Description
Washington Group International (WGII) provides design, engineering and construction services in six market segments, including power, infrastructure, mining, industrial, defense and energy/environment. All the company's segments are profitable and backlog exceeded revenue booked both last year and YTD. Overall, backlog grew 20% in 2003; management's guidance for backlog growth in 2004 is 18% to 22%.
At 6.4x EV to my 2004 EBITDA estimate WGII trades at a discount to peers such as Fluor and Jacobs Engineering. Fluor (FLR) and Jacobs (JEC) trade at roughly 10x and 7.5x EV / 2004 street EBITDA estimates, respectively. The discount afforded WGII may in part be due to a residual disinterest in the firm based on their 2001 bankruptcy. However, should the firm continue to post growth in backlog and earnings I believe the valuation gap can be narrowed and the stock can be worth $45 to $50.
Many will recall that WGII landed in bankruptcy back in 2001 thanks to their acquisition of Raytheon Engineers and Constructors International from Raytheon. The acquisition came with poorly bid fixed-priced contracts and the cost overruns did them in. They emerged from bankruptcy in January, 2002 and today they are debt free, have $148M in unrestricted cash on the balance sheet and enough NOLs and Goodwill deductions to avoid paying cash taxes on a federal level for a decade. (Deductible goodwill of $694M and NOLs of $248M.) See 10K for details. Previous post-bankruptcy VIC write-ups from 2002 provide further detail on this matter and the business in general.
The extended period in which the company will avoid federal taxes muddles P/E comparisons. On a P/E basis FLR and JEC trade at multiples of 20x and 17x 2004 street estimates, respectively. This compares to WGII's 20x multiple on my 2004 GAAP earnings of around $1.75. (The street has a higher '04 of around $1.88 which I do not believe is out of the question, but pushes assumptions for revenue and/or margins in ways I am not willing to do yet.) WGII's 2004 cash EPS (net income plus non-cash taxes divided by diluted shares) should be around $3.30 and thus a forward p/e on cash earnings of 11.
On a by-segment basis, segment revenue, segment revenue as % of total revenue, segment operating income before G&A/intersegment, and OI as a % of total Op Inc before G&A/intersegment in 2003 was spread across the various segments as follows:
($M)
Power 512 21% 39 17%
Infrastructure 575 23% 30 13%
Mining 84 3% 34 15%
Industrial/Process 458 18% 7 3%
Defense 506 20% 49 22%
Energy & Envrnmnt 306 15% 67 30%
Intersegment (3)
Total 2501 226
WGII also owns 20% of Westmoreland Resources and 50% of MIBRAG mbH, a lignite coal mine and power plant operator in Germany.
Though the company is diversified across a number of business units, 40% of revenue in 2003 and an even higher proportion of operating income come from government contracts. Most of these gov't contracts are cost-plus as opposed to fix price. (Firm-wide business is roughly half cost-plus and half fixed-price) Additionally, the company only records two years worth of government contracts into backlog and adds nothing to backlog for government ID/IQ awards (indefinite delivery/indefinite quantity) until they receive an actual contract or task order to conduct a portion of the work and then only that portion is added to backlog.
The Defense and Energy & Environment segments account for a significant portion of government revenue and much of that is on-going projects. Defense is dominated by major chemical weapon destruction programs that take 2-3 years to construct, 6-9 years to conduct the weapons demolition, and another 2-3 years to decommission. The company is involved in six projects in various stages of completion. Threat reduction in the form of protection of embassies and military bases is also a component. The Energy segment is involved in a number of on-going nuclear clean up projects. Detail on many of these and other projects are provided on the company website. Arguably, these long-term projects in Defense and Energy & Environment segments provide a foundation for backlog and revenue.
Infrastructure and Mining are segments with reasonably clear growth drivers. Infrastructure is driven by federal and state spending on road, bridge and rail projects. WGII may be able to grow faster than the industry as it begins to win back share lost due to the bankruptcy. A Southern California light rail project worth $300M is an example of a contract win in this area in 2004. Mining is growing strong along with the rise in commodity prices. In August the company announced a five-year contract to mine 67M tons of copper ore worth an estimated $228M. Mining projects are paid on a fixed price per unit mined and are not based on the price of the commodity.
The Power segment is driven by new power plant construction, clean air upgrades to existing plants and projects to extend the life of nuclear power plants. Backlog and revenues are down from previous peaks, but new contracts continue to be won. (e.g. new Puerto Rico power plant worth $153M and a Wisconsin Energy desulfurization retrofit worth $180M, both announced in Q3)
The Industrial/Process segment is growing but is not a significant source of profit. This segment focuses on building and management of manufacturing and pharmaceutical facilities. LNG plant construction is one potential source of new business. Management notes that achieving a higher revenue run rate and becoming more cost efficient in the segment are keys to improving margins, but when pushed admit they also need to see improvement in pricing on jobs. I’m not expecting much in the near future.
