Chicago Bridge & Iron: Compelling Value In An Expensive Market

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Mar 15, 2015
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CB&I: Compelling Value In An Expensive Market

Dr. Steve Sjuggerud likes to say: “Buy what’s cheap, hated and in an uptrend.” Dr. Sjuggerud is a very successful investor and quite the talented analyst. I am sure this mantra has served him well over the years because I have personally benefited from it. However, I like to take his view one step further by adding “and supplies a product or service necessary to our way of life.”

This added criteria certainly narrows the playing field significantly but successful investing is all about identifying the absolute best opportunities for capital allocation and that includes minimizing our risk.

After all, Warren Buffett (Trades, Portfolio), the greatest investor of our time famously said: “Rule #1 is never lose money. Rule #2 is never forget rule #1.”

Self-made billionaire investor Jim Rogers, when asked about his investment style commented: “I just wait until there is money lying in the corner and all I have to do is go over and pick it up.”

18th century British nobleman Baron Rothschild, a member of the famed Rothschild banking family, is credited with coining the phrase: “The time to buy is when there’s blood in the streets.”

All of these quotes provide us with sage investment advice. They also all direct us to buy shares of exceptional businesses after they have been decimated by emotional reactions to short-term events that have little to do with the long-term intrinsic value of a business whose products or services are necessary to our way of life.

Today, shares of Chicago Bridge and Iron (CBI, Financial) appear to fit quite nicely into all of the scenarios described above.

What Does Chicago Bridge & Iron Do?

CB&I is a complete energy infrastructure focused company. It is one of the top suppliers of engineering and construction services for major energy projects in the world and a major provider of government services. The company has 125 years of experience and the expertise and employs approximately 54,000 people.

It is one of the most complete providers of energy project related products and services in the world today. Whether it is design, engineering, construction, fabrication, maintenance and environmental services, or all of the above, no project is too big for CB&I. The company not only satisfies its customers’ needs, but also improves the quality of life for people around the world.

CB&I is organized into four business groups that serve the needs of our clients in the energy and government markets.

The Technology group offers licensed process technologies, catalysts, specialized equipment and engineered products for use in petrochemical facilities, oil refineries and gas processing plants.

The Engineering, Construction & Maintenance group provides engineering, procurement, fabrication and construction of major energy infrastructure facilities, as well as comprehensive and integrated maintenance services.

CB&I’s Fabrication Services group is a leading provider of piping solutions and the world’s leading supplier of storage tanks and vessels for the oil and gas, water and wastewater, mining and power generation industries.

And, its Environmental Solutions group leads large, high-profile programs and projects – including design-build infrastructure projects – for Federal, state and local governments.

An overview of the breadth of the company’s projects is displayed on its website. It is very easy to see that this business provides products and services upon which our global economy depends. We must also keep in mind that businesses in this type of competitive industry do not get to this size and scope, or survive for 125 years, without being very good at what they do.

Why Does The Opportunity Exist?

There have been questions in the minds of some analysts regarding whether CBI overpaid for its acquisition of Shaw that was completed two years ago. Even though the company acquired approximately $18 billion worth of outstanding contracts when it executed the $3 billion deal. It also acquired some key technical talent in the area of nuclear power projects that should provide serious long-term benefits to CBI and strengthen what was previously an important area that was a bit lacking in strength.

“Analysts at first were “fairly negative” about CB&I’s plans to purchase Shaw,” said Randy Bhatia, who follows both companies for Capital One Southcoast in Houston. “A lot of people thought they were overpaying for a company that did not fit in with their strategic vision,” Bhatia said.

Short-selling specialist firm Prescience Point issued a scathing review of CB&I’s acquisition of Shaw indicating that the company was guilty of vastly overpaying for Shaw and suggesting the company would be forced to write down the value of goodwill it was carrying on its book related to the acquisition. Added to the existing doubts already in the minds of some observers and shareholders, this negative assessment seemed to pour gasoline on an already smoldering fire and the share price of CB&I went into a freefall over the next several months. This transpired even in the face of solid results the company reported for the June 2014 quarter.

