Babcock & Wilcox Enterprises (BW): A Risky Stock Getting Activist Attention
I’m trying something different this week. In an effort to share more ideas with members, I’ve decided I’ll write about whatever stock I’m looking at – even if I don’t like what I see. This will give you some insight into my stock selection process at the earliest stages. It will also let me give you more regular, stock-specific content. The downside, of course, is that it’s risky. I’m risking getting you interested in a stock you shouldn’t be interested in. So, I’ll rate the initial stock ideas I write up here with an interest level (from zero to ten) at the end of the article.
This week I’m writing about Babcock & Wilcox Enterprises (BW). I once owned this stock, because I bought the pre spin-off Babcock & Wilcox and kept my shares of BWX Technologies (BWXT) through to today. I sold my shares of Babcock & Wilcox Enterprises about 11 months ago at $15.48 a share.
Where is the stock today?
It’s at $5.80 a share.
Your first step in researching Babcock & Wilcox Enterprises should be to read the old report on Babcock & Wilcox in the “reports” section of this website. That report describes what would become BWXT and BW in great detail. I’m not going to spend time here discussing what it is that Babcock does, because you have a report available to you that describes that in greater detail than probably any public information on Babcock that’s out there.
However, that report describes what those businesses looked like as of about two and a half years ago.
Some things have changed since then with BW.
Let’s start with the recent news items that might get a value investor interested in the stock. The company has attracted two major investors.
One is Vintage Capital Management. It owns 14.9% of the company and now has two board seats. You can read Babcock’s announcement of the deal with Vintage here. You can also visit Vintage’s website for yourself and see what other companies are in their portfolio.
The second – and more recent – investor in Babcock is one you’re more likely to have heard of: Steel Partners.
The details I’m going to give you now come from Steel Partners’ 13D on Babcock filed February 5th. Steel Partners owns 11.8% of Babcock & Wilcox shares. These shares were bought between January 26th and February 5th at prices between $5.99 and $6.58. The stock now trades at $5.80. So, you can get your shares a bit cheaper than Steel Partners got their shares. That’s one reason for writing this up obviously.
Another reason is that the stock trades at $5.80 a share and Steel Partners apparently wanted to buy all of Babcock for $6 a share. This quote is from the 13D:
“On December 15, 2017, Steel Holdings made a proposal to the Issuer to acquire all of the Shares not owned by Steel Holdings or its subsidiaries for $6.00 per share in cash, representing a premium of approximately 33% over the then 30-day volume-weighted average price of the Shares. However, the Issuer has been unwilling to engage in any meaningful discussions with the Reporting Persons regarding this proposal. The Reporting Persons intend to continue to communicate with the Issuer’s management and board of directors about a broad range of strategic and operational matters…”
It’s worth noting the timeline there. Apparently, Steel Partners made a proposal to buy all of Babcock on December 15th for $6 a share. Steel Partners was rejected. A little over a month later, it started buying Babcock shares at prices about even with its original proposal. So, it has been creating a minority stake in Babcock at about what it wanted to buy the whole company for.
The final recent piece of news is that Babcock has also announced a new CEO. That announcement was made at the start of February. So, you have a lot of news items with this company. Recently, the company has gotten two big, new shareholders – one owns 15% of the company and has a deal for board seats and the other owns 12% of the company and had its $6 buyout proposal rejected out-of-hand. You also have a new CEO.
Babcock & Wilcox is not just a troubled stock (at one point in the past year, it had fallen from over $17 to under $2). It is also a troubled company. The financial position is weak.
The company violated its debt covenants earlier this year.
Also, in 2017, Lightship Capital had bought 9.9% of Babcock & Wilcox Enterprises stock. Lightship is affiliated with American Industrial Partners and Babcock took out a loan from American Industrial Partners to buy out Lightship Capital’s equity stake.
When Babcock released earnings results on November 8th of 2017, they said they “…ended third quarter in compliance with our financial covenants and forecast that we will remain in compliance going forward.”
However, they still talked about strategic alternatives for some of the company’s businesses. This is potentially interesting to us – or at least, me, as an investor – because Babcock may dispose of businesses I was unsure of how to evaluate and keep the ones I was more sure of.
Here, I will finally touch on what it is Babcock does (remember: read the report). But, first let’s take a look at how Babcock breaks its business into segments and what outlook it gives for each segment for next year.
The company has 3 segments: renewable, industrial, and power. I am least interested in renewable and most interested in power.
The 2017 guidance is for renewable to generate $350 million in revenue and have “positive” gross margins in the second half of 2017. We may have to consider that business worthless for any analysis we do of what Babcock’s value is. Guidance for industrial is that it will be at the “low end” of the previous guidance of $400 to $500 million in revenue. Let’s call that $400 million. And the gross margin will be “in the mid-teens”. If we assume “mid-teens” means 15%, that would be $400 million * 0.15 = $60 million in gross profit contribution. Then we have the “power” segment which is said to be at the “low end” of the previous range of $825 million to $875 million in revenue. Gross margin is said to be in the “low 20% range”. Let’s say this means $825 million in revenue times a 20% gross margin equals $165 million in gross profit contribution.
