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Thesis:

With McDermott International hovering in the low to mid 20’s, the opportunity is there for informed investors to take advantage of the value that will be unlocked by the 3Q 2010 spinoff of their Babcock & Wilcox (B&W) unit, as well as the value that has already been underpriced in the cyclical heavy construction market. This is not only a nuclear power play in B&W, but I also believe the post-spin off, J. Ray McDermott, is just as good of a company with tremendous potential to continue being a major player in the oil services industry.

The currently consolidated company, McDermott Int., is a cyclical company that has been beaten down, like the majority of heavy construction firms in the last year or two, but has more or less not skipped a beat in its strategy, which was working wonderfully over the last 5 years. They did suffer mildly in this recent economic collapse but only by a loss in revenues of 5.7%, wherein they have increased revenues by 233% since 2005.

From those numbers and the fact that they have enough cash to cover their debt 17 times, I think they can afford a small set back…as long as its truly a small and temporary one. Their strategy continues to improve with their decision to split the company into two successful brands with management to be more focused on the long-term goals of each respective company.

J. Ray McDermott has a long history of being the first to complete some of the deepest and largest offshore oil projects in the world. That kind of reputation and technical ability is something that will help them continue to be a leader their industry, especially as drilling depths get deeper and deeper in search for new oil reserves. Babcock & Wilcox on the other hand essentially wrote the book on power generation systems, predominately coal fired and nuclear steam generation systems.

They also have many patents on their environmental solutions that help clean the sulfur and CO2 out of the emissions of coal fired plants in an effort to make them more environmentally friendly. The fact that both of these companies are well known as two of the best companies in their respective industries is just the starting point to why they are a good investment.

The next stop is whether or not they will stay on top of their respective industries post spin off and beyond and whether or not all of this information has been priced in already. First, we need to know a little more about each individual company and what kind of prospects they have for future growth.

J. Ray McDermott

J. Ray is a leading engineering, procurement, construction, and installation company (EPCI) focused on the offshore upstream oil and gas market. It provides front-end design and detailed EPCI of offshore production facilities, pipelines and subsea systems. J. Ray’s customers include national and major oil and gas companies worldwide (90% of which are outside the United States), and it has a significant presence in the Americas, Asia-pacific, Caspian and Middle East markets. They also have a growing presence in the newly discovered and little developed Brazilian Campos Basin oil fields, which could be a huge area of growth for the company seeing as Petrobras, the majority owner, has just committed around $200 billion plus into the project to get the field into full production by 2013.

Prospects for Growth:

They currently have a $4.2 billion backlog as of Q1 2010, which is 1.26 times their 2009 revenue and has only been below $4 billion once in the last 4+ years and that was 2009. The breakdown of their backlog is rather diverse and mostly away from United States exposure (Asia = 34% of backlog, Middle East = 58%, Atlantic = 8%, and most notably, for concerns sake, only 5% in the Gulf of Mexico).

The main areas of growth for them, according to management, are their floating production stations (FPS) and their newly developing Subsea infrastructure, Umbilical, Riser, and Flow line systems (SURF), which over the next couple decades will become even more important to the global economy with drilling depths getting deeper and necessarily more technologically enhanced. They have already recently been awarded a major offshore project in the Brazil Campos Basin as part of a joint venture with Kappel FELS, of which the contract is said to be worth around $1.1 billion (or $500+ million each). They have also been awarded their first major SURF project in the Asia Pacific, which is a result of their strategy to increase their presence in that area in an attempt to diversify their revenue (75% of their $10+ billion potential bids are in the Asian market).

Another big project that they were recently awarded was a complete Engineering, Procurement, Construction, and Installation (EPCI) project for Saudi Aramco, which includes construction of a new tie-in 6000 tonne topside platform and the refurbishing of the old platform, complete with new subsea infrastructure, and is set to be the largest contract they have received in their 40-year history of working with Saudi Aramco.

