DNOW Inc. Q4 FY2020 Earnings Call

Hello, and welcome to the Fourth Quarter and Full Year 2020 Earnings Conference Call. My name is Cheryl, 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. Please note that due to the recent severe weather conditions, if the speakers and the call get disconnected please standby and we will work to reestablish their connection. I will now turn the call over to Vice President, Marketing and Investor Relations, Brad Wise. Sir, you may begin.

Good morning, and welcome to NOW Inc.'s Fourth Quarter and Full Year 2020 earnings conference call. We appreciate you joining us, and thank you for your interest in NOW Inc. Please note, should there be connectivity issues during the current severe weather conditions in the Houston area, I wanted to remind everyone listening today that a replay will be available through our website later today. Now with me today is David Cherechinsky, President and Chief Executive Officer; and Mark Johnson, Senior Vice President and Chief Financial Officer. We operate primarily under the DistributionNOW and DNOW 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. Please note that some of the statements we make during the call, including responses to your questions, may contain forecasts, projections and estimates, including, but not limited to, comments about the 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 in the quarter or later in the year. We do not undertake any obligation to publicly update or revise any forward-looking statements for any reason. In addition, this conference call contains time-sensitive information that reflects management's best judgment at the time of the live call. I refer you to the latest forms 10-K and 10-Q that NOW Inc. has on file with the U.S. Securities and Exchange Commission, for a more detailed discussion of the major risk factors affecting our business. Further information as well as supplemental financial and operating information may be found within our earnings release or our website at ir.dnow.com or in our filings with the SEC. In an effort to provide investors with additional information relative to our results as determined by U.S. GAAP, you'll note that we also disclose various non-GAAP financial measures, including EBITDA, excluding other costs, sometimes referred to as EBITDA, net income, excluding other costs, and diluted earnings per share, excluding other costs. Each excludes the impact of certain other costs and therefore have not been calculated in accordance with GAAP. A reconciled on each of these non-GAAP financial measures to its most comparable GAAP financial measure is included within 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 and full year. As I mentioned at the top of the call, a replay of today's call will be available on the site for the next 30 days. We plan to file our fourth quarter and full year 2020 Form 10-K today and it will also be available on our website. Now let me turn the call over to Dave.

