When I emphasized the need to own infrastructure stocks on October 23, 2007 (“Subprime” NOT the headline from Honeywell’s quarter - Part 2: Strength in Energy, Construction, and Infrastructure), I made a mistake.I apologize to my portfolio’s performance, and to my readers, for recommending Flour Corp. (FLR) and Foster Wheeler(FWLT). Not that Flour Corp. and Foster Wheeler (I bought FWLT on my own recommendation) aren’t great investments, it’s just that McDermott is a completely different beast all together. Foster Wheeler is still my number one Engineering and Construction [E&C] pick, make no mistake (Foster analysis in another piece soon). Wait, isn’t McDermott an E&C company you ask?
The McDermott Secret
After much research, I believe McDermott is actually a Oil Service and E&C hybrid. I anoint McDermott as my number one oil service investment for the next five years rather than Schlumberger, Transocean (which I own), or any other companies in the Oil Service Holders (OIH) ETF. This was my mistake, trying to view McDermott as a E&C company and being faked out of making the right connection between the business, the stock’s ridiculous performance the last 5 years and the stock’s future performance.
Analysts on the street probably got faked out as well. There’s little or no coverage, no mention in the media, of one of the most amazing stocks in the last 5 years and with one of the best prospects for the next 5 years. Barron’s seems to have a similar view in the piece “Power Play in the Oil Patch.” (here’s a summary on SeekingAlpha, “McDermott International: An Inexpensive Energy Play - Barron’s“) If, as Ken Fisher says, the way to roll in dough is investing by knowing what others don’t, then I hope my angle on McDermott is unique, true, and one of the most profitable investments I’ll ever make. So, here’s my engineer’s view on why McDermott should continue to trump any component of the OIH.
click on image for larger version.
Oil and gas accounts for less than 50% of revenues, but more than 50% of income, suggesting oil and gas has higher margins, allowing more of the revenues to fall to the bottom line. The backlog shows slightly more oil and gas projects on a percentage basis, suggesting even more of future income coming from oil and gas, which I believe has been and will be the source of accelerating growth.
I look at higher margins for engineering projects as a sign of expertise and efficiency in that field. How do they do it? The moment you enter McDermott’s website, it tells you: “McDermott is large, repeatable projects” It’s as simple as that.
How McDermott Rolls: Large
Emphasizing “large” projects tells me the McDermott’s work requires expertise, scale, and resources. Thus, McDermott’s competition is limited due to the high costs of becoming a full-service offshore construction contractor. While there are many less-integrated providers of offshore construction services such as engineering firms or pipelaying companies, McDermott’s full range of services makes them the smarter and safer choice for clients.
A one stop shop for all the work required for a particular project usually leads to smoother progress for the project. Less collaboration between different companies means less confusion over different methods, standards, and procedures.
The engineering & construction landscape is scattered with tons of small and mid-sized firms who get their fair share of infrastructure projects such as highways and commercial buildings. Going up against these smaller firms likely puts pressure on the likes of Chicago Bridge and Iron (CBI), Jacobs Engineering (JEC), and The Shaw Group (SGR) which get meaningful revenues from these projects.
Common infrastructure projects often do not require cutting edge engineering technology, but the major oil and gas developments sure do. McDermott’s coal, and especially the nuclear power, projects require even more expertise and proprietary technology. People should really look at these engineering and construction/oil and gas service companies like they do tech companies: each of these companies own proprietary skills and/or technology that makes them a cornerstone in the world’s development. Microsoft has windows and Cisco has routers like TransOcean has one-of-a-kind deep sea drilling vessels and Foster Wheeler has circulating fluidized bed [CFB] boilers.
How McDermott Rolls: Repeatability
Repeatability suggests knowledge and efficiency, which leads to quality and speed, which ultimately leads to more and more returning customers for higher profitability. Just like a production line, once you’ve got the equipment and the procedures down, the products get printed out like hotcakes. In the same way, once the engineering research and design is done for a certain type of project, similar projects in the future would be done easily without having to reinvent the wheel.
