Last Thursday, Chicago Bridge & Iron (NYSE:CBI) reported its second-quarter 2014 and despite reporting better than expected results, declined by about ten percent on Friday. This decline's root cause appears to be concern over a short thesis by Prescience Point, which alleges that CBI's accounting is allowing it to over-inflate its performance. While some of the allegations may be accurate, it appears that most of the facts were already priced into CBI and that the reaction is already excessive.
CBI's Reported Results
CBI reported adjusted earnings of $148.3 million, or $1.36 per share, while GAAP earnings per share came in at $1.31. Adjusted earnings were above the average street estimate by about 7 percent and an increase over Q2 2013 results by about of 30 percent.
Revenues increased by about 15 percent to $3.3 billion due to continued demand for energy infrastructure, and especially regarding liquefied natural gas ("LNG"). The engineering, construction and maintenance revenue was $2.3 billion. The environmental solutions, fabrication services and technology segments all sustained small declines to revenue in the quarter
CBI reported new contracts totaling $4.2 billion primarily from engineering, construction and maintenance contracts. At the end of the quarter, the company's backlog was $31.5 billion with the engineering, construction and maintenance backlog representing about $20 billion. Cash flow from operating activities was negative $374.4 million, compared to negative $300.7 million in Q2 2013.
The Claims Against CBI
On June 17, Prescience Point published a report on CBI claiming the company used creative acquisition accounting relating to the Shaw Group acquisition, to conceal losses and inflate GAAP financial performance. The report notes that after acquiring Shaw Group in 2013, CBI made adjustments to goodwill and purchase price allocation changes, and created a $1.56 billion reserve that it can use to inflate profitability.
The report claims that CBI would have had losses without the use of those reserves and that it will sustain losses after the reserves are used. Further, the report claims the company shall be left highly levered and that either a goodwill write-down or financial restatement may trigger the breach of a debt covenant. The report concludes that because of this, CBI is worth only $37 per share.
The Shaw Group Acquisition.
In 2012, CBI agreed to buy Shaw for approximately $3 billion, and the transaction closed in February of 2013. Both CBI and Shaw were engineering companies that primarily provided services to energy interests. CBI is a Dutch corporation that has become an acquirer of engineering construction companies servicing hydrocarbon and other energy industries.
Shortly after it was announced that CBI would acquire Shaw in a mixed transaction of stocks and cash, a one percent shareholder, Denali Investors, claimed the deal was undervalued because the energy segment was generally undervalued and there was debt on the books related to Westinghouse Electric that was really Toshiba's. Nonetheless, the deal was approved by 83% of the company's outstanding shares.
Shaw was also an acquirer of companies, and had a large cash position and buyback in place when CBI made the deal. During the prior decade, share count doubled because of those acquisitions, but the company began repurchasing some of those shares. Shortly prior to the deal, Shaw had sold its 20 percent stake in Westinghouse Electric to Toshiba, and Denali believed an associated phantom debt of $1.7 billion was causing Shaw to be undervalued.
Since buying Shaw, CBI has made changes to goodwill relating to the price it paid over book. Adjustments to goodwill often follow acquisitions, but there is concern that adjustments can allow a company to avoid recognizing expenses, which would make reported earnings and margins increase. Similarly, if the value of property, plant and equipment are understated or reduced, a company could receive a boost to earnings from the reduction to depreciation expense. Goodwill adjustments must occur within the first year following an acquisition, so there can be no further adjustments going forward regarding the Shaw acquisition.
Beyond questions of purchase price allocation adjustments, it appears some of Shaw's revenue estimates were either high and/or that projections smoothed out what was going to be a lumpy stream of contract payments. If revenue from Shaw's contracts is below what was projected, the lost revenue can show up as a negative to cash flow. There are many reasons that revenue may come in less than anticipated, including currency fluctuation, lumpiness in payments, delays, cancellations and other problems.
When the deal was first announced, CBI shares declined due to a belief that the company was overpaying for Shaw, but those losses were short-lived. Upon second glance, the marriage appeared to be made at a time where the industry as a whole was facing headwinds from nuclear power concerns following Japanese disasters, and subsequent bottoming for natural gas prices, but that better times were on their way.
