Description

McDermott International (MDR) is very cheap on a sum-of-the parts basis.  The stock is off nearly 80% since its June highs on lower oil prices, and concerns of global energy and power infranstructure build-out. If you believe that these two concerns are of temporary nature, as it is our humble opinion, MDR offers limited downside and significant upside.  The stock was recommended twice before on this website with extensive write-ups (2003 and 2004) so we will try to be a bit more succint. Interestingly, the stock is back to its 2005 levels.

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)

• J. Ray McDermott (JRM) (~43% of revenue) – This segment houses McDermott’s offshore oil and gas construction services by providing FEED, EPC, and fabrication services to offshore drilling and production facilities. The company also does installation of marine pipelines and subsea production systems. This segment operates in most major offshore oil and gas producing regions, including the United States, Mexico, Canada, the Middle East, India, the Caspian Sea and Asia Pacific.
• Babcock and Wilcox (B&W) (~13% of revenue) – This segment includes three lines of business: BWX Technologies, Babcock & Wilcox Nuclear Operations Group, and Babcock & Wilcox Technical Services Group. The segment primarily supplies nuclear components and services to the US government such as uranium processing, environmental site restoration services and management and operating services for various nuclear weapons complex for the US Department of Energy (DOE).
• BWX Technologies (BWXT) (44% of revenue) – The BWXT segment provides FEED, EPCI, and fabrication services to the power industry. Specifically, it provides fossil-fired steam generators, replacement steam generators for commercial nuclear plants and post-combustion air quality equipment.

Investment Considerations

	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   +     Increase in negative sentiment - most analysts recently downgraded the stock despite an 82% YTD decline	-    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

• On the last conference call the management announced three projects with costs overruns due to lower productivity, bad weather, insufficient/inadequate vessels. 
  • Management has stated that they have taken a very thorough and cautious consideration of all future overruns from these projects and have factored those in the charges of this last quarter. 
  • However, according to the analysts prior experience suggests that there is a chance that there are more charges potentially coming (the theory of "there is never one cockroach"). These projects are less than 50% done so there will be impacts stretching for another 4 quarters. Recent negative experience with CBI which had 7 quarters with costs overrun.

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

• All of E&C sector is trading at depressed valuation due to expectation of economic slowdown
  • Multiples have contracted by 50%-60% in recent months. MDR trading at a deep discount to comps

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

• Potential price pressure in E&C contract negotiations
  • Flour said in recent conference call that there are getting some pricing pressure for renegotiations of some contracts. There is fear that this trend may spread through industry although there are no signs of it yet.

v Rationale: MDR managed to eke out positive margins in prior periods of backlog declines (2004, 2005) with disciplined cost controls

• Declines in cash reserves in a potential slowdown
  • MDR has fixed costs assets and large employee base which it may try to hold onto in a slowdown

Catalyst

Oil price rise; Resolution of Contract cost overruns, Further insider buying, Potential spin off of Goverment Business (the issue has surfaced in the past and on the last call). Renewed infrastructure buildout boom.