Description
McDermott International Inc. (MDR - $3.80) is a name only a true deep value contrarians could love (GARP investors please proceed to the next idea). But if you can live with controversy and complexity, and like to have the opportunity to make two to three times your money, please read on.
McDermott now has three operating companies: J. Ray McDermott, BWX Technologies, and Babcock & Wilcox. Babcock & Wilcox has been operating under the protection of Chapter 11 for several years due to asbestos litigation. J. Ray is a global manufacturer of ultra deep water drilling platforms and also performs marine services with a fleet of nine vessels. BWX Technologies is a specialized provider of nuclear parts and services to the U. S. Department of Energy. The company has a complex holding company structure with a Panama Corporation (MII) which holds J Ray, which is also incorporated in Panama. MII also owns a group of Delaware based corporations including BWX Technologies and Babcock & Wilcox.
First let me address the asbestos situation. The company reached a “memorandum of understanding” for a settlement with the plaintiff group in August of 2002. The agreement hands over B&W shares to a trust along with related insurance rights, 4.75M shares of MDR stock (with a three year, $19.00 minimum guarantee), and a $85M ,7.5% 10 year promissory note. In return MII will receive the full benefit of a Section 524 (g) of the Bankruptcy Code with respect to personal injury claims and certain other claims. The next steps are as follows: (1) court approval of the plan in the first quarter of 2003, (2) approval votes by plaintiffs (75% required) and MDR shareholders in the second quarter of 2003, (3) trust created and bankruptcy resolves by third quarter 2003. MII has totally written off its investment in B&W and will take an additional charge of $130M for the present value of the stock and note when the settlement is completed.
J Ray McDermott (JRM) is one of two remaining businesses post settlement. JRM designs and constructs large deep water and ultra-deep water drilling platforms as well as providing marine services such as platform installation and laying of off shore piping systems with its fleet of nine vessels. This business has been the other area of disappointment and controversy for the company. JRM has experienced huge cost over runs on a type of project known as an “EPIC Spar”. The company took on three large scale Spar projects which required new engineering, the opening of previously closed yards, and hiring of new personnel. In prior construction of Spar projects JRM constructed the “top side” and Aker Marine constructed the hull. This was JRM’s first attempt at doing the whole structure and they took on much more than they were prepared for. The current estimate is that these projects will result in over $90 million in losses by the time they are completed in early 2004. The first Spar, known as the “Medusa”, has been completed (in January 2003) and has resulted in the majority of the loss ($73M). The second two projects will be completed in early April 2003 (“Devil’s Tower”) and early 2004 (“Front Runner”) respectively. The company has been able to incorporate lessons from the first project on the final two in order to materially reduce the losses. The balance of JRM has been profitable and generates a 3-4% operating margin. One of the large fabrication yards is dedicated to British Petroleum on a cost plus basis. The company has a total backlog of $2.0 billion, with the Spar projects representing $411 million of the backlog. During the September quarter the JRM took a loss of $65.5 million to cover the expected future loss on these projects.
The key question is: what is the value of JRM on a “normalized” basis. The company believes that it can achieve a mid single digit margin on a sustainable basis with low maintenance capital expenditures ($30 million). The back log is projected to stay flat and sustain annual revenue of approximately $1.0 billion. The business is mature and cyclical and should receive a low multiple. Using a 12.5% free cash flow yield or 8 times eps (which should be a good proxy for free cash flow) gets you a valuation of $260 million or $4.10 per share. Cash taxes will likely be zero for many years given the recent losses and charges. The pension plan has a modest under funded status that will result in a non cash charge of $90 million in 2003 and $20 million in funding.
The final remaining business is very attractive. BWX Technologies (BWXT) provides specialized equipment and services to the Department of Energy. BWTX manufactures critical components used in nuclear reactor cores, performs uranium processing and blending, manages secure nuclear facilities, and provides nuclear remediation and restoration. This is a growing business with a healthy margin and low capital requirements. The company projects the backlog to grow to $1.6B by March of next year from the current $900 million level. Using $550 million in 2003 revenues and a 8% operating margin gets you 45 cents in earnings per share. I am using a 12 multiple to reflect the visibility and steady nature of this cash flow stream for a target of $5.50 per share for this business.
The balance sheet of MDR is also complicated. There is $289. million of cash and investments of which $226 million is pledged or restricted. So there is $63 million in “free” cash. The company has $144 million in available credit under two existing credit facilities (which expire in February of 2003). Of the restricted cash, $105 million is backing a $100 million credit facility which has no cash drawn against it. The reason for this unusual arrangement is the B&W bankruptcy and the need for letters of credit to execute the BWXT business. Once the settlement is complete a new credit line will replace this facility that will not require 105% cash collateral. Adjusting for this unusual arrangement the company has $168M in unrestricted cash. Debt outstanding totals $95 million in long term notes. Therefore, net available cash is approximately $73 million post settlement of the asbestos claims. The settlement itself creates a new liability of $175 million of stock and notes.
The company has two pension plans that when combined are under funded and will require about $20 million in cash funding during calendar year 2003. There will be non cash pension expense of $93 million run through the income statement in 2003. It is hard to get exact figures on the status of the plan because the asbestos settlement will split the MII plan into B&W and remaining BWICO employees. This plan is over funded and it is not yet clear who will benefit from that over funding. The J Ray plan is under funded and will require the cash contribution in 2003.
I arrive at a price target using a sum of the parts analysis looking at the two business’ post asbestos settlement. This is not purely theoretical because management has stated firmly that the two companies have no strategic benefit in being together and that a study of maximizing shareholder value will be conducted once the asbestos settlement is finalized. As stated earlier I believe J Ray is worth $4.10 per share and BWXT is worth $5.50 for a total value of $9.60 per share. My estimates for earning at both companies may be exceeded and my valuation targets are also conservative. This stock traded at $15.00 per share in both 2001 and 2002 with the asbestos situation unresolved.
The major risk to the story is that the assumptions surrounding J Ray prove to be wrong. The assumptions are that the company has properly estimated the losses and that the remaining backlog is profitable. My confidence in this first assumption is based upon the fact that the first Spar (Medusa) was installed last month. The remaining project loss estimates are based upon the experience with the Medusa project so the risk of a surprise at this point looks very low. I still believe the stock is undervalued if J Ray turns out to be worthless based upon the value of BWXT, but the up side would be limited to 50% verses the two to three times up side available if J Ray returns to historic profitability.
Catalyst
The catalysts here are numerous given the low expectations: (1) new bank credit lines will be announced shortly that will eliminate fear of a near term liquidity issue (2) affirmation of Spar loss estimates will reduce fear of a J Ray “black hole” (3) the asbestos settlement will be approved by Q3 of 2003 (4) strategic review of business including spin or sale of BWXT will unlock sum of the parts value that has been over looked (5) continued strong deep water oil and gas production and better execution will lead to higher value being placed upon J Ray business (considered to have significant negative value based upon today’s stock price).