Prescience Point Research Group is pleased to release the contents of its latest research report. The full version can be downloaded at our website here. We also encourage our readers to follow us on Twitter here for notifications of future Seeking Alpha publications and research updates.
PRESCIENCE POINT BELIEVES,
Shares of Chicago Bridge and Iron Co N.V. (NYSE:CBI) are grossly overvalued. The company has used creative acquisition accounting to conceal losses, resulting in GAAP financial statements divorced from economic realities. Management has misled shareholders and analysts into believing that nothing is wrong with its Shaw Group acquisition or business. After acquiring Shaw Group in 2013, CBI made unusual and repeated retroactive adjustments to its purchase price allocation. Doing so enabled CBI to amass a ~$1.56B reserve that can be converted directly into gross profit to offset future costs, thereby inflating profitability, but also resulting in dramatic deterioration of CBI's earnings quality. In 2013, CBI reported Adj Net Income of $454m, the highest in its history, and CFFO of -113m, the lowest in its history. CBI is struggling with certain Shaw contracts that may prove to be severely loss making, and the reserve is being used to mask their financial impacts and CBI's increasingly fragile financial condition. Q1'2014 results confirm our expectations that CBI continues to face headwinds, including continued losses, divergence of earnings and cash flow, and a rising dependency on debt. While the company has $1.35B in revolver availability, we believe CBI will be forced into a goodwill write-down or financial restatement, either of which would trigger debt default, heightening the risk of a liquidity crisis or dilutive equity raise.
Meanwhile, Wall Street analysts are missing the forest for the trees, assuming CBI's reported financials represent its future and anchoring their projections to CBI guidance and reported Adj EPS, both of which are significantly inflated by non-cash income from the release of the reserve. We believe CBI has presented itself to the investing public in a highly questionable manner and that, as a result, it has been successful in its efforts to inflate its stock price beyond reasonable measure. Based on our analysis, CBI stock is worth ~$37 per share, ~49% below current trading levels.
Diversified Balance of Accounting/Non-Accounting Red Flags is Concerning
- Use of Creative Acquisition Accounting Conceals Financial Problems, Inflates Profitability: We believe by using creative acquisition accounting, CBI inflated its 2013 gross margin by 27% and reported EBITDA and Adjusted EPS by 36% and 52%, respectively, and can continue inflating its profitability for years. CBI coincidentally wrote-up its backlog by $1.8B.
- CBI Appears to be Concealing Losses from Certain Contracts: CBI is struggling with certain Shaw contracts that may prove to be severely loss making, and Prescience Point believes this reserve is being used to mask the negative financial impacts of those contracts; however, based on our estimated use of the reserve in Q1'2014 results, even a reserve so large may not suffice to protect the bottom line.
- Signs of Deception / Lack of Transparency: Despite financial statements showing that the SHAW acquisition was at best an utter failure and at worst an attempt to hide declining profitability, CBI touts the success of the transaction, which we believe is misleading. CBI does not disclose that its underlying financial performance is dramatically different from what it reports to investors; CBI does not disclose by exactly how much income is inflated by its release of the reserve or why the reserve was created in the first place. CBI also appears to misrepresent the nature of the Contracts in Progress account, to which the adjustments were made, and blames increasing backlog on currency movements instead of the adjustments.
- Pattern of PPA Adjustments Raises Red Flags; May Point to GAAP Violation: CBI made incessant pre-acquisition assurances of having thoroughly vetted the Shaw nuclear projects and reiterated its confidence post-acquisition, which is why the pattern of CBI's PPA adjustments is bizarre: $1.2B of the total ~$1.56B reserve was created in Q3 and Q4, 8 to 11 months after the acquisition & ~18 months after CBI and Shaw entered a definitive agreement in July, 2012.
- Flawed Corporate Governance May Encourage Earnings Manipulation: Management comp is skewed towards their success at generating as much in earnings as possible, regardless of quality, and the adjustment may have allowed them to pay themselves over 200% more than they should have been paid in FY2013.
How We Expect the Dominoes to Fall
- CBI is more leveraged than it appears, and in our view overleveraged given its risk exposures. On our adjustments, we estimate LTM Q1'14 leverage to be 3.0x EBITDA, ~50% higher than indicated by its reported financials. Meanwhile, CBI's $420m cash balance is misleading - its net Contracts in Progress liability is effectively a direct claim on this cash.
- CBI likely has no excess cash; if CBI continues taking cash losses, as it has been, and/or bookings decline, which we anticipate, CBI would be forced to depend further on its revolvers, as it did in the most recent quarter: In Q1'14, CBI reported income of +$89m, which we estimate was boosted by reserve release of +$134m, meaning CBI would have reported a net loss of -$46m absent the noncash boost. Our calculation of a quarterly loss is reflected by reported CFFO of -$145.7m. CBI drew on its revolver, increasing total debt from $1.84B in Q4'13 to $2.034B, enabling it to report a flat cash balance. CBI still has $1.36B of available capacity under its revolving credit facilities.
- However, we believe CBI will be forced to write-down its grossly overstated goodwill, which CBI wrote-up to offset its repeated write-downs of Shaw's book value, but at a time when Shaw's value was declining. CBI's write-down of Shaw goodwill is likely to trigger a debt default, heightening the risk of a liquidity crisis or a pre-emptive dilutive equity raise.
CBI equity is overvalued on almost every metric
- As is evident in the 1Q2014 results, non-cash income released from CBI's loss reserve has led to a significant detachment between reported net income and operating cash flows. The reality of CBI's business without the Shaw adjustments leads PP to initiate CBI with a $37 price target, or 49% below the current share price.
CBI created a loss reserve using acquisition accounting that we believe results in a highly misleading portrayal of its true economics, rendering its reported financial statements useless toward evaluating its business. Based on our analysis, excluding the non-cash income boost resulting from creative accounting reveals that,
- CBI's reported Gross Margins, Adjusted EBITDA, and reported Adjusted EPS are all significantly inflated: For example, 2013 gross margin was inflated by 230 basis points, or 27%, and Adj EBITDA and reported Adj EPS were overstated by 36% and 52%, respectively.
- CBI would have reported a -22% miss - not the +17% beat it did report - of the 2013 Wall St consensus Adj EPS target: While CBI reported a beat, with 2013 reported Adj EPS of $4.91 handily surpassing the guidance midpoint (i.e., $4.17) and Wall St's consensus estimate (i.e., $4.18) by over +17%, CBI would have reported a severe miss of each.
- CBI would have reported a 2013 pro-forma EPS contraction of -10%, not the pro-forma EPS growth of +47.4% that it did report.
- Wall St analyst estimates are severely inflated, as their consensus targets are anchored to CBI's reported Adj EPS and guidance.
- CBI appears overleveraged, with its leverage ratio as of Q1'14 exceeding 3.0x, ~50% higher than represented by its financials.
- CBI has made retroactive adjustments to backlog - the principal driver of valuation for E&C companies - acquired from Shaw, increasing it (and therefore its consolidated backlog) by $1.8B, seemingly with the simple strike of a pen!
The table below contains the summation of our adjustments to CBI's reported financial statements, each of which we detail in the sections that follow.
Background: The PPA Adjustment Process Can be Abused to Enable Earnings Manipulation
CBI's acquisition of Shaw Group was completed on February 13, 2013. As required by GAAP, CBI adjusted the acquired assets and liabilities to fair value and carried out a purchase price allocation (PPA). This preliminary PPA was disclosed in CBI's 10-Q for Q1 2013.
Under GAAP, an acquirer is allowed to make retroactive adjustments to the purchase price allocation for a period of up to 12 months following the acquisition date (i.e., the 'measurement period'). Post-acquisition PPA adjustments can, of course, be legitimate but can potentially be used as a device to enable earnings manipulations, particularly when the acquirer artificially depresses the book value of the target company by writing-down its assets and/or writing-up its liabilities; this gives the company the ability to generate 'fictional' (i.e., non-cash) earnings by later reversing the asset writedowns and/or liability writeups.
As a result of this type of cookie jar accounting, all else equal, the acquirer will be able to go on to report margin expansion (or maintenance if costs are rising), inflated earnings, and increased book value, but with no corresponding increase in operating cash flow.
