Babcock & Wilcox (BWC) is an industrials company, which provides specialized components to the nuclear power industry. The company has been in existence for over 140 years and provides its products primarily to the government and utilities companies. Babcock & Wilcox was spun-off of McDermott International (NYSE:MDR) in June 2010, and the company has existed as an independent entity ever since.
The company operates in four segments. In the Power Generation segment, the company provides boilers fired by fossil fuels and related environmental equipment and peripheral equipment to power plants and other industrial clients. The company also engineers, erects and services the equipment. The profitability of this segment is dependent on commodity prices across the various fuels, electricity prices, environmental regulation, and general economic cyclicality.
In the Nuclear Operations segment, the company primarily contracts with the U.S. Department of Energy's (DOE) National Nuclear Security Administration in Naval Nuclear Propulsion Program. The company manufactures components and fuels for both defense projects, institutions of higher education and the national laboratories. This segment is heavily dependent on government spending on the aforementioned applications, which are projected to rise with approaching replacement cycle of nuclear-powered naval vessels.
The Technical Services segment provides uranium processing along with environmental services and management to the aforementioned government bodies. This segment should continue to operate regardless of governmental spending cuts since existing nuclear installations require continual management throughout and after their useful lives.
In the Nuclear Energy segment, the company provides steam generators along with auxiliary plant equipment. The company has formed a joint venture with Bechtel Power to develop small modular nuclear reactors with four-year operating cycles without refueling.
In the Power Generation and the Nuclear Operations segments, the company enjoys a strong competitive advantage, while in the other two segments there is substantial competition. The advantage stems from the company's 140 years of experience along with technical knowhow and steep barriers to entry within the regulated nuclear industries.
The mPower joint venture is a 5-year development project of a new modular "mini nuclear reactor." The company signed a cooperative agreement with the Department of Energy in development of this product. The reactor should consist of a single module whereby the reactor and the spent fuel should be housed underground creating a passively safe unit. The performance of the unit should 180 MWe and 100 times safer than the latest standard, with twice the longevity. The government is funding large portions of the project with incentive awards and cost sharing funding. This venture may be a large revenue driver past 2018 when the unit should become operational.
The company has done a magnificent job paying down the heavy debt load, which they were originally saddled with, and remains with negligible long-term debt. The $472 million of cash on hand is sufficient even considering the fact that the company is quite capital intensive. Recently, along with the amortization of the majority of long-term debt, the company has begun to increase capital expenditures and to return cash to investors in the form of an approximately 1% dividend. Once again, the large cash reserves imply that this dividend is sustainable, and is likely to increase in the future. The company also recently doubled its allocation to a $500 million program to repurchase shares in the open market.
Revenues have been inconsistent over five years due to the tapering of capital expenditures in the aftermath of the recession. In the past three years, there is a clearer trend of growing revenues at 9.7% and 11.5% year over year in 2011 and 2012 respectively. Over the same periods, cash flows grew by 10.4% and 34% year over year.
The Company has a significant backlog of $5,749 million of orders. This amounts to 1.75 years' revenues and should bode well for the future of the business. Of this backlog, $2,484 should be recognized in this fiscal year. With such a large portion of revenues anticipated from backlog, the company should easily be able to surpass the revenues from FY' 12. The incremental increase in revenues should help with defrayal of fixed costs and result in slightly higher margins this year. Historically, margins have hovered around 6%, but will likely come out closer to the 9.5%, which we saw in FY '08 if the company sees similar revenues to those of 2008. While backlog is often considered a crude predictor of future revenues, in the case of BWC the backlog indicates contracted orders, which are significantly more material than those of many other manufacturers.
The company's inventories are also positive indicators of management's outlook. Inventories of both Raw Materials and work in progress grew dramatically, while Finished Goods dropped significantly. This indicates that the company will likely ramp up production in the coming months and that old inventories are selling well.
The company has also taken steps to increase efficiency and expects to save $50 million annually after full implementations with up to $15 million this year. The source of these efficiencies will be in operation costs and via pension restructuring with an upfront cost of approximately $50 million. The costs savings should materialize as follows:
Additionally, management has emplaced a $700 million revolving credit facility of which $548 million is available. This will provide necessary liquidity to allow turnaround time between production and realized revenues. The credit facility also has an accordion feature, which allows for an additional $300 million of additional capacity.
In the company's May 2013 presentation, management guided for $3.4-3.55 billion in revenues and $2.25-2.45 adjusted earnings per share. Using these numbers to model future cash flows the company appears to be undervalued. The following scenarios highlight possible outcomes under varying market conditions:
Assuming company guidance is correct; the following graphs show revenue and EPS:
These numbers imply a P/E of 12.6X 2013 earnings and that the shares currently trade at 0.98X revenues. The PEG ratio is a miniscule 0.68. The company trades at 9.3X EV/EBITDA and has generated a 21.68% return on equity. Using the top line of management's guidance margins are expected to grow to 7.7% this year as well. Using the low end of guidance the company trades at an implied P/E of 18X 2013 earnings, which is still somewhat cheap for such high growth.
Modeling for optimistic and consistent growth and including the cost savings, going out to 2018 at which point the results of the joint venture will begin to impact revenues the implied share price is $43.40. This implies that the shares are undervalued by a whopping 40%. Using management's lower figures the shares are still worth over $38.64. Remember that this model takes the costs of restructuring and does not reflect the savings! Assumed is a market return of 11% even though the beta implies less risk thanks to the markets at 0.79. This valuation also assumes steady margins at the 2013 level.
Assuming margins growth at a steady 9% the shares could be worth as much as $52. Add an assumed market return of 9% and the shares are worth over 56. Now imagine what would happen should we assume that the cost savings do work. Take into account that EPS will also rise due to management's attempt to buy back 14% of outstanding shares at today's value.
To find my margin of safety, I modeled the worst-case scenario. What if margins are flat, along with revenues, and that the company trades at 0.9X revenues instead of 16X earnings. Let's assume that margins are flat at 7.7% and that the cost savings never materialize. Let's also assume that management can't actualize any savings. Let's also lower the P/E to 14X to account for what we will assume is a miniscule 2% annualized growth rate. We've painted quite the grim situation, just to come out with an implied share price, which is fair at today's market value.
So, why are these shares trading so low and what might catalyze the shares to appreciate to market value? It's hard to explain many market inefficiencies. Investors may be fearful of the risks associated with the sequester on military contracts. This is not of concern to me as the Department of Energy and not the Pentagon contracts are with BWC. Also, replacement of older vessels with nuclear vessels should counteract discretionary spending declines. There is no avoidance of maintenance on existing vessels, and when nuclear fuel is spent you cannot avoid replacing it. To drive the shares higher, any significant government contract could send shares soaring. Other than that, this company doesn't face many associated risks, and really should appreciate nicely. I am patient and I will hold my shares until the market decides to act rationally.
Disclosure: I am long BWC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.