Meanwhile, other companies who’ve never done this work before are at a disadvantage, having to invest a lot of time and capital to reinvent the wheel. Futhermore, the work that McDermott does, such as pipelaying, requires rare and expensive ships (along with all the knowledge and skill to operate them). Other engineering companies have little or no chance of entering the business as competitors for these reasons.
I believe McDermott achieves repeatability by focusing in on projects they’re good at rather than being a diversified engineering shop like Flour or Jacobs Engineering. By concentrating resources for certain niches, McDermott becomes very good and efficient at what they do. Expertise leads to quality of work, which customers would likely pay up for, as well as doing the job quickly, allowing McDermott to turn to the next project and the next. Tying up too many resources to reinvent the wheel is likely a reason why other firms have lower operating margins than McDermott.
At the Citigroup’s 21st Annual Global Industrial Manufacturing Conference, CEO Bruce Wilkinson emphasized that McDermott has contract stability in the oil and gas industry because McDermott focuses on the later stages of oil field development. A lot of McDermott’s work, such as laying pipelines, are done after oil fields have been searched for, discovered, surveyed and planned, drilled, etc. With a proven oil field and millions or more invested, it is highly unlikely the particular oil field’s project will be scrapped by the time McDermott begins installing oil production facilities and pipelines.
On the contrary, exploration companies like Schlumberger or TransOcean are more subject to contract changes and cancellations. For oil companies, drilling for potential oil fields is very uncertain, so at times, certain prospects might be canceled depending on budgets, strategies, and the price of oil. Whether if oil’s at $70 or $100, the oil reserves are low so I don’t expect exploration activity for TransOcean or Schlumberger or Halliburton to slow anytime soon, but these companies will likely experience a more volatile environment than McDermott.
Ingredients for explosive growth are in place: growing revenues and accelerating operating income growth.
Backlogs are strong. While this chart shows a backlog of $5.25B revenues for 2008, history tells us that McDermott’s revenues at the end of the year will likely be significantly higher. At the beginning of 2007, McDermott estimated 2007 backlog revenues of $3.87B while coming in with $5.63B of revenues at the end of 2007. Likewise, in 2007, McDermott’s estimate of 2008’s backlogs was only $1.55B, which ballooned into the $5.25B seen in the chart below.
With operating margins breaking out above the 8 to 9% range, I agree with some analysts’ aggressive predictions of hitting 20% earnings growth during the next 3-5 years alongside a revenue growth prediction of 17%. Trading at a forward P/E of 16x, this makes McDermott pretty cheap for a growth company with a PEG of near or below 1. With $1.4B in cash ($12.6B market cap) and no debt, McDermott’s balance sheet is as strong as any, especially during this credit crisis. Numbers like this should attract investors’ money out of CD’s like a magnet.
- Hydrocarbon-based energy (oil, nat gas, etc.) will remain the dominant energy source. Even with advances in alternative energy like wind and solar, and increased energy efficiency, energy demand outpace any energy supply these improvements provide.
- Oil companies have under invested in oil exploration and developing new oil fields and now have to accelerate make up the lost work. “Exxon Mobil announces spending boost: The company plans to invest between $25 billion and $30 billion a year through 2012 to find more oil.“
- Future in oil is offshore. All the easy to find oil (i.e. oil fields on land- and in non-hostile countries) have been tapped dry. Oceans cover about 70% of the earth’s surface, so there’s just that much more potential oil fields deep under sea. Just ask Brazil’s Petrobras: “Offshore discovery could make Brazil major oil exporter” Moreover, these new discoveries will be producing oil in the next few years, requiring McDermott’s late stage services and making McDermott’s backlog in the out years (2010+) way too low.
I wanted to get this piece on McDermott out because on the conference call the CEO had mentioned over $1B of contracts to be secured within a month and it seems like they’re starting to flow in:
Note that much of the $1B+ in backlog orders that CEO Bruce Wilkinson mentioned are likely backlogs for 2009 and beyond, so it doesn’t say much as to whether McDermott will miss or beat this quarter’s earnings estimates or by how much.
Disclosure: I own shares of FWLT, RIG, and MDR as of this post