Value Investors Club / MCDERMOTT INTL INC (MDR)

Description

MDR 10 5/8 unsecured bonds of 2024 traded down to 87 on Friday reflecting a 14% Yield to

Maturity and 19% yield to call (2021). I believe this reflects an attractive risk reward

opportunity.

We think the bonds are money good and the stock worth around $25 to $30 per share in the

long term pre Chiyoda Liability and the Bonds money good and the stock worth $1-3 less per

share should Chiyoda fail to perform.

I wrote MDR equity up in January on the heels of the announcement of the merger with CB&I.

For background on the merger I recommend reading that write-up.

Since the merger closed, the company has increased cost synergy guidance from $250 million

per year to $475 million per year but has also increased cost estimates for the CB&I’s “Troubled

Projects” first by $234 million on the Q3 call and then by another $744 million on the October

30th Q3 call ($125 million increase to the cost synergy guidance got lost in disappointment

about the project losses).

MDR’s stock which had been in the low 20s to high teens post merger declined from $18 to $13

during the month of October along with the slide in Oil, possibly concerns about MDR’s

exposure to Saudi Arabia in the case of any sanctions following the Kashoggi affair, and

probably primarily due to leaks/insider trading from people who knew about the forthcoming

increase in cost estimates for the Freeport and Cameron LNG projects. With 180.5 million

shares outstanding, this decline in MDR’s stock price represented $900MM of Enterprise Value.

To deal with the increased working capital needs of the troubled projects, MDR proactively

executed a $300 million preferred stock deal with Goldman Sachs Merchant Banking (I think the

Special Situations Group). This was pretty expensive financing. $300MM of preferred stock at a

12% coupon that can be cash pay or PIK at the company’s option. Any PIK preferred would be

at a 13% coupon. Goldman also got 3.75% of the company’s stock (i.e. about 6.8 million shares)

in penny warrants and 1.2x liquidation preference and repayment requirement. Heavy, but It

will stabilize MDR’s working capital (when it closes at month end November).

MDR also announced that they would be selling two of CB&I’s businesses that they identified as

Non-Core: The Storage Tank business and the Pipe manufacturing business. Why MDR

management has said they would have been selling these businesses anyway, it seems the

need to delever is the real driver. EBITDA for these two businesses is about $200MM. Mgmt

indicated they would receive proceeds in excess of $1 billion. I think 7-8x or $1.5 billion is a

reasonable price.

MDR’s stock fell from $13 to a low of $7 intraday on Oct 31st

following the announcement, closing at $7.76. The 10 5/8ths bonds fell to 91c.

MDR held a mini investor investor day on Monday, November 5th

where they took people through the details, reassured investors that the full extent of the losses were accounted for

and that the company would attempt to do better through managing sub-contractors tighter

and attempting to recover some of the increased costs from the client. They also made clear

that they expect do receive process “in excess of $1 billion” on the Tank and Pipe business sales

not “ $1 billion”. MDR stock recovered to the high $9s on Tuesday November 6th

and the bonds traded up to about 94.

After the Close on Tuesday November 6; MDR disclosed that three MDR executives purchased

stock on Tuesday: Chairman Gary Luquette purchased 50,500 shares at $10 ($504,854); CEO

Dickson purchased 39,800 shares at $9.96 ($396,332) and CFO Spence purchased 25,000 shares

at $9.98 ($249,458). On Wednesday, MDR’s stock rose to above $10.50.

On Thursday night (Friday afternoon) in Japan, MDR’s JV partner in the two material loss

projects Chiyoda (6366 JP) disclosed that they had “doubts as a going concern” in their regularly

scheduled earnings call. Chiyoda had disclosed charges of over $900 million on October 31st along with MDR.

Chiyoda is a 33% JV partner in the Freeport LNG project (along with MDr at 33% and Zachry

Construction at 33%) and a 50% JV partner with MDR in Cameron LNG Project. Despite being

aware of Chiyoda’s estimated losses for over a week, the going concern disclosure from

Chiyoda spooked MDR stock and bonds. The stock traded down from the mid 10s to $9.60ish

on Thursday and down another $1 on Friday to $8.46 on Friday.

MDR and Chiyoda (And Zachry on Freeport) are joint and severally liable for the costs of the

troubled projects. So the market is now concerned that MDR will be responsible for all or a

portion of Chiyoda’s losses on Freeport and Cameron. For reasons I will lay out here, the

Chiyoda concern is a contingent liability that is unlikely to materialize and is if it does is unlikely

to be material to MDR in the long term. Certainly, the market has fully discounted the full

extent of the possible additional Chiyoda costs (about $392 million after tax or $2.10 per share)

when only half seem possible ($204 million after tax or $1.09 per share) and any liability seems

unlikely.