The overall potential for growth with J. Ray McDermott is tied with how much oil & gas companies are willing to spend for exploration and production of new and existing oil fields. The price of oil rising will help these companies be more willing to spend more money to find more oil. Some of which should find its way into J. Ray’s backlog if they continue to be a top competitor. There is no reason to believe that there isn’t potential for growth long into the future with this company. They have competent management that is focused on long-term goals, and they already have a reputation as one of the best oil & gas engineering and construction companies in the world. It seems to me that this split will only allow them to become better at what they already do well.

Babcock & Wilcox

B&W is a leading technology innovator in the power generation industry, a specialty manufacturer of nuclear components and a premier service provider, which has a history that spans more than 140 years. B&W designs, engineers, manufactures, supplies and constructs power generation systems and environmental control systems, primarily for large utility and industrial customers, as well as provides related aftermarket parts and services (which already benefits from 38% of the U.S. installed base). For its largest customer, the U.S. Government, B&W supplies nuclear components for defense programs and manages and operates nuclear facilities and environmental management sites.

Their full portfolio includes coal-fired, nuclear steam, commercial nuclear, natural gas, thermal solar, and renewable waste-to-energy/biomass power generation systems. This just shows the diversity they have in the power generation industry. They also have environmental solutions that help make more traditional (and so called “dirtier”) forms of energy production more environmentally friendly. These solutions include Flue Gas Desulphurization, Selective Catalytic Reduction Systems, Bag houses, Precipitators, and Mercury control systems. They also have a newly developed Carbon (CO2) capture technology that will allow 90% of the CO2 created from existing coal-fired plants to be captured. B&W has been a leader in retrofit supply and integration of air quality control systems for a long time, and even their competitors recognize this. B&W recently formed a strategic alliance with Fluor (FLR), industry leader by revenue, to help market and sell these systems in the United States and Canada, which could be a sizeable area of growth for the company.

Prospects for Growth:

They currently have a backlog of $4.75 billion as of Q1 2010, which is 1.66 times their 2009 revenue. Their backlog was growing explosively before 2009 (53% increase 2006-2008), which was a tough year for the company, but they have already started to book multiple lucrative contracts that will help them get back on that path of explosive growth, especially with the turn towards nuclear power in the near future. B&W has already received letters-of-intent and signed agreements from the Tennessee Valley Authority, First Energy Corp., and Oglethorpe Power Corp., committing to help B&W get their small modular reactors (SMR’s) put into use for potential power plants. This is the kind of potential growth that is not currently reflected in their backlog and could be the most significant area of growth for the company. It is my belief that these reactors will change this company, and in effect this country, for the better for many years to come (more about SMR’s later in this paper).

Outside of small modular reactors, there is still a tremendous amount of potential for growth. They recently received an order from the U.S. defense program for $450 million in nuclear components and have booked over $250 million in environmental solutions (i.e. waste-to-energy plants, flue gas desulfurization, etc.) over the last couple months.

They also recently entered into a joint venture with Thermax Ltd., an Indian power company, to build highly efficient subcritical and supercritical boilers and pulverizers for the growing Indian energy market. The joint venture also conjured up talks that in the future Thermax Ltd might make use of the B&W’s mPower small modular reactors, which would bring even more revenue in for the company and more exposure to a country with a large demand for reliable power generation. They will own 49% of the joint venture, which should contribute a significant amount to their bottom line but is more than likely not completely reflected in their backlog.

The most promising developments in the environmental solutions area are the waste-to-energy plants, which have been gaining popularity all over the world recently. Norway and Sweden are the latest countries to enlist B&W to design and install waste-to-energy systems for them, and even colleges across the United States are converting to these more efficient systems. The University of Missouri is one of the first colleges to commit to building a waste-to-energy plant, but is by no means the last. This is a growing trend in the U.S. collegiate circle as a way to save money on energy in the long run.

Another area of potential growth for B&W, and an interesting one at that, is their medical isotope program. They were recently awarded a $9 million contract from the National Nuclear Security Administration (NNSA) for the company's medical isotope production program. B&W and Covidien, a radiopharmaceutical manufacturer, are developing a technology to manufacture molybdenum-99 (Mo-99), the parent isotope of technetium-99m (Tc-99m), which is the most widely used radioisotope in the world for molecular imaging and nuclear medicine procedures.