CBI Made Several Adjustments to the PPA, in Each Case Further Depressing Shaw's Book Value
Over the course of the year following its acquisition of Shaw, CBI made repeated retroactive adjustments to Shaw's assets and liabilities, in each case furthering the write-down of Shaw's book value. CBI does not provide a summary of all its post-acquisition adjustments in any of its filings. We summarize all these adjustments - compiled from four different CBI filings - in the table below, and have highlighted the most substantive changes to account values.
The most significant adjustments CBI made were to Shaw's Contracts in Progress, net (CIP), an account used in the accounting for construction contracts. It is the net of an asset account (unbilled receivable) and a liability account (deferred revenue). On the acquisition date (February 13, 2013), the net sum of these two for Shaw was a liability - deferred revenue - of $754m. As of Q4'2013, CBI had significantly adjusted this account higher to an ending value of $2.317B.
In sum, CBI made cumulative adjustments to Shaw's Contracts in Progress totaling $1.56B. Since Contracts in Progress is a net account, it would include any of the additional costs in the $1.56B CIP account adjustment. In other words, it appears CBI's PPA adjustment is essentially 100% margin revenue - a cookie jar of $1.56B of non-cash income that CBI can use to inflate its profitability and/or hide losses in the future.
Furthermore, because the loss reserve was created via acquisition-related PPA adjustments, CBI was able to offset the cost with an increase in goodwill, preventing any signs of its creation from hitting its income statement as a charge to earnings, which likely would have drawn investor scrutiny.
And we cannot emphasize enough just how gargantuan this cookie jar reserve is in size:
- $1.56B is equal to ~90% of the market value of Shaw's equity before the CBI acquisition offer!
- $1.56B is also equal to ~3x cumulative Shaw profits spanning the twenty years from 1993-2012 ($555m)!!
- The combined CBI's entire gross profit and net income (based on our adjustments) as of LTM Q1'2014 were $967m and $316m, respectively. The reserve equates ~1.6x CBI's gross profit for an entire year, and ~5x its net income!
Reserve Made Against Nuclear Contracts, Implies CBI Increased Shaw Nuclear Project Margin by ~3x
CBI discloses in its 2013 10-K that the Shaw CIP fair value adjustments totaling $1.56B were made to Shaw's two large nuclear project contracts - the Vogtle project in Georgia and V.C. Summer project in South Carolina:
The acquired Shaw operations included a net contracts in progress liability of $2.3 billion, primarily related to upfront payments received on our two large nuclear power projects prior to the Acquisition Closing Date and fair value adjustments associated with the contracts.
We note that in CBI's 'Shaw acquisition presentations' (dated August 2012 and November 2012), CBI discloses information revealing the total margin it expected from the two nuclear projects to be ~$782m (refer to extract below).1 Comparing this with the $1.56B of cumulative margin fair value adjustment indicates that CBI is doing the equivalent of raising its margin on these two projects by ~3x!
Adjustments Indicate Shaw Acquisition at Best a Failure, at Worst Driven to Obfuscate Decline
We believe both the existence and size of the fair value adjustment indicate that either,
- The Shaw acquisition is a CBI failure: Management either misjudged the quality of Shaw's assets prior to the acquisition or Shaw has turned for the worst, substantially deteriorating under CBI's ownership, or,
- The Shaw acquisition was made to obfuscate what was bad: In other words, the Shaw assets are performing as CBI had anticipated in its pre-acquisition due diligence, and the loss reserve was created solely as a device to cover up a precipitous decline in the rest of its business.
Either way, as we will demonstrate extensively in this report, we believe CBI has not been honest in informing shareholders of these realities.
PPA Adjustments Result in Earnings Mirage
CBI notes that a large part of these adjustments will be included in revenue over the next five or six years. Per the 10-K for 2013:
Contracts in Progress - Included in contracts in progress is a margin fair value adjustment of approximately $745,500 associated with acquired long-term contracts that were less than fair value at the Acquisition Closing Date. This margin fair value adjustment will be included in revenue on a POC basis as the applicable projects progress over approximately five to six years.
The note above states that $746m will be recognized over the next five to six years; however, the total adjustment was $1.56B, which leaves the treatment of the remaining $744m undisclosed. CBI has not disclosed how this remainder will be recognized in revenue, but we would expect for it also to be recognized in the time it takes to complete the nuclear projects - over 5-6 years - and, this was corroborated on our recent call with management.
Assuming recognition of the $1.56B total adjustment on a straight-line basis, we estimate that on average $286.7m of non-cash income will be released into gross profit each year for 5.5 years.
In the table below, we demonstrate the impact of an adjustment of this size on CBI's LTM Q1'2014 reported financials. We estimate CBI's net income was inflated by 53% - 72%!
(Note that in our summary adjusted financial statements in the intro to this section we assume a point estimate for the PPA FV Adjustment of $286m, the average of the two 'Benefit to Revenue per Year' figures derived in the above table.)
Mysterious Inflation of Acquired Backlog Coincides with PPA Adjustments
CBI also retroactively adjusted backlog acquired from Shaw over the course of 2013, mysteriously increasing it by $1.8B! In Q4 alone CBI inflated this backlog by $1.2B!
This is very important, as backlog growth is a principal driver of valuation in the space. Backlog translates to visibility and is used by investors as a gauge of future profitability.
PPA Adjustment Results in Understated Credit Risk
In reflection of overstated profitability, we believe CBI's credit risk is understated by its reported financial statements.
Among E&C's, which tend to keep funded debt balances low because of generally highly volatile cash flows, CBI stands as a high-leverage outlier, the result of using debt-financing to acquire Shaw.
As of Q1'2014, its debt balance was $2.035B. Based on its reported financials for CBI's leverage ratio was 2.1x; but based on our adjustments, its leverage climbs to 3.0x, ~50% higher than the level indicated by its financial statements. And as we discuss in the section detailing CBI's Q1'2014 results, our estimate of 3.0x more likely understates rather than overstates CBI's reality.
Furthermore, CBI has only $420m of cash on its balance sheet, and will likely have to spend a significant amount of that cash, if not all of it, to actually "earn" the deferred revenue sitting on its balance sheet and fund unexpected losses from its nuclear contract - we believe it has an already small margin for error, which may be narrowing. As we will discuss, we believe CBI will be forced to write-down its goodwill (or restate its financials), triggering a debt default; if this were to take place as bookings were to decline, CBI would be at heightened risk of a liquidity crisis. While we have no edge in making such a prediction, we believe the risk exists based on CBI's financial position and that it is not priced into the stock at current levels.
BIZARRE PATTERN OF FV ADJUSTMENTS RAISES RED FLAGS; MAY POINT TO GAAP VIOLATION
It is surprising that CBI needed to make any post-acquisition fair value adjustment in the first place given both its incessant pre-acquisition assurances of having thoroughly vetted the Shaw nuclear projects over a 3 month period and the projects' high level of transparency as being public works projects.
Per the extract below, taken from a presentation CBI gave in November 2012 to explain the merits of the Shaw acquisition, specifically assured investors that, based on its 3 month long analysis and that of external counsel, the "risk profile and expected profit of the nuclear projects is consistent with Shaw public statements".2
CBI's S-4 filing, dated November 13, 2012, contains many similar assurances, for example stating that the "nuclear contracts were well-structured from the perspective of protecting Shaw (and thus CB&I post-Transaction) in the event of overruns, increased input costs, or performance delays or customer dissatisfaction".
We would expect that CBI should, indeed, have been able to complete a thorough pre-acquisition due diligence process, given the high level of transparency into Shaw's nuclear projects: As public works projects, nuclear project progress reports are required to be filed with public service commissions on regular basis and are then made publicly available. These reports extensively detail project progress and challenges being dealt with. Progress reports for the Plant Vogtle construction are filed with the Georgia Public Service Commission and those for VC Summer are filed with the South Carolina Public Service Authority. Project progress is also widely reported on by the mainstream press. Based on our review of the public disclosures and press accounts (for example, here, here, here), Shaw's specific projects were widely known before the acquisition to have been marred by delays and problems that were resulting in cost overruns.3
Furthermore, months after the acquisition, CBI maintained its confidence in its pre-acquisition due diligence. For example, at a Credit Suisse conference on June 6, 2013, CBI's CEO stated, "…we don't feel that there's anything different than what we talked about when we looked at the original project during the diligence, so we feel pretty comfortable…if anything, we were fairly conservative in our original outlook."
