McDermott Fails To Execute

| About: McDermott International, (MDR)

It has been a rough year for shareholders of McDermott International (NYSE:MDR) as shown in the following chart. Unfortunately, based on the firm's pretty poor quarterly results, which sent shares plunging 8% after hours, investors have no reason to expect the trend to change. While its valuation may compel bottom fishers to take a stab at MDR, I am not sure this is a prudent bet given management's poor performance.

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McDermott provides engineering, construction, and procurement solutions for off-shore drilling projects. Unfortunately, many of the integrated oil companies like Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) have been refocusing their cap-ex budgets towards land-based projects that have less risk, which has definitely put pricing pressure on the market. Unfortunately, McDermott has compounded its problems by simply failing to execute, struggling to deliver projects on time and on budget. Its failure to do so forced write-downs that led to a $150 million loss in August.

In this quarter, McDermott faced $66 million in additional costs at a Malaysian deep-water project, though its customer agreed to pay $33 million to help offset these costs, still that it is certainly not a way to engender goodwill and repeat business. In addition to making current projects less or even unprofitable, these cost overruns make it hard for McDermott to win new business. Why would an oil company hire a firm who has struggled to meet deadlines when others have not habitually under-delivered?

In fact, in this quarter, we are seeing evidence this has begun to happen. The firm's current backlog stands at $4.6 billion compared to $5.3 billion last year. The backlog also fell by $500 million just from the last quarter. As the firm generated $686 million in revenue, it had truly horrendous new bookings of $186 million, meaning customers have clearly soured on McDermott. The company does have bids out on $9 billion in projects and plans to bid on another $8.9 billion in the coming five quarters. However with its delivering issues, McDermott will likely have to offer significant discounts to win business, which will pressure margins. Before MDR regains any pricing power, it must first win back credibility from customers.

At the same time, MDR's $4.6 billion backlog is even weaker than it looks. The company is in a loss position on $565 million of its backlog projects while another project worth $151 million will also likely end up losing MDR money. Right now, MDR can only be confident that it has a profitable backlog of $3.9 billion, which it should exhaust in 12-15 months. MDR needs to begin delivering on contracts it has if it wants to win new ones and be a viable player in the space several years from now as one or two projects can sharply change a company's prospects.

This quarter really illuminated that fact with revenue falling from $1.03 billion to $686 million this year because the firm finished several projects. With the firm not adding as many new projects as it is completing, we will likely see continued negative revenue growth. Now, the quarter did have one bright spot in that its Middle East segment was profitable, though the company still lost $64 million on the quarter, largely due to that Malaysian cost overrun and late fees. While revenue declined by 32%, cost of operations only fell 23%, and SG&A fell by 5%. With the company facing overruns and running below capacity, margins are being squeezed with gross margins of 0% in the quarter.

McDermott has now yet to beat analyst estimates in 18 months. Moreover, operational problems are clearly hampering future orders as oil companies choose to hire other firms to help with their offshore rigs. Cost overruns should continue in 2014 while revenue will be pressured by a diminishing backlog. Compounding these problems, margins will continue to be near zero as much of the backlog is already declared unprofitable. Over the last 12 months, MDR has missed estimates by a combined $1.02 per share. There is virtually no way MDR can return to profitability next year given the state of its operations.

Up until this quarter, analysts had been giving the company the benefit of the doubt. With 2014 consensus only falling $0.35 in the last ninety days to $0.52. I expect this quarter (-$0.27 vs. consensus $-0.03) to force analysts to drastically cut 2014 estimates to no more than $0.25, giving the company a forward multiple of 27x after the after-hours drop, though I still believe this is too high. I am looking for EPS of -$0.40-$0.60.

If you want to go long McDermott, you have to look out beyond 2014, which can at best be a transition year. 2013 has obviously been a disaster with horrible new orders, cost overruns, and write-downs. If the company can manage to meet targets in 2014, perhaps it can regain the trust of customers and rebuild its order book for a strong 2015. That is the bullish thesis. It is hard to see this turnaround happening though. Bulls can point to decent results in the Mideast, but cost overruns remain elsewhere, leaving the picture far from clear. The question bulls have to ask is whether they are being fairly compensated for the downside risks to buy here on hopes of a turnaround.

On the positive side, MDR has fallen slightly below shareholder's equity of $1.74 billion after hours, which would seem to provide a compelling case that shares are at rock bottom. However, it must be noted that book value has been consistently declining, dropping $214 million in the past year. With several more quarterly losses ahead, book value will deteriorate further. McDermott is being forced to consume its equity to operate. The question is whether MDR has enough liquidity to stay in business long enough to actually engineer a turnaround.

Fortunately for the bulls, MDR has a mere $53 million in long-term debt, positive working capital of $237 million and total cash of $301 million. This strong financial position definitely buys MDR some time; the question is how much. So far this year, operations have burned $170 million in cash while investing activities have consumed another $167 million. It is also worth noting that despite significantly lower revenue and backlog, the company has actually increased its capital expenditures in 2013. With weaker operating performance, MDR is clearly not getting much for its investment.

I would expect the company to burn cash at a slower pace over the next 12 months, closer to $25-$35 a quarter from operations while investing a net $35-$45 billion quarterly on average. This would suggest that McDermott would consume virtually all of its cash in a year. Now, it is critical to note McDermott has a $950 million credit facility that would provide it with ample liquidity even after the firm exhausted its current cash position. This credit line does not expire until August 2016. I would view the chances of bankruptcy before that time as virtually nonexistent. McDermott has to thread the needle just right to make a turnaround possible in 2015 by getting projects completed on time next year, incrementally improve operating cash flows, and maintaining serious capital discipline. If it does not do this, the firm will be forced to begin drawing on its credit line.

Given these factors, I do not consider MDR a good risk/reward trade even for those optimistic about a turnaround. While the company is trading at book value today, investors need to recognize book value is dropping by the day with operating losses. Its weak backlog suggests those losses will continue for at least 12 months in my estimation. At the same time, the company has a significant cash burn rate that could force the company to borrow from its credit facility, subordinating equity holders. With these risks, I would want a $300 million cushion below book value before investing. Even a turnaround bull in MDR should not consider buying shares unless they drop below $6.

Personally, I do not see the company able to turn around its operations because core problems of cost overruns are still occurring and customers are clearly looking elsewhere. I expect losses through 2014 and likely into 2015. Investors would be best served avoiding this serially underperforming company and its deteriorating business.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.