2008 | 2009 | ||||||
Price: | 9.39 | EPS | |||||
Shares Out. (in M): | 0 | P/E | |||||
Market Cap (in $M): | 2,142 | P/FCF | |||||
Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
TEV (in $M): | 0 | TEV/EBIT |
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Company profile
McDermott International provides Front-End Engineering & Design (FEED), engineering, Procurement, Construction and Installation (EPCI), fabrication, and maintenance services domestically and internationally to clients in the energy space. The company operates in three segments: J. Ray McDermott, S.A. (JRM), Babcock and Wilcox (B&W) and BWX Technologies (BWXT)
Investment Considerations
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STRENGTHS |
RISKS |
McDermott International |
+ Pure-play E&C firm focused on Global Power and Energy Infrastructure ($9.3bn backlog 3q08, $1.3bn in award, $6bn in bids) + Broad geographic reach (US 50%, Europe 2%, Asia/ME 48%). "Blue Chip Clients" - BP, Exxon, Shell, National Oil Cos. + Secular tailwinds behind E&C cycle in Global Power and Energy - albeit there could be cyclical slowdown + Long-term agreements until 2012 ($3bn) with Saudi Aramco. Long-term government relationships + Significant leverage to offshore E&P in Asia Pac/ME/Caspian; Nuclear Power / Defense (best franchise in US), power + Potential for high margins due to greater turnkey operations and hence full control of cost + Government business has recurring revenues and high mid-teens margins + Solid balance sheet and cashflow generation (c$5/shares of cash on balance sheet) + Low valuation - buying the company for the cost of government business
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- Three projects (combined value $1bn, i.e. 20% of J. Ray) have had cost overruns. Concerns of future overruns given that projects are less than 50% completed - Decelerating growth of company' backlog. Some anectodal evidence of price pressure (Flour), slowdown - Fixed contracts could lead to cost overruns (75% of contracts are fixed) - Sensitivity to energy prices. Oil & Gas E&P usually lags Capex cuts, which lags prolonged oil prices declines - Exposure to economic cycle. Although financing is not an issue for large majors, projects can be delayed
- BWXT has exposure to Coal-generated Power - environmental concerns could hinder growth
- Fixed costs (fabrication, engineers etc) could hurt profitability and drain cash in a prolonged downturn - Exposure to some politically volatile areas - New CEO - John Fees joined last quarter, replacing long-term CEO Wilkinson - untested. |
Why has the stock underperformed recently + Our rationale
v Rationale: While future costs overruns are hard to estimate, it is possible that the new CEO could have taken “kitchen-sink” quarter approach. Management indicated that they have done a very thorough review of projects and have taken all necessary costs in current quarter. Guided towards 6-8% gross margins in 2009.
v Rationale: In a decelerating, deflationary environment costs should decline and resources should be deployed more effectively
v Rationale: MDR controls its costs and does not use subcontracts as was the case with other E&C contractors with cost overruns
v Rationale: The market is assigning negative value to MDR already after only one quarter of negative results after multiple quarters of positive growth and margins
v Rationale: Oil and Gas investment cycle has not turned down yet, i.e. it is a late cycle play, the majors are still investing in development of new fields, but a prolonged recession could change that and backlogs and pricing could head down
v Rationale: MDR managed to eke out positive margins in prior periods of backlog declines (2004, 2005) with disciplined cost controls
Valuation of Government Business
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2008 Run Rate
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Sales
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$806
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EBIT
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142
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(Does not include Corp. Overhead of MDR,
should be subst. less than current $40mm, given size of Gov. bus.)
