Description

I recommend purchasing McDermott International, MDR.  MDR has reported a string of disappointing quarters resulting in a decline in the stock of 40% year to date.  The most recent quarter saw the stock fall 20% as the company took more charges on several problem contracts and indicated that profitability of its backlog has deteriorated into the low single digits.  While execution has been horrible recently, now is the time for patient long term value investors to benefit from short term overreactions to bad news.  The current book of business will generate subpar profitability and returns, but the long term earnings power of the company has not been impaired.  Furthermore, MDR is trading at or below liquidation value, creating a solid margin of safety.  MDR can potentially double in the next 2-3 years as loss making projects in backlog are burned off and the new book of business reverts to historical margin levels.

MDR has been written up several times in the past on VIC, starting with will579’s amazing call in 2003, but much has changed over the years and subsequent write ups and I feel it is a great time to revisit the story.

MDR is a leading engineering, procurement, construction and installation (EPCI) company focused on designing and executing complex offshore oil and gas projects globally.  The company is incorporated inPanamafor tax purposes and headquartered inHouston,TX.  Its fully integrated services deliver fixed and floating production facilities, pipeline installations, and subsea systems from concept and design through construction and commissioning.  MDR supports these activities with comprehensive project management and procurement services.  Its customers are national and major oil companies and other oil and gas E&P companies.  It has 14,000 employees and operates in 20 countries.  Revenues are broken down by three geographic regions: Asia Pacific 36%, Atlantic 29%, andMiddle East36%, in 2Q13.  96% of revenues are international.  MDR operates several JV’s with local operators in order to gain access to some markets that are more difficult for foreign companies to penetrate.  Most contracts are awarded through a competitive bidding process and are fixed price.

The company was founded in 1923 by Ralph McDermott inEastland,TXto provide construction related services to the drilling industry.  It went public in 1954 as J. Ray McDermott and acquired Babcock & Wilcox (BWC), a leading designer and manufacturer of power generation equipment, and a provider of nuclear services to theUSgovernment in 1978.  In July, 2010 MDR completed the spin off of BWC, transforming it into a pure play upstream offshore E&C company.

What went wrong?  Previous management focused on shallow water for the most part and underinvested in terms of personnel and assets.  Over time MDR fell behind some of its foreign competitors in more complex and lucrative deals in deepwater and subsea.  As new management came on board after the BWC spin, they began to transition the business more towards these arenas, but they stumbled.  MDR’s senior management and project managers did not successfully navigate the long complicated process of bidding and executing contracts in these areas, which has led to a series of disappointments and multiple large charges.

A review of 2Q13 highlights these ongoing issues.  All three segments reported significant losses.  Overall revenues fell 27%.  TheMiddle Eastsegment declined 48%, driven by delays in project execution and projects that had higher fabrication and marine activity in 2012.  The decline was partially offset by new projects inSaudi Arabiaand the Caspian.  Middle East had an operating loss of $69 million partially as a result of a $38 million charge from an increase in cost of completion on an EPCI project inSaudi Arabia.  Asia Pacific revenues fell 32% to $230 million due to delays in project execution and lower marine activity that led to a $32 million operating loss driven by an increased loss estimate of $62 million due to delays on a deepwater pipelay project inMalaysia.  Excluding this charge though, MDR would have posted a 13% operating margin.  The Atlantic segment revenues increased 69% to $187 million primarily because of increased fabrication activity on new projects inMexico, partially offset by lower activity at itsMorgan   City,LAfacility.  Underutilization and a lack of productivity have led to a long history of unprofitability in this segment.  In the most recent quarter it recognized an operating loss of $49 million due to changes in estimates on two projects for $10 million, but also on restructuring charges of $16 million in the quarter as management finally decided to address its structural problems.  RestructuringAtlanticcould total $60 million through mid 2014.

After several downward revisions the current outlook is for approximately $3 billion of revenues in 2013.  3Q13 should be breakeven to a slight operating loss.  Signs of recovery should begin to show in 4Q13, as a large JV project (Papa Terra) on deferred profit recognition starts to contribute to earnings.  MDR defers profit on certain projects, in this instance because of its first of a kind nature, so that revenues and costs are recognized equally until an estimate of final profitability can be made.  For 2014 management has guided to 5-8% operating margins, which is below full potential, but marked improvement from the dismal performance of 2013.  Eventually beyond 2014 there is no reason that operating margins can not return to the historical average level of 10-12%.  Peak margins have often been considerably higher than this, as well.  There is even the possibility of higher margins in the future as MDR’s mix shifts towards higher value added areas.  Capex is being reduced from the original target of $400-500 million to $300-350 million for each 2013 and 2014.