Thanks Brad. Good morning, everyone, and thank you for joining us. Before I get into strategy and talk a bit about the quarter, I want to take a moment to thank our employees and acknowledge their hard work, their dedication to serving our customers and supporting our key suppliers, for making safety a priority and for their perseverance overcoming a year that few will remember fondly. It goes without saying 2020 was a year of change. But as we round the corner, my view is one of expanding opportunities and optimism moving from a period of duress to a period of stabilization and growth. DNOW stands in a cherished financial position and is on firm footing. This is no longer a moment of extreme uncertainty and concern, but a period of promise, prosperity and possibility. Our focus is on providing the market with the innovative solutions and products to power the world for a sustainable future. What this means is we will be a trusted partner to help our customers unlock the power of energy and pursue sustainability by expanding our innovative solutions in support of our customers' ESG goals. Last year, we laid out a strategy to recompose our brick-and-mortar infrastructure. As we transition away from a distribution model tuned to a 2,000 U.S. rig environment to a model suited for 400 rigs cognizant that our customers are consolidating and driving procurement centrally and that consumers and companies buying habits have changed abruptly. These changes necessitate that our fulfillment design will continue to transform. Our branches will be smaller, leaner and utility-oriented, which means stocking the staples our local customers expect, but not stocking locally, speculative items or quantities for projects or large dollar orders. We are laying the groundwork for long-term profitable growth by standardizing the branch design. One that lowers operating costs is nimble and flexible and has the ability to expand and contract more responsibly to market volatility. We hold a formidable upstream position and expect to accumulate market share by capturing upstream spend in the form of maintenance CapEx from those customers seeking to maintain production. In addition, expanding our presence outside of upstream is a key part of our end market diversification. Last year, we made inroads with key midstream and downstream customers in renewing MRO agreements, implementing digital solutions and repositioning our sales and operations teams to compete on larger capital projects. Technology will play a key role in how we use information, process customer requests and fulfill orders. In prior calls, I've talked about the benefits of our new order management system, where we see notable productivity increases and customer response times. Our e-commerce platform and digital tools like eSpec, which I'll expand on later, provide our customers a platform to access, acquire information, price, procure and manage spend in our ecosystem with greater speed and efficiency. Expanding user adoption, shifting work processes to these digital channels and leveraging our centralized fulfillment model will drive top line growth and lower transaction costs. On our goal of aiding in customer sustainability, as noted in our 2019 sustainability report, DNOW provides a broad range of products and services, which help our customers minimize their environmental impact. By targeting opportunities to reduce or eliminate emissions and providing responsible water management solutions for water reuse and disposal. Some examples include efficiency audits for pumps and compressors, capturing and properly disposing of methane or BOC emissions with our vapor recovery units or providing fluid handling equipment with leak detection and sealing technologies that help transfer and dispose of produced water in a sustainable way. More to come on customers and technology, but first to the fourth quarter, all of our locations continue to remain open during this pandemic. But current deep cold winter weather in the U.S. has customer sites idled and nearly 60 DNOW locations closed for what could be days, complicating the seasonal recovery we expect sequentially. COVID conditions are still debilitating the global economy. There remain government restrictions impacting our customers and employees. Yet we continue to follow WHO and CDC guidelines to help keep our employees safe and supporting our customers. For the fourth quarter of 2020, revenues were $319 million, a sequential decline of $7 million or 2%, beating our revenue guide from the last quarter, which suggested a sequential decline in the high single digits. In the U.S. and Canadian markets, rig activity improved sequentially, helping offset a lower international market and buttressing revenues against seasonal and COVID gravitational forces. Having zero debt and ample cash allows flexibility around organic capital deployment and inorganic growth. We continue to invest in our expanding DigitalNOW offering designed to improve the customer experience, drive increased revenue and reduce transaction and fulfillment costs. On Friday, we successfully completed our first acquisition of 2021 into U.S. Process Solutions. The acquired business is a small but strategic engineering and construction company based in Odessa, Texas. We are excited to leverage and expand on their 20 years of experience, providing EPC services to handle gathering systems for new field, upgrading or debottlenecking of existing transportation lines in facilities as well as other services in the upper midstream. Current and previous clients include independent and major energy companies for design-build projects and EPC work for independence. This addition of non-commoditized capabilities expands DNOW's engineering and construction capabilities by adding an additional channel to proactively market and sell our pipe valves and fittings or PVF as well as pumps, process, production and measurement equipment earlier in the project development cycle. This acquisition should enhance DNOW's early look at gathering and related midstream projects bolstering project wins. To the talented employees joining our company and listening today, welcome to the DNOW family. In our further pursuit of M&A, managed like an investment portfolio, we are seeking to add companies which expand customer appeal, create competitive advantage, differentiation and build barriers to entry for DNOW, while as evidenced last year, exiting low-margin commodity product lines, locations and divesting two businesses in 2020 that didn't support our strategy or were margin dilutive. Now to our operating segments and end markets. U.S. energy revenue increased sequentially due to increases in drilling activity in the Permian, while we experienced increased operator activity in the Eagle Ford, taking advantage of higher natural gas prices. The DJ Basin started to improve towards the back end of the quarter, while customers in the Bakken and Northern Rockies operated and maintenance CapEx mode. Workover rigs increased in the Bakken resulting in revenue gains from our MRO well maintenance products. Revenue declines occurred in the western U.S. as midstream-related activity was lower sequentially. Among E&P customers, we were awarded a PBF and MRO contract from an IOC operator for operating assets in the Northeast. We were also awarded a PVF MRO contract from a large U.S.