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Comparable Multiple
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URS Implied Government Multiple
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9.4x
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(Weighted Average of URS
(Government & Private Sector) - FWLT (Private Sector))
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Discount to URS Multiple
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15%
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Implied Multiple
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8.0x
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(URS and FWLT EV/EBIT multiple was in the teens in recent quarters)
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(Previous cycles, P/E multiples troughed at c. 10x)
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(Given low hist. tax rates of less than 30% and
high interest income, P/E and EV/ EBIT should be comparable)
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Enterpise Value of Gov. Business
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$1,135
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Downside Cash Burn (assumes 50%
of cash is burnt in a slowdown)
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Current Net Cash Position
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1,206
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$603
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Implied Market Value of Stock
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$2,341
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$1,738
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Shares Outstanding
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228
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228
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Implied Value of Gov. Business
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$10.27
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$7.62
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(Assumed downside in MDR valuation)
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(including net cash position)
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show sort by |
# | AUTHOR DATE SUBJECT |
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6 | |
See my previous reply - overall better than feared - with less than expected hits in JRay, more conservative reserving and nice increases in the backlog. | |
5 | |
Hi Skimmer, Great questions. Here is an attempt to answer some of your questions/reservations. J Ray awards represent about 20% of backlog so even in the $40-$50 oil environment, where, presumably, awards will decline the overall impact on backlog would not be huge. Furthermore looking back to 2004-2005 when oil prices were lower and "the peak oil theory" was not as popular as it was last year, J Ray still managed to generate positive segment oper earnings ($86mm in 2004 and $159mm in 2005). Another historical reference, MDR's ~$1.3 billion enterprise value is not inexpensive given the company had a $1 billion enterprise value in 1986 after suffering through three years of oil and gas losses in a cyclical oil and gas downturn. Lastly, J Ray platforms are used in E&P rather than finding and development, where most of the recent cutbacks have occurred. In terms of whether or not they have reserved enough with respect to the three "problematic projects" the recent pre-announcement shed some light on it. They did have another hit but much smaller than before ($35mm net) and it appears that they are more conservative with reserving for potential future delays. Most importantly liquidation damages were not levied this quarter. On the recurring revenues, here is some data that I have collected from research reports and company filings. B&W and BWXT should continue to report a significant amount of recurring revenues related to maintenance work, parts and services, and relatively stable annual government contracts (where competition is limited) even in a significant U.S. recession. Here are some data from barclays:
2008E 2010E Sales Government Operations $806 $600 Power Generation New Generation 500 100 Parts and Service 1,000 1,060 Environmental $1,023 $500 Operating Income Government Operations $142 $108 Power Generation New Generation 60 8 Parts and Service 150 159 Environmental 125 40 Corporate (43) (40) Total Operating Earnings $434 $275 Net Income (after tax) $300 $197 Earnings Per Share $ 1.30 $0.85 Assigned P/E Multiple 12x Value of Government/Recurring Power $10.26 The above numbers are 2008 and 2010 conservative estimates showing that approximately $300-400mm of operating income is recurring at MDR, apply a conservative multiple to that and add the excess cash and you get to values above current market price. I hope that helps | |
2 | |
I have struggled with that as well and have not received great guidance from the management. There are opposing views on the Street with respect to the amount of net cash available to MDR. Here are my views. 1) Customers prepay for work to E&C company and such amounts are accounted for under liabilities as Advanced Billings ($1.1bn). The offsetting accounting entries on the asset side are spread among Cash, Accounts Receivables, Inventories and Advanced Payments Assets ($1.9bn, with cash of $614mm). 2) If a customer decides to cancel a project, such customer has to pay closing fees and in most cases the customer does not receive its advance deposits, although it depends on the contracts (the E&C company has to hire engineers, buy equipment etc) This is from 10-K ->”…In the event of a contract deferral or cancellation, we are generally entitled to recover costs incurred, settlement expenses and profit on work completed prior to deferral or termination. While we have not generally experienced significant project cancellations, significant or numerous cancellations could adversely affect our business, financial condition and results of operations. ..Reductions in our backlog due to cancellation or modification by a customer or for other reasons may adversely affect, potentially to a material extent, the revenues and earnings we actually receive from contracts included in our backlog. Many of the contracts in our backlog provide for cancellation fees in the event customers cancel projects. These cancellation fees usually provide for reimbursement of our out-of-pocket costs, revenues for work performed prior to cancellation and a varying percentage of the profits we would have realized had the contract been completed. However, we typically have no contractual right upon cancellation to the total revenues reflected in our backlog. Projects may remain in our backlog for extended periods of time..." 3) If a project is delayed or not completed to specifications then the E&C is liable to pay liquidated damages to the customer (as was the case with MDR having to pay to Qatar Natural gas company for the overruns of its projects.) I believe that is how money in almost all cases can flow back to customers from Cash accounts at E&C companies back to customers. 4) MDR generated $300mm in FCF in the last few years so the cash growth on balance sheet came largely from that and not advance billings (since customers prefund projects, there is little CAPEX spend at these companies) 5) Backlog is $9-10bn run rate where advanced billings liabilities are $1+bn so clearly the company is recognizing as advanced billings only a portion (c10%) of the project costs which makes sense as they use a % of completion method. Given that there are 60-70 projects at any time, i.e. c$15-$20 advanced billings per project. It is highly unlikely that all of the projects will be cancelled at the exact same time (i.e. not earning any pro-rata revenues during the period). For the above reasons I feel comfortable that the company has access to the majority, if not all of its cash. Furthermore, it has $380 mm of long-term investments held in Treasuries. (Concervatively one can add net working cap +$65mm to lont-term investments that yields about c$2 of net cash on BS vs c$5. adding all the cash) |
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