Management has slowly reacted to these problems and is beginning to focus on improving execution.  2013 has been a write off, but there is reason to believe that 2014 will be a year of recovery and that longer term MDR will become very profitable again.  Notably in the most recent quarter, management announced the restructuring of the chronically loss generating Atlantic segment by shutting down theMorgan City,LAfacility once the current projects finish.  It will consolidate it fabrication activity in itsAltamira,Mexicoyard.  The restructuring could add $40-60 million to operating income when complete, so Atlantic could be breakeven in the back half of 2014.  There is also a new strategic initiative to improve the bidding and execution of contracts.  Part of this process has been to terminate some key employees, while also adding to leadership in subsea, partially through the acquisition of Deepsea Group in theUK, which provides subsea and engineering services, as well as through outside hires.  There was nothing wrong with management’s vision of an MDR with more deepwater and subsea capability, but there was a serious problem with its execution.  In addition to bolstering leadership, management has been focused on an aggressive capex budget to upgrade its fleet to better access and serve deepwater and subsea markets, but also to reduce reliance on third party vessels through subcontracts, which can increase risk and cost in a project.  Reputation is extremely important in this business because customers are relying on E&C providers to reliably complete projects according to plan and on time, so as execution improves MDR should receive more consideration on larger, complex, higher margin contracts.  Longer term the case for higher margins can also be made because of its fleet upgrade to larger more technologically advanced vessels with the Derrick Lay Vessel 2000 and the Lay Vessel 108 coming online in 2015.

Current backlog is $5.1 billion, of which $375 million relates to active projects in loss positions, where future revenue is expected to equal costs, which creates a drag on operating margins for the next several quarters.  $187 million of these losses is for a project inMalaysia, while $181 million pertains to a charter inBrazil, so this is the vast majority of the losses at this point.  The loss position has been steadily declining from $429 million in 1Q13 and $545 million in 4Q12.  It is common for MDR to burn through at least 60% of its backlog in a given 12 month period, so despite the challenges most of these problems will be behind the company in early 2014 and then margins should begin to revert to their historical mean.  Book to bill has also tended to bottom out in the .6 to .7 range.  MDR hit .68 in 1Q13 and should begin to increase this again because it has record bids outstanding and deepwater offshore activity continues to be strong.  As book to bill increases, asset utilization and margins will pick up driving return on equity.

The particularly challenging projects that MDR is currently working through are inMalaysia,Saudi ArabiaandBrazil.  In Malaysia MDR is working on the subsea infrastructure of the Siakep North – Petai development project operated by Murphy Sabah Oil Co, which involves the installation of deepwater rigid, reel pipe.   It has experienced delays, which have led to a $62 million increase in estimate to complete in 2Q13.  In 4Q12 management said they had underestimated the duration of the installation and increased the estimate then as well.  In 2Q13 they experienced supplier delays and prolonged reconfiguration of their Lay Vessel 105.  As a result of the delays, the marine campaign must now take place in two phases to avoid monsoon season, so there will have to be two vessel mobilizations.  TheLV105 has completed trials and is ready to go.  MDR is now completing its first pipelay on the project, which if it goes according to plan should signal that the project is back on track and the charges already recorded were sufficient, although some uncertainty remains. The project will be mostly executed by the end of 2013.  The $38 million charge inSaudi Arabiawas because of changes in estimates that included revisions to the project execution plan, an increase in estimated cost to complete due to an extended offshore hookup campaign requiring multiple vessel mobilizations, and also delays in the completion of on shore activities.  The onsite project management team has been fired and a new team leader who recently successfully completed another project has taken over.  The project will be significantly de-risked at the end of October as the hookup phase ends.  Despite this costly setback, this project is still profitable and will be completed in the first half of 2014.   In Brazil MDR’s Agile vessel is on a five year charter and is in a loss position, but it was not material in 2Q13 and has not deteriorated at all in the past year, so management is optimistic that it will not cause any more negative surprises.  The problem contracts in Atlantic are smaller and one has already been completed and the other will be completed in the next couple of months.