This is why the pattern of CBI's fair value adjustments appears downright bizarre. As the table below demonstrates, CBI made $1.2B of the total ~$1.56B (>75%) fair value adjustment in Q3 and Q4 alone, 8 to 11 months after the deal was completed and nearly 18 months after CBI and Shaw entered into a definitive agreement in July 2012.
We believe that in light of having stood by its due diligence for many months following the acquisition, that CBI had indeed completed its due diligence of Shaw's nuclear projects, and that because the PPA adjustments were made later, CBI may have violated GAAP. The basis for our assessment is grounded wholly in management comments, and taking management at its word.
Fact Pattern Consistent w/ CBI Having Made the Adjustments in Response to Post-Acquisition Events
Were they made in response to unanticipated losses resulting from post-acquisition events?
Based on our review of the public service filings and press accounts, the post-acquisition period has been littered with events we would expect to have resulted in losses CBI would not have been able to anticipate in its pre-acquisition due diligence, especially given that its contracts are heavy on fixed price components. (For more examples, please refer to the Appendix, which contains an exhaustive analysis of nuclear project challenges arising post-acquisition that could be expected to negatively impact CBI's financials.)
For example, CBI is so far behind schedule on the fabrication and delivery of certain components for Plant Vogtle construction that the work has been reassigned to 3rd party fabricators. Use of 3rd party contractors is typically thought to be a major source of cost overruns. Mackson, for instance, as of 9/3/2013 has taken over the CA03 module fabrication. We would expect that transferring fabrication to a third party would result in previously unanticipated costs, thereby reducing CBI's nuclear contract margin and impacting its income statement.
In another example, on June 5, 2013, Scana, CBI's client for nuclear plant construction at VC Summer, announced that completion of its Unit 2 reactor would be delayed by ~1 year. Delays are a major cause for unanticipated losses. CBI gave a presentation at the Credit Suisse conference the following day (June 6, 2013), during which analysts expressed great concern about the implications of the delay on CBI's financials. CEO Philip Asherman assured them the delays would have no impact on guidance or CBI's financials going forward, meaning CBI would not be responsible for any of the additional costs on the nuclear cost overruns.
However, we believe CBI is likely on the hook: A recent report to the South Carolina office of regulatory staff indicates, the delay was in part due to CBI's failure to deliver modules on time and to quality from is Lake Charles, LA facility, which would indicate CBI should be on the hook for some of these costs.
Of course, if CBI is on the hook, as we suspect, but it made PPA adjustments in response to post-acquisition events such as the one above, then indeed, it would be enable it to demonstrate no impact on guidance or go-forward financials, given that the reserve would allow it to avert the reporting of contract losses.
In our view, the fact pattern appears to be consistent with CBI having made PPA adjustments in response to unanticipated costs arising from post-acquisition events.
PPA Adjustments Made in Response to Post-Acquisition Events Violate GAAP
If it did, the PPA adjustments are not legitimate and CBI has violated GAAP. As previously stated, GAAP allows an acquirer to make retroactive adjustments to its purchase price allocation for a period of up to 12 months post-acquisition. But it also stipulates that such adjustments must be based on information "known to be available or obtainable" as of the acquisition date. In other words, to be legitimate, adjustments cannot me made in response to post-acquisition events; asset write-downs necessitated by post-acquisition events must be charged against earnings.
In sum, in light of the pre-acquisition level of due diligence CBI conducted, made possible by a high level of transparency for project progress, and CBI's reassurance in its due diligence process months after the acquisition, the pattern of CBI's fair value adjustments - with the lion share of the total adjustment being made in Q3 and Q4, 8 to 11 months after the deal was completed - appears to indicate they were made in response to post-acquisition events. Our assessment is supported by the existence of a litany of post-acquisition events we would think should negatively impact CBI's guidance and financial statements, but that never did - which would be consistent with CBI having made the adjustments in response to post-acquisition events.
CBI APPEARS DECEPTIVE IN INFORMING SHAREHOLDERS OF ITS REALITIES
Regardless of the legitimacy of its acquisition accounting, we believe CBI is knowingly or recklessly failing to disclose that its underlying financial performance is dramatically different from what it reports to the investing public. Based on our review, outside the confusing disclosures located primarily in the Acquisitions footnote of its 2013 financial statements, there is a pervasive omission of any discussion about the PPA fair value adjustments: CBI does not disclose by exactly how much income is inflated by its release of the reserve or why the reserve was created. Worse, management can be observed, we believe, to actively mislead investors to prevent the discovery of its accounting shenanigans: Despite financial statements showing that the Shaw acquisition is a failure, management touts the success of the transaction on conference calls, which we believe is misleading.
CBI is Taking Losses, as Reflected by CFFO; Shenanigans Cause Earnings Quality Decline
CBI is taking cash losses, and we believe those losses are being concealed from shareholders.
In 2013, CBI reported the highest earnings in its history as a public company; this was accompanied by the lowest level of reported Cash from Operations in its history. 2013 was the first year in CBI's history that it reported negative cash from operations.
The wealth-generation historically represented by CBI's GAAP profits is no longer observable in the company's cash flows - it now appears to be 'paper' wealth generated by accounting entries.
CBI does not disclose by exactly how much income is inflated by its release of the reserve.
Investors Misled by Touts of Success of Shaw Integration & Nuclear Projects; No Mention of Losses
If the disclosures in CBI's SEC filings are to be believed, management seems to have been deceptive with investors. Based on our review of public disclosures, management never discusses losses CBI is taking, and has only good things to say about the Shaw acquisition - continually touting the success of the Shaw integration and noting positive progress in the nuclear projects. Furthermore, we should mention that in spite of the cash-basis shareholder losses and a dramatic miss of CBI's 2013 internal free cash flow targets (see section on management comp), CBI's CEO was paid a $2m bonus for the successful integration of Shaw!
The below display management commentary across time. In taking it in, keep in mind that CBI took additional write-downs against the Shaw CIP account of $658.7m in Q3'2013 and $537.6m in Q4'2013.
Investors Misled by Incomplete Explanation for Declining Cash Flow Conversion
We believe that, when asked to explain the disconnect between CBI's net income and cash flow on the Q4'2013 earnings call, CFO Ballschmiede again appears to mislead investors in a way that might prevent discovery of the reserve and/or its financial impacts. He cites upfront payments received on the nuclear projects as the cause of the divergence, stating they will be worked off over the life of the pertinent nuclear projects, at a rate of $200-300m per year for 4-5 years. He completely ignores mention of the fair value adjustments, which we believe to be the primary driver! The $1.56B cumulative fair value adjustment is the largest component of Shaw's net CIP liability, by our estimates making up ~67.5% of the $2.32B account per CBI's final purchase price allocation.
He then continues to apparently stretching the truth, telling investors the source of the income-to-cash flow discrepancy is money "essentially sitting on our balance sheet somewhere", a comment which cannot, in our view, be more misleading. He appears to be making it seem to investors that the Shaw CIP liability is deferred revenue that resulted entirely from the acceptance of upfront cash payments: In essence, he seems to be trying to leave investors with an impression that can be summarized as follows: 'Yes, while the account has caused income and cash to diverge, it is not all bad news. The flipside is that the cash has helped to fortify our balance sheet'. Get real. As previously stated, by our estimates ~67.5% of that account can be attributed to the PPA fair value adjustment, which is an accounting entry that involves no intake of cash; it is essentially created with the strike of a pen.
Investors Misled by Explanation for Mysterious Increase in Backlog
As previously discussed, CBI retroactively adjusted backlog "acquired in connection with the Shaw acquisition" from $15bn in Q1'213 to $15.6B in Q3'2013 and then to $16.8B in Q4'2013, seemingly adding $1.8B to its backlog with a simple accounting entry, and with no explanation.
When asked by an analyst on the Q4'2013 earnings call as to what he was missing in not being able to reconcile CBI's reported Q4 backlog number based on its driving factors, CFO Ronald Ballschmiede again appears to mislead investors in a way that would prevent the identification of potential shenanigans. Specifically, he not only makes no mention of the retroactive write-up of backlog acquired from Shaw but appears to mislead the analyst, attributing the discrepancy primarily to hundreds of millions is from currency movements.