My point here is that – as of now – whatever value there is in Babcock & Wilcox Enterprises seems to be lopsided in favor of the “power” segment. Roughly speaking, we may have to consider renewables inappropriate for a sum of the parts analysis and then assume industrial is 25% to 33% of the value of Babcock and power is more like 67% to 75%. In any case, power could provide as much as two-thirds to three-quarters of all the value in Babcock. So, we need to check if the power segment of Babcock is potentially worth as much as the company’s current enterprise value. The logic behind that approach is that if power is possibly 65% or more of the total company’s value and we – as value investors – want at least a 35% “margin of safety” (that is, we want to buy a dollar for 65 cents) – we can’t buy into a stock where the enterprise value is higher than something that represents 65% of the overall company’s value.
So, in this case, our first sort of valuation check is simply to put “industrial” and “renewable” to one side and compare our appraisal value of Babcock’s power segment to the current enterprise value.
Let’s start with enterprise value. If we calculate net debt by adding the (very big) pension obligations shown on the balance sheet and the second-lien loan (this is the American Industrial Partners loan) and the revolving credit balance and then we subtract out both restricted and unrestricted cash – we get right around $400 million in “net debt”. Market cap is only $255 million right now. So, this business basically has a $650 million price-tag that is 60% debt and only 40% equity. As value investors – who want a margin of safety – we can’t just use the leveraged part of that. We have to count the debt. So, the overall price tag is $650 million for this business.
Is the power segment of Babcock & Wilcox Enterprises worth $650 million?
We wrote about the power segment of Babcock and how to appraise it in our report. First, I should say something that might worry you here about how difficult it is to appraise this asset…
The closest peer to Babcock’s power segment is Alstom. That’s the company GE acquired and has definitely hurt the business results – and stock price – of GE since then. Alstom is more dependent on capital spending at natural gas plants and on capital spending on power plants outside the U.S. Babcock is more dependent on capital spending at coal power plants and on power plants inside the U.S. I should point out though that we never considered “new build” an important part of the value in Babcock’s power segment. So, if the U.S. doesn’t build another coal power plant in the future – that really doesn’t have much to do with the appraisal of Babcock’s power segment. Without new build, the amount of coal power plants will trend down and Babcock’s maintenance revenue with it. But, as you can see from the results at Alstom – and from Babcock’s recent experiences in everything but U.S. coal – a buggy whip business like maintenance on coal power plants is a lot less likely to threaten a company’s existence than expanding into other types of projects (however fast growing you may think long-term demand is for those projects).
Basically, we assumed that the profit contribution from Babcock’s power segment would be maintenance work on the U.S. coal power plants where Babcock built the original boiler. So, what we’re talking about here is maintenance work on U.S. coal power plants.
The original appraisal we put on Babcock’s power generation business was just under $1.3 billion. That was only two and a half years ago. All of Babcock & Wilcox now trades for a $650 million enterprise value. So, if Babcock’s power business was only worth 50% of what we assumed it was – the power segment alone could still justify B&W’s present-day enterprise value.
So, the stock might be cheap. Recent results are very messy and trying to calculate normal earnings based on performance since the spin-off probably doesn’t make much sense.
Am I interested in this stock?
No.
There are two reasons why I’m not interested in Babcock & Wilcox Enterprises and am unlikely to continue to follow the stock.
One: the company’s financial strength is weak. It has a big pension obligation and now has big loans as well. I don’t want to go into an analysis of B&W as a credit risk – you can look at the balance sheet yourself and try to work out the future cash flows. But, when you get to the point where you need to do a detailed credit analysis to decide whether you want to buy the equity – you probably should drop the stock right there.
Two: the company’s capital allocation has been the opposite of what I wanted to see before the spin-off. I though there was value – free cash flow that could be milked for a while – in doing maintenance on U.S. coal power plants. The cash flows from that could be used to fund pension obligations, eliminate debt, build up cash and lead over time to a smaller, safer company. Instead, Babcock has tried to diversify away from coal (and, in so doing, away from the U.S.).
In our report on Babcock we felt their competitive strengths were tied to coal power plants and the United States. It’s not just that acquisitions of higher growth businesses may be made at too high a price. It’s actually that none of these new and international power projects may ever have the kind of economics U.S. coal does. It’s very dangerous to invest in an engineering company that is doing projects it hasn’t done before and is changing the mix of its business.
This stock has become both risky (in terms of insolvency) and too hard for me to understand (in terms of diversification).
Right now, I rate my interest level in Babcock & Wilcox Enterprises a 1 out of 10.
It does, however, look like the stock could be cheap on a business value to enterprise value basis. And, because of the leverage in the stock, B&W shares could rise a lot in price if the business was turned around. Obviously, there are big shareholders in the stock who may work for such a turnaround.
Geoff’s Interest Level: 10%