MDR’s end market remains vibrant.  GS expects a 14% CAGR for total offshore capex though 2018 with certain segments much higher.  Ultra-deepwater, for example, is expected to grow 30% annually, hence the strategic initiative to reposition MDR to better address this opportunity.  MDR has $8.1 billion of bids outstanding and $21 billion of target projects that could be tendered in the coming years, so revenue growth will pick up again.  The market is very competitive, but rational because of the fixed price nature of most contracts.  MDR’s closest competitors are generally larger international firms based inEurope, like Technip, Saipem, and Subsea 7 that have greater scale and global reach.  The industry is beginning to see more, smaller local content providers in different regions that might focus on specific niches of the value chain, rather than providing an integrated EPCI offering.

While recent results have been bad and management mis-execution disconcerting, the longer term outlook for MDR remains bright.  Its addressable market is very healthy and growing, MDR owns a solid set of assets that will once again produce good margins and cash flow as management takes corrective actions and puts problem contracts behind it.  MDR has traded at 6.5-7.5x EBITDA and 12-13x EPS over the past few years, and at a slight discount to its peers.  By the back half of 2015 MDR should be on a $3.75 billion run rate of revenues.  And as margins return to historical levels MDR should generate at least $440 million of EBITDA and $1.00 of earnings.  So the stock is trading for 3.2x a normalized level of EBITDA and could be worth $12-15.  As execution and the mix of contracts improve, and margins follow suit, there is also the opportunity for a rerating of the stock to at least inline with its peers.

In the bear case, 2014 could look a lot like 2013, if cost overruns and delays persist.  A realistic worst case scenario might be a couple hundred million of charges, although it would still not diminish the long term earnings power of the company.  In this scenario, MDR’s reputation would be damaged and management would be distracted, leading to a slower rebuilding of backlog, so 2015 revenues might be more in the order of $3.3 billion.  If operating margins remained at a substandard level EBITDA could be in the $150 million range, so the stock could fall just below $6 at 6-7x. 

In the bull case, better oversight of bidding and project execution could lead to dramatically higher backlog of large, complex, higher value add contracts.  In three years revenues could be approaching $4 billion with EBITDA margins well in excess of what it has had in the past.  In 2010 EBITDA margins were 18%, so cyclical peaks can be quite a bit better than the average, and a greater mix of deepwater and subsea will provide a lift to margins, as well.  At $4 billion of revenues and EBITDA margins rising to 17%, MDR could generate around $675 million of EBITDA, which sounds extravagant, particularly in light of recent problems, but not out of the realm of possibility.  At 7x that could translate into a $21 stock.

Asset value should provide some support for the stock.  Book value and tangible book value per share are $7.21 and $7.03, respectively, which is fairly representative of a fire sale liquidation.  I have spoken with some people in the industry that facilitate vessel loans and several sellside analysts have taken a crack at a liquidation analysis.  There is a very wide range of potential values for the individual vessels because this is an illiquid market with highly differentiated assets, but the bottom line remains that the stock is cheap in relation to its net asset value.  The estimated value of the vessels ranges from $875 million to $1.5 billion.  The DLV 2000 andLV108 are expected to cost about $710 million to build and there is approximately $200 million of paid up capex on those currently, which I include in the asset valuation.  Incidentally, MDR could always unload these into a tight market if the cash burn becomes too much because competitors would be happy to put them into service in 2015 rather than waiting until 2017 or beyond if they ordered similar vessels themselves.  MDR’s fabrication yard and other equipment could be worth $600 million and there is $332 million of net cash.  So asset value supports a share price of $8.50-11.15, i.e. higher than where the stock is currently trading.  A further sanity check comes as MDR had its fleet insured for approximately $1.2 billion in 2012, which corroborates the asset value.

