Can McDermott(MDR) Spinoff Babcock & Wilcox Generate Power For Your Portfolio?

By the time United Technologies(UTX) offered to purchase Babcock & Wilcox for $42 per share in March 1977, the company’s storied history already extended over a century.  Founded to manufacture and sell the water tube boiler invented by Stephen Wilcox, the company’s products powered the first New York City Subway, Teddy Roosevelt’s Great White Fleet and the company had been a supplier to the Manhattan Project and the first nuclear submarine!  It was an attractive prize and soon after it rejected UTX’s bid, McDermott(MDR) entered the fray.  A furious bidding war ensued and when the dust finally settled, McDermott had acquired Babcock & Wilcox for over $62 per share or $750 million. Unfortunately for McDermott, Babcock & Wilcox also had a history of asbestos use and over the next two decades, McDermott would spend $1.6 billion settling asbestos claims until the Babcock & Wilcox unit was forced into bankruptcy.  McDermott was able to retain control of the company as it emerged from bankruptcy in 2004.

Fast forward to December 2009 when in the latest chapter of B&W’s long history, McDermott (market cap of just over $6 billion) announced that they will be spinning out the Babcock & Wilcox unit into a fully independant operation. During their recent Q1 conference call, McDermott talked about the spinoff and the plan is to spin out its power generation systems unit along with its government operations segment as Babcock & Wilcox, which will then trade under the ticker BWC. McDermott will retain their Offshore Oil & Gas operations.

According to the company, Babcock & Wilcox, the Power Generation Systems segment:

“supplies fossil-fired boilers, commercial nuclear steam generators and components, environmental equipment and components, and related services to customers in different regions around the world. It designs, engineers, manufactures, constructs and services large utility and industrial power generation systems, including boilers used to generate steam in electric power plants, pulp and paper making, chemical and process applications and other industrial uses.”

…while McDermott, the Government Operations segment:

“manufactures nuclear components and provides various services to the U.S. Government, including uranium processing, environmental site restoration services and management and operating services for various U.S. Government-owned facilities, primarily within the nuclear weapons complex of the U.S. Department of Energy.”

In 2009, these businesses generated revenues of $2.9b and operating income of $270m, down from $3.4b and $444.5m respectively, in 2008. In their Q1 earnings report the downward trend continued as the power generation systems segment had a 22% yoy reduction in revenues. The government operations segment held relatively firm though, with revenues declining only 1.5%.

In its Form 10 filing, the company listed its reasons for pursuing the spinoff and not surprisingly, it is filled with the usual ‘management speak’ such as better allocation of capital, management’s increased ability to focus on the individual businesses and the potential for more accelerated growth in their respective markets. I am sure there is some truth to these assertions – cutting out layers of bureaucracy and having one goal instead of two or three definitely improves efficiency. Additionally, the cyclicality of their business units could make balancing the growth and risks a challenge.

One interesting listed reason was that by spinning off these divisions they would prevent the possibility of losing new government contracts. Apparently, recent modifications in the law prohibit awarding contracts to ‘inverted’ companies, a category into which McDermott International would fall into. Considering the government (via the Department of Energy) is the government operations sole client, that could have been a serious problem. The concentrated client base is one risk that is difficult to ignore, but at least government spending can be fairly consistent, especially when it comes to our nuclear arsenal and waste.

Unfortunately, through ever changing legislation, the government impacts earnings for the power generation segment as well. In fact, one of the reasons for the segment’s Q1 revenue decline was a result of “a decrease in orders…as a result of the Federal Appeals Court’s overturning the Clean Air Interstate Rule, the Clean Air Mercury Rule and the industrial boiler rule on Maximum Achievable Control Technology.” Additionally, proposed greenhouse emissions and other legislation will have a meaningful impact on the power and utility industries and all of their underlying components.

CONCLUSION:

Aside from sounding like a porn movie title, the new Babcock and Wilcox will face significant risks . In addition to client concentration, economic and operating risks, the company also faces significant regulatory risk. Additionally, the terms of its new credit agreement will need to be analyzed in depth. This business can require immense amounts of credit and without the safety net of McDermott’s other businesses, the company could find it difficult to raise capital without onerous covenants. Obviously, that could negatively affect its growth potential as strong bondholders are rarely an equityholders’ friend. That said, there appears to be significant potential for this spinoff. The power and utility industries are undergoing tremendous changes in the US and around the world creating a lot of opportunity. Diversification of energy portfolios has led to immense interest in renewables and so called ‘smart grids’. The need for new infrastructure and equipment could play right into the company strengths. Favorable environmental legislation could be a tremendous positive for the company. Additionally, the company’s expertise in nuclear power could be very beneficial as nuclear energy is gaining favor throughout the world.

The management team appears strong and almost all senior members have held key positions at the Babcock and Wilcox subsidiary. The CEO, Brandon C. Bethards, has been with the company for over 30 years. The company’s compensation plan has historically been heavily tied to results, which means they should be highly motivated to generate returns.

While there are many risks and likely increased volatility, there is also the potential for a profitable investment. Obviously, much of that will be determined by the company’s valuation. Hopefully, we will get a chance to dig into some of the financials (which can be found in the Form 10) and come up with an idea of what it will be worth.

Disclosure: The author holds no position in any stock mentioned