McDermott Is A Must Sell

Mar. 4.14 | About: McDermott International, (MDR)

McDermott (NYSE:MDR) shares were down 10% after-hours Monday as the company reported disastrous quarterly results (press release and financial data available here). With shares back near a 52-week low, investors may be inclined to try and bottom-fish here. However, I believe this is more akin to catching the proverbial knife, even if you are optimistic about the offshore oil industry. Frankly, McDermott has proven itself to be a low-quality operator that consistently underperforms expectations and faces cost overruns. In fact, management pulled the forward guidance and suspending its practice of offering guidance, which is a sign of serious problems.

Revenue fell by 48% year over year to $517.3 million; Wall Street analysts expected revenue to come in at $728 million. McDermott's sales missed expectations by 29%, and as a consequence, earnings also missed badly with a loss of $1.37 compared to expectations for a $0.01 profit. This quarter was a massive miss as costs stay elevated, and McDermott struggles to win new contracts. Now, $102 million of the $316 million operating loss came from asset impairments and restructuring charges. Even if you excluded these impacts, McDermott's ran a substantial loss of about $214 million.

The company currently has a backlog of $4.8 billion, which is down 5% year over year. About $700 million of that backlog is at or nearing a loss position, and I expect that figure to keep growing given the results just announced. This backlog will deliver little value to shareholders if management cannot fulfill these contracts in a profitable fashion. Further, MDR's high cost of operations will make it difficult to win new contracts or at least win contracts that will be profitable. McDermott needs to grow revenue in excess of 20% to reach a sustainable breakeven point, but with a declining backlog, this will be a Herculean task.

Now, time is on McDermott's sign. At quarter end, it had $150 million in cash and cash equivalents against $89 million in debt. The company also had an undrawn credit facility of $950 million, providing ample liquidity. Since quarter end, it has drawn $250 million from this facility. Its cash pile jumped $185 million and it paid back $32 million in debt, which suggests its cash burn so far this year is $33 million (though there could be working capital changes). McDermott has a lot of liquidity, but its balance sheet has eroded over the past year.

Cash has dropped $500 million from $640 million last year. Accounts receivable also fell $33 million, which is consistent with lower revenue. Along those lines, contracts in progress are valued at $426 million compared to $560 million last year. Even with the decline in revenue, PP&E is up nearly $200 million to $1.48 billion, which explains MDR's cost problem. It is using more fixed assets to generate less revenue. Thanks to continued losses, book value has fallen by $512 million to $1.44 billion. Debt is certainly no concern at this point, but MDR's balance sheet has deteriorated and is unlikely to get better over the next six months.

Last year, operating cash flow was a negative $257 million while investing consumed another $231 million in cash. At this pace, MDR would easily have another 2-2.5 years to turnaround its business, and it seems like it has managed its cash flow a bit better so far this year. Put simply, there is absolutely no reason to expect a solvency issue for quite a bit of time. Nonetheless the fact management withdrew guidance and did not replace it suggests the future is extremely uncertain, which makes it extremely difficult to pick the bottom.

While McDermott's balance sheet is strong enough to withstand continued operational problems, these problems are still costly. I expect McDermott to be cash negative over the next two years, so it will be forced to add debt. With guidance pulled and the massive decline in revenue, I also expect McDermott to report an operating loss of greater than $0.25 this year. With a declining backlog, high expenses, negative cash flow, it is hard to see a bottom in the business in the next 6-12 months. Book value is currently sitting at around $6, but further losses this year will erode that figure. Cost overruns may also force some asset impairments. If an investor wanted to make a bet MDR can make a drastic turnaround, I would be hesitant to pay more than $5. With no turn in sight, I think the best play is to short MDR. After this quarter, the only trade is to sell.

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.