In light of this and other misleading comments discussed, we are left to conclude that CBI management is engaged in a coordinated effort to avert scrutiny of its aggressive accounting practices.
Q1'14 RESULTS MAY INDICATE INCREASING LOSSES & INCOME-TO-CASH FLOW DIVERGENCE
Q1'2014 results indicate CBI is currently even more dependent on masking losses than our estimates, based on straight-lining the reserve suggest. We believe Q1 is a harbinger of accelerating losses and income-to-cash flow divergence, raising the specter for a liquidity crisis, a risk previously discussed.
CBI reported Q1 net income of $89m and EPS of $0.82, missing consensus of $1.11 by -26%. We estimate the results were boosted by reserve release of $134m, far greater than we would have expected based on our straight line estimates (i.e. $286m per year, or $71.5m per quarter). Excluding the non-cash income boost, we estimate CBI would have reported a net loss of -$46m, or -$0.43 per share. Our calculation of a quarterly loss is reflected by CBI reported negative quarterly CFFO of -$145.7m. We note that CBI's cash balance, $420m, was stable from Q4'13 to Q1'14, made possible having drawn from its revolving credit line, with total debt rising $1.84B to $2.034B over the same period.
Our assessment of CBI's Q1'2014 results follows:
- PPA Fair Value adjustments contributed $134m to net earnings
- CBI reported EPS of $0.82 missing consensus of $1.11 by -26%. Without the benefit of the FV adjustment, EPS would have been a loss of $(0.43)! We believe that Q1 2014 shows just how material the FV adjustment is to results.
- Cash flow from operations was negative, with cash out flow of -$145.7m. This was mainly driven by a $422.5m decrease in the CIP
- Future losses may be even higher than reserved for in the PPA, meaning that that once the reserve has been used up, the losses will flow to the bottom line.
How we derived our conclusions:
- CBI states in its Q1 2014 10-Q, p.31, that, "The $300.5 million net change in our Contract Capital balances was due primarily to progress on our two large nuclear power projects (approximately $295.0 million)." Per the data in the table below, it is clear that the $295m is related to the change in CIP. Additionally the FV has been identified as being for the nuclear projects.
- The FV adjustment was 67.5% of total Shaw CIP (all related to Nuclear Projects); assuming recognition in the same proportion, we calculate that CBI used a massive $199m of the FV adjustment in Q1 2014, equating to $135.4m after-tax.
- We adjust net income to remove the non-cash boost; we estimate that without the adjustment CBI would have reported a - -$46.4 LOSS vs. the reported $89m gain.
GOODWILL GROSSLY OVERSTATED; A WRITE-DOWN WOULD TRIGGER DEBT DEFAULT
We believe CBI will be forced to write-down its goodwill balance, which will result in a default on its debt covenants. The company's balance sheet is bloated by a grossly overstated goodwill balance, the direct result of CBI's PPA fair value adjustments.
As of Q1'2014, CBI had amassed $4.2 billion of goodwill, relative to a book equity totaling $2.6 billion (i.e., goodwill is 162% of CBI's book value). $3.3 billion of that goodwill balance, or 126% of the consolidated company's book value, is attributed to Shaw. This means that the company's shareholder equity would be negative without the Shaw goodwill and, generally, that any substantial write-down in goodwill would send shareholder equity plunging. Moreover, CBI's Revolving Credit Facilities have a financial covenant that as of March 31, 2014 requires it to maintain a minimum net worth of $1.762B. CBI's current net worth is $2.441B, meaning that a goodwill write-down of only $679m would result in a debt default.
- Even if we take CBI at its word by assuming the reserve it created is based on a legitimate estimate of future losses that were not expected when the deal was agreed upon, then by definition the Shaw goodwill on CBI's balance sheet is overstated, necessitating a write down; because Shaw is expected to be making significant losses, there should be an impairment.
- CBI management, when they were courting Shaw from May - June 2012, set forth their expectation that Shaw would generate revenue in 2013 of $6.3B. Based on CBI's post-acquisition financials, Shaw actually generated revenue of $4.5B in 2013, falling short of their projections by 40%!! Shaw's business seems to be much weaker than CBI had expected when they purchased it, which indicates that a goodwill write-down is necessary, especially given that its balance was increased ~33% over the course of the year CBI was carrying out its PPA adjustments - a time frame in which its value was declining!
- Comparing Shaw's performance in 2013 to its performance in 2012 offers further evidence that its business has deteriorated under CBI's ownership. Based on the pro-forma financials located in CBI's 2013 10-K, Shaw generated revenue of $5.373B in 2012 vs $4.5B in 2013, down -16% in one year! Again, Shaw's business has weakened substantially since being acquired, and yet over the same timeframe its goodwill balance was increased >33%.
- Lastly, the amount of goodwill CBI has allocated to Shaw, ~$3.3B, has grown to 1.5x the value placed on the entire entity ($2.2B) at acquisition!
All roads lead to the same destination. We are confident CBI will soon have to take a crippling write-down to its goodwill.
FLAWED CORPORATE GOVERNANCE MAY ENCOURAGE EARNINGS MANIPULATION
The PPA adjustment feeds right into the core driver of CBI's incentive structures - Adjusted EPS. As this measure rose sharply in 2013, management realized both, 1) a large payout of annual incentive - 3x what they would have been paid absent the acquisition accounting adjustment - and 2) an acceleration in the vesting of CBI shares doled out as part of CBI's long-term incentives plan. With the bulk of cash incentive compensation tied to Adjusted EPS targets, management's accounting for the Shaw acquisition translates to a tool that can be used toward assuring lavish annual cash bonuses, resulting in little long-lasting accountability for shareholders and incentivizing more empire-building at the expense of long term cash on cash returns for shareholders.
Decisions made by CBI's board also seem to evidence a tacit acknowledgement that they have all but given up on CBI's ability to generate cash earnings. In 2013 the board made a change to the management annual incentive structure, reducing the weighting of Free Cash Flow as a determinant of bonuses, indicating a reorientation toward lower quality earnings vs. higher quality, cash-based earnings. The board's position can also be gleaned from its decision to award CBI's CEO with a $2m discretionary bonus for the 'successful integration' of Shaw in 2013, the same year the company generated the lowest level of free cash flow in its history.
Management Incentives Based on Adjusted EPS, a Primary Beneficiary of PPA Adjustments
Adjusted EPS is the primary determinant of CBI management's annual, and the only determinant of its long-term, incentives structure. In congruence with what we'd expect of this company, CBI of course defines Adjusted EPS as "EPS excluding merger and acquisition costs," but does not appear to exclude the non-cash benefit from recognition of the PPA fair value adjustment. This translates to a management capability to artificially inflate CBI's underlying earnings, meet EPS bonus targets, and get paid out of shareholders' pocket books; from a moral standpoint, this is akin to a theft. We cannot even fathom that CBI's board would vote and agree to implement this and some of the other policies soon to be discussed.
For annual incentives, the Adjusted EPS target comprises 40% of the weighting, and offers a 250% payout if Adjusted EPS meets or exceeds the maximum target set by the board, giving it the highest max payout rate among the performance measures considered. Because it bears the greatest influence on bonus payouts, managers are likely to focus on maximizing Adjusted EPS even as the company maybe underperforming, as related by other measures taken into account.
Per the table below, CBI missed dramatically on its target for free cash flow and barely achieved the minimum target for New Orders in 2013, even after slashing the FCF minimum by approximately 50% compared to 2012. As such, the relative contribution of adjusted EPS to the calculation of the cash incentive was 66% of the total. Fortunately for management, the bonus system has been structured such that it still was able to achieve a bonus of 152% of base salary. We estimate that by releasing non-cash income from the reserve, management was able to "earn" 3x the cash bonus (as a % of salary) that would have been paid absent this accounting adjustment!
Long term incentives consist of restricted stock and performance shares. The restricted stock vests 25% per year over a 4 year period and performance shares vest 33.3% over a 3 year period. Performance targets - entirely determined by Adjusted EPS - need to be met each year in order for vesting to occur, as follows: at minimum performance (50% vest), at target performance (100% vest), and at maximum performance (200% vest). CBI's 2013 reported Adjusted EPS of $4.91 exceeded the maximum performance levels of $2.48, $3.30, $4.35, as set in 2011, 2012, and 2013, respectively, at the 200% of target level. This amounted to an acceleration of management pay, yet another gift management doled out as the result of a most giving soul - acquisition accounting.