This collaboration is an initial step toward establishing a large-scale U.S. supply of medical isotopes. Currently, the U.S. imports 100 percent of the Mo-99 supply, which is manufactured at a handful of aging nuclear reactors. Unplanned shutdowns of these reactors for maintenance needs or safety-related issues have led to periodic shortages of medical isotopes. Because Mo-99 has a half-life of only 66 hours, shortages have an almost immediate impact on the ability of physicians to perform critical patient procedures. This shows the urgent need for a process to be developed that will make it more affordable and less subject to shortages. The process is also much safer in terms of waste generated. The reactor technology uses low enriched uranium (LEU) and generates only about 1 percent of the radioactive waste compared to spent fuel and processing wastes generated by current reactor production of Mo-99, most of which uses highly enriched uranium (HEU).

The program has the potential to supply close to 50 percent of U.S. demand for Mo-99, which is astonishing because even though current benefit from this is only $9 million the potential for future revenue is unknown, but certainly on the positive side, especially since Mo-99 is used in 80% of nuclear medicine procedures around the world. The current U.S. demand for Mo-99 is 5500 6-day curies a week, and that doesn’t include the potential to supply this technology around the world as well. (In 2006, each 6-day curie cost about $125-$325 to produce, which will be reduced with the use of this technology, and around $470 as a market price, or $96 a curie individually.

To put that into perspective there are about 480,000 curies in a gram, which makes a gram of Mo-99 worth around $48 million. I could not find more recent numbers, but the fact that the company is putting significant effort into developing a process for this medical isotope is a good sign for the direction of demand and in effect the direction of the price of Mo-99.)

It seems to me that this company is more than set in terms of potential for many years to come and if this so called “nuclear renaissance” picks up steam as it should, B&W will reap the rewards from their patented technology for quite a while. Even if something reverses the current trend and the so called renaissance doesn’t pick up steam as it has been, B&W is well diversified and well managed enough that they should still see the fruits of their labor pay off exponentially, especially since 40% of their business is already recurring revenue.

Reasons for the Spin Off (According to Management):

The main reason for the spin off is a new federal law that bars McDermott Intl. from being able to bid on government projects because they are an “inverted” company. “Inverted” company essentially meaning that they have tax haven incorporation in Panama, so they can’t receive government contracts. This would severely hurt their Babcock & Wilcox unit because of the large amount of revenue they receive and stand to receive from the government, so it makes perfect sense for the spin off to be made.

The spin off also creates two independent pure play companies that are positioned to accelerate growth driven by distinct strategies, market opportunities, robust free cash flow, and strong customer relationships. The separate companies will also enjoy a more efficient capital allocation system, which enables each company to develop an independent investment program without the constraints of a holding company structure.

Why Are They Mispriced?

This is a question that to me can be answered half by the cyclical nature of the industry and half because of the value and potential that is unrecognized as a currently combined company. This spin off is for the good of both companies. It is not just because one wanted to get rid of the other, but instead because these two companies are much better off fending for themselves and focusing on their own specific strategies as opposed to the sometimes conflicting strategies of a holding company structure.

The offshore oil and gas industry itself has taken a little bit of a beating in the last couple of years due to the slowing down of capital expenditures by oil companies that is a result of the less than prosperous world economy. This has taken its toll on the oil services firms in the short term, but in my opinion will not last. The world relies too much on oil and gas for this kind of slump to last forever, especially with oil prices rising. The more demand rises, the more money the oil companies will have to spend on exploration, development, and extraction of oil from new and existing oil fields all over the world. There continues to be new discoveries of vast oil fields in deepwater every year (such as the Brazil Campos Basin and Ghana) and there will need to be someone there to meet that demand for rigs, platforms, and subsea infrastructure. The cyclical nature of the industry is known and it seems to me that this industry has already hit its bottom and is starting to turn back around. This is not to say that it will climb right back up to where it was before the recession, but I do not believe that the current industry valuation is right.

