- Analyst

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

Robert R. Workman -- President and Chief Executive Officer

Absolutely. 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, the four clients that are in that bucket, a lot of those guys did midstream work in 3Q that benefited us.

Sean C. Meakim -- JPMorgan -- Analyst

Got it. That's really helpful. And actually it's not late in the call, maybe I'll sneak one more in. And thinking about offshore so it's obviously 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 Severn's getting pretty excited about activity and these rigs going back to work. Irrespective of the day rate, rigs get back to work and it's certainly 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 of years and therefore as rigs are 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?

Robert R. Workman -- President and Chief Executive Officer

I would separate the conversation into deepwater versus the shallow water jackup market. Shallow water jackup market is -- 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'll 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 I'm probably a year away from getting deepwater semis and drill ships to impact our topline.

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 -- highly likely could end up being that they get through any duplicative inventory sometime in that team because -- just because they scrapped the 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 drive work. So, we'll get benefit there too. I'm just -- I'm in the glass half full or half empty boat right now and 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.

Sean C. Meakim -- JPMorgan -- Analyst

That nuance is very helpful. Thanks for that, Robert.

Robert R. Workman -- President and Chief Executive Officer

You're welcome.

Operator

Our next question is from Blake Hirschmann with Stephens. Please go ahead.

Robert R. Workman -- President and Chief Executive Officer

Hi, Blake.

Blake Hirschmann -- Stephens, Inc -- Analyst

Hi guys. Good morning and congrats on a good 3Q here.

Robert R. Workman -- President and Chief Executive Officer

Thank you.

Blake Hirschmann -- Stephens, Inc -- Analyst

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?

Robert R. Workman -- President and Chief Executive Officer

Well, kind of what's happening so far. In this industry my information is only as good as today because it'll change tomorrow. But what's happened 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 positive affects our supply chain group, our energy centers, and our process solutions group because you have to -- once the oil and water and gas come out of the ground, you've got to separate that stuff and you got to treat it and you got to measure it and you 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.

Blake Hirschmann -- Stephens, Inc -- Analyst

Got it, all right. That's helpful. And then just one more I guess on the tariffs and with restraints 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?

Robert R. Workman -- President and Chief Executive Officer

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.

Blake Hirschmann -- Stephens, Inc -- Analyst

Got it. Thank you for taking my questions.

Robert R. Workman -- President and Chief Executive Officer

No problem.

Operator

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.

Robert R. Workman -- President and Chief Executive Officer

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.

Operator

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

Duration: 53 minutes

Call participants:

David Cherechinsky -- Senior Vice President and Chief Financial Officer

Robert R. Workman -- President and Chief Executive Officer

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

David J. Manthey -- Robert W. Baird & Co. Inc. -- Analyst

Ryan Mills -- Keybanc Capital Markets Inc. -- Analyst

Steve Friedberg -- Seaport Global Securities LLC -- Analyst

Sean C. Meakim -- JPMorgan -- Analyst

Blake Hirschmann -- Stephens, Inc -- Analyst

More DNOW analysis

Transcript powered by AlphaStreet

This article is a transcript of this conference call produced for The Motley Fool. While we strive for our Foolish Best, there may be errors, omissions, or inaccuracies in this transcript. As with all our articles, The Motley Fool does not assume any responsibility for your use of this content, and we strongly encourage you to do your own research, including listening to the call yourself and reading the company's SEC filings. Please see our Terms and Conditions for additional details, including our Obligatory Capitalized Disclaimers of Liability.

Motley Fool Transcribers has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends NOW. The Motley Fool has a disclosure policy.