Chiyoda Financial Position

Chiyoda announced a $96.3 billion Yen loss for Q3 primarily resulting from a $108.6 billion Yen

($955 million) charge related to troubled projects with most of this charge related to Cameron

LNG. After the charge, Chiyoda has about 47.5 billion Yen ($418 million of shareholders equity)

and $386 million of tangible equity.

Chiyoda 9/30/2018 Balance Sheet
	Yen (billions)	$s (millions)
Cash & Depsoits	76.5	673
Operating Assets	81	713
Accounts Receivable -other	45.6	401
JV Assets	134.9	1187
Other	3.8	33
Current Assets	341.8	3008


PP&E	11.7	103
Intangible Assets	5.7	50
Investment and other Assets	16.5	145
Non Curretn Assets	33.9	298

Total Assets	375.7	3306



Short Term Loans	0	0
Operating Liabilities	262.7	2312
Provision for Losses	26.1	230
Other	18.8	165
Current Liabilities	307.6	2707

Long Term Loans Payable	15	132
Other	3.5	31
Long TermLiabilities	18.5	163

Total Liabilities	326.1	2870

Shareholders Equity	49.6	436

Tangible Equity	43.9	386

Definitions
Operating Assets
Notes reciavable, AR from completed projects, costs on uncompleted construction projects

JV Assets
Cash & deposits of JV proportional to Chiyoda's interest

Operating Liabilities
Notes payable, Accounts payable for construction contracts, & advances received on uncompleted construction contracts

Based on these disclosures it appears to me that Chiyoda has provisioned for and can meet its

obligations on Freeport and Cameron LNG without being insolvent. However, with an only

12.7% Equity ratio, Chiyoda would not be a viable contracting entity going forward.

Text of Chiyoda Financial Release- Highlights

November 9, 2018

Due to the above [Loss] the Company expects deterioration of cash flow and new financing will be required during this fiscal year. Under this circumstance, the Company recognizes events and conditions which may cause substantial doubts about the Company's ability to continue as a going concern....

1. Ongoing project...

2. Enhancement of risk management capabilities...

3. Extensive cost reduction...

4. Strengthening financial performance

Amid its massive second quarter losses it is the Company's highest priority to reinforce its financial standing securing the reserves necessary. The Company is considering any possible choices such as alliance with industrial partners and financial investors, loans from lenders and others.

Along with the above outline in order to secure necessary fund for its operation, the Company has consistent communications with its major shareholder [33%] Mitsubishi Corporation and other stakeholders. However as countermeasures are still in progress, and discussions, including financial support, with Mitsubishi corporation as well as other stakeholders are still ongoing, no consensus has been reached as of today.

It is uncertainty about Chiyoda’s ability to raise capital to pursue future projects which is the

primary issue for Chiyoda. Even so, Chiyoda is sitting on 832.7 billion Yen ($7.3 billion) of

Backlog. This backlog should be the reason Chiyoda should be able to raise equity and debt

rescue financing. In total we believe Chiyoda probably needs someone around $500 million of

new equity. Chiyoda has disclosed:

Company's highest priority to reinforce its financial standing securing the reserves

necessary. The Company is considering any possible choices such as alliance with

industrial partners and financial investors, loans from lenders and others.

Along with the above outline in order to secure necessary fund for its operation, the

Company has consistent communications with its major shareholder [33%] Mitsubishi

Corporation and other stakeholders. However as countermeasures are still in progress,

and discussions, including financial support, with Mitsubishi corporation as well as other

stakeholders are still ongoing, no consensus has been reached as of today.

We would like to point out there is a long history of Japanese companies and banks supporting

troubled affiliates. Chiyoda is a member of the Mitsubishi Keiretsu and Mitsubishi owns about

1/3 of the company and MFUG Bank another 4-5%.

Framing the Liability if Chiyoda Does not perform:

MDR discloses the expected cash flows (for MDR) from the two LNG projects for which Chiyoda

is a partner.

	Freeport	Cameron
Q4 2018	-174	-81
2019	-64	-320
2020	47	43

Given Chiyoda’s 1/3 position in Freeport and 50% position in Cameron, MDR would be responsible for an additional ½ of the Freeport #s above and 100% of the Cameron #s above if Chiyoda had ceased performing beginning on October 1st. This would amount to $549 million

pre-tax ($392 million after tax), or $2.10 per share after tax.

