Description

Babcock & Wilcox, BWC, is an engineering and consulting company focused on power generation and being a contractor to the US government for nuclear components and services that was spun out of McDermott, MDR, in August 2010.  Short term headwinds have depressed BWC's results and valuation, but it has numerous attractive long term growth opportunities, as well as a business model with high barriers to entry and stable, recurring revenue streams.  BWC is worth at least $30/share.

BWC operates four segments: Power Generation, Nuclear Operations, Technical Services, and Nuclear Energy.  Power generation includes coal fired power generation, environmental systems, renewable energy facilities, as well as service, operation and maintenance. Demand for the Power Generation segment depends mainly on the capital expenditures of electric power generating companies and other steam using industries.   Prices for electricity, prices for fuels, the state of the economy, and environmental issues, among other things can influence this capital spending.   Nuclear operations are mostly reliant on defense spending by the US government and mainly involve US Navy submarine and carrier programs, as well as fuel services.  It is a major supplier of nuclear components for these critical government programs.  Technical services revenues and equity income is mainly a function of spending by the US government for high consequence operations at nuclear weapons sites and national laboratories for a variety of services, like materials handling, storage, security, decontamination, and decommissioning.  It participates in the cleanup, operations, and management of nuclear sites maintained by the DOE.  The Nuclear Energy Segment is field services, plant modifications, component manufacturing and installation, and fuel enrichment.  It is dependent on the future demand for nuclear energy and for R&D for the modular nuclear reactor, mPower.  BWC relies on large contracts for a significant portion of its revenues with percentage of completion accounting.  Competition in power generation segments is Alstom, Doosan Babcock Foster Wheeler, Mitsubishi Heavy Industries, and Hitachi.  For government contractors, competitors are Bechtel, URS, CH2M Hill, Flour, Northrop Grumman, Lockheed Martin, Jacobs Engineering,  and EnergySolutions.

Revenue breakdown:

The company was spun off in order improve both BWC and MDR's positions since there were few synergies from the combination, but considerably different end markets, strategies, and opportunities.   The main reason, however, was that Federal Acquisition Regulation, FAR, rules prevented the US Government from contracting with companies that are incorporated offshore for tax purposes, like MDR is.  Therefore, the separation should dramatically enhance BWC's ability to bid on government work.  The strategy since becoming independent is to expand its global presence, diversify its business portfolio and transition towards services and solutions.  BWC can leverage its fossil fuel and nuclear expertise to branch out into Europe and Asia.  It will expand its business portfolio with nuclear field services, mPower, and new programs with the US Navy.

In most of its business lines, BWC enjoys long-term recurring revenues with good margins that are very stable and predictable.   BWC generally has low capital requirements, ranging from 2-3% of revenue per annum.   Licensing, qualification, and specialized facilities provide enormous barriers to entry in many of its segments due to the sheer amount of time it takes to build expertise in the field, to obtain the requisite permitting, and  to perform trials and build a track record, not to mention the significant capital that would be required to recreate such assets.   These attributes result in an impressive pretax ROIC of 13% LTM, 20.3% 2010, and 37.7% 2009.

Over the past few years, BWC faced several formidable headwinds, which caused booking and margins in 2010 and YTD 2011 to be disappointing, which has consequently resulted in a compelling valuation.  The power generation segment is leveraged to power demand, which is a derivative of general economic growth, so the credit crisis and recession had a negative impact because there has been a sizeable decline in orders in North America over the past 18-24 months due to decreased electricity demand and lower capital spending by utilities.  There has also been some impact from increased usage of natural gas for power generation.  A lack of clear US energy policy and regulatory uncertainty held up many power generation projects and related services.  While government deficit concerns have not had much of an impact on BWC's fundamentals, it probably has played a role in compressing its valuation.   Sentiment towards nuclear services can also be impacted by catastrophic events, so the March 2011 earthquake in Japan and subsequent Fukushima disaster could affect the pace of global licensing and construction of new nuclear power facilities, in addition to weighing on the stock.  Although there are promising growth opportunities that will outweigh the shorter term issues, they have been underappreciated as a result of the lack of visibility regarding timing.

Backlog:

Perhaps the most important growth driver for BWC, due the certainty of timing and the scope, is the required utility capital investment from new EPA regulations: the Clean Air Transport Rule, CATR, and the Mercury Maximum Achievable Control Technology, MACT, which aim to reduce pollutants like SOx, NOx, and mercury.  In July 2011 the EPA released its final cross state air pollution rules.  The compliance period for utilities begins in January 2012. These EPA regulations will drive increased demand for environmental remediation design, engineering, equipment supply and installation for the next few years.  Management anticipates that the implementation of these rules affecting approximately 180 coal fired power plants in 31 eastern states will create a $12 to 24 billion market opportunity over the next 5 years.  Historically, BWC has had 25-30% market share of scrubbers and other addressable equipment, so it could potentially capture about $5 billion in revenue from emissions work during this timeframe.  Although this is a nearer term opportunity, there is still potential for delays as a result of appeals, but clarity should come in the next 2 months.

