Date: Mar 26, 2010
Competitive Moat: C-
Financial Health: B
Opinion: Timing might not be right, but an OK buy.
Chicago Bridge & Iron (NYSE:CBI) is yet another Magic Formula engineering and construction (E&C) company, joining the likes of similar firms like Fluor (NYSE:FLR), Jacobs Engineering (NYSE:JEC), and KBR (NYSE:KBR). CBI's closest cousin amongst the Magic Formula E&C stocks is probably Foster Wheeler (FWLT), as both companies focus primarily on energy related projects for oil and gas companies.
I thought it was interesting that Chicago Bridge & Iron is not located in Chicago (in fact, headquarters is in the Netherlands!), and does not construct bridges. The "iron" part might make some sense, as about a third of sales come from the steel plate construction business, which constructs modular structures for use in energy and storage applications.
The bulk of revenues (almost 60%) come through the CBI Lummus division, which provides services for the design and construction of liquified natural gas (LNG) plants and terminals, oil and gas refineries, and pipelines. The recently acquired Lummus Technology business, about 8% of sales, sells proprietary technology (licensing) and equipment that can be utilized as a component of these same projects. CBI relies on the oil and gas majors for the bulk of its business. The majority of the company's business is overseas, with 72% of 2009 revenues out of the U.S. and 90% of new orders.
Through our analysis of several E&C companies, there are a few trends we've encountered. For one, the type of services these companies provide can be roughly separated into project-based and maintenance-based, where the former consists of large one-off contracts, and the latter consists of smaller dollar but longer duration (and ultimately, more stable) business. The second important trend is whether contracts are fixed dollar or cost-reimbursable. Since these large E&C jobs frequently have cost overruns, it is more desirable to see a majority percentage of cost-reimbursable contracts that protect us as investors from having to swallow charges for unexpected costs.
CBI falls squarely into the "project-based" and "fixed dollar" categories. The strategy here is to win large contracts for LNG and refinery construction projects. For example, the firm recently won a Columbia refinery job worth nearly $1.5 billion, and is in the process of completing a $1 billion LNG terminal job in Texas. When business is good and a lot of big new jobs are being won, there is nothing wrong with this project-based strategy. In fact, right now business is pretty good. CBI ended 2009 with $7.2 billion in backlog, near an all-time high. With global demand for energy ever-increasing, and with CBI's excellent international footprint, the long-term potential for growth is solid here.
Mitigating this positive a bit is CBI's exposure to fixed-price contracts, which account for about 50% of backlog. While this is significantly down from a few years ago, the company also has had serious problems with cost overruns over the past few years. A large LNG job in England suffered over $400 million in extra costs, which were swallowed by the company. Unpredictable factors like weather and political forces can contribute to these, in addition to normal execution-based problems.
Another potential risk is competition. Project-based E&C companies do not have any true long-term competitive advantages. The majority of jobs are one-timers, unlike firms like Jacobs who have primarily recurring maintenance and management based revenues. These large refining and LNG jobs are characterized by competitive bidding amongst the different contractors mentioned earlier.
Over-aggressive bidding can hamper margins and exacerbate the problem of potential cost overruns. CBI has had good success recently, as operating margins have improved to nearly 7%, some of the highest levels in the past decade. I believe these may fall back to more historical 5-6% levels in the next few years due to more competition in the bidding process. Management at Jacobs recently has alluded to what they saw as irrational bidding to win big new jobs. The backlog number is just revenue, it doesn't tell us how profitable those jobs will ultimately be.
The bottom line on Chicago Bridge is one of good long-term growth prospects, but few things to get excited about in the near term over a one-year Magic Formula Investing (MFI) holding period. 2010 estimates are for about 9% revenue decline, with better margins leading to flat operating income against 2009. That gives us about a 10.4% MFI earnings yield - not bad but not quite as high as we like to see to consider a stock for the Top Buys list.
2011 looks better, as the current backlog begins to work off. The estimated forward earnings yield against 2011 is about 11.3%. Since we usually see stock pricing look ahead 6 months or so, waiting a few extra months to buy might give us a better opportunity to catch 2011 expectations.
Either way, Chicago Bridge & Iron is a middle-of-the-road MFI choice. There is growth potential, and financial health is fine, but a lack of any identifiable competitive advantages and the unpredictability of oil and gas demand make it difficult to call a slam dunk.
Disclosure: Steve owns JEC