Description
McDermott International (MDR) is a “sum of the parts” value investment featuring significant (and possibly huge) undervaluation and some important near-term catalysts. MDR is a holding company with three subsidiaries: BWXT, J. Ray McDermott (“JRAY”) and Babcock & Wilcox (“B&W”). There are many ways to look at this investment, one of which is that BWXT (which is a gem of a business and is described below) alone is worth more than the current quote, and therefore investors are getting JRAY (which I think has value) “for free” plus a “free” option on a national asbestos trust settlement (more on this below) which IF it hit could add $10-14 per share of value to the stock. Apologies in advance for the length of the write-up – this story is actually pretty complex (which is maybe among the reasons the opportunity exists in the first place).
BWXT
BWXT is the largest, and, in most cases the sole source, manufacturer to government customers of precision nuclear components (they have been a sole-source manufacturer for nuclear submarines since 1946). The company also assists the U.S. in safely converting and disposing of nuclear materials that remain from the legacy of the Cold War and manages a host of Department of Energy Nuclear sites through various joint ventures. Given the highly sensitive nature of what it does, BWXT’s business has large entry barriers. The business has demonstrated impressive growth in the past, growing EBIT from $44mm in 2000 to $75mm in 2003. There is also good visibility into its future profitability; BWXT has a backlog equal to more than three years of revenue and margins have been stable to slightly increasing over time, and capital needs fairly modest. Not included in backlog are some very meaningful projects BWXT is bidding on, two of which (contract bids for Department of Energy nuclear sites in Idaho and Albuquerque) could add a combined $20mm in EBIT within the next two years. The Idaho INET bid is in 2H04 and the Los Alamos Albuquerque bid is in 2H05. BWXT has bid on additional manufacturing business from the government that would be additive to its base manufacturing backlog and has proposed a venture that BWXT calls JOMB which could be a multi-billion dollar contract to build deep-sea portable military bases. A great website to review the JOMB project is:
(http://popularmechanics.com/science/military/2003/4/battle_island/index.phtml).
Based on the backlog it has in hand I believe BWXT basecase will do about $50.5mm of NOPAT in 2005 which I think is worth roughly $800mm, or just under 16x ’05 NOPAT. This is the equivalent of 8.5X EBITDA.
JRAY
J. Ray Mcdermott is involved in the front-end and detailed engineering, fabrication and installation of offshore drilling and production facilities and installation of marine pipelines and subsea production systems. The JRAY business is the reason that MDR is so cheap. The marine construction business is a fiercely competitive, highly volatile, high fixed cost, cyclical business – there’s not much chance Warren Buffet is looking to add this to the Berkshire stable. While the business has been volatile, it is has historically generated significant EBITDA; from 1994 – 2001 JRAY generated annual EBITDA ranging from $46mm to over $200mm (remember there are only 67mm fd shares of MDR). In 2002, the company agreed to construct a number of “first-of-a-kind” engineering projects under fixed price contracts. Big mistake! These projects ran hugely over budget (let’s skip all the gory details) and almost forced JRAY into bankruptcy. During 2002 and 2003, JRAY took $255 million in charges on four of these contracts, consuming significant cash resources. MDR management replaced the majority of JRAY’s senior management and claims to have put more stringent bidding procedures into place.
There has been concern in the market about JRAY’s liquidity situation. In late 2003, the Company completed a $200mm Senior Secured bond offering which partially ameliorated the liquidity situation caused by these ill-fated contracts. JRAY only has about $20mm of net debt, however almost 140mm of the cash is restricted pending completion of a specific project (front-runner epic spar) or to cash collateralize letters of credit. In it’s first quarter JRAY reported more unrestricted cash than I thought it would ($68mm as of 5/6/04) and management said that it had enough liquidity to run the business through the remaining two quarters of negative cash flow (JRAY is supposed to start generating cash again by the end of q3). I am comfortable with JRAYs liquidity in that management has some options even if the current unrestricted cash is not enough. First, JRAY could secure a letter of credit facility; management has indicated that it expects to close on such a facility by the end of Q2 (the next three weeks). Additionally, JRAY can factor some of its North American receivables to MDR, which would bring $25mm of cash down to JRAY. Third, the company should announce within the next couple of months the sale of the DB-60 marine vessel. This sale should generate $20-$50mm in proceeds. With this sale, JRAY will have net cash once again and, using the mid-point of expected proceeds, $40mm equates to $0.60 cents a share of value.