Power and Infrastructure business in Iraq has been a source of growth 2H '03 and 1H '04. Recently, however, new task orders for Iraq business of this sort has ground to a halt as funds are being shifted to security and away from rebuilding in advance of the January elections. (Task orders in Iraq contributed 23% of 1H 2004 revenues.) Management has only $125M additional Iraq business in backlog and as of the time guidance was last issued (August) was already counting on a greatly reduced Iraq book of business in 2H 2004 revenues. I've queried management to try to get comfort that the war effort's shift would not cause WGII to miss their full-year guidance. They claim that they are only counting existing task orders, that no existing task orders they have received have been rescinded and that they remain on track to meet their guidance. I quess we'll see.
The potential for delayed Iraq business is a meaningful short-term risk, but is also likely to be an intermediate term benefit as it is likely that funds not spent now are spent later. Unless the U.S. abruptly pulls out of Iraq, it is likely to recommence rebuilding power plants and infrastructure in order to calm the country. WGII should derive significant revenue if spending begins again.
I will not argue that a company in this industry will meet all their guidance objectives all the time. The lumpy nature of contract wins and booking of revenue can turn any quarter into a disappointment and lead to a sell-off -– even when business is generally on track. However, if the intermediate term story remains intact the stocks seem to work their way back. If I am not betting that every single quarter will be what the street wants, I am betting that the sum of the next 4 to 8 will be. What I see now is a company in which backlog has grown in excess of revenue both last year and so far this year. In 1H '04, new work added to backlog was $1.67B compared to revenue of $1.44B. And, though I cannot identify every project opportunity or if their guidance is too aggressive, I like the fact that management is seeing enough activity in their pipeline that they felt comfortable raising guidance as recently as August. Business is going in the right direction.
Management indicates that backlog may be higher margin, although that also means more fixed-price contracts. They claim to have religion on bidding and, for instance, have passed on contracts for their industrial segment that they believed to be unprofitable. I’m sure bidding discipline comes and goes in cycles. One should note that it is not WGII management that mis-priced the Raytheon contracts.
Management is unwilling to part with any of the cash on their balance sheet as they believe they need it to demonstrate stability and liquidity as they seek to win new work given their bankruptcy background. At the very least, the cash, along with improving business has allowed them to reduce the cost of commitment fees on their credit facility to a rate of $14M from $25 in 2003.
The company is doing a good job generating cash. I estimate $120 to $125 in EBITDA in 2004 and free cash flow on the order of $65M (I included non-cash taxes in FCF.)
2004 EBITDA estimate
Net income: $47.6M
Depreciation 16.4
Interest 15.2
Tax provision 43.1
Total 122.3
FREE CASH FLOW estimate, including non-cash taxes
Net income: $47.6M
Depreciation 16.4
EIIOUALDR* (22.0) a little uncertain of exact amount
Capex (15.0) management guidance
Non-cash taxes 38.3 ~89% of tax provision
Total 65.3
* Equity in income of unconsolidated affiliates less dividends received.
One risk is a recent rise in unbilled receivables due to the 1H surge in Iraq work. It should begin to reverse by year-end, especially given the 2H decline in this business. I would consider it a red flag if this reversal was not to occur and it could give me pause. I have no special insight regarding the outcome. They claim to have not had problems in collecting billed Iraq receivables to date. Net-capex varies year-to-year as projects of varying capital intensity are ramped up, completed and then the equipment sold off. Net capex was negative $4M in 2002, $22M in 2003 (due to Iraq ramp) and is $1.0 YTD 2004; management anticipates as much as $15M in capex for the whole of '04. Infrastructure and Mining segments tend to be the most capital intensive.
If management can meet their own guidance for 2004, which is a midpoint of $2.9B in revenue and $1.75 in GAAP EPS they stand to generate $120 to $125 in EBITDA as noted above. Another 10% to 15% increase in revenue in 2005 with similar or slightly improved margins should yield a 10% to 25% increase in GAAP earnings to $1.92 to $2.15 and ~$145M in EBITDA. If free cash as defined above amounts to $65M in '04 and meets my estimate of $80M to $90M in '05, then the 6 quarters between Q3 2004 and Q4 2005 should add another $113M (half of $65 + $80) in cash to the balance sheet.
By end of 2005 EV could be approximately $705. (Current market cap of $966, calc'd at $35 share price x 27.6M fully diluted shares, less $148 in unrestricted cash today, less $113 million in additional free cash generated in the next 6 quarters (as noted above). EV of $706 by ~$145 in 2005e EBITDA = EV/EBITDA of 4.9 by end of '05. A closer to market multiple of EV/EBITDA of 8x yields a stock price of ~$47 in the next 12-18 months. (The price would be higher, but diluted shares at a stock price of $47 should rise to around 30.6M. Significant reorganization warrants and options drive up the count, they are all in the money and I've accounted for them using the treasury stock method.)
Risks: Lumpy revenue/earnings due to uncertain timing of contracts and booking of revenue; problems with Iraq receivables; a downturn in company's end markets; lower margins on new business; and/or an inability to win their share of new contracts; mispricing of fixed priced contracts.
Catalyst
Continued growth in backlog in excess of revenues.
Margin expansion as higher margin backlog flows into revenues.
A sense on the street that the company has fully shed it's past problems.