The nuclear power industry is a story of a different kind. There has not been much potential for explosive growth in the United States and elsewhere for nuclear power plants because of their known safety risks that go back many years and the regulatory wrath the industry faced because of said risks. This is a concern that to me is no longer valid. In my opinion, the push for clean energy is not necessarily a valid and realistic one on a large scale without the use of nuclear energy. The technology has gotten much safer and much more affordable through the development of small modular reactors, of which B&W happens to be one of the first companies with this kind of technology, and also one of the only companies with this kind of technology that can be implemented to meet large energy needs of 1,000+ MWe. B&W’s small modular reactors are capable of up to 150 MWe and can be easily strung together (10+) in a power plant to create much larger capacities reminiscent of conventional nuclear power plants, while other small modular reactors have only conjured up the technology for around 40 MWe per reactor. This consequently limits their ability to be strung together, as easily and cheaply, to get over 1,000 MWe.

These reactors are built at a factory and shipped on site, so the construction time and amount needed for construction is drastically reduced (potentially 1/10th the cost, 1/3rd the size, and only 3 years construction which is 2 less than conventional). So when looking at the nuclear side of energy industry, the storyline is one that has yet to reach its climax due to challenges early on in the story (i.e. Three Mile Island, Chernobyl, and the subsequent regulatory restrictions all over the world). That is why this is an industry that is more than ready for what Barron’s dubs a “nuclear renaissance” of which the U.S. government has already decided to put forth $150 billion plus to develop nuclear clean technology over the next 10 years.

Babcock & Wilcox’s growing nuclear and bio-energy solutions, combined with J. Ray McDermott’s stable and still growing offshore oil & gas business, doesn’t seem lend a reason as to why McDermott International has dropped more than 50% from their 2008 high of $65. I’m not saying that the company wasn’t overvalued at $65, but for them to still have a strong, unchanged financial position and no deterioration in either business or their respective prospects shows me that the selloff was more a broad brush being painted over an industry. This is a company that suffered less than most (only 5% loss in sales and actually an increase in operating income from 2008 to 2009), but still got beaten down just as much, if not more than, the rest because of the cyclical nature of the industry.

The only real concern is whether or not the US government defaults on its contracts or stops spending money on the nuclear and alternative energy industry because they are, and stand to be for the near future, the biggest customer of Babcock & Wilcox. The question of default is indeed a valid one and something to keep an eye on, but with all of the other wasteful spending in congress and a congressional agreement on the need for alternative energies I don’t believe that they would back out on their recent commitments or even future commitments to the industry. They could cut spending quite a bit with the things that aren’t necessary before they ever got to the things that are necessary to maintain the countries technological dominance, and therefore its growth. (And though I wouldn’t put it past anyone in Congress to cut the necessities and keep the garbage, I am merely assuming that hopefully the reason they got elected was because they had some common sense, not just because they “burned” the other guy worse than he did them).

Anyway, the point I wanted to make was that B&W has tremendous potential and drive to diversify their portfolio in terms of customers with their emerging technologies and the beginning of changing nuclear sentiments globally. Their small modular reactors make the most sense for poorer countries that can't afford to finance a $10 billion dollar conventional reactor. It also reduces the cost because with these reactors there is no need to build a separate storage facility to store waste.

Post-Spin Off Valuations:

Note: I used Ben Graham’s formula for valuing companies, but to be more conservative I used a modified version that was created by fellow seeking alpha contributor, Jae Jun of Old School Value. I wanted to be even more conservative with the numbers for the growth (G) and the assumed P/E of a no growth company (the 8.5x to 7x) to be sure that even in a bad case scenario I wasn’t overestimating the value and therefore overpaying. (6% was used for the corporate bond rate, Y)

Ben Grahams Formula: V = [Norm. EPS x (8.5 + 2G) x (4.4/Y)]

Adjusted Formula: V = [Norm. EPS x (7 + 1.5G) x (4.4/Y)]

J. Ray McDermott:

This is a company that is in a highly competitive, yet stable and still growing market. There is not much of anything to build a moat off of besides maybe reputation, of which J. Ray McDermott has quite a good reputation. The company has always been a pioneer in the offshore engineering and construction field because they regularly complete some of the bigger and deeper water projects before anyone else can, which is a tribute to their technical ability and expertise in the area of offshore drilling.