-based independent for Permian and South Texas assets, and we began in Alaska as well with the PVF contract from a customer operating assets with two fields on the North Slope. For our large committed supply chain services customers, we observed muted CapEx spend during the quarter with increased maintenance as more workover rigs were deployed to maintain well production, resulting in consumption of MRO products and tubing services. We also received orders for a scheduled gas plant turnaround set for the second quarter of 2021. We've been focusing on further end market diversification by actively marketing our products and services and expanding our customer base. During the fourth quarter, we were awarded a three-year well connected program in the Rockies from the midstream natural gas gathering and storage asset company. Our platform of digital solutions plus our preferred valve product offering was a contributing differentiator to winning the business. We recently completed our DigitalNOW e-commerce integration with the Company, establishing them as part of our digital ecosystem. During the quarter, we had some meaningful project wins for PVF, pumps and fabricated equipment with another midstream customer with assets in the Rockies and Permian in gathering, natural gas and disposal produced water. We signed an agreement with the Midwest Mid-Continent gathering and transmission midstream company that should provide additional revenue in 2020 as well. During the quarter, we were successful in providing PVF and a fiberglass fall line project to a water management company with operations in the Bakken, Permian and South Texas. In the midstream and industrial arena, refinery activity was sequentially lower as major projects and turnarounds were pushed out to 2021. Finally, during the quarter, we renewed a two-year MRO and safety services contract from a major refinery company and extended an existing PFF agreement for an additional three years with another major IOC refiner. U.S. Process Solutions revenue for the fourth quarter was down sequentially. During the quarter, we experienced increased quoting activity, especially from municipalities a good reversal from what had been significantly reduced in 2Q and 3Q 2020. Odessa Pumps experienced reduced activity in the fourth quarter due to oil and gas seasonality and partially offset by new orders related to municipal water projects and a sizable hydro pump rental contract for a terminal operator moving water from tanks, pipelines and firewater bypass systems. The first quarter has started off better, booking a large municipal water order from municipality in North Texas as we continue to target water opportunities. With a large independent E&P, we expanded our aftermarket pump program to an additional producing field that will result in servicing up to 170 pumps with ample runway to grow. Some notable market share gains from our Casper power service facility include a 20 vessel package for an E&P operator in the Powder River Basin, sizable orders to the Bakken and Eagle Ford for production equipment and lack units as well as several water transfer units sold to a large independent E&P. At our Tomball, Texas facility, our orders are recovering from the 2Q and 3Q low points as we diversify products with wins for lack units and pump packages for E&P and midstream operators. In Canada, market activity increased for the quarter, allowing for sequential revenue growth despite 4Q headwinds mentioned earlier. We secured wins in the quarter in our valve and actuation product lines with several midstream terminal customers IOCs and oil sands customers. In the unconventional areas, we are successful providing an EPC and IOC customer valves and variable frequency solutions, well site automation and control offering. On the conventional side, we increased market share with a new natural gas E&P customer operating in the Alteris region providing PVF products. In the Regina, Saskatchewan region, we expanded our market share with a midstream pipeline operator by performing aftermarket work, replacing existing actuators with our preferred actuation product line. The valve actuation aftermarket has been a key target market for us, resulting in a first win for this application with additional opportunities for growth. Finally, in Canada, for our composite piping systems, we completed work with an oil and gas operator in the Manitoba region from the previous third quarter contract award. The project deployed our spoolable fiberglass pipe for 19 oil flow and water injection line applications. For international, in the fourth quarter, international rig count was at a more than 20-year low, international sales languished on lower rig activity, reduced spending, project holds, et cetera. In much of the region, COVID restrictions interfered with logistics and operations, putting limitations on travel. On a positive note, our total valve solution initiative that was expanded to a major IOC in the Middle East as we implemented our valve life cycle asset managed solution combined with an MRO agreement, leveraging our digital e-catalog. Now a little more on technology. In 2020, we committed to becoming a leader in our space by investing in digital technology, not only to make our internal systems more productive, but also to speed the journey and customer appeal of our DigitalNOW ecosystem. Connected to our technology environment, informing the outer layers of our customer ecosystem, are a number of our digital platforms, where we offer access to customer-specific content, web-based and mobile applications, analytics, data sets and other digital tools. The goal is to provide our customers with a seamless, connected end-to-end experience for a wide range of products and services through a single access gateway without leaving the ecosystem. And for our suppliers and partners, it allows a framework for digital collaboration that will accelerate solutions to the marketplace. One example, which I talked about last quarter, where we're beginning to get traction is on a strategic third-party drop ship partner, which provides customers a broader range of products, not normally stocked at our branches, but readily visible and available to our customers. It is similar to the marketplace experience on Amazon. By growing our partner ecosystem, DNOW benefits by expanding our catalog and convenience to customers while realizing working capital benefits through the optimization of our inventory investment while lowering future inventory risk. We previously announced the rollout of our new DigitalNOW eSpec product. The eSpec tool is a digital product configurator that enables customers to select, configure and price out a number of our Process Solutions products. At our initial launch in November, we had three fabricated products available for customers to configure. Today, we have expanded the available products to nine. The products available on eSpec range from ASME production vessels used to separate the crude oil mixture to several transfer and measurement units for separated oil and gas. Since the launch, eSpec has been a valuable customer collaboration tool, allowing our technical sales professionals the opportunity to have meaningful discussions involving processing, facility design and budgeting for our eSpec products. Customer registrations and use has grown since our initial launch, more than doubling since the 1st of January to over 120. Over the next six months, we will be releasing additional digital tools that further enhance our technology, including an upgraded e-commerce platform. With that, let me hand it over to Mark.

