Credit: Shutterstock photoBy Lume Group :
Chicago Bridge & Iron Company's ( CBI ) common stock is trading in the mid $30s which represents a compelling investment opportunity.
Wonderful Economics of Being A Contractor
Whether you want a pool in your backyard or redo your kitchen, you need to hire a contractor. The beauty of the contractor-customer relationship is the following: most of the capital (funding) of a project is put up by the customer (you the future pool owner), not the contractor. The contractor brings in the labor and supplies/equipment (which you are paying for), while the main source of value he provides is hisexpertise .
You as the customer are supplying the capital for the project, the contractor is putting very little of his own into play (though he holds your capital on his balance sheet as a liability - almost like insurance float). Hence, a contracting firm is a capital-light business though involved in capital-intensive activities (large construction projects). The contractor is compensated from your funds for expertise though most of the capital goes to the project which is capital-intensive (and so margins of the contractor seem thin though his personal returns on capital are high).
Buffett and Munger consider capital-light businesses like See's Candies, Coca Cola (which doesn't own its bottling plants), Washington Post, and IBM as wonderful businesses primarily because they are capital light (in addition to being great brands). It's why Coke doesn't own its own bottlers, why IBM sold off many of its hardware (a.k.a. capital-intensive) operations. The great thing about owning a capital-light business is that it can write you a check (buybacks, dividends) over time that compound while capital heavy businesses have to constantly reinvest in their assets (like airlines or auto companies for example). As Charlie Munger in his usual brevity has endorsed:
Many investors falsely consider E&C contracting to be capital-intensive, but the E&C contractor should instead be viewed as an engineering consulting firm that plans the project and spends the client's capital on executing the project.
Like in insurance, a moat is hard to come by in E&C. There are small contractors littered around the country that work on swimming pools, drainage ditches, bridges, and roads. Unlike the vast majority of these firms, CB&I has a moat due to its deep history (in many cases up to 100 years) in various areas of the energy space (storage tanks, nuclear maintenance via Shaw acquisition, LNG terminals, petrochemicals, midstream/downstream projects). Furthermore, management's relentless focus on safety is admirable not just on moral grounds (which is most important) but also due to the fact that employee and environmental liabilities can cost huge sums for shareholders.
In large projects where cost overruns are common, regulation is high, and safety is key, CB&I's reputation often allows it exclusive bidding rights. According to the U.S. Bureau of Labor Statistics, in 2014, the Lost Case Incidence Workday Rate was 0.03% for CBI while that number was 0.7% for its peers. During 2015, CBI was awarded the National Safety Council Green Cross Award as a testament to this fact (a first for an EPC company). This fact would lead safety-conscious customers to seek and pay CBI a premium for work, especially highly complex and potentially dangerous projects.
The Risks of Large Projects
The problems with customer-contractor relationships generally come in when costs run over the initial budget (cost overruns) and when the project takes longer than expected. Most homeowners are probably seasoned in cost and time overruns when it comes to home renovations.
In his book " Anti-Fragile ", Nassim Nicholas Taleb discusses how with project planning, the fundamental nature of time leads to non-linear outcomes with regards to projects and air travel:
So flights are more likely to be late and projects more likely to end late because time only moves in one direction (forward). Now imagine larger, more complex projects such as nuclear plants and LNG export terminals: the overruns can be significantly more dramatic.
Taleb illustrates how large projects tend to be "fragile" (i.e. have significantly larger cost and time overruns):
Think about a major construction project in your city or state that ended up costing significantly more than budgeted and taking years longer than expected. Newspapers love printing stories about such projects and politicians love lambasting them, while few citizens appreciate the long-lived benefits of large infrastructure projects. However, these projects are necessary for society and will continue to be built.
The Burden of Overruns
So when an overrun occurs, the contractor has been using customer capital to pay for the project (labor, supplies, etc.) until the funds dry up. So who usually pays for this extra cost? The answer should be obvious for many homeowners from experience: the customer, not the contractor usually ponies up the extra cost.
And the customer has little choice, for a half built pool, a half remodeled kitchen, or a half built LNG export terminal all have one thing in common: all are equally useless . Because you (the customer) have put in so much capital already into the project, you are now sunk and slave to the contractor. You have to pay the extra costs that have arisen during the project to finish it. The contractor usually gets his dues despite those unexpected costs that came up (this includes compensation for his services).
There can, however, be disputes (again, as many homeowners must be personally aware), and rarely the issue escalates to become legal (usually when negligence on the part of the contractor can be claimed). The burden of proof usually falls on the customer and most delays do not reach this stage.
Nuclear Construction Dispute
There is a notable incident for CB&I where the dispute did bubble up to costly levels: the nuclear projects in South Carolina and Georgia. The disputes were ongoing for over a year and CB&I took on the costs by taking a major $1.5 Billion charge that included Goodwill impairment of its Shaw acquisition. Over the many quarters during the dispute, CB&I management stated hope that the disputes would be resolved while posting contrasting negative cash flows and positive earnings. Eventually, reality caught up and CB&I had to take an earnings charge (the cash flows statements ended up being the more reliable).
CB&I management made a serious miscalculation with the Shaw acquisition when it came to the nuclear construction projects. Fortunately, that portion of Shaw was disposed of to Westinghouse late last year. Given the size, scope, the novel reactor design, limited recent nuclear projects in the U.S., and heavy regulations surrounding the project, that project is bound to encounter further overruns and problems. CB&I is also absolved of all future liabilities (accidents, defects, etc.) associated with its part in the project. As one can imagine, liabilities associated with a nuclear power plant construction can be limitless (i.e. think of the BP oil spill). The cost to shareholders last year was dear, but a great deal of underlying risk has been removed from the firm.