Board Awards CEO $2m Bonus for 'Successful Shaw Integration' as FCF Falls to Lowest Level in History
It is notable that on February 20, 2014, just past the one year anniversary of CBI's Shaw acquisition, CEO Asherman was granted a $2m discretionary bonus, payable in restricted stock units vesting 33⅓% per year based on the closing price of the stock on February 20, 2014. CBI's Compensation Committee attributed the payout to the CEO's "exceptional performance and the successful integration of the Shaw acquisition in 2013."
The payout of Mr. Asherman's bonus coincides with CBI having generated the lowest level of free cash flow in its history as a public company and creating a reserve for future losses that it appears to hide from investors, calling to question the board's standard in representing shareholder interests. Moreover, as discussed in our section no Goodwill, Shaw appears to have deteriorated significantly in 2013 under CBI's ownership, with revenues collapsing by -16% YoY!
Who knows what the board is really rewarding management on? Whatever it is, it seems to at the expense of long-term shareholder interests.
Who Exactly is the Board Representing?! CBI Misses its Own FCF Targets; Board Cuts FCF Weighting
As the ability to manipulate Adj EPS to achieve higher bonus payouts were not bad enough... CBI's board now seems to be giving up on the company's ability to generate free cash flow; and, rather than increase incentives for management to turn the ship around, it appears to be pacifying management at shareholders' expense. It has taken measures to reduce damage to management compensation packages should free cash flow remain elusive.
In 2013, it reduced the weighting for the Free Cash Flow target for annual incentives from 20%, where it was set in 2011 and 2012, to 10%, and established a new target measure for Acquisition Integration.
We note that CBI had not achieved the minimum FCF target requirement in either 2012 or 2013; further, CBI was so far off from its minimum FCF target in 2012 that the miss raises serious questions as to the health of the underlying business. In 2013, CBI reduced its FCF target levels by almost 50%, but still came nowhere close to achieving the minimum threshold set, even though the company seemed to be expecting additional cash flow from the Shaw acquisition:
Fortunately for management, CBI's board has structured its bonus pool to minimize the impact from failures to generate cash flow. The dominance in weighting of Adjusted EPS, in conjunction with the ability to manufacture it courtesy of acquisition accounting, is sure to result in hefty bonus payouts for years to come.
In studying CBI's proxy statements, we come away with the sense of an almost tangible absence of shareholder representation by CBI's board.
PP TALKS TO MANAGEMENT - CONFIRMED: THE RESERVE IS USED PRIMARILY TO OFFSET COSTS
Given the gravity of our findings, we arranged calls with CBI Investor Relations (IR), and tried arranging calls with CFO Ballschmiede, for more clarity. We spoke with a CBI IR contact on 2 occasions (3/26/14 and 5/14/14). He was helpful in answering questions and had a working knowledge of the PPA adjustments and how they are used, although we asked several questions he either did not know the answer to or just did not want to answer, asking that we follow-up by emailing him a written list of these and other questions we might have. We found it interesting that, even though we contacted the company anonymously, without prompt they asked to review anything we might plan to publish. We requested two different times to have a follow-up call with the CFO but these requests were never met. Following our 5/14/14 call, we emailed IR with our follow-up questions, which dove deeper into the financial statement impacts of the PPA adjustments. We have followed with multiple calls and emails, yet - now over 30 days later - have received no follow-up.
Regardless, the conversation that did take place, we believe, served to confirm our core thesis - that CBI is inflating its profitability as a result of CBI's post-acquisition adjustments to the Shaw PPA.
Highlights from management commentary on the 5/14/14 call (a segment from our call is displayed below):
- The PPA adjustments basically relate to changes in the fair values of project assets. They should be thought of as an impairment, and are amortized over the life of the projects that were affected as a function of the percent of completion on these projects.
- The adjustments should not be thought of as implying a re-recognition of revenue. They are primarily an impairment of an asset that will be reflected in CBI's financials on a percent of completion basis.
- They primarily serve as a cost offset.
- Backlog is not affected by (the adjustments). It is not an adjustment to contract price. It is an adjustment to the assets of the project.
- Management refuses to talk about what drove the adjustments, which we find very strange. Furthermore, in an interesting flip, CBI seems to go back on its incessant pronouncements of the quality, depth, and completeness of its pre-acquisition Shaw due diligence:
CBI: "That I think we have not clearly laid out in our financials as to why we say there was a change in the fair value of the assets that we acquired. We have not pinpointed a specific cause for these adjustments beyond the change in value. As you know when you go through an acquisition you don't have 100% visibility as to the quality of the assets. We have not specifically discussed the cost and drivers for that adjustments."
Prescience Point Takeaways:
- The fair value adjustment is not a re-recognition of revenue but an off-set to costs (either in the revenue line or as a deduction to COGS).
- Seems confused but, per our assessment in the preceding sections, it appears they go straight through to the bottom line
- After so much due diligence and public information - shocking that they have had to make such large adjustments
- It was more shocking they wouldn't disclose what drove the adjustments; however, based on having taken asset impairments we assume cost overruns are to blame, highlighting that the downside scenario for these projects appears to be in play
- Concern that reserve was created for post-acquisition events
- IR says the adjustments do not affect backlog but its SEC filings indicate something has driven acquired backlog from Shaw, which was marked up from $15bn in Q1'13 to $16.8b as of Q4
The below is an excerpt from our call (with emphasis added to highlight key points):
VALUATION AND PRICE TARGET
The market was initially skeptical of CBI acquiring Shaw, and time has proven its initial assessment was prescient: CBI's stock fell -14% and was downgraded by several analysts on July 30, 2012, the day after CBI announced its agreement to acquire Shaw Group. Shaw was known to be the much riskier company, and the market was skeptical. Credit Suisse, for example, downgraded CBI stock, stating, "we remain cautious on the deal… We think SHAW's power (fossil and nuclear business) introduces risk to CBI's business model, evident by historic financial performance… We believe investor concern will remain centered on the risk associated with acquiring SHAW and we reduce our rating to Neutral from Outperform." 4 Since that time, analysts and investors have changed their tunes in response to CBI's strong reported financial results, and the stock price has more than doubled.
We believe this levitation is the function of an acquisition accounting-created earnings mirage, which is effectively concealing that the downside risks the market originally feared have materialized as CBI's reality. By our estimates the stock price remains inflated beyond reasonable measure, representing 49% downside from current levels.
Distorted Financials Lead to Disconnected Wall St Estimates & Unjustifiably High Target Valuations
The consensus stock price target of $92.97 per CBI share is founded on both artificially juiced financials and unjustifiably high valuation multiples that fail to reflect the risks of CBI's nuclear contracts - risks that have been concealed by creative accounting.
The vast majority of sell-side analysts who cover CBI anchor their projections to CBI management's guidance, without knowledge that CBI is using cookie jar accounting that enables it to achieve or 'close the gap on achieving' this guidance. For example, the Wall St consensus 2014 Adj EPS estimate of $5.17 compares to CBI guidance of $5.23, at the midpoint of the range, indicating analysts are being misled into issuing financial projections that overstate CBI's true earnings potential.
Analysts compound their mistakes by attributing unjustifiably high multiples to value CBI stock, an indication that CBI's substantial risk exposures are not being accounted for. As previously discussed, CBI is effectively masking the financial impacts of its nuclear contracts, which may prove severely loss-making. The resultant smoothed and 'growing' earnings are reflected by the analyst consensus target multiples implied by the $92.97 price target - 10.1x forward EBITDA and 17x forward Adj EPS! These valuations are preposterously high and defy logic for a company with elevated financial and operational risk exposures.
Although we believe analysts have been misled, given the plethora of red flags we are shocked in how completely they have missed and continue to miss the forest for the trees; several warning signals were shot off by CBI's 2013 reported CFFO alone. When CBI was marketing the Shaw acquisition to investors in 2012, management guided for 'significant combined free cash flow', indicating they expected additional cash flow from the Shaw acquisition.5 This would not materialize; CBI ended up reporting CFFO of -$112.8, marking its lowest reported CFFO and first year of negative CFFO ever! The message was loud and clear: The Shaw acquisition had gone very wrong, an assertion supported by CBI's severe miss on its own internal 2013 FCF targets (as discussed in the section on Corporate Governance). In the table below we have compiled forecasts for analysts who had published estimates for 2013 CFFO. CBI's dramatic miss on each one's expectations alone should have been a wake-up call; that CBI at the same time reported Adj EPS which greatly exceeded their estimates should have set off alarms. In 2013, CBI reported its highest ever net income and, again, its lowest ever reported CFFO. It is hard to believe the innumerable warnings were never heeded.
