Summary
- Chicago Bridge & Iron is a company with borderline moderate risk to the value investor, with creditworthiness and efficiency as primary risk factors to consider.
- Volatility in the oil markets and ongoing issues with contractual recoveries related to the nuclear projects depressed CBI’s market price to a point where it now reflects excessive pessimism.
- Our valuation analysis indicates that Chicago Bridge & Iron trades at an 18.5% premium for future growth and at a stunning 36.5% discount to intrinsic value.
- Embedded expectations are so pessimistic that we can expect significant upward movement in the near future.
- Lastly, though CBI is deep in the energy infrastructure business, the company’s revenue diversity mitigates its exposure to oil prices.
Company Overview:
Chicago Bridge & Iron Company N.V. (CB&I) is an energy infrastructure focused company and a provider of government services. The Company operates in four segments: Engineering, Construction and Maintenance; Fabrication Services; Technology, and Government Solutions. The Engineering, Construction and Maintenance segment offers engineering, procurement, and construction for energy infrastructure facilities, as well as integrated maintenance services. The Fabrication Services segment provides fabrication of piping systems, process and nuclear modules, and fabrication and erection of storage tanks and pressure vessels. The Technology segment offers licensed process technologies, catalysts, specialized equipment, and engineered products. The Government Solutions segment undertakes programs and projects, including design-build infrastructure projects for federal, state, and local governments, as well as offers environmental services for government and private sector customers.
Source: Thomson Reuters
When we glanced at Chicago Bridge & Iron (NYSE:CBI), we thought it looked like an excellent contrarian play. Prices have dropped nearly 50% from the high $80 mark. P/E ratios dropped to the high-single digits from the mid-teens and the low 20s seen over the past 15 quarters. Yet, in spite of this, the company enjoys ROEs above 20%.
The company’s fall from grace coincided with the heightened volatility of oil markets popping up frequently on the commodity headlines, and many of our fellow contributors on Seeking Alpha frame CBI as another victim of the intense competition between OPEC oil and U.S. shale.
But… we find this quite strange.
CBI’s quarterly revenues exhibited a negative, moderate correlation of 0.45 to WTI prices over the past 15 quarters (i.e., falling oil is good for CBI). The same shows positive, moderate correlation of 0.48 to the Henry Hub Natural Gas prices, and no correlation whatsoever to the EEI Weekly Total U.S. Power Output in GWH. Shortening our time frame to five quarters (1.25 years) reduces these correlations considerably, to a point where the company should be fairly cushioned against adverse movements in energy commodities. See the table below.
Source: Thomson Reuters, calculations by Saibus Research
Further research on CBI’s ~50% drop in its annual reports and recent conference calls led us to an ongoing dispute resolution process related to the Georgia and South Carolina Nuclear Projects inherited from the Shaw Acquisition. (The Shaw Group had a 20% stake in the Westinghouse Electric Company, which had contracts with two separate customers for the construction of two nuclear power plants.)
Gregg Rosenberg covered this in his October 2014 article, and wrote:
… the disputed costs may not ever be paid. If CBI is not reimbursed, it will result in an earnings hit and an adjustment to the balance sheet, potentially to goodwill. In its 10-K filings, CBI maintains that it is contractually protected for the overruns with rights to collect certain amounts from the customer and, whatever the customer does not pay, they have rights to collect from Westinghouse. The market is skepticalof how things will be decided by the arbitrator. In the meantime, the whole issue has caused them to go cash flow negative, spooking many investors. CBI believes payments from other projects in its huge project backlog will allow them to re-establish positive cash flow in the second half of this year, but market participants are clearly taking a wait-and-see attitude.
(Our emphasis added)
Nevertheless, we see good signs in this stock, and thus, we ran Chicago Bridge & Iron through the gauntlet. As will be discussed later in this article, we conclude that CBI is heavily undervalued and is trading at a large margin of safety, more than enough to justify the risks present in this company.