Beyond the regulatory arena, BWC's Power Generation business will also benefit from the cyclical recovery in the coal fired boiler market because there has been underinvestment in the space as a result of the lower demand for power.  BWC has a strong presence with a large installed base with almost 40% market share in services and aftermarket.  Aftermarket services in this area are very strong and provide a very long lived recurring stream of revenues.

There is heightened scrutiny of government budgets, particularly in defense, but the Nuclear Operations segment is well positioned to grow 5-8% over the next several years.   BWC is the sole supplier of nuclear reactors to the US Navy's submarine and aircraft carrier programs.  The US Navy is in the process of replacing 44 Los Angeles class submarines with 30 Virginia class subs.   This program should remain in place for at least the next 10 years with 2 submarines being completed annually.   BWC also has good opportunities in Ohio class submarines and Ford aircraft carriers.  These programs have already had cutbacks in the past few years, but management does not expect further reductions due to the cuts that were already made, the cost reductions that have been implemented, and the importance to national security.

Opportunities abound in Nuclear Energy also.  BWC divested its nuclear aftermarket business to Areva just over 20 years ago and the non-compete recently expired in 2009.  BWC will be very competitive in this field.   Furthermore, disasters like Fukushima can have a negative impact on new reactor builds, but should also have a positive impact on maintenance and security standards.  Shaw group has also estimated that 67 nuclear reactors in the US and more internationally could be candidates to overhaul, creating a market opportunity of $25 billion.

Longer term, BWC has a tremendous opportunity in nuclear power generation with mPower, although material revenues might not come until 2015 or later.   BWC plans to leverage over 50 years of experience in designing modular nuclear technology for the US Navy submarine program into a unique commercial nuclear reactor for utilities.  mPower reactors will be small and modular providing cost and operating efficiencies to utilities with less upfront cost, shorter construction times, and scalable capacity.  These reactors should also be safer than those currently in service, so there will be less fallout from negative sentiment due to the potential for catastrophic events at traditional reactors.  There is also a better alternative with respect to spent fuel storage.  BWC is beginning to get traction with the idea with the Tennessee Valley Authority, TVA, and a consortium of 13 other utilities to exploring  mPower's viability.  TVA sent a letter to the NRC for instructions on the potential construction for 6 mPower reactors last year.  In July 2010 a JV was formed with Bechtel to design and construct mPower.  In addition to the utility market, management believes that mPower's value proposition will also make it applicable in refining, petrochemical facilities, desalination, etc, as well as with prospects internationally.

Technical services growth is also poised to accelerate with new business at the DOE Portsmith enrichment plant and potential extensions at Y-12 and Pantex with the National Nuclear Security Administration for the production, refurbishment, and dismantlement of weapons components.

Additionally in technical services, a recent project win at USEC to provide integrated manufacturing and assembly of centrifuge machines could be meaningful in several years, but uncertainty remains.  In May 2010 BWC signed an agreement to invest $100 million in United States Enrichment Corporation's American Centrifuge Project.  Most of the commitment is contingent upon USEC obtaining a conditional loan guarantee, which has taken longer than USEC management expected, although $37.5 million was already distributed in 3Q10 by BWC.  As a result, USEC is reducing costs and will continue to fund the project, but at a 30% slower rate.   In June 2011, BWC, along with co-investor Toshiba, and USEC agreed to a standstill to allow for more time for the loan guarantee.  Expectations are low at this point for the project, but it does have the promise of being a big revenue generator with strong margins long term, potentially generating an incremental $150-200 million of revenue once it has ramped to the expected peak production of 400 units/month.

Technical services also has a JV with Covidien, which could potentially supply more than 50% of US demand for the isotope, Mo-99.  There are roughly 16 million nuclear medicine procedures performed annually in the US, which depend on Mo-99.  Currently, the entire supply of Mo-99 is imported and supply is chronically interrupted by unplanned reactor shutdowns that cause shortages. 

BWC also has JV's in India and China for power generation, which are relatively small currently, but should be high growth ventures in the future.

BWC has 117.8 million shares outstanding with 1.1 million options that strike at $14.21.  There is $268.6 million of cash, $4.2 million of debt, and minority interest of $.8 million.  At a price of $21.52, the market cap is $2.5 billion and an enterprise value of $2.3 billion. 

In 2012 BWC should generate approximately $3.25 billion in revenue, $410 million in EBITDA, and $215 million of net income.  For 2013 it should generate $3.7 billion, $430 million, and $250 million, respectively.   Running a DCF for various scenarios yields an intrinsic value in excess of $30/share.   At $30 the stock would trade around .9x EV/revenues, 7.5x EV/EBITDA, and 14x P/E, which is relatively in line with its peers.  One could argue for a premium valuation also due to the stability and diversification of its revenue streams, its attractive ROIC, its promising growth prospects, and the fact that it is a potential acquisition target.

Risks include economic weakness and its impact on demand for power and capital expenditures at utilities.   Adverse regulatory and environmental events could also pose a risk.   Increased scrutiny of government budgets and austerity programs could reduce demand.  There could also be higher than expected pension expense. 

Catalyst