We Believe Warren Buffett Would Agree w/ Our Conclusions if Made Aware of the Highlighted Issues
Berkshire Hathaway is the largest holder of CBI stock, owning 8.8% of the company. As (grateful) students of Warren Buffett's teachings, we are confident that if he were made aware of CBI's use of accounting entries that inflate earnings, as highlighted in this report, he would be agreeable with our primary conclusion - that for valuation purposes, CBI's reported earnings need to be adjusted to exclude the non-cash income boost from purchase price accounting adjustments.
Mr. Buffett covers this very topic in the appendix to Berkshire's 1986 Chairman s Letter to Shareholders, entitled Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy." In explaining his philosophy, he begins by demonstrating that, because of the mechanics of acquisition accounting, it is possible for identical businesses that generate the same amount of cash for owners to report substantially different GAAP earnings.
In his example, he compares the post-acquisition income statement of Scott Fetzer - a business Berkshire acquired in 1986 - to the 'cleaner' income statement Scott Fetzer would have reported had Berkshire not acquired it. Although in either case, Scott Fetzer has identical economic characteristics, the two income statements are substantially different - the cause relates to simple accounting distortions that result from purchase price accounting.
Because of the presence of such distortions, Mr. Buffett suggests that when conducting a business valuation, investors should begin by making adjustments to the company's reported financials toward calculating a more sustainable measure of profitability, which he refers to as "owner earnings" and defines as follows:
These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges such as (purchase price adjustments) less (C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in …)
Mr. Buffett states that reported earnings should be adjusted for certain non-cash items, specifically mentioning purchase price adjustments. Accordingly, we believe that if CBI had more thoroughly disclosed its post-acquisition purchase price adjustments, Mr. Buffett would likely adjust CBI's financials for the resultant noncash gains. Furthermore, given his openness with his own shareholders, he may look with disapproval at CBI's lack of transparency with its shareholders and indications it may have misled them.
In closing, we leave you with another quote from Mr. Buffett, extracted from Berkshire's 1998 Chairman s Letter to Shareholders, in which he describes a situation we believe to be relatable to CBI's.
In the acquisition arena, restructuring has been raised to an art form: Managements now frequently use mergers to dishonestly rearrange the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings.
An example from the property-casualty insurance industry will illuminate the possibilities. When a p-c company is acquired, the buyer sometimes simultaneously increases its loss reserves, often substantially. This boost may merely reflect the previous inadequacy of reserves -- though it is uncanny how often an actuarial "revelation" of this kind coincides with the inking of a deal. In any case, the move sets up the possibility of 'earnings" flowing into income at some later date, as reserves are released.
Berkshire has kept entirely clear of these practices: If we are to disappoint you, we would rather it be with our earnings than with our accounting. In all of our acquisitions, we have left the loss reserve figures exactly as we found them. After all, we have consistently joined with insurance managers knowledgeable about their business and honest in their financial reporting. When deals occur in which liabilities are increased immediately and substantially, simple logic says that at least one of those virtues must have been lacking -- or, alternatively, that the acquirer is laying the groundwork for future infusions of "earnings".Warren Buffett, 1998 Chairman's Letter to Shareholders
Price Target and Conclusion
The mirage of CBI's reported gross margin, EBITDA, and EPS, has existed for long enough to result in the levitation of its stock price to a valuation that defies reasonable measure.
On the surface, CBI appears to be trading at moderate valuations -- 8.7x and 14.5x 2014E EBITDA and reported Adj. EPS, respectively However, both EBITDA and EPS fail to reflect the true costs of CBI's business. By adjusting these metrics accordingly (as previously detailed), we calculate CBI is selling at 'true' 11.6x 2014E EBITDA and 22.4x EPS, meaning that CBI is the most expensive (and in our view the highest risk) E&C in its sector and yet is in our opinion the absolute riskiest.
CBI's closest E&C comps include Fluor Corporation (NYSE:FLR), Jacobs Engineering (NYSE:JEC), KBR (NYSE:KBR), Foster Wheeler (FWLT), and URS Corp (NYSE:URS). As a group, they trade at average multiples of 8.3x and 17.3x 2014E EBITDA and EPS, respectively - much cheaper valuations than our estimates for CBI. CBI, however should trade at a significant discount to these peers, primarily because it is the most highly exposed to nuclear projects, which entail substantial tail risk (refer to the Appendix for more information).
We note that just prior to CBI having announced its intent to acquire Shaw Group (at July 27, 2012), Shaw traded at 5.1x and 8.5x forward EBITDA and EPS, respectively, on the basis of higher risk exposures - exposures CBI now carries. Moreover, it appears Shaw's risk exposures have risen under CBI's ownership, ramping up alongside nuclear plant construction in early 2013.
We believe CBI's stock is at risk of significant downside from its current price of $73.58. Based on our analysis,
- CBI used creative acquisition accounting to conceal ongoing operating losses from its nuclear contracts, resulting in financial statements that dramatically overstate its underlying earnings potential. Backlog appears to have been manipulated with no explanation. Credit risk is substantially understated and the company is overleveraged.
- CBI's realities are better reflected by our estimates, which demonstrate that absent creative accounting, CBI would have reported a 2013 earnings miss relative to Wall St estimates and its own guidance, and a contraction in 2013 pro-forma earnings.
- CBI is knowingly or recklessly failing to disclose that its underlying financial performance is dramatically different from what it reports to the investing public. CBI does not disclose by exactly how much income is inflated by its release of the reserve or why the reserve was created. Worse, despite financial statements showing that the Shaw acquisition is a failure, CBI touts the success of the transaction, which we believe is misleading. Management also appear to actively mislead analysts in several instances to prevent the discovery of the reserve and its impacts on CBI's financials.
- CBI is struggling with certain contracts that may prove to be severely loss making, and PP believes the reserve is being used to mask the effect of those contracts. CBI's Q1'2014 results confirm our expectations and signal continued losses and income-to- cash flow divergence. The Q1'2014 results indicate an increased reliance on debt to cover cash losses, with CBI drawing on its revolver, taking total debt from $1.84B in the previous quarter to $2.034B and enabling it to maintain a flat cash balance.
- CBI is at high risk of a liquidity crisis or dilutive equity raise. CBI's $420m net cash position is misleading, in that the company is likely to have no excess cash. CBI will have to spend a significant amount of that cash, if not all of it, to actually "earn" the deferred revenue balance sitting on its balance sheet. Continued cash losses or a decline in bookings would necessitate CBI increase its dependency on its revolver. While the company has $1.36B of available capacity under its revolving credit facilities, we believe CBI will be forced to write-down its bloated goodwill balance, triggering a default on its minimum net worth covenant and heightening the risk of a liquidity crisis.
- The bizarre pattern of PPA fair value adjustments may point to a GAAP violation. CBI made $1.2B of the total ~$1.56B (>75%) fair value adjustment in Q3 and Q4 alone, 8 to 11 months after the deal was completed and nearly 18 months after CBI and Shaw entered into a definitive agreement in July 2012. In light of the completeness of CBI's pre-acquisition due diligence and its reassurances in its due diligence process months after the acquisition, the pattern appears to indicate the adjustments were made in response to post-acquisition events. If so, the PPA adjustments are not legitimate and CBI has violated GAAP by not taking charges against its earnings.
- CBI's has a flawed corporate governance structure that may encourage earnings manipulation. Adjusted EPS is the primary determinant of management incentives. CBI of course defines Adjusted EPS as "EPS excluding merger and acquisition costs," but its calculation does not appear to exclude the non-cash benefit from recognition of the PPA fair value adjustment. This translates to a management capability to artificially inflate CBI's underlying earnings, meet EPS bonus targets, and get paid out of shareholders' pocket books; from a moral standpoint, it is akin to a theft.