Thank you, Dave, and good morning, everyone. As Dave mentioned, we entered 2021 with relief and optimism, relief that one of the most difficult years in the Company's 159-year history is behind us and optimistic for our future given the significant actions taken and underway. We are encouraged by the recent worldwide deployment of COVID-19 vaccines, improved crude oil prices and the progress we are making on our strategy. For the fourth quarter of 2020, our revenue outperformed, our guided revenue percentage declined of high single digits, with revenue of $319 million or down 2% sequentially. The U.S. segment fourth quarter 2020 revenue was $224 million, down $4 million or 2% from the third quarter of 2020. As our traditional 4Q headwinds of fewer business days, extended vacations, customer budget exhaustion plus COVID impacts were partially offset by increased rig count and completions activity. Our U.S. energy branch revenue was up 1% from the third quarter as we captured increased drilling and completion activity during the end of the fourth quarter, partially offset by the expected seasonal declines due to fewer billing days and customer activity around the holidays. U.S. Energy revenue accounted for 81% of the U.S. segment revenue in the fourth quarter compared to 79% in the third quarter of 2020. Our U.S. Process Solutions revenue was down 13% from the third quarter mainly a result of seasonality and customers' continued order deferrals as they draw down their surplus pumps, vessels and fabricated inventory. With the increase in rig and completions noted at the end of the fourth quarter through today, we began to see some life from customers in terms of future activity increases and project work. Both should create opportunities for pump and vessel orders in the first half of 2021. In our Canadian segment, fourth quarter 2020 revenue was $48 million, up 14% from the third quarter. As we supported increased customer activity levels and expanded our value for many clients through DNOW's unique combination of bundled solutions and products. Outside of North America, momentum slowed through the fourth quarter with additional COVID lockdowns and travel restrictions, continued customer project approval delays and the slowing activity in places like Russia, Middle East and offshore. International revenues were $47 million for the quarter, down $9 million as working rigs fell and drilling activity slowed, in addition to generating stronger than guided revenue in the fourth quarter, pricing on product margins held steady when compared to the third quarter of 2020. In the fourth quarter, gross margins were 14.1%, including a fourth quarter noncash inventory charge of $24 million or 7.5% of revenue in the quarter. We've historically experienced inventory charges to be higher than normal during depressed market conditions. These elevated inventory charges were the result of additional product rationalization initiatives in connection with market dynamics, customer preference changes and adjustments to our product lines and locations that no longer align with our strategy and activity levels. In the fourth quarter of 2020, warehousing, selling and administrative expenses, or WSA, was $81 million or down $2 million sequentially and $4 million below our fourth quarter WSA implied guidance of $85 million. As a result of accelerated cost transformation initiatives that more than offset the sequential $4 million reduction in government subsidies. At the onset of the pandemic, we swiftly identified and implemented initiatives focused on maximizing customer service and transforming our operating model. These bold actions bring our annualized fourth quarter 2020 WSA exit run rate to $324 million or a $270 million reduction, a reduction of 40% in WSA compared to 2019, the most consequential effort taken in recent history. The collective effort of our team to respond to the market challenges is notable and worth acknowledging as a strategic shift in our discipline to activity and actively transform DNOW. While we are not yet at the finish line, this is a major milestone, it would not have been possible without the customer focus and dedication of our talented managers and employees. We, together, are working every line on the financials with a focus on profitable market share gains, pushing for reduced costs for manufacturers, targeting high-margin product lines and rigorously pursuing fitness at the expense line. We're deploying technology to augment labor content, automating and digitizing processes and activities, reducing discretionary and infrastructure costs and seeking resources to match the current market activity levels. Including the cost reductions completed, we expect WSA to remain relatively flat in the first quarter of 2021 compared to the fourth quarter of 2020, as the new year brings a seasonal increase in expenses driven primarily by the resetting of limit-based payroll taxes and healthcare cost inflation. Moving to net loss. Net loss for the fourth quarter was $44 million or a loss of $0.40 per share. Net loss, excluding other costs was $28 million or a loss of $0.25 per share. Non-GAAP EBITDA, excluding other costs for the fourth quarter of 2020 was a loss of $29 million, which includes $24 million in unfavorable inventory charges. With liquidity challenges faced by many worldwide, we continue to stand in a position of strength. We took decisive and proactive steps during the year to focus on what we control, and that shows by our record cash level of $387 million, more than doubling our net cash position in the year. As of 12/31/2020, total liquidity from our undrawn credit facility availability plus cash on hand totaled $584 million. Accounts receivable in the period were $198 million with DSOs of 57 days. Inventory ended the year at $262 million with inventory turns of 4.2 million. And our accounts payable ended at $172 million with days payable of 57 days for the fourth quarter. Net cash provided by operating activities in 2020 was $189 million, was $56 million in the fourth quarter. And after considering $1 million in CapEx, free cash flow was $55 million. Our total 2020 free cash flow was $181 million, beating our previous full year guide. Additionally, as I mentioned on our last call, in the fourth quarter, we completed the divestiture of a small regional lighting business in the U.K., bringing our full year 2020 proceeds from divestitures to $26 million. And when looking back on our successes in optimizing working capital and strengthening our financial position, over the last two years, we've generated $419 million in cash when considering free cash flow and cash generated from our divestitures. Further improving what was already an enviable balance sheet. Our focus on fortifying the balance sheet can also be seen in working capital efficiency improvements in the year with a record low cash conversion cycle in the quarter. And as of 12/31/2020, working capital, excluding cash as a percentage of fourth quarter annualized revenue was a record low, 15.8%. And when using the trailing 12 months revenue, working capital as a percent of revenue was approximately 12.5%. We entered 2021 with optimism for the future. Our revamping of the business model, transformative cost reduction initiatives, technological enhancements and shedding of non-core businesses have primed DNOW to be in its best position for sustained value creation for our customers and shareholders in our 159 year history. With that, I'll turn the call back to Dave.