The market is currently valuing JRAY at zilch, but there are a number of recent events that make me think daylight is in sight for the business. First, the company announced last week that they have completed two of the loss making projects, Carina Aires and Front-Runner. These contracts were the last of the evil four. The Company only has one more loss-making project (which hopefully was fully reserved for in the fourth quarter of 2003). As a result, the risk of additional cash being drained by these contracts is small. Second, the company has bids out on $1.8 billion of new projects and has recently been awarded over $150 million of backlog on three contract wins (excluding $100mm of revenues from a JV it owns in Mexico that was also recently awarded). As the backlog grows again with profitable business, JRAY should start to generate decent results again. In an average industry year, management has stated that JRAY should generate EBIT margins of 8-10% on revenues of $1.1 – 1.3 billion per annum or EBIT of $88mm – 130mm and EBITDA of 116 – 157mm. I haircut management estimates and assume the company, once it completes its restructuring, will generate 6-8% operating margins and EBITDA of roughly $100mm pre corporate center expenses. By comparison, Gulf Island Fabrication (GIFI), one of the only good pure play construction comps, currently has EBIT margins of 11.6% and trades at 7.0x LTM EBITDA and 9.0x LTM EBIT.
In the event of a catastrophe at JRAY, MDR has “ring-fenced” BWXT. Based on covenants in various loan documents at BWXT and JRAY, MDR does not have the ability to take money generated from BWXT and funnel it to JRAY (or vis versa), thereby limiting the downside risk in investing in holding company (MDR) stock.
B&W
B&W is currently in bankruptcy as a result of asbestos liability caused by the use of asbestos in boiler insulation. This unit provides a variety of services, equipment and systems to generate steam and electric power at energy facilities worldwide. The company primarily operates with coal powered generation assets. B&W has a strong, repeatable base-load business that generates roughly $1.5 billion in annual sales and is expected to grow due to the significant manufacturing and services the company provides to coal producing utilities that will require environmental upgrades in the next 3-5 years. The key to realizing value from this asset for shareholder of MDR is through asbestos trust legislation. Although many investors look to USG or GRA as vehicles to play asbestos, MDR is equally if not more levered to a positive result on legislation without the downside risk. MDR has reached agreement with the asbestos litigants on a transaction that would pass ownership of B&W to the litigants as part of a plan of reorganization (“POR”) and would force MDR to issue shares and a note to asbestos litigants that will cost the company roughly $175mm. The POR is currently being contested by a number of insurance companies, but the expectation is that the plan will become effective at the end of the second quarter of 2005. There is virtually no risk that this deal fails, so the risk on the downside is negligible. However, the opportunity on the upside is significant as this creates an option, with a roughly one-year time horizon for asbestos legislation to pass. If it does, MDR would be the beneficiary of a huge windfall. Here is how the numbers work – B&W currently has roughly $425mm in net cash and generates somewhere between $90 – 150mm of EBITDA. In the first quarter of 2004, B&W generated EBIT of $33mm. The actual liability in the most recent legislation S2290, would require B&W to contribute 1.518% of 2002 revenues per annum to the trust fund, or roughly $23mm per year for 23 years. The trust allows companies to pay the NPV of their contribution upfront and assuming a 6% discount rate, B&W would be required to pay roughly $280mm to the trust fund. That would allow B&W to remain debt free and keep approximately $150mm in net cash. The net result of asbestos legislation would add $10-$15 per share of value to MDR.