If management is not able to right the ship, MDR could very well become an acquisition target.  Over the past five years, E&C takeout multiples have averaged roughly 7.5x EBITDA.  With an increasingly valuable fleet in a market that is increasingly becoming tighter on capacity many of its competitors could be interested, although in the near term there is not a clear suitor, partially because of MDR’s troubles, and partially because individual issues at the likely acquirers.  Technip is probably the most likely buyer, but it recently purchased Global Industries in 2011 for almost 9x EBITDA, which has very similar assets to MDR.  Technip might be out of the market for now as it integrates Global Industries.  Subsea 7 could benefit from increased scale and global reach, but it too recently made an acquisition in 2011.  Saipem would also be a good fit, but is currently dealing with many problems of its own that make MDR look very well managed.  Asian multinationals in the space, like Samsung Heavy Industries or Hyundai Heavy Industrial, could benefit from MDR’s expertise. Diversified US E&C companies might also be interested, particularly KBR, which has experience in offshore construction.  Companies that currently work with MDR on JV’s could, as well, like Keppel Corp.  At 7-9x normalized EBITDA, MDR could fetch $14-18 in an acquisition.

Why is this opportunity available?  Time arbitrage appears to be the reason.  Most of the street has recently downgraded the stock to “throw in the towel” and/or maintained their “wait and see” rating.  Tax loss selling season is approaching and investors have given up on MDR in the short term.  2013 has been extremely disappointing and while 2014 will be a year of recovery, MDR will not achieve normalized margins until 2015, which might be beyond many people’s investment horizon.  The fear of unknown unknowns is also contributing to the depressed valuation.  Clearly, there is considerable earnings power here and asset value provides a significant degree of margin of safety.  So the most important question becomes: how much more value can management theoretically destroy?  Or perhaps more importantly: how much value has management already destroyed that we don’t know about yet?  As explained earlier the bulk of the current problem contracts should be resolved in relatively short order.  However, there is one project in its early phase that management claims is on track, but it obviously still warrants a healthy dose of skepticism.  The Ichthys project is an offshore LNG development inWestern   Australiafor INPEX.  The contract is worth over $2 billion of revenues and competitors have noted that MDR bid aggressively, so there is a chance that management exercised the same lack of bidding discipline on this project that it did on some others recently.  The contract is 3% complete with 2/3 of the engineering completed with the balance done by the end of the year.  $1.2 billion of the contract has been subcontracted out for procurement.  MDR started fabrication on time at its Indonesian fabrication yard and the North Ocean 102 that has previously worked in the area is doing most of the installation.  There have been reports of delays in onshore activity, but management has stated that everything has gone smoothly on its end thus far.  The marine campaign does not begin until 3Q14, so it might take that long for any problems to trickle through to MDR.  The risk to this project notwithstanding, the successful completion of the project would place MDR firmly in the top tier globally and should improve contract wins on far more lucrative projects in the future.  And while there is that risk in backlog, in the $8.1 billion of bids outstanding over 80% is conventional work, as management has stepped back from bidding on subsea business until it is better prepared to handle it.

Stephen Johnson was appointed CEO in July, 2010, following the BWC spin off.  He had already been running the offshore E&C business J. Ray since April, 2009.  Prior to joining MDR he was a senior executive vice-president at Washington Group, which was acquired by URS.  Following the most recent earnings miss, Johnson bought 74k shares at $6.74 for about a half a million dollars.  This is certainly not chump change, but not exactly huge when compared to his total compensation in 2012 of $6.9 million, which seems egregious given the hole he was digging at the time.  MDR has stock ownership guidelines and he is still about $1 million shy of his requirement of 5x base salary, so for a real all clear signal follow his activity over the next 18 months, which is the remaining period to meet the requirement.  On paper management looks good, but clearly their performance has created a complete lack of credibility and confidence.  Management is committed to their initiatives, but also aware of the need for scale and better, more consistent operating results.  The board of directors seems solid and I would expect them to take action in the event of any more missteps, lest shareholders decide to take it upon themselves to do so.  Management is also well compensated in a change of control.

The main risks with MDR are execution with the corollary of more losses embedded in current backlog from past mis-execution.   Aside from those issues, competition, the economy, fluctuations in commodity prices and FX are all risk factors.  Tax laws could also have an impact as MDR is incorporated inPanama, but operates in other locales.  MDR is also aggressively spending capex on new vessels, which will produce long term benefits, but make free cash flow negative through 2014.

In summary, this is a good, albeit volatile, business with good assets that has considerably more earnings power than it is given credit for today.  As the problem contracts roll off, charges lessen, and bidding discipline and execution improve, margins will rebound and MDR will again generate substantial cash flow.  As you wait for that to happen, asset value should support the stock.  The recovery process will surely be a long and bumpy road, but it should also be very rewarding to those patient investors with a long term horizon.

Catalyst