Thank you, Mark. And now I'd like to shift the focus to the first quarter. Looking ahead, there is cause for optimism with oil trading in the high $50 range and North American activity continuing to improve, playing off fourth quarter momentum. In the U.S., companies continue to add rigs and frac spreads, but some customers seem restrained as they meter rapid production growth in favor of returns to shareholders. We expect midstream gathering systems to follow suit, favoring modernization projects over capacity expansion. Domestic refinery runs are currently at their highest since the start of the pandemic. We expect the U.S. to improve sequentially in the first quarter as customers complete recently drilled wells, convert DUCs than build out tank batteries and gathering systems. The Canadian market continues to be structurally challenged with the Keystone XL pipeline paused again in the heavy oil coming in by rail. However, the current market we do expect sequential improvement in revenue as we build on our market presence and capture increased activity with our customers. Internationally, the visibility is uncertain into the first quarter as we await an inflection point to start a recovery and therefore, guide international revenue lower sequentially. The global uncertainty related to COVID-19 and the possibility of future industry and economic volatility certainly temper our ability to forecast deep into the year. As more vaccines are administered, we expect greater energy demand, yet the pace of vaccines remain slow, thus the impact on a full year outlook remains cloudy. Except for unknown weather impacts related to the current deep freeze in the U.S. 1Q '21 DNOW sequential revenue could expand into the mid- to high single-digit percentage range. In closing, I'm encouraged by the DNOW transformation underway and its success to-date, although the global COVID pandemic has had a material impact. It has provided a great opportunity for us to carry out our strategy. A downturn this severe provides the motivation for transformative change. Necessity itself is fuel. This kind of transformation is really most successfully delivered in a market model like this. 2020 was a year of rapid change in our industry and at DNOW, and we view 2021 optimistically. We expect it will be more fun and exciting as we build back then grow. The execution of our strategy in what has been a tough year for our industry, our employees and our customers enables us to create a more resilient, stronger company, enabling us to better manage risk in future energy cycles. In closing, I'm very pleased about the stronger-than-expected fourth quarter top line and thrilled about emerging from the lowest points in the market downturn with a great deal of flexibility in how we shape our company and expand on our success in the future. The women and men of DistributionNOW are the reason for our enviable position today. The faith and confidence I have in our employees because of their perseverance through all the trials and tribulations of 2020, their continued patience, their innovation and their constant focus on our customers reaffirms my confidence. We are absolutely on the right path to ensure maneuverability in the evolving energy space. A record cash balance of $387 million and zero debt provide a firm financial footing. Couple that with the profound cost transformation, buoyed by favorable oil price trends, the completion of our first acquisition of the year, the promise of vaccines and hunger for getting back to life as we once enjoyed it, all give us plenty to be excited about as we enter 2021. With that, let's open the call for questions.