Risk Assessment:
We evaluated Chicago Bridge & Iron Company using a systematic, rule-based risk assessment method. It is a balanced scorecard that considers the past performance, historical volatility, and underlying trend of over 40 different risk factors in multiple factor groups, and utilizes proprietary standards to systematically score these risk factors across five levels. We believe such analysis adds value for the reader, as they adequately define the major risks in any business, accurately measures them, and succinctly describe them in an easily comprehensible format.
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Source: Saibus Research
Overall, Chicago Bridge & Iron Company is a business that exposes the long-term investor to borderline moderate risks. However, we will discuss the company’s creditworthiness, efficiency, and management candor in more detail. The first two drive CBI’s attractive returns on investment, while the latter is necessary, given CBI’s primary use of the percentage-of-completion method for revenue recognition.
Creditworthiness is a function of solvency and liquidity, the ability to meet financial obligations in the long term and the short term without risking bankruptcy or sacrificing competitiveness. However, we go beyond this natural bifurcation of credit risk and also ascertain which of the two components is more important than the other, as there may be certain circumstances when a solvent but illiquid company can fail to meet its financial obligations and slip into hot water.
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Source: Saibus Research
Prior to the July 30, 2012 acquisition of the Shaw Group, Chicago Bridge & Iron operated at 70% total liabilities to total assets, on average. Although this did not change in fiscal years 2012, 2013, and 2014, what shifted was the introduction of financial leverage in the company’s capital structure.
And while CBI’s solvency ratios are seeing inclines from their low points in 2005, 2008, or even 2014, they have been and still remain poor, to the extent that they consistently fail to meet our 20% benchmark of safety, regardless of whether EBITDA, NOPAT, or even Free Cash Flows are used.
Fortunately, our sobering interpretation of CBI’s solvency ratios is tempered by its Altman Z-Scores and its probability of courting corporate bankruptcy in the short and medium terms.
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Source: Altman Z-Scores provided by Thomson Reuters. The 1.8-3.0 range corresponds to an area of ambiguity, where scores below 1.8 have high risk of bankruptcy over the next two years, and scores above 3.0 are safe. CHS scores calculated by Saibus Research, reflecting the methodology used by Campbell, Hilscher, and Szilagyi in 2010 as an improvement over the Altman Z-Score. The lower the CHS score, the better, as it corresponds to a lower probability of bankruptcy over the next 36 months (74% accurate). A score of negative 3 corresponds to a 5% probability.
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Source: Thomson Reuters. Note that Reuters’ StarMine credit risk model did not start until October 2013. The computed bankruptcy probabilities look ahead by 12 months. 0.9% to 0.11% correspond to the BBB+ S&P credit rating, BBB for 0.11% to 0.15%, BBB- for 0.15% to 0.19%, BB+ for 0.19% to 0.26%, BB for 0.26% to 0.35%, and BB- for 0.35% to 0.51%.
We are seeing a fairly positive picture from all line graphs above. CBI’s historical Z-Scores indicate low risk of failure, though this risk is gradually increasing over time, and especially in the recent years. The StarMine model reflects this, with bankruptcy possible within the next 12 months at a 0.20% chance – equivalent to S&P’s BBB rating – but this has been declining from 0.30% three months ago, which indicates a more favorable position. Lastly, the CHS scores we calculated show little probability of failure over the next 36 months.
Still, we note that liquidity is far more important than solvency. Prior to the Shaw acquisition, 77-92% of liabilities were current. This may have fallen to 60-70% in the last three years, but their magnitude is such that liquidity issues can haul in big problems if the company is not careful.
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Source: Calculations by Saibus Research. The earnings metrics used to calculate earnings coverage were adjusted to avoid double-counting of some required obligations.
This chart here summarizes Chicago Bridge & Iron’s leverage and liquidity. As shown, current liabilities comprise a substantial portion of total liabilities, and almost all of it reflect operating leverage. This has changed just slightly after the Shaw Acquisition, but we repeat: liquidity remains critical.
