Turnaround Letter Buy-rated McDermott International (MDR) reported surprisingly weak second quarter results and 2019 outlook, driving its stock down to its long-time lows. The recent trade and currency war salvos only added to the downward pressure on the shares.
With the stock trading at about $5/share, investors are showing no confidence in the company’s ability to complete the LNG projects without significant cash flow losses or in its ability to convert its new book of business into much profit. At 5.8x expected 2019 EBITDA1, the market is essentially saying, “this is as good as it gets”.
While the disappointing news delays the turnaround and frustrates those believing that the issues had been nearly fully scoped out (including us), it does not derail it. We continue to believe the company is on the right track, will put its Chicago Bridge & Iron issues behind it, and is likely to have a much better 2020.
Summary of major line items
McDermott’s 2Q revenues of $2.1 billion increased by 23% from a year ago, although much of this was driven by the Chicago Bridge & Iron (CB&I) acquisition completed May 10, 2018. The revenues were about 5% below consensus. We put less emphasis on McDermott’s revenue progress at this stage of its turnaround due to the (appropriate but complex) percentage-of-completion accounting rules that obscure the cash consumed and produced by their long-term construction projects.
The company’s EBITDA, a more useful measure of the company’s progress, was $112 million, an increase of 32% from a year ago, but 43% below consensus expectations for $196 million. Perhaps the most useful metric is cash flow from operations, which measures the company’s ability to generate cash profits and release cash held as receivables. In the second quarter, McDermott consumed $205 million in cash flow from operations, worse than the $175 million expected and nearly as weak as the $244 million consumed in the first quarter.
A few words on the source of McDermott’s over-runs
The two most troublesome problems are the Cameron (Louisiana) and Freeport (Texas) LNG projects. These involve constructing highly complicated and relatively unique facilities that convert natural gas into liquified natural gas (LNG). Exporters are selling the immense supply of low-cost natural gas to other countries around the world where the prices are much higher. Converting the natural gas to liquified form allows it to be transported economically and safely by specialized ocean freighters. These LNG construction projects carry a wide range of risks beyond their already-risky engineering complexity, due to tight labor conditions, cost-of-materials variability and variable weather conditions, among others.
With such projects, it can be said that “the profit is made or lost at the contract signing” – meaning that if a project is properly scoped out and the contract includes provisions to protect the contractor from the wide range of possible cost over-runs, there is a very strong chance that the project will produce a good profit. CB&I failed with both of these aspects, and likely didn’t properly perform the actual construction. These errors appear to have made the projects money-losers at the signing, and now is requiring McDermott to cover these costs as well as pay for correcting the lower-quality construction.
Both of these two projects are more than 92% complete. However, until they are 100% complete, their ultimate costs can’t be fully determined.
While we believe that McDermott’s processes are sound, particularly given the success they had with their turnaround several years ago under the then-new CEO David Dickson (who is now in his second turnaround at McDermott), the company appears to have mis-judged the depth of the problems at CB&I during their pre-merger due diligence. The company and its shareholders (including us at The Turnaround Letter/New Generation Research) are now paying the near-term price.
Details on the quarter’s weak profits
McDermott’s EBITDA fell short due to cost overruns that include $38 million on the Freeport project. Another $33 million came from an offshore project for Mexican oil company Pemex. This latter overrun is a surprise but appears to be contained to liquidating damages on a completed contract. We believe the consensus estimate was too optimistic in general regarding the company’s pace of overall improvements, particularly in the North/Central/South America segment (NCSA).
Asset sales will produce lower net cash proceeds
The company’s sale of its storage tank and pipe fabrication businesses are progressing, but net cash proceeds will be below their initial $1 billion estimate. Most of the remaining deals are expected to be completed by year-end.
Lower 2019 guidance
The company reduced its full-year adjusted EBITDA guidance by $375 million, to $725 million. Part of the reduction was due to the weaker 2Q results. Part was due to the delayed profits from about $500 million of revenues that now won’t be booked until next year along with higher related costs of carrying those projects. Other factors include delays in Cameron incentive payments and some lower margins on other CB&I projects in NCSA.
Outlook for 2020 and beyond
McDermott didn’t explicitly provide 2020 guidance but pointed to their strong order book and backlog. The company booked $7.3 billion in new awards in the second quarter, with its total backlog now at $20.5 billion. Of this total backlog, about $2.9 billion is legacy CB&I contracts, likely at zero or negative margins. By the end of 2020, all but $400 million of these legacy contracts will have rolled off, likely replaced by lower-risk, higher margin contracts. About $7.3 billion in 2020 revenues are in the backlog, supporting the view that revenues aren’t the problem for McDermott – the profitability of those revenues is the issue.
Management spoke to the quality of their order book, saying that all the contracts signed since the CB&I acquisition have been scoped and priced based on the “One McDermott Way” program that incorporates stringent risk management protocols and other quality/profit assurances. After 2020, the company’s sturdy backlog growth and the robust energy project demand by major customers for large projects should convert into healthy profits, particularly as younger projects begin to mature and realize their higher-margin late-stage profits.
The company is targeting low double-digit EBITDA margins in each of their geographic segments, which if achieved would produce about $1.0 billion in EBITDA in 2020.
Liquidity
McDermott’s liquidity appears more than adequate to carry them through the turnaround, given its strong cash and credit line availability, and that the bulk of its cash outflows appears to be behind it.
The company expects to begin producing positive operating cash flow in the fourth quarter and likely stronger positive operating cash flow in the following quarter. The cash burn for the rest of this year was guided to about $66 million in negative cash flow from operations, compared to a cash burn of $429 million in the first half. Free cash flow, which includes capital spending, was guided to negative $158 million for the rest of the year, compared to negative $482 million in the first half.
The company has $1 billion of available liquidity (of which $445 million is from unrestricted cash balances) as well as additional expected net cash proceeds from its assets of perhaps $800 million. McDermott’s credit ratings remain below investment grade at CCC+/B3, with gross debt/EBITDA currently at 8x. Their goal is to bring this ratio down to 2.0x. We believe that a 3.5x ratio is achievable by the end of 2020: with $3.5 billion in gross debt compared to $1.0 billion in EBITDA (at least at a run-rate).
Overall, while 2Q results were highly disappointing, the company’s turnaround is delayed but remains on the right track.
We continue to rate McDermott International (MDR) shares a buy with a $28.50 price target.
- EBITDA is earnings before interest, taxes, depreciation and amortization, which is a measure of cash operating profits. This metric is helpful in assessing McDermott’s profits, but less useful than cash flow from operations as this latter measure captures the cash outflows due to cost over-runs on its projects.
Disclosure Note: One or more employees of the Publisher own MDR shares.