It is difficult for companies in this industry to precisely predict when contracts and payments will be secured. There are very few companies that one can go to when wanting to build or repair a LNG facility and it is difficult, if not impossible, for a new competitor to emerge with the technological know-how and army of engineers necessary for such projects.
Projects are locked down years in advance, which is why CBI has a backlog of $31.5 billion and growing. Future demand should come in near proportion to the growing need for gas liquefaction, LNG transportation and nuclear power production. This appears probable, with LNG demand coming from the United States and Europe, and nuclear demand coming from Asia.
CBI is a Dutch entity, which is now a beneficial attribute that could improve Shaw's international income, even if EBIT/EBITDA do not increase. Similar possible tax benefits have been driving recent pharmaceutical deals. Nonetheless, much of CBI's current opportunity exists within the United States.
Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A) has become a major owner of CBI. Berkshire first acquired a position in CBI in the first quarter of 2013, around the completion of the Shaw acquisition. The following quarter, Berkshire increased its stake to about 8.8 percent, where it subsequently stayed.
The position may not be the work of Warren Buffett, but instead either Todd Combs or Ted Weschler. In 2011, Buffett picked both as investment managers and began giving each billions to invest, with the intention to give more over time. Nonetheless, it could be Buffett, as the business is complementary to Berkshire's Burlington Northern and Mid-America Energy assets. Berkshire Hathaway has also recently built positions in Exxon Mobil (NYSE:XOM), National Oilwell Varco (NYSE:NOV) and Suncor Energy (NYSE:SU). This makes the CBI investment appear to be part of a broader energy thesis.
CBI did increase its goodwill by $859 million between the first quarter of 2013 and 2014, which is part of what is now drawing scrutiny. There is no doubt that such accounting is questionable, as is goodwill generally. CBI can make no further adjustments to goodwill regarding the Shaw acquisition, limiting any confusion or phantom benefit from further addition. Since reporting Q1 2013 earnings, CBI shares have declined in market value by about twice the goodwill increase.
It is also true that the company has current poor recent cash flow, but this is not entirely unexpected or out of the ordinary. The nature of this business is that revenue does not arrive in a smooth manner. Revenue and expenditures will fluctuate depending upon when contracts are beginning, progressing and ending. CBI expects to have more revenue in the second half of 2014 than it did in the first half, but more importantly, it has contracts in place for over $31 billion in future work. Moreover, CBI is highly likely to continue securing significant contracts due to its position as a trusted partner to large energy companies and governments, with decades of global experience and familiarity to the entities that are going to pay for energy infrastructure services.
CBI appears likely to continue acquiring U.S. assets that are doing international business, but it may also divest itself of some non-core businesses. CBI does have a reasonably high rate of taxation due to its significant level of business in the United States.
In the near term, CBI will have to work itself through this recent bout of uncertainty. The price reaction on Friday appears excessive given that the accounting information was already disclosed and that the short analyst report was released about five weeks ago. Following CBI's Q2 earnings release, the company's CFO was absent for the conference call, and this absence may have spooked investors (perhaps rightfully so, but that remains to be seen).
Precise dates for certain project payments are difficult to provide because many are dependent upon reaching milestones that may be delayed for various reasons. Similarly, executing contracts and receipt of down payments can occur later than expected. Uncertainty around accounting matters is frightening to both retail and institutional investors, and these issues now require some greater clarification. Many investors may simply wish to follow Berkshire's lead, but its next reporting of shares held will be in mid-August and refer back to holdings at the end of June. Therefore, we may be entering a short-term period of increased uncertainty.
I believe any further weakness in CBI will end up being remembered as an opportunity, because the company appears poised to continue receiving contracts for global energy projects. While the Shaw deal may have had an element of overpayment, the deal should result in long-term opportunities for the business. CBI should get numerous projects from still budding domestic LNG infrastructure and Chinese nuclear power development demand. Moreover, CBI could be a derivative beneficiary of many projects it does not get, due to its significant fabrication capacity. All of this indicates that CBI's long-term prospects continue to be strong.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Family members hold CBI and BRK.B