We note weak current ratios and strong quick ratios, but we are comforted very well by the excellent earnings coverage we’ve seen over the last ten years. CBI’s EBITDA and NOPAT both surpassed 100% of the company’s required obligations consistently and by large margins, with one or two outliers in its record. This can be attributed to its low required obligations:
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Source: Calculations by Saibus Research.
Historically, CBI’s largest sources of required obligations are its depreciation and amortization (i.e., maintenance capex) and its operating lease expenses. Debt did not play that big of a role until after the Shaw acquisition, and should CBI maintain its current capital structure, debt payments would not pose a significant threat due to the high earnings coverage, as the Senior Notes expire four times through 2024, with principal payments ranging from $150-275 million each.
However, investors should keep an eye on CBI when the year 2017 comes in: The company will be required to pay out $575 million for the Term Loan’s final installment, in addition to $150 million for the Series A Senior Notes. As a reference point, in FY 2014, debt payments amounted to $103 million (not including the $409 million from other obligations), while CBI generated $1.18 billion in EBITDA (excluding unusual items).
Moving on, we break down efficiency into three areas: how well the company manages its working capital; how well it utilizes its assets to generate sales, and how well the company can keep its costs under control.
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Source: Saibus Research. 1 means low risk and 5 means high risk.
For CBI, we gave the company’s operating efficiency more weight than its cost controls. This is due to the fact that the company generally has very low profitability margins, especially after gross profits where margins fall into the single digits. This puts more emphasis on sales volume relative to its assets, and thus accentuates economies of scale and of scope, which CBI’s business possesses in terms of its diverse customer base, its wide geographical area of operation, and the technical expertise needed to provide excellent engineering and construction services.
We direct our attention completely to the Asset Turnovers, as these generate the most risk.
The chart below depicts the levels of sales generated, net operating assets, and total assets, as well as their corresponding turnover ratios.
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Source: Thomson Reuters, Calculations by Saibus Research. NOA Turnovers are not shown, due to low figures.
As seen above, CBI’s turnovers look decent. Asset turnovers are generally interpreted as a measure of operating efficiency with respect to the utilization of assets to generate revenues. As one can easily see in the above chart, there has been a gradual decline in the company’s asset turnover. Unfortunately, we could not properly ascertain the strength with which Chicago Bridge & Iron utilizes its operating assets, as its net operating assets were either miniscule or negative, which can result from too much cash or excessive operating liabilities. At the moment, we believe Chicago Bridge & Iron’s sales figures at least justify the value invested in the company’s total assets.
We also looked into the composition of CBI’s assets over time.
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Source: Thomson Reuters. Current Liabilities in the first chart excludes the current portion of debt.
The very first thing we noticed is how goodwill ballooned from 17% of total assets to 45% right after the Shaw acquisition, which ate into how much of CBI’s assets are directly concerned with business operations. (We do not consider “goodwill” as an operating asset.)
Operating liabilities excluding debt remain very high, reflecting the liabilities relating to the long-term construction contracts. One reason for this immense size can be CBI’s consistent overbilling. And as a quick side note on that, in FY 2014 Chicago Bridge & Iron had overbilled nearly $2 billion on contracts worth approximately $26 billion – 7.67%. This is lower than the 11.64% seen in FY 2013.
Lastly, we go over the earnings quality to check for the reliability and trustworthiness of the management team running CBI. Earnings quality is critical to any analysis performed on a company, because it validates the numbers backing it and vets them out.
This risk factor is evaluated by comparing profits produced by accrual accounting and profits calculated from a cash basis, by computing accruals ratios using either the balance sheet or the cash flow statement, and by referring to both the Beneish M-Score of earnings manipulation and the Thomson Reuters’ StarMine Earnings Quality model, which systematically looks for earnings persistence based on accruals, cash flow, high returns on assets, and similarity of pro forma earnings to GAAP earnings, and grades virtually all businesses in the Reuters database from 1 to 100, classified by geographic region.
However, with accrual-cash divergence extremely volatile especially after the Shaw acquisition, we believe the StarMine EQ model and the Beneish M-Score can give us more insight on whether the company is engaging in something suspicious with its books.