The poor result of the nuclear dispute may actually have been a result of the old Shaw management formulating a poor E&C contract (which CBI acquired when it bought Shaw). We may never know whether Shaw management deserves blame, but CBI management cannot be exempted even in that case because they made the expensive decision to purchase Shaw after (what was claimed to be) appropriate due diligence (why we are always skeptical of large acquisitions).
For another example of contractor-customer disagreement, in Colombia, the government expressed discontent with time and cost overruns of the REFICAR Expansion led by CB&I, however this project is already completed and operational. Furthermore, the project was plagued by factors out of CB&I's control such as labor strikes . So in the end, the customer ponied up the increased costs and tolerated the delays, with (likely inconsequential) protest at the end. On a recent call, CBI's CEO Asherman discussed the lack of material consequences of this dispute:
Given the risks associated with large projects, CB&I must tread carefully with large scope projects such as LNG in Mozambique. Mozambique is an underdeveloped country with difficult to establish political stability. The firm should only engage in such projects if there are clear milestones with tangible cash payouts and reduced liability for the contractor. Otherwise, it will likely find itself in the same boat as with the nuclear construction projects.
High Returns on Capital
Because contracting is capital-light (for the contractor, not the customer), the contractor can earn high returns on equity with smaller net margins than most other businesses (because the denominator is small, the numerator doesn't have to be that big). It's key to remember that the liabilities represent client capital.
Over the past 20 years, CB&I has generally kept ROE at about 20% with the exception of years with major charges (such as the 2008 crisis and 2015 due to the nuclear disposition charges):
CB&I: 20 Years of Return on Equity. Source: annual corporate filings. Chart by Lume Group.
Return on equity is a measure of the business' use of shareholder capital. Companies that maintain high ROE (without excessive leverage) will translate into high returns for owners. Because CBI does not pay out large dividends, much of this capital remains on the balance sheet for growth in book value per share. CB&I has significantly grown book value per share over the past 20 years. The fact that the company can maintain ROE of about 20% or more and trades at just 1.75 times book makes it a compelling opportunity:
CB&I: 20 Years of growth in Book Value per share. Source: annual corporate filings. Chart by Lume Group.
Cash Flows
Because CB&I's property, plant, and equipment predominantly consists of office space (for engineers) rather than construction equipment, its capital expenditures are generally minimal when compared to its operating cash flows. Thus, the firm is capital-light:
CB&I: 20 years of cash flows. Source: annual corporate filings. Chart by Lume Group.
We believe that with the disposition of the nuclear business, CB&I can generate operating cash flows largely in excess of capital expenditures, thereby generating large amounts of free cash flow. We estimate that the firm can generate free cash in excess of earnings ($5 to $5.50 this year) for many years.
For this to occur, management must refrain from further fallacious acquisitions and avoiding risky projects that can lead to disputes. We think the best use of this capital is what management has already endorsed: pay down debt, and repurchase shares (especially at current depressed levels).
CB&I and Low Energy Prices
The fall in the price of oil and natural gas has caused a drop in CBI's price as foolish analysts have concerns about project prospects. CBI has been thrown out with the bathwater: investors who have dumped any holding with "energy" exposure have also dumped CBI. The idea may be that such projects might dwindle in such an environment. There are, however firms that are investing heavily into energy infrastructure: Phillips 66 is one company, and Berkshire Hathaway is another:
Investors must think independently and apply the principles of supply & demand to this situation: a drop in commodity prices should overall boost demand for these commodities (there will be a lag period) and more immediately boost the feasibility of midstream/downstream energy projects (like LNG export terminals, crude storage facilities ). Already, a drop in natural gas prices has led to a surge in LNG facilities (like the huge proposed plant in Mozambique ), hydrocarbon crackers (like Total's project which CB&I received a contract for), and many other opportunities in areas such as petrochemicals (like the Liwa Plastics Project which was recently won).
Many cursory analysts (and that includes those on Wall Street) fail to recognize the fact that downstream projects that consume crude oil thrive with low oil prices because input costs to make refined products and petrochemicals fall. This is one reason why refiners and chemical companies are benefiting from the current oil price environment. CBI has very little exposure to upstream energy (where oil prices have a direct negative impact). Additionally, CBI's business model allows flexibility in building whichever projects happen to be in vogue (right now it's LNG, petrochemicals, and pipeline/storage projects, tomorrow it might be something else). One thing will remain constant: energy infrastructure will always be needed by society as Warren Buffett has concluded.
Management's Reputation Needs Work
In our view, CB&I management has demonstrated questionable proficiency. Management had not been forthright with problems regarding the nuclear construction business and has still not admitted to the very large mistake of the Shaw acquisition (which is now largely behind it after disposition of the nuclear construction business).
Furthermore, perks such as paying over half a million dollars for CEO Phillip Asherman's personal use of corporate aircraft in 2014 demonstrates that the board of directors may not be very good stewards of shareholder capital. There may not be a culture of independently questioning corporate executives and prioritizing shareholder returns at CB&I.
If CB&I had been ranked in the Financial Times' study regarding personal use air travel, it would have ranked in the top 10 of S&P 500 companies with regard to most spent on its CEO for personal (i.e. not business related ) travel in 2014. This is a major red flag and we will closely follow further proxy statements, compensation arrangements, and moves by the board, especially in light of last year's massive loss (and significant increase in debt) by the company.
Conclusion
CB&I is a wonderful business that has been led by less-than-stellar performing management. We believe there is evidence that management has learned from errors regarding its acquisition and will devote cash to debt payments and share repurchases. We will also observe closely whether the board will be better stewards of shareholder capital, especially in light of poor performance by current management. At current prices, we find CBI to be a compelling opportunity due to the underlying fundamentals of the business.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