Thank you. We will now begin the question-and-answer session. Our first question comes from Jon Hunter from Cowen. Your line is now open.

So my first question is just as it relates to your guidance for the first quarter of up mid-single to high single digits sequentially. It seems like that doesn't include any impact for the weather that we've seen just recently here, so curious if you've attempted to kind of quantify what kind of impact that may have on your outlook? So that's the first question. And then the second one is, just as it relates to the guidance you put out there for the first quarter, how are we tracking so far either through the end of January or currently through mid-February here? Thanks.

You're welcome. Currently, we have about 60 locations closed due to a lack of power and water, affecting both our business locations and the employees there, as well as our customers. We anticipated sequential revenue growth in the mid- to high single digits as stated in our guidance, but I noted that this weather situation is quite severe and will lead to several days of lost revenue. Although we are unsure how much of a recovery we might see from increased demand for our products, we are maintaining our guidance of low to mid sequential improvements with the expectation that conditions will improve in March. As for performance, January was somewhat weaker than December, which was unexpectedly strong for a fourth quarter month. January was down slightly and February is following a similar trend. However, March looks promising as we move out of the adverse weather conditions and begin to see progress with vaccines. We believe we can still achieve our guidance, but we cannot quantitatively measure the weather impact. Additionally, I want to clarify that our guidance was for mid- to high single digits while acknowledging that weather effects could influence that figure. Did I answer that?

Yes, yes. That's helpful. And then next one is as it relates to gross margins. Obviously, you had the elevated inventory charges here. How should we think about the level of inventory charges going forward in 2021 and your ability to get to 20% plus gross profit margins and whether that's in you think you can get there in the first quarter, second quarter? Or is that later on in the year?

Okay. That's a great question. I wanted to provide some additional information that we didn't mention in our opening remarks. Our EBITDA loss for the year was approximately $56 million, which includes about $54 million in inventory charges. I think those are solid figures, Mark?

Yes, $57 million for the year.

