McDermott International is one of the world's leading offshore oil and gas engineering and construction companies. The stock sold off from $25 down to $10 after several earnings warnings reflecting disappointments on two projects. While the problems appear limited, this disappointment likely places MDR in the “show me” category until its next quarter or two of results and the company is already beginning to show signs of improvement. Operating margins over the past six years average approximately 10%, which imply a run-rate of EPS of approx $1.30 --> at $13 per share, MDR is discounting "no growth" from here despite $5 billion-plus in near-term signing opportunities coupled with $2 per share of net cash on the balance sheet. With a few favorable outcomes in signings in 2012, I would expect the stock to appreciate to better reflect the company's growth opportunities. A more normal year would likely contain revenues of approximately $4.0 - $5.0 billion at 12.5% margins, or $1.70 in EPS --> $20+ stock price. Also, margins have some upside potential (i.e., could be higher than 10% intermediate term). Over the past six years, MDR has been able to generate margins of 10% - 16% except during the downturn of 2008-2009, and as expansion into deepwater along with the run off of some older margin contracts should aid margins.
MDR has only $82mm of long-term debt (due 2014), over $500mm of unrestricted cash and a new $950mm unused credit facility. The company no longer carries asbestos risk and its pension plan is 92% funded and duration matched. MDR’s credit rating is BB (stable), relating largely to the industry cyclicality and the fixed price contract risk.
MDR has a diversified client base that operates in both developed and developing nations, with 95% of business coming outside the U.S. Backlog is currently around $5 billion (>1.3x NTM sales) and could potentially expand given outstanding bids on larger projects. Over the past year, the company has significantly increased its capacity utilization yet still has 30% available for expansion. The company’s balance sheet has minimal debt and therefore has the ability to make new capital expenditures should the number, size and scope of their projects increase. Also, there should be a significant increase in free cash-flow yield as the company sells assets related to discontinued operations. Net capital expenditures could be negative from 2011-2013.
BACKGROUND
Domiciled in Panama, based in Houston, Texas and with a history dating back to 1947, McDermott International is the leading global construction company for the fixed production and oil pipeline industry. MDR’s business activity depends mainly on capex for offshore construction services of oil and gas companies and foreign governments and the company generally relies on large contracts.
Key Investment Attributes
Full service offshore oil and gas E&C
Attractive industry outlook; strong secular growth potential
Global presence with strategic assets
Diversified and strong customer base
Substantial backlog with good visibility
Strong risk management capabilities – any project >$40mm gets reviewed by top management
Experienced management team
Strong balance sheet and capital structure
In mid-2010, the company spun-off the Babcock and Wilcox segment of their business to focus exclusively on offshore Engineering & Construction in the Oil & Gas space. MDR now employs 14,000 in 20 countries and operates in three geographic regions, Asia-Pacific, Atlantic and the Middle East. The company focuses on designing and executing complex offshore oil and gas projects. It is involved in the fabrication and installation of fixed and floating structures, and bottom-founded production platforms; installation of pipelines and subsea systems; and provision of engineering and procurement, and project management and procurement services.
Offshore and Underwater Facilities
Rank
Firm
$ Millions
1
McDermott International
$1,770
2
Kiewit Corp.
$595
3
Fluor Corp.
$358
4
KBR
$201
5
The Shaw Group
$11
Source: Engineering News – Record 2010
Pipelines
Rank
Firm
$ Millions
1
Bechtel
$3,670
2
McDermott
$1,165
3
Michels Corp.
$748
4
Willbros Group
$727
5
Sheehan Pipe Line Construction
$672
Source: Engineering News – Record 2010
MDR boosts a strong customer base in developing economies (59% Middle East, 25% Europe and Asia). Gulf of Mexico exposure is limited at 10% of revenues. The majority of that exposure is conventional shallow water work. Customers include majors like Conoco, Exxon, Chevron, BP, along with NOCs like SaudiAramco, Pemex and Petrobras. Saudi Aramco was the largest customer in 2010 (30%), followed by Chevron (15%), then Exxon (10%).
Key Drivers
Oil and gas prices
Cost of exploration
Terms and conditions of offshore leases
Discovery rates of new oil and gas reserves
Local and international political and economic conditions
Cost of potential future litigation
INDUSTRY FORECAST
Industry forecasts suggest that while shallow water will continue to comprise the majority of offshore spending, deepwater is expected to grow at a faster rate. Deepwater spend is projected to increase from $541 billion (2001-2010) to $1.3 trillion (2011-2020). Brazil, West Africa and Asia Pacific are expected to drive growth in the deepwater.
MANAGEMENT
MDR is run by Stephen Johnson, a former EVP at Washington Group (WGII was bought by URS in 2007). Prior to WGII, Johnson began with Fluor back in 1973. He has surrounded himself with a deep team, with senior management having about 35 years of experience on average. Management receives two-thirds of its compensation in stock options and RSUs, aligning them fairly well with outside shareholders.
Risks
Over 70% of MDR’s backlog is fixed price which presents greater margin volatility risk than cost-plus.
If new project capex slows significantly. MDR’s backlog of $4.7bn is near the company’s record high. Can this be sustained? Why is the market wrong? Industry forecasts call for a doubling of oil and gas capex over the next decade which seems intuitively likely unless oil prices drop considerably. MDR should be a direct beneficiary of this industry growth.
If cost over-runs continue and become more significant.Why is the market wrong? Management has already erred to be the side of conservatism with regards to its recent overrun experience, suggesting that if anything, controls will be even more stringent going forward.
Weather. This may be the biggest risk factor for MDR. High winds, flooding, earthquakes, can all push back the delivery of a project and/or raise the cost.
Cost overrun risk. 70% of backlog is fixed price. MDR can suffer operating losses if it fails to delive a project on time and/or within budget.
Oil prices / macro. If oil prices collapse (or it is perceived that they will), large energy companies and NOCs could likely materially reduce oil and gas capex, which would negatively impact MDR’s backlog and operating performance.
Hazard risk. MDR frequently operates in challenging and dynamic locations. The company procures insurance and operates its own captive insurance company. MDR also has the risk of a damage (or loss of) a vessel.
Environmental. MDR’s operations are subject to a wide range of environmental standards. The company is currently in the process of investigating and remediating some of its former operating sites, with reserves totaling $3mm. Due to the uncertainties associated with environmental remediation, there can be no assurance that actual costs will not exceed recorded reserves.
Currency risk. MDR generates 95% of its sales outside the U.S., which creates currency risk.
Tax risk. MDR is organized under the laws of the Republic of Panama.
Catalyst
McDermott International is one of the world's leading offshore oil and gas engineering and construction companies. The stock sold off from $25 down to $10 after several earnings warnings reflecting disappointments on two projects. While the problems appear limited, this disappointment likely places MDR in the “show me” category until its next quarter or two of results and the company is already beginning to show signs of improvement. Operating margins over the past six years average approximately 10%, which imply a run-rate of EPS of approx $1.30 --> at $13 per share, MDR is discounting "no growth" from here despite $5 billion-plus in near-term signing opportunities coupled with $2 per share of net cash on the balance sheet. With a few favorable outcomes in signings in 2012, I would expect the stock to appreciate to better reflect the company's growth opportunities. A more normal year would likely contain revenues of approximately $4.0 - $5.0 billion at 12.5% margins, or $1.70 in EPS --> $20+ stock price. Also, margins have some upside potential (i.e., could be higher than 10% intermediate term). Over the past six years, MDR has been able to generate margins of 10% - 16% except during the downturn of 2008-2009, and as expansion into deepwater along with the run off of some older margin contracts should aid margins..
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