However, Given we are half way through Q4, and Given that Chiyoda has committed to

performing on the projects and Chiyoda’s cash position and the JV cash positions, we believe it

is unlikely that Chiyoda does not perform on the two projects in 2018. If Chiyoda were to fail

starting with 2019 the losses MDR would have to assume would be $286 million pre-tax or $204

million after tax or $1.09 per share.

[For both analyses above we are assuming a 28.5% tax rate and the other 1/3 partner on

Freeport LNG, Zachry Group (#138 on Forbes list of U.S. private companies does perform and assumes its ½ ($8.5 million) of Chiyoda’s losses from 2019 on].

Given that MDR will be working to get losses lower than those estimated at this time, the loses

could be even less.

From the bonds perspective:

MDR had a market value of equity of around $3.2 billion before the increased cost estimates

and increased in cost synergy guidance came out. 5x-8x the increased cost synergy guidance of

$125 million is $625 million to $1 billion of theoretical increased equity value versus $744

million of increased pre-tax liabilities.

Goldman is putting $300 million (ok ok…$289 of proceeds) of new money in behind the bonds.

Goldman is unlikely to have “missed” the JV joint and several liability issue which the public

markets did not think through.

Management knew about Chiyoda's financial position and their Joint and Several liability when they purchased $1.1 million of stock on November 6th

The $1.3 billion of unsecured bonds at 87c are suggesting another $169 million of losses after

the $1.6 billion of remaining common equity and $300 million of preferred are wiped out.

We think the bonds are money good and the stock worth around $25 to $30 per share in the

long term pre Chiyoda Liability and the Bonds money good and the stock worth $1-3 less per

share should Chiyoda fail to perform.

Below are Sum of Parts Analyses on MDR before any Chiyoda liabilities. The New loss estimates are captured in the negative Net working capital numbers in the net debt:

SUM OF PARTS 1
Basic Shares	180.6
Goldman warrants	6.8
Diluted Sharecount	187.4
Share Price	8.73
Market Value Equity	1,636


Net Working Capital	(1,915)
Cash	580
Warrant Proceeds	0.1
Restricted Cash	380
Preferred Proceeds	289
Senior Secured Term Loan	(2,249)
10.625% Senior Unsecured Notes	(1,300)
Other Debt	(25)
Remaining Costs to Achieve Synergies	(84)
Preferred	(360)
Net Debt	(4,684)

Enterprise Value	6,320
Expected Tank & Pipe Proceeds	1,600
RemainCo EV	4,720

RemainCo EBITDA
MDR	400
CB&I	600
Tank & Pipe	(200)
Cost Synergies	475
	1275

EV Multiple	7.0

RemainCo Target Value	8,925
Net Debt	(4,684)
Downside Tank & Pipe Proceeds	1,000
RemainCo Equity Target Value	5,241
Shares	187
Per Share	$ 27.97

Another Sum of Parts analysis using public offers for parts of the business in the past year:

SUM OF PARTS 2
Lummis bid	2,600	From December 2017 Process
MDR takeover Approach from Subsea 7	670	from April
Conservative Tank & Pipe Sale Proceeds	1,500	7.5 x EBITDA
	4,769.66

CB&I RemainCO
EBITDA	200
Multiple	7
Value	1400

Merger Synergies
EBITDA	475
Multiple	7
Value	3325

Total Value	9,495

Net Debt	(4,684)

Equity Value	4,811

Per Share	$ 25.68

MEMO: NET WORKING CAPITAL
Accounts Receivable (Trade)	1093
Contract Assets	723
Accounts Receivable (other)	252
Inventrory	58
Other Assets	145
Current Operating Assets (excluding Cash)	2271

Accounts Payable	-874
Contract Liabilities	-1733
Other Liabilities	-1579
Current Oper Liabilities	-4186

Net Working Capital	-1915


MEMO: CB&I EBITDA SEGMENTATION
CB&I EBITDA
Tank & Pipe	200
Lummis	200
CB&I Core	200
	600

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Chiyoda receives rescue financing

Completion of Cameron LNG and Freeport LNG projects

Reduction of loss estimates as time passes and mitigation efforts achieve sime success

show sort by

			2018	2019
Price:	87.00	EPS	0	0
Shares Out. (in M):	1,300	P/E	0	0
Market Cap (in $M):	1,300	P/FCF	0	0
Net Debt (in $M):	4,684	EBIT	0	0
TEV (in $M):	6,269	TEV/EBIT	0	0