This has been an exceptionally challenging year for the energy industry, likely the worst since the Great Depression. If we exclude the inventory charges, we managed to break even. While we do not adjust for inventory charges when calculating EBITDA, as they are legitimate expenses for our business, we have experienced significant rig declines of 50% to 70% globally from a previous high of 800 rigs in the U.S. and 2,000 rigs worldwide. I want to highlight that we successfully converted inventory into cash despite the market's drastic downturn. To address your query directly, we will not have $54 million in inventory charges for 2021, although they may remain on the higher side. As mentioned in my prepared remarks, we are still undergoing a transformation. We aim to position our field locations close to our customers, although the utility of those sites will shift. I anticipate inventory charges to remain elevated, but not to the extent seen in the fourth quarter. I expect them to normalize later in the year, with typical inventory charges around 1% of revenue, though they will be higher this year. By the end of the year, we should be able to evaluate which countries we might exit or which locations to downsize. Determining how to establish our supercenters in proximity to our customers, given a different inventory situation, will affect our gross margin. Although our inventory charges are set to decrease, they could still remain elevated as we undergo this transformation.

Thank you. Our next question comes from Sean Meakim from JPMorgan. Your line is now open.

So Dave, I want to discuss margin progression. Gross margin appears strong if we exclude the impact of inventory charges, and we've made significant improvements in cost management over the past year. General and administrative expenses are expected to remain flat in the first quarter. It’s important to consider margin expectations excluding inventory charges, and are we anticipating a stable state for general and administrative expenses, with adjustments based on market conditions? There are two key factors to consider regarding margin progression in 2021.

So that's a good question, Sean. So except for acquisitions, so we did a small one, and that will have limited impact on SG&A. So I'm not even going to speak to it, but our WSA should be coming down each quarter, except for acquisitions. So that line needs to continue to go down, and that's going to come from the evolutionary nature of transforming the business. We've done a lot of heavy lifting, a lot of the harder things early in the process, but I expect that number to come down even despite growth in revenues. So that's a challenge for us. Now speaking to what that number is as the quarters progress, we're really only speaking to the first quarter right now. And I think Mark said that that's basically going to be flat. But the fourth quarter, which was lower than we expected. And I think it was $3 million lower than we expected. So I think we'll be flat in that regard. But to answer your question generally, the WSA numbers should come down each quarter, outside of acquisitions, and there are some things like pipe prices that will impact product margins. But like we've said for several quarters now, our pricing and our product margins have been really resilient. So I think there could be some lift there. Now to the extent we do large projects, you know that projects would drag down margins a little bit. But I'm pretty comfortable that product margins will remain resilient. It's just a matter of what kind of inventory charges will endure in the coming quarters. So that's kind of the cadence. Increased revenues will give a little more flavor to that in the next 90 days. Hopefully, we'll be in a much better position to guide the rest of the year. But that should be the trajectory, continued reduction in operating costs in WSA flat to improved gross margins and elevation and revenues as well.

Understood, that's helpful. And then thinking about working capital, you've generated a lot of cash last year. I think that's expected given the countercyclical cash flow profile of the business, your working capital metrics at the moment are also helped somewhat by those inventory write-downs, right, and about 1/4 of the reduction in inventory over the past year, we've talked about that issue. So if we're generating, let's say, nominal EBITDA and we're growing volumes. There's likely some reinvestment required in working capital, as just receivables but also getting in the right inventory. What's your confidence level about generating free cash in '21?

Looking at our inventory balance, Mark mentioned that our working capital, excluding cash, is about 15% to 16% of revenue, which is very low. If we account for the $24 million in inventory charges, it rises to around 18% or 19%. However, this still indicates we are turning working capital five times, which is strong. If we experience revenue growth, which we are predicting for the first quarter, we will begin to rebuild our inventory. We are currently in a transitional phase where, while we are not projecting a significant revenue increase beyond the first quarter, we expect some revenue growth. Our inventory levels are quite low, but we are prepared to restock. We anticipate that our cash consumption will relate to inventory and receivables, and this could lead to a situation where we do not generate free cash flow as early as the first quarter. That’s my assessment. If revenue remains flat, we might still generate cash on a quarter-to-quarter basis, but we are not predicting that; rather, we hope to see revenue growth and have adequate planning in place to meet demand, ensuring that we have the necessary products for our customers at a cost that helps us maximize gross margins. Mark, do you have any additional thoughts?

