Description

CBI is an EPC company focused on fixed price contracts. Currently, about 70% of the company’s backlog is fixed price, compared to 30%~40% at other EPC companies. The company is domestically focused with 80% of backlog in the US. The company is vertically integrated and self performs most of its contract work.

The company has four segments: Engineering and Construction, Fabrication Services, and Capital Services. The E&C segment (60% of revenue, 56% of backlog) provides EPC services for major energy infrastructure projects, such as LNG liquefaction plants, regasification terminals, electric power plants, refineries and petrochemical facilities. The Fabrication Services business (19% of revenue, 12% of backlog) makes steel plate structures, piping systems and engineered products for the oil and gas, petrochemical, power generation, water and wastewater, and mining industries. The Technology business (3% of revenue, 5% of backlog) provides licensed process technologies and catalysts for use in petrochemical facilities and oil refineries, and offers process planning and project development services. The Capital Services business (19% of revenue, 28% of backlog) provides maintenance services, environmental engineering and remediation, construction services, program management, and disaster response and recovery for public and private sector clients.

Both the E&C and the Fabrication businesses have sizeable exposures to the construction of LNG facilities. About ¼ of the company’s total backlog is related to LNG.

All segments, other than the Capital Services segment, focus on fixed price contracts. Capital Services is roughly ¾ cost reimbursable and ¼ fixed price.

The Technology business has the highest EBIT margin in the 30% to 40% range due to the possession of proprietary know-hows and catalysts. E&C has EBIT margins around 8%, which is 300~400 bps higher than comps. CBI gives up a more predictable profit model (cost plus) and gets a higher but potentially more volatile margin in return. Fabrication Services’ margin is a little higher at  around 10%, and Capital Services has the lowest margin of 3~4%.

I think the stock presents an attractive risk/reward profile at these levels and outline my reasons below.

1. Valuation is compelling.

Currently, the stock is trading at 6.8x this year’s EPS guidance, 5x this year’s operating cash flow (OCF), and 5.9x this year’s free cash flow. EV/EBITDA (Q3 2016 annualized) is only 5.6x.

Other EPC companies trade at 14~15x P/E multiples, and 10~11x EBITDA multiples.

In the last 10 years, CBI on average traded at 12x next year’s earnings.

2. CBI is generating cash to deleverage and repurchase stock.

Management is frustrated with the stock’s multiple, and has outlined their playbook to increase shareholder value at last year’s analyst day. Importantly, they are focusing on generating operating cash flows equal or above net income, and use the ample free cash flow to reduce debt and buy back shares.

The company has executed on its promise to generate strong operating cash flow. In each of the three quarters of 2016, CBI’s OCF is at least 1.3x of net income. This compares to -0.2x in 2013, 0.4x in 2014, and -0.1x in 2015. CBI achieved this through better management of working capital, which has become much easier after the divestment of the nuclear business. Importantly, CBI’s strong cash flow this year was not driven by advance payments from customers (billings in excess of costs and estimated earnings), but by getting paid for the work it does (when CBI performs work and doesn’t get paid, costs and estimated earnings in excess of billings increase). In fact, in the first nine months of 2016, billings in excess of costs/earnings declined by $700M, while costs/earnings in excess of billings decreased $1.4B.

In the first nine months of 2016, the company bought back $200M of shares, reducing share count from 107M to 100M, and paid down $200M of debt.

The company’s credit facility agreement restricts share repurchases to $250M on a trailing 12 months basis, if leverage ratio (calculated using total debt) is more than 1.5x (currently: 2.45x). Having already maxed out this amount, we won’t likely see share repurchases until the end of 2017. So in 2017, I think the company will aggressively pay down debt. Management’s leverage goal is 1.5x in 2018, which happens to be the threshold below which CBI is free to buy back as much stock as it wants.

3. Operations have stabilized following a decline in LNG awards, and there are new LNG contracts on the horizon.

Following a decade of worldwide LNG liquefaction facilities construction boom and resulting over-supply, new projects/awards dried up following the oil price collapse since LNG prices are typically index to oil. CBI’s E&C segment, which is most exposed to LNG, saw its backlog collapse from $19B at the end of 2013 to $12B currently.

However, CBI’s LNG business is not dead. CBI was awarded a contract (through a JV in which CBI has ⅓ stake)

to build 2 trains for Anadarko in Mozambique. This project is expected to receive Final Investment Decision (FID) in late 2017, and CBI’s share of the contract value is worth at least $2B.

In addition, Eni will select a contractor this year to build two trains in Mozambique. CBI, through another JV which it owns ⅓, is bidding. If they win the contract, CBI’s share of contract value is worth at least $2.5B.

As for potential new awards, management is confident that the Rio Grande LNG project in Texas and Goldboro LNG project in Nova Scotia, Canada will move forward this year. Rio Grande is a six-train project and will likely cost >$10B, and Goldboro is estimated to cost between $8~$10B Canadian Dollars.

Currently, CBI’s total backlog is $20B. It is booking about $11B of revenue a year, and guides new awards of $8 to $10B this year. So the market is obviously concerned that the company burning its backlog. But I think even if the company burns $3B of backlog a year, it has almost 7 years of backlog left and currently you are paying 6x FCF. And if CBI wins any of the opportunities described above, it will be able to materially increase its backlog.

