Chicago Bridge & Iron (NYSE:CBI)
Chicago Bridge & Iron is an engineering and construction company focusing on infrastructure projects in the energy sector. End markets within the energy infrastructure sector range from downstream activities such as gas processing, LNG, refining, and petrochemicals, to fossil-based power plants and upstream activities such as offshore oil and gas and onshore oil sands projects.
In the spring of 2014, the price of WTI crude was north of $100 per barrel, everyone was happy and CBI shares were at all-time highs of $87. Since that time, things have only gotten progressively worse for CBI and other companies operating in the energy space. Crude reached a high of $108 in June of 2014 and then proceeded to fall precipitously all the way to a low of $26 in February of 2016. Over the same time frame, prices for natural gas and liquid natural gas also plummeted in tandem with the price of crude.
With the market coming to accept lower energy prices as the "new normal," companies have been increasingly making the decision to suspend or delay oncoming new capital projects until the situation improves. This is evident when reviewing Chicago Bridge & Iron's financial performance. Sales are down 12% over the past twelve months and are expected to be down 16% for the full year of 2016. Reviewing the company paints a similar picture as CBI's backlog has fallen from over 30 billion two years ago, to under 20 billion USD at present.
Clearly, we have a picture where Chicago Bridge & Iron's customers are in a weaker financial position than they were before the crash in energy prices and thus, the company's sales and backlog are suffering.
But is there more to this story than meets the eye? One of my favorite investing books of all time is "The Most Important Thing" by Howard Marks, who also happens to be good friends with the greatest investor of all time, Warren Buffett. What does Howard Marks think is the "The Most Important Thing" to be a successful investor? It is a skill that he refers to as Second Level Thinking. He goes on to say a first level thinker will come to the most obvious, or apparent conclusion while a good second level thinker will look past the obvious for a conclusion that is being missed by the average observer.
Here, with the case of CBI, we have a good opportunity to exercise our first and second level thinking skills. Obviously, we have a case where the outlook for CBI appears to not be so great. But what does a second level thinker see?
For one, we should not be so concerned with the fall off in backlog. It makes sense for oil and gas companies to put large infrastructure projects on CBI's backlog to save for a later date when there is a lot of activity in the market. Putting an order on backlog will secure the terms of an agreement and most importantly, secure a delivery schedule - ensuring the project is completed on time amidst all the other projects CBI has going on.
However, in a slower market such as the one we are in now, with limited activity for bids, the advantage of a backlog order is limited, particularly when considering the size of commitment on the part of CBI customers for such a large infrastructure project.
There are not many projects on order to compete with for delivery, thus, we should not expect an increase in backlog orders until after the market has already turned. So while some investors may wait for the backlog to improve before investing in shares of CBI, I would suggest the backlog to be a better lagging indicator, rather than a leading indicator.
So we shouldn't expect a material change in CBI's backlog for the time being, what might we see in the interim? We may see some strategic maneuvering on the part of CBI's customer base. One strategy would be for the oil and gas companies to wait it out, trying to obtain better contract terms, hoping that as time rolls on, CBI's management becomes increasingly desperate. The other avenue these companies could follow is to take advantage of a soft market and bump up a project and take advantage of the available resources that CBI has at its disposal today.
To some extent, this is already happening as the company reports in its most recent conference call that it is seeing more orders for smaller, high-margin projects. If we see both these scenarios play out, it shouldn't be expected to have much impact on the bottom line, compared to past years.
Larger orders may be negotiated at terms less favourable to CBI, which are then offset by the inclusion of these smaller, higher-margin projects. CBI management maintains that pricing discipline will continue to be priority number one during the current downturn, and if management is true to its word, we may just see the market for CBI's services resolve itself organically.
Going back to first and second level thinking for a moment. Let's address the issue of lower energy prices. The first level thinker may see today's lower energy prices and say "Oil and gas companies won't invest at these prices," while the second level thinker may see more nuance on the subject. The type of projects that CBI completes for its customers are relatively sticky. That is, we should not expect that short-term weakness in oil and gas prices will be a major factor in CBI's customers' capital budgeting decisions to build a large project like an LNG terminal, for example.