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Source: Thomson Reuters for the Earnings Quality model. Model results are applicable for North America. Companies are graded from 1 to 100, with 100 being the highest quality. The Beneish M-Score is computed systematically by Saibus Research, and reflects the possibility of management manipulating reported earnings. Scores greater than -2.22 indicate higher probabilities of earnings management taking place.
We observed declining quality after FY 2011, and CBI is presently ranked at 40 – a six-year low that sank lower to 37 in Q1 2015. The Beneish M-Score also took a dive after the Shaw acquisition, and it is presently hovering much closer to the -2.22 mark.
In addition, CBI switched auditors from Deloitte, Haskins, & Sells to Ernst & Young in 2006. Both auditing firms maintain an unqualified opinion over the past ten years, but we believe this additional detail is worth mentioning.
Caution should be advised here.
Valuation Analysis:
Moving on, we ran our valuation analysis using a risk-adjusted WACC of 9.11%, a terminal growth rate equal to 1.4% in long-term inflation (Netherlands), average free cash flow margins of 6.02%, which reflects a 7.6% operating margin, a 28% tax rate (the median), and net investments equivalent to -0.37% of sales (i.e., capex will average below rate of depreciation). We also use a competitive advantage period of 8 years to account for high GPA and OPA ratios and an economic moat of moderate strength. Pre-tax earnings were also penalized by $20 million a year to be safe.
Enterprise values as computed are subject to a negative $2 billion adjustment that accounts for non-operating cash, debt, and dilution, as well as other extraneous factors like deferred tax liabilities. This overall adjustment corresponds to $18.37 per share. Of this, -$16.88 were derived from its current debt position, in addition to a -$9.65 valuation penalty, which we stacked onto CBI for carrying an absurd amount of goodwill in its balance sheet. About +$5 was added to the per-share valuation to account for dilutive securities and the probable impact of future share repurchases.
The penalties we described above were done out of caution, because we are wary of the potential impact the nuclear projects may have on the intrinsic value of the company.
In a steady-state scenario, we presumed sales to instantly decline almost 25% to $9.85 billion and stay there indefinitely, with profit margins steady at 3.59% (calculated with an operating margin of 6.44% and a sustainable tax rate of 44%, which reflects the average). Capitalizing the profits and adjusting them will yield a $4.37 billion equity value, or $40.24 per share. Note that we did not include the impact of share repurchases in the steady-state scenario.
In a growth scenario, using the conservative assumptions and adjustments as defined above, we further presumed a very conservative CAGR sales growth of 3% from 2018 onward, as we did not want to use any of the historical growth rates or make any sort of prediction, due to the recency of the Shaw acquisition. The result is an equity value of $8.45 billion, or $77.74 per share.
Before we move on, we’d like to point out that CBI is trading at $49.35 per share.
The gap between Net Assets and Stagnation demonstrates the strength of CBI’s economic moat, which contributes to 43% of the firm’s earnings power.
Comparing Stagnation to the market price produces a $9 difference. We interpret this to mean that 18% of Chicago Bridge & Iron’s market price contains a premium that investors pay for the company’s future growth. We think the company’s fundamental performance (and its problems with the nuclear projects) supports the premium investors are paying for at this price level.
The two-stage DCF H-Model used to produce our estimated intrinsic value shows that the market is selling Chicago Bridge & Iron Company at an attractive 37% discount to intrinsic value, and implies a potential upside of nearly 58% over the long run. Given the risks we are taking, we believe this margin of safety is more than enough compensation.
Next, we take this DCF model and its adjustments and “reverse-engineer” our valuation to arrive at the expected growth implied by the market price and Wall Street’s price targets for the next 12-18 months. As the tables below show, their expectations appear very pessimistic.
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The expectations embedded in the market price and in Wall Street’s consensus targets assumes sales would decline considerably over the next nine years. Looking at Chicago Bridge & Iron’s record, we think there is a good chance for outperformance. This probability is especially high, as this indicates:
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