- CBI's board's actions signal FCF to remain elusive: Had CBI not reduced the weighting of FCF in determining executive compensation, we might entertain that there in fact was a strategic path towards generating free cash flow. We believe that doing so signals that CBI itself - with its board's stamp of approval - has written off the possibility of any sustainable FCF generation in the foreseeable future.
- The equity has been the beneficiary of a Wall St consensus that values CBI on both inflated profit forecasts and inflated multiples. Analysts are being misled into issuing financial projections that overstate CBI's true earnings potential; they anchor their projections to CBI management's guidance, without knowledge that CBI is using cookie jar accounting that enables it to achieve or 'close the gap on achieving' this guidance. Analysts compound their mistakes by attributing unjustifiably high multiples to value CBI stock, an indication that CBI is doing a good job in concealing the substantial risks of its nuclear contracts.
Given our belief that CBI's goodwill is grossly overstated and that it may have violated GAAP, CBI will likely be forced into a goodwill write-down or a financials restatement. Either scenario would result in a debt default, potentially resulting in its lenders limiting or withdrawing CBI's access to credit, and at a time in which CBI appears to be growing more debt-dependent to fund cash losses. CBI likely has no excess cash as a cushion to fall back on. As a result, we believe CBI is at growing risk of a liquidity crisis or a dilutive equity raise to prevent one. We value CBI at 6.5x - 7.5x our forward Adj EBITDA (i.e., 9.1x - 11.3x our forward Adj EPS), implying an intrinsic value in the range of $33.26 - $41.49 per share and reflecting ~49% downside from the current price.
APPENDIX - AN ANALYSIS OF SHAW NUCLEAR PROJECTS AND INHERENT RISKS
Nuclear Projects Notoriously Risky - Downside Scenario Appears to be in Play
As history demonstrates, nuclear projects are often marred by unforeseen delays that extend project lives out by years, making them notoriously risky endeavors. Unlike standard fossil fuel projects, nuclear projects are also licensed and overseen by the U.S. Nuclear Regulatory Commission (NRC) and add a new layer of complex regulatory compliance. While costs for large projects are never static, nuclear projects are subject to extensive reworking and/or redesigning that can meaningfully increase cost - costs that become burdensome to the contractor participating in fixed-price contracts. During the prior cycle in the 1970s and 1980s, nuclear construction projects went over budget by 2-3x.6 In the current cycle, nuclear builds cost 2-3x what they did in the past cycle. Because of this and the current low price of natural gas, nuclear economics are disfavored today with only 5 new reactors under construction.
By acquiring Shaw, CBI assumed the buildout of 4 of them - 2 reactors each at plants Vogtle in Georgia and V.C. Summer in South Carolina. These contracts were signed by Shaw in 2008. The Vogtle project is monitored by Georgia Power (Southern Company subsidiary), and the V.C. Summer project is being monitored by South Carolina Electric & Gas Company. These reactors are the same commercially untested Westinghouse AP1000 reactor design, purportedly quicker to build and more safe than previous plants.
CBI is very highly exposed to the risk of loss that might result from delays and other factors causing budget overruns. Although CBI represents these nuclear contracts as hybrid-type projects (include fixed-priced and cost-plus components), our research indicates the Vogtle projects are heavily tilted to fixed-price and that V.C. Summer is two-thirds fixed-cost with escalation. Fixed-price (a.k.a. lump-sum) contracts shift more of the risk of project execution to the EPC contractor, such that project cost overruns result in reduced project margins. From our conversations with project managers for fixed-price EPC contracts, even for run of the mill power plants, the risk management process for fixed-price contracts can be extremely challenging.
The underlying risk from fixed price contracts is disclosed by CBI as follows:
"Under fixed-price contracts, we perform our services and execute our projects at an established price and, as a result, benefit from cost savings, but may be unable to recover any cost overruns. If we do not execute a contract within our cost estimates, we may incur losses or the project may be less profitable than we expected. The revenue, cost and gross profit realized on such contracts can vary, sometimes substantially, from the original projections due to a variety of factors"
CBI is highly exposed to substantial losses in the event of major budget overruns.
As these projects are public works projects, the Owners are required to file regular progress reports with the Georgia Public Service Commission (for Vogtle) and the South Carolina Public Service Authority (for V.C. Summer) for the purpose of assuring project costs are prudent and to protect the interests of all electricity ratepayers. We have reviewed the public filings and spoke with former project participants to describe the financial risks embedded in these projects. In this report, we provide insights that better explain the aggressive accounting stance taken by CBI that is not providing details about these large EPC contracts and generally sidestepping analysts questions on these issues.
CBI Awarded Shaw a Clean Bill of Health - Analysts Thought Otherwise
While mainstream press accounts (here, here, here) detailed delays and problems with Shaw's nuclear projects, CBI failed to discuss these issues in its due diligence section of the Shaw acquisition slide deck as shown below:
However, these risk were not unknown to analysts and CBI faced several downgrades and some questions from analysts. [Section of what analysts thought and CBI downgrades - by Eiad]
From the period 2008-2012, prior to Shaw's acquisition by CBI, we identified several aspects of the Vogtle projects that were likely to pose future risks to CBI. For example, the earliest delays with the project concerned approvals required for the Design Control Document (DCD) by the Nuclear Regulatory Commission and combined construction and operating licenses (COLs). The COL was applied for in March 2008 and it was issued Feb 2012 with only a 6 month delay relative to expectations. The red tape challenges to this type nuclear project were alluded to in the 2009 construction monitoring report: "The Company [Georgia Power] has responded to over 1,600 requests for additional information from the NRC" and "The Company is watching and managing several areas of exposure to the schedule and cost, but as of now it believes the Project will stay on budget and on schedule from a licensing perspective."
In 2010 and 2011, the Vogtle project was reported to be largely on-budget and on-schedule according to Georgia Power's public report. In reality, Shaw was already experiencing major issues. Shortly after Shaw Modular Systems (SMS) started work on the CA20 module (a major component of the reactor), several short stop work orders were issued by the NRC "due to inadequate procedures and failure to comply with existing procedures." Only 13 out of 26 planned fabrication starts had been commenced on schedule. Other internal audits showed that Shaw was not following procedures for background checks, a requirement for the NRC Fitness For Duty program. In 2H of 2011, although GA Power cited these increased costs, they reiterated the higher costs will be borne by the contractors per the EPC agreement and not ratepayers.
In early 2012, the problems were becoming incrementally worse. The 7th Semi-Annual Construction Monitoring Report (VCM) represented a shift to a more cautious tone and the acknowledgement by Georgia Power that cost increases were forthcoming and completion dates were being moved back by 8 months for both reactors to November 2017 and 2018, respectively. Georgia Power disclosed cost disputes of $425m that ended in litigation which commenced 11/1/12 and has since provided CBI an excuse not to discuss the cost overruns as it is now an active legal matter. To summarize the litigation, GA Power alleges that in 2010 and 2011, Shaw (a.k.a. Stone & Webster) asserted entitlement to Change Orders concerning 1) AP1000 Shield Building (May 27, 2010); 2) Structural Modules (November 23rd, 2010); and 3) delays concerning Limited Work Authorization (LWA) (March 1, 2011). According to statements filed by both GA Power and CBI, they still intend to solve this dispute outside of court. We believe this is increasingly unlikely.
In the 8th VCM for 2H 2012 (released 2/28/13 - just 2 weeks after the Shaw acquisition), a bombshell was dropped indicating an additional 1 year delay with 4Q 2017 and Q4 2018 as the new completion dates or approximately 19-21 month delay from the original completion dates. GA Power also requested an increase to capital costs of $381m to over GA Power's increased costs of oversight of the project and for project delays.
CBI Has Been Challenged to Fix the Nuclear Projects - Delays & Cost Overruns Persist
Even after CBI acquired Shaw in 2013, problems have persisted. Here we discuss aspects of these projects that illustrate higher than expected project costs likely offset by the CIP liability cookie-jar and thus have avoided the income statement.