No. I think as you pointed out, the metrics at the end of the year were record efficiencies on working capital.

So then adding back the inventory charge to, Sean, is a good one.

Exactly. And so, I think you're right, the easing there on some of those metrics. And we actually have the cash to fund that growth that Dave mentioned to make sure we do have that inventory deployed. So, I think that free cash flow generation for us is really just the stellar job in the past 12 months by our team.

Could you provide us with a target for working capital related to sales by the end of 2021? We are uncertain about the sales figures and what the volumes might look like.

Yes, I believe it will be around 20%. To provide a bit more detail, we will be prepositioning inventory. You may notice that the working capital to revenue ratio will be higher than 20%, but it should trend towards that figure. In the initial stages of recovery, we will be stocking up and seeing growth in receivables, which will cause those ratios to stretch a bit. We plan to manage that over several quarters moving forward, but it will be around 20%, possibly a little higher.

Thank you. Our next question comes from Nathan Jones from Stifel. Your line is now open.

I have a follow-up on the WSA side of this. Dave, as we've gone along through this recession here, have targeted being at least breakeven and maybe profitable at the bottom of cycles. If we're looking at the second half of '20, run rate of revenue is about $1.3 billion in the second half of '20. Let's say, 20% product margins, would mean that you'd need to get down into probably the mid- to upper 60s on WSA. And you've talked today about continuing to drive that number down. Is kind of getting that down under $70 million, a reasonable target as we go through 2021?

Yes, let me clarify what we've guided. We discussed the first quarter, and we won’t reach $70 million then. It depends on the revenues. My instinct tells me that we won't reach $70 million this year, partly because we plan to take on new deals — I hope to report in 90 days that we secured another, larger deal. However, achieving $70 million this year seems unlikely. If we did get that low, it would result in increased inventory charges as we would rapidly push our transformation efforts. Over the past 12 months, we've undertaken numerous initiatives. I mentioned a few months ago that I want to embark on this journey with our customers and maintain those relationships as we make some significant changes in the business. Therefore, I don’t foresee reaching $70 million in EBITDA in 2021. While it’s a possibility, we currently don’t have a projected figure that low.

That helps. And I guess my follow-up question is, you've made a real transformation to the business model here with less inventory at local locations, more essentially held, more online, which means that we're probably not going to see costs to return to the business in the same way that they have done in past cycles. So maybe you could give us some help on how you envision WSA coming back into the business, kind of how much revenue could you layer on to where you're at today, where you're going to get to in 2021 before you really have to add some costs back? And then maybe if you've got any idea of incremental dollars of WSA per dollar of revenue growth as we get out further? Because my assumption here is that, that's going to be lower than what it's been historically.

I completely agree. We've seen an uneven recovery since late 2016 through 2018, which led us to add locations and personnel. We expect to see a similar trend moving forward. For instance, we recently opened a branch in Canada because we believe we are capturing market share there, and we will incur costs as necessary. There are still areas in Canada where we are reducing costs, and we will keep doing that. Overall, as we increase our revenue, most of those gross margin dollars should contribute to our bottom line. Historically, we've seen EBITDA flow-throughs to revenue in the 10% to 15% range. The WSA increase per revenue dollar should be between $0.02 and $0.05, as we anticipate flow-throughs will be in the 15% to 20% range. While I mentioned earlier that WSA may not be consistent every quarter, I expect it to decrease consistently as revenues grow. Therefore, I'm anticipating strong flow-throughs approaching that 20% level.

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 David Cherechinsky, CEO and President, for closing statements.

Okay. Well, thank you, everyone, for joining us. Thanks everyone listening on the call who prepped us without having power and water and all the hard work done giving this here, but thank you, everyone. We'll see you next quarter. Thank you.

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