And while we wait for a turn in LNG, CBI is diligently improving the business and looking for new opportunities. In Q3 2016, the E&C segment recorded a historic high EBIT margin of 8.1%. CBI is also actively pursuing opportunities for the Technology segment, and thinks this segment can grow to $200M EBIT in the next 2 years (currently $120M). Awards are picking up too - book to bill ratio improved to 1.0x compared to 0.7x in Q2 2016 and 0.5x in Q1 2016.

4. Westinghouse dispute is an overhang, but based on available information I think CBI will prevail.

In 2015, CBI sold its Stone & Webster nuclear construction business to Westinghouse with no payment at closing. Post closing, CBI expects to receive $229M of contingent payments related to project completion milestones and CBI’s continued supply of goods and services to Stone & Wester. Stone & Webster was acquired as part of CBI’s acquisition of Shaw Group in 2013. After numerous delays and cost overruns in nuclear projects in Georgia and South Carolina on which Westinghouse was a partner, CBI wanted to get rid of the nuclear business.

The transaction is subject to a post-closing working capital true-up. If at closing working capital of Stone & Webster is greater than Target Net Working Capital of $1,174M, then Westinghouse would pay CBI the difference. In contrast, if working capital at closing is less than the target, then CBI would pay Westinghouse the difference.

The Purchase Agreement defines net working capital as consolidated current assets minus consolidated current liabilities, calculated in accordance to GAAP.

At closing, CBI calculated working capital to be $1.6B ($428M greater than the target) while Westinghouse calculated it to be NEGATIVE $977M ($2.2B less than the target). As a result, Westinghouse is seeking CBI to pay them $2.2B. CBI subsequently filed a lawsuit against Westinghouse and the two parties went to court in November 2016. The judge’s opinion memo published in December 2016 shed further light on why the two parties have such different figures:

The wide gap stemmed from four changes that the Buyer made to the Seller’s

Closing Payment Statement. First, the Buyer reduced by 30% an outstanding receivable on

the Company’s balance sheet called the “claim cost.” The claim cost asset represented

“costs incurred and paid for by the Company for items that would be presented for recovery

from either the project owners or the Buyer as a matter of contractual entitlement or as

claims for overruns for which the Company was not responsible.” Compl. ¶ 29. The Buyer

asserted that the Seller’s estimate of “100 percent collectability” violated GAAP.

Second, the Buyer adjusted the claim cost receivable to reflect the cost of the design

changes that were mandated during regulatory review. The Buyer established a reserve for

these costs and deducted the amount of the reserve from the Seller’s Closing Payment

Statement.

Third, the Buyer increased by 30% the estimates of the cost to complete the projects.

The Buyer made this adjustment because it believed that the projects would cost $3.2

billion more to complete than the Seller had initially predicted.

Fourth, the Buyer claimed that the Seller had violated GAAP by omitting a liability

of $432 million that related to the Seller’s acquisition of the Company. The Buyer deducted

this amount.

In response to CBI's lawsuit, Westinghouse argued that CBI’s calculation was not GAAP compliant. The judge ruled that the companies should let an Independent Auditor decide the GAAP compliance of their figures.

It is worth noting that after the dispute arose, Westinghouse wanted to go through the Independent Auditor route. When the judge asked CBI why it was against using an audit review if it thought Westinghouse’s maneuvers would be obvious to the auditor, CBI said that Westinghouse’s actions were based on fraud claims that should be addressed in a court. CBI was also concerned that a compromise-minded auditor would recommend an unacceptable middle ground.

I am far from a legal expert and hope those who are could chip in here, but my opinion is that Westinghouse is the one distorting accounting rules. The purchase agreement says that both parties’ calculations of working capital have to comply with Agreed Principles and GAAP, and “Agreed Principles” means the “accounting principles, policies, methodologies, categorizations, definitions, practices, estimation techniques, assumptions and procedures set forth on Schedule 11.1(a) hereto.” To me, this means that CBI’s working capital calculation should have already budgeted in cost overruns in a way that the two parties previously agreed to, and Westinghouse shouldn’t adjust it to extract payments from the seller. .

Target price

Assuming no net benefit/liability from the Westinghouse dispute, I think it is appropriate to value the company on an EV/EBITDA basis given the deleveraging story. Assuming 1.0x FCF conversion in the next 3 years, the company will generate about $1.5B of FCF. I assume the company pays down $1B of debt, which will put its leverage ratio just below 1.5x, and repurchase $500M of stock (roughly 15M shares at current prices). So in 3 years, the company will have $800M of net debt and 85M shares. Valuing the stock at a conservative 8x EBITDA, we get $7.3B of EV and $6.5B of equity value, or $76/share. This is more than a double from the current price. On a EPS basis, the company will earn about $485M this year. Pro forma for the $40M of interest expense savings ($32M after-tax), the company will earn $6.1/share. My $76 price target implies a 12.4x P/E, which seems reasonable.

Catalysts

2017 debt repayments and resumption of share repurchases at the end of 2017

Awards of material LNG contracts

Removal of Westinghouse dispute overhang

Risks

Predominantly fixed price backlog

Adverse outcome from dispute arbitration

Currently run by the same management team that got into the Webster & Stone mess through the Shaw acquisition

Catalyst

2017 debt repayments and resumption of share repurchases at the end of 2017

Awards of material LNG contracts

Resolution of Westinghouse dispute