The 8th VCM , in particular, created substantial concern for the Georgia Public Service Commission with several hearings and events evolving from that filing, particularly with regard to the issue of cost contingencies. The project was budgeted with a 3-5% contingency but then as costs escalations continued, GA Power indicated a 20-25% contingency was more typical of this type of EPC project, particularly a project of this magnitude. The GA PSC was incredulous as to why the original contingency was so low. A stipulation reached for the 8th VCM was required after GA Power had acknowledged that costs were going to exceed the approved costs by 5%. As the contingency threshold was set at 5%, this meant that all additional costs must instead be specifically approved if shown to meet the "prudence" legal standard and then approved. However, due to the ongoing litigation and inability to ascertain future costs, it was jointly decided that "any further requests to increase the certified cost should be held in abeyance until the completion of Vogtle 3", now estimated to be Q4 2017. In effect, this delays the decision as to which costs are "reasonable and prudent" until at least 3.5 years from today - a discount factor likely not recognized by most investors.
GA Power did indicate a higher confidence that CBI was more competent than Shaw to complete the project. From the 8th VCM Testimony 6/28/13: "And again, the reason that we believe that is we have seen CB&I Services successfully -- very successfully -- procure and put together the modules for the containment vessel. They've now taken over the [Shaw] facility and taken over the running of not only the Lake Charles facility but they're responsible for all module fabrication." In the interim report filed for 1H 2013, it was indicated that 50% of the EPC contract was completed based on milestones.
However, problems have persisted. From January 2013 through March 2013, CBI received a stop work order to prevent delivery of materials with deficiencies. This restriction continued past March for Lake Charles. These challenges were summarized as follows in the interim report: "The Contractor has established more rigorous review processes that include CB&I, Westinghouse, and Lake Charles personnel, with SNC oversight, to ensure that sub-modules meet licensing and quality requirements and project schedule needs. This area continues to be a challenge and focus for the project, and process improvements have resulted in nine structural sub-modules being released in the last four months."
In the combined VCM report for FY 2013 released 2/28/14, which is also the most recent semiannual report, Georgia Power commented on the impact for the CBI takeover of Shaw: "This change resulted in key leadership changes and the Company has seen overall improvement in the Contractor's transparency, cooperation and communication as well as execution with a focus on quality and schedule." The major structural module CA20 was set to be placed May 2013, but was then projected for November 2013. During this time, CBI established an extension site of Lake Charles now referred to as Lake Charles-Vogtle to create "parallel work paths to mitigate schedule impacts of delayed sub-module deliveries". However, CA20 was actually placed March 2014 - 4 months later than the last expected date.
CBI is so far behind schedule on some components they have been reassigned construction to other 3rd party fabricators. For example, Mackson has taken over the CA03 fabrication as of 9/3/13. Additional evidence CBI is not self-performing other work is discussed below in the section regarding V.C. Summer. We do not know the cost differences of CBI using a 3rd party for worked originally intended to be done by themselves.
Southern Company commented in its 2013 10-K, that claims from the contractor have continued to increase from the initial claim of $300m. According to 2013 Georgia Power parent Southern Company (NYSE:SO) 10-K, these costs have since escalated to from the $300m as identified in the lawsuit to $425m - "The portion of the additional costs claimed by the Contractor that would be attributable to Georgia Power with respect to these issues is approximately $425 million (in 2008 dollars). Georgia Power has not agreed with either the proposed cost or schedule adjustments or that the Owners have any responsibility for costs related to these issues." As Georgia Power is a 45.7% owner of the project, this implies the total claim by CBI to all project owners is $930m.
To close, Commissioner Echols of the Georgia Public Service Commission expressed candid concerns about the open ended nature of the cost escalations - "I mean we'll be over and done with this whole hearing in one day and this code interpretation could cost our ratepayers $100 million. And the paperwork incident at Lake Charles that we talked about in the last hearing could cost our ratepayers $100 million. And this is really serious that we are -- you know, that we're going down this road. And that the contractors and their errors are having such an impact on our ratepayers." "And it's concerning and I -- you know, to think that we're going to delay making a prudency decision until 2017 or 2018, I don't know how much I'll remember then. That's a long time." We agree wholeheartedly with this sentiment.
Problems at V.C. Summer Reflect Those at Vogtle
CBI is also building 2 additional and identical AP1000 reactors at V.C. Summer under the direction of South Carolina Electric & Gas Company. Like Vogtle, the project has been marred by delays and unexpected costs, as widely reported in the press here, here, here. Currently, V.C. Summer Unit 2 is delayed by 9 months to December 15th 2017 and Unit 3 is also delayed by 7 months to December 15th 2018.
Although CBI has generally referenced Vogtle with respect to possible financial impacts, a recent US Department of Energy presentation (pg. 14) cites $200m in increased and unallocated costs at V.C. Summer with a different presentation (pg. 18) indicates SCE&G will contest these costs while a new project schedule and cost estimates won't be available until Q3 2014. The placement of the large CA-20 module at V.C. Summer Unit 2 on 5/9/2014 indicates similar progress compared to Vogtle which placed a CA-20 in March 2014.
According to public filings with the South Carolina Office of Regulatory Staff (SC-ORS) and interviews with former project managers, the primary issue at V.C. Summer is the delayed delivery of structural sub-modules.
Relevant quotes from SC-ORS public filings include the following:
- "The most significant currently identified challenge to the project is the continued inability of CB&I to reliably meet the quality and schedule requirements of the project." (pg. 21)
- "The most significant issue is the continued delay in the delivery of the structural sub-modules" (pg. 1)
- "Although some progress has been demonstrated, fabrication of modules CA20 and CA01 remains the most significant challenge to meeting the project construction schedule." (pg. 2)
- "Since assuming responsibility for the facility from Shaw in late 2012, CB&I has made several management changes; increased the staff from 700 in February 2013 to 1,205 as of September 25, 2013" (pg. 20)
Coincident with the announced takeover of Shaw by CBI, it was first noted in Q3 2012 SC-ORS that some Unit 2 modules were going to be reassigned to another fabricator. This issue was further elaborated upon in the Q4 2012 SC-ORS report as follows "Because of the production and quality issues associated with SMS (NYSE:SHAW), fabrication of the Shield Building modules has been reassigned to Newport News Industries ("NNI"). However, NNI's sustained, reliable performance has not yet been demonstrated, and a delivery schedule had not yet been provided as of December 31, 2013. A presentation from NNI indicates they are responsible for "Dry shield modules for both sites at Vogtle and V.C. Summer (~670 modules)". A non-conformance report from the NRC directed at NNI indicated that "Chicago Bridge & Iron contracted NNI in Newport News, VA, to fabricate, assemble, inspect, transport, and deliver shield building structural modules to the Vogtle & V.C. Summer new construction sites."
The inability of CBI to self-perform module construction has persisted after the acquisition of Shaw and is a probable factor that has eroded project margins. Beginning in Q2 2013, there was ample evidence that additional Unit 2 modules that were previously the responsibility of CBI are now being completed by other vendors.
- "The sub-modules for CA03 were originally scheduled to be manufactured by Chicago Bridge & Iron's module fabrication facility, known as CB&I Lake Charles ("CB&I-LC"), but in order to expedite the work on other modules, the fabrication of these sub-modules was transferred to Pegasus Steel, LLC earlier this year." (pg. 5)
- From the Q2 2013 SC-ORS filing "In an effort to improve delivery times, CB&I shifted work from CB&I-LC to other fabricators, including the CA04 module, the CA03 module, and Shield Building modules."
- For Unit 3, the use of additional 3rd parties is also expanding as included in the most recent report in Q4 2013 SC-ORS - "With regard to Unit 3 sub-modules, SCE&G advised ORS that the Consortium plans to transfer responsibilities from CB&I-LC to additional fabrication vendors and will finalize these plans soon." This language suggests the Consortium has latitude within the terms of the EPC agreement to take away sub-module construction rights or force the contractor to use a 3rd party.
The incremental costs to outsource key modules is not being discussed by management or analysts and we are doubtful that CBI is able to realize the project margins that were anticipated when the EPC contract was bid.
1 CB&I and the Shaw Acquisition presentation November 2012, slide 11
2 CB&I and the Shaw Acquisition presentation November 2012, slide 11
3 Goldman Sachs. Engineering & Construction: End market selectivity key in late stages of E&C cycle. April 2013
4 Credit Suisse Research. CB&I: Chicago SGR Daddy. July 2012
5 CBI's Shaw Acquisition presentation August 2012, slide 32
6 Goldman Sachs. Engineering & Construction: End market selectivity key in late stages of E&C cycle. April 2013
Disclosure: The author is short CBI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
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