B&W EBITDA $110.0
Multiple 7.0x
Business Value $770.0
Net Cash 400.0
Underfunded Pension (164.0)
Total Enterprise Value $1,006.0
Unwinding of POR contribution 173.0
Payment for Trust Legislation (280.0)
Total Legislation Value to MDR $899.0
Shares Outstanding 66.7
Value Per Share $13.41
Currently, there is pessimism over the likelihood of asbestos reform occurring in the near term. There are a number of recent events that indicate that the prospects for legislation in this session of Congress are much better than the Street expectations. First, the asbestos defendants and insurers have been negotiating with the AFL-CIO with not much luck. The AFL-CIO had been reticent to agree to a deal that was not perfect. They had rejected a deal for $119B with $15mm in contingency funding because they wanted approximately $150 billion. Since the end of public negotiations, five of the largest unions that are members of the umbrella AFL-CIO organization, broke ranks and sent letters to Senators jointly with the Defendant companies indicating they wanted a legislative solution as soon as possible. Subsequently, staffers from Senators Frist and Daschle’s (majority and minority leaders, respectively) offices spent last week working on a compromise bill. Daschle and Frist are supposed to meet early next week to see if they can come to agreement on a legislative solution. As many Democrats were on the fence for fear that they would vote against Labor, without a unified voice, odds are labor will not lobby against a bill if it falls short of the $150 billion. The bid/ask spread on the bill has also narrowed – currently the defendant companies and insurers are offering $131 billion and Labor has requested $140 billion. This turn of events is significant and helps the chances of legislation being passed in the near term. No doubt the question will come up – “what do you think are the probabilities” or “who are you to guess a political outcome”. The answer is I don’t have a clue of what the odds are – I only note that they are greater than zero and appear to me to be increasing, and more importantly I don’t think investors are paying anything for the option, which if it hit would have a huge payoff.
Back to MDR
There’s one last catalyst here, which is the separation, possibly through a spinoff, of BWXT and JRAY. MDR management has maintained that the various businesses need not remain together (they are separately managed and financed and there are no operating synergies) and pending resolution of the B&W bankruptcy (either through legislation or POR), they would split JRAY and BWXT. A split, which could occur in the second half of 2005, would be a significant positive for the stock (greater transparency of the values, freeing BWXT from JRAY taint, etc).
Here are some potential scenarios for MDR by the end of 2005.
A. JRAY files for bankruptcy and no Trust legislation – Draconian Case
BWXT EBITDA – 2005 $101.0
Corporate Allocation -7.0
Pro-Forma EBITDA 94.0
Multiple 8.5x
Business Value $799.0
Settlement Funds (173.0)
Excess Cash 200.0
Debt (116.0)
Underfunded Pension (160.0)
Total Enterprise Value 550.0
Shares Outstanding 66.7
Value Per Share $8.25
This assumes the JRay ships, that are appraised for $300mm with $707mm replacement cost, are sold and the proceeds are used to repay JRAY debt in full and all other fixed assets are sold to pay all remaining liquidation costs.
B. JRAY Turnaround – JRAY earns 6% operating margins on 1.2B in sales. No Trust legislation
JRAY EBITDA – 2005 $101.6
Corporate Allocation -10.2
Pro-Forma EBITDA 91.4
Multiple 6.0x
J RAY Business Value $548.0
BWXT Business Value 799.0
Settlement Funds (173.0)
Excess Cash – Year end 2004 317.0
Debt (316.0)
Underfunded Pension (246.0)
Total Enterprise Value 929.0
Shares Outstanding 66.7
Value Per Share $13.93
C. JRAY Turnaround – JRAY earns 8% operating margins on 1.2B in sales. No Trust legislation
JRAY EBITDA – 2005 $124.0
Corporate Allocation -10.2
Pro-Forma EBITDA 113.8
Multiple 6.0x
J RAY Business Value $682.8
BWXT Business Value 799.0
Settlement Funds (173.0)
Excess Cash – Year end 2004 317.0
Debt (316.0)
Underfunded Pension (246.0)
Total Enterprise Value 1,063.8
Shares Outstanding 66.7
Value Per Share $15.95
D. Trust Legislation – JRay Earns 6% operating margins on 1.2B in sales
JRAY EBITDA – 2005 $101.6
Corporate Allocation -10.2
Pro-Forma EBITDA 91.4
Multiple 6.0x
J RAY Business Value $548.0
BWXT Business Value 799.0
Settlement Funds (173.0)
Excess Cash – Year end 2004 317.0
Debt (316.0)
Underfunded Pension (246.0)
Net Asbestos Trust Benefit 899.0
Total Enterprise Value 1,828.0
Shares Outstanding 66.7
Value Per Share $27.40
Note: In the above scenarios I did not include MDR’s net NOLS of $215mm which don’t begin to expire until 2022. – so there is this extra piece of value.
Catalyst
Improved JRAY liquidity (LC facility, sale of DB 60, etc)
New J Ray Backlog
BWXT new contract wins
Asbestos Trust Reform
Seperation of BWXT from JRAY in late ‘05/06.