I cannot say that this will be a business that will grow as it has in the last couple of years, but its also hard to argue that they wont at least grow at a good, consistent rate. There is potential for explosive growth as dependency on deepwater drilling gets more evident, but that is a mere assumption that they will get much of that business and is not something that I would include in a conservative estimate of value.

The normalized EPS numbers for J. Ray McDermott are going to look quite a bit lower than B&W because the spin off distribution gives 1 B&W share for every 2 MDR shares. This means that B&W will have half as many shares by which to divide their earnings among, therefore making their earnings appear much larger in comparison.

Over the last 5-years (2006-2010), J. Ray has posted normalized earnings of $1.12 per share. When put into the modified Graham equation, with an 8% growth rate, I came up with a valuation of $14.22 per share. When I put the growth rate at 5%, which I believe is an apocalyptic view on this companies growth; I still got a value of close to $11. (I also did a DCF analysis with an 8% growth rate and got a value of $19, and an apocalyptic view at 5% of $16.87.)

Babcock & Wilcox:

The B&W unit of McDermott is more along the lines of those investors who like moats. This is a company that holds many patents for its products, and is currently in the process of developing multiple unique technologies for which they will have patents or already do have patents (i.e. small modular reactors, medical isotopes, etc.). Their small modular reactors stand to be a huge source of future income for them, and it is a relatively hard thing to start up. There are a few companies with small modular reactors currently, but B&W is considered by most to have the best and most feasible technology for a small modular nuclear reactor. This is mainly because the power generation capacity in their reactors (125+ MWe) compared to their competitors (40+ MWe) makes it more susceptible to large-scale nuclear energy production. This, to my delight, is not the only source of prospective growth for this company, which I believe has not even seen the tip of the iceberg in terms of growth. Which, combined with its Pat Dorsey style “moaty” business, is why I believe the competitive advantage period is longer with this company than J. Ray McDermott.

The normalized earnings for B&W during the last 5 years, including an estimated 2010 EPS, is $2.67 per share. The ability of B&W to create those kinds of earnings into the future is a possibility given their growth potential, but that is a little ambitious for a conservative estimator like myself. So, for that reason I knocked the normalized EPS down to $1.80 and then chose a growth rate of around 9% because I believe they will grow more than their spin off counterpart. With these inputs placed into the formula, I got a value of $24.60 per share. I then performed more sensitivity analysis work and dropped the growth rate to 5% again, which for a pioneering company in this industry is an even more apocalyptic outlook in my eyes than that of J.Ray’s “5%” growth. This pushed out a per share value of $18. (I again did a DCF analysis with this company as well and got $17.8 for the expected case and $14.09)

Conclusion:

Both of these companies have been pioneers of their respective industries throughout the years and both provide a different play on the current economic environment. One, J. Ray McDermott, is a solid and reputable leader in the offshore oil & gas construction industry, and the other is an industry pioneer in the nuclear and bio-energy power generation industry. The oil industry is held up by the stable global demand for oil & gas and the power generation industry is held up by the push to find more efficient and cheaper sources of energy, especially clean energy, as well as maintain it. These are two industries that show no signs of stopping because of the demand that will always be present in one industry or the other (but most likely both). Because of this, there is no reason not to believe that both of these companies as separate entities will be along for the ride.

I tried to be as conservative as I could be without being too conservative and hurting my overall point, but even with the bad case scenarios the combined entity comes out to be $30 (DCF $30.96). With the current price at around $24, it seems from the bad case perspective to be getting $6 per share for free. From my still somewhat conservative growth perspective, I believe that currently you are getting one company for free with the combined valuations being around $38.82 (DCF $36.80), but if we want to be safer then well go with the bad case numbers, which at $30 is still not a bad investment (A 24% return on investment). J. Ray McDermott may perform better in the short run (and yet still do well in the long run), but in the end I believe Babcock & Wilcox is the more attractive opportunity as the nuclear power revival talks begin.

P.S. if you don't get in before the spinoff, watch for a selloff of B&W shares after the distribution. Institutions and others often receive shares they did not choose to buy and have no intention on keeping, regardless of the business prospects of said spin off.

Disclosure: Author is long MDR

Source: McDermott International: Hidden Potential Unlocked by Spinoff