It is far more probable that CBI's customers will be basing capital budgeting decisions based on longer-range forecasts for energy prices - and it appears that the cycle bottom is safely behind us at this point. As $26 oil fades into the rear view mirror, fears should continue to abate and spending should for the most part resume.
Evidence to support this forecast is apparent in the company's annual report. CBI states that it will tend to lag the recovery of the broader market - in this case, oil and gas prices. In reality, an investment in CBI is as good as a gift from above. While the whole of the energy market has already recovered since February of last year, here we have a golden opportunity to find the one stock left that is only just starting to turn.
As much as it's important to understand the narrative around a prospective investment to assess its potential risks, the bedrock of any investment thesis is the company's valuation.
Here, we will attempt to look past short-term pressures on the company to assess its fair value based on what I call "normalized" earnings, or performance that takes into account the environment at the top of the cycle, the bottom of the cycle and everywhere in between.
When I go about determining what normalized earnings are for a company, I look for the indicators of performance that are most reliable over time, preferably ones that are consistent across more than one business cycle. In the case of CBI, we are in luck as we have two reliable indicators, profit margin and ROE.
When we review the last ten years of financial performance for CBI, the company is profitable in all but two years, 2008 and 2015. In 2015, the company was not profitable due to a large asset impairment on assets sold to Toshiba. 2008, I hope we can all agree, was an outlier year as well and thus, we will be excluding these two years from our analysis. Remember, we are trying to asses normalized performance and we view these two years as being non-recurring.
Between 2006 and 2015, CBI's average net profit margin was 4.5% and in all 8 years under consideration, net profit margin fell between 3.7% and 5.7%. Pretty reliable right? In 2015, CBI's revenues were 12.9 billion USD and are forecast to fall to 10.3 billion USD in 2017. If we assume that over the next business cycle, revenues will fall somewhere around the mid-point, or 11 billion, we can then take a conservative estimate of what we think net profit margin will be, and derive our estimate for normalized EPS.
I'll suggest using a 4% profit margin which is slightly lower than the ten-year average and towards the low end of the company's historical range to account for the fact that we are currently in a weaker operating environment, and even though we think the market will recover, we acknowledge there is some uncertainty around the future. Applying a 4% profit margin to 11 billion USD in sales and dividing by 100M shares outstanding gives us EPS of $4.40.
Before we assign a value to these earnings, let's first see if we can make our investment case even that much stronger by also incorporating an outlook for ROE. Over the past ten years (excluding 2008 and 2015), CBI's average ROE was 23% and fell between 21% and 26% in each of those 8 years.
This is great! Now we have two reliable indicators. Now, just take that estimate of ROE and multiply it by our estimate of Book Value Per Share to come up with a second normalized estimate of EPS. Taking 23% and multiplying by book value of $20 per share gives us a second EPS estimate of $4.60. At this point, we can safely say we are well on our way to finding the real value of Chicago Bridge & Iron.
Now that we have an estimate of EPS, what multiple should we apply to this earnings stream? A review of historical price and earnings data tell us that over the past 10 years, the average P/E that CBI has received from the market has been 15x. Apply this 15x multiple to $4.50 of EPS and we get a fair value estimate for this company of $67 or nearly 100% upside from the current price. A fair return for any investor, no question.
Caveat Emptor: Buyer Beware
Lest we forget, there is the ongoing litigation between CBI and Westinghouse over the sale of CBI's nuclear construction business from late 2015. Essentially, Westinghouse is claiming that CBI withheld key information during the negotiations and is suing CBI for losses of over 2 billion USD. People I have spoken with on the matter seem to believe that this is a case of buyer beware - that Westinghouse most likely made some oversights in conducting its due diligence on the deal, and CBI is likely off the hook, although will probably settle for some lower amount out of court.
I tend to believe this although I am no lawyer, and more importantly, I am not a lawyer working on the details of this case. While I am no lawyer, I believe myself to be a competent financial analyst and so I would offer the following to someone who is considering an investment in CBI and debating the effects of the ongoing litigation.
A loss of 2 billion USD in market capitalization as a result of the impending lawsuit would be your apparent worst-case scenario. Taking into consideration our earlier valuation and then subtracting 2 billion in company value for the legal charge will still offer you a fair value for the company of $47.50, or 40% - still well above the margin of safety most reasonable investors will be hoping to achieve.
Disclosure: I am/we are long CBI.
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.