When evaluating the veracity of allegations made by short-side firms, it is always best to see how what they are claiming might affect what they are doing with their own capital. SL Advisors has published an interesting piece that might shed a bit of light on the intentions and actions of Prescience Point as they relate to its review of CB&I. This piece reveals some rather questionable practices in which Prescience appears to routinely engage in advance of publishing their “research” and the actions they seem to take after these reviews are made available to the public.

As of March 13th, 10.87% of CB&I’s shares have been borrowed and sold short and it would require 3.71 days at 100% of the average daily trading volume to cover these short positions. Panic works in both directions. If the share price of CB&I continues its recent trend higher, it is logical to wonder just how long the shorts can stand the pain as the “buy low” crowd of value oriented investors begin to recognize how cheap this company is right now.

CB&I is also part of a group of companies developing two nuclear projects; one in South Carolina and one in Georgia, that have experienced major cost overruns. CB&I contends that these overruns are due solely to unapproved change orders and are the responsibility of the provider of the technology, Westinghouse Electric, whose job was to design the project. CB&I was only responsible for construction and is, therefore, entitled to be paid for the cost overruns resulting from changes in design that were made after the project was bid based on the designs they had been provided.

In this type of dispute, it is unlikely that CB&I will be left holding the bag for the full $1 billion worth of unapproved changes and far more likely that the companies involved with reach an agreement. Generally, it is the responsibility of the design group to gain cost approval on change orders during the construction phase of the project and it is unlikely that CB&I could have received notice of the changes from any source other than Westinghouse. Therefore, it would seem to follow that Westinghouse will ultimately be judged liable for the cost of these change orders in regard to paying CB&I for the work. It will then be up to Westinghouse to go after the plant owners to recover their cost.

Regardless of the ultimate resolution to this issue, it is a temporary issue that will not have a material impact on the future prospects for CB&I’s business. I encourage you to think back to Walmart’s Mexican bribery scandal that temporarily crushed its share price and created an exceptional opportunity for long-term investors to open new positions at a bargain price simply based on widespread panic related to a short-term issue. Philip Asherman, the company’s CEO, assured analysts on the recent earning conference call for CB&I that this issue will be resolved and also asserted his confidence in the position of CB&I that they are entitled to be paid for the change orders they implemented.

All of these concerns, along with the fear of a coming write-down of “goodwill” on the books if the Shaw acquisition were to be devalued, drove the price of CBI from its 52-week high of $89.22 on April 4, 2014 to its 52-week low of $32.16 reached on January 30, 2015.

It would seem evident that the CEO is confident that the current share price reflects far more risk than that to which the company believes it is exposed. It appears the market is beginning to share that view as well.

Since hitting its 52-week low the share price has rebounded to close at $45.48 on March 13th. This 41.4% rise in 2 ½ months would sound warning bells in many cases; until one realizes that CBI is still trading almost 50% below its 12-month high.The 12-month chart of CB&I’s share price clearly shows how the stock collapsed on the short-term fear. It has already rewarded those who bought when there was “blood in the street”. But, it still has plenty of room to provide exceptional returns for those of us who have waited for things to go from just cheap and hated to “cheap, hated and in an uptrend”. This is the time when I have the most evidence in our favor that I truly “see money lying in the corner and all I have to do is walk over and pick it up.”

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What Is The Current Value Of CB&I?

Stocks that have been beaten down can present stellar value or they could have simply been overvalued to begin with and fallen back to fair value. The price to earnings multiple of a stock is one of the most common methods used for comparative valuations. At this time, the S&P 500 is trading at a valuation of around 19 times expected earnings. This is higher than it long-term average of about 15 times earnings but well below the highest range of 24-26 times earnings.

EPS Trends Current Qtr.
Mar 15
Next Qtr.
Jun 15
Current Year
Dec 15
Next Year
Dec 16
Current Estimate 1.19 1.44 5.64 5.46
7 Days Ago 1.19 1.44 5.64 5.46
30 Days Ago 1.27 1.40 5.64 5.50
60 Days Ago 1.30 1.45 5.86 6.10
90 Days Ago 1.30 1.45 5.88 6.01

Based on the March 13th closing price of $45.48 and the consensus earnings projection of $5.64 for 2015, CB&I is valued at a P/E multiple of only 8.06 times this year’s earnings. Considering that CB&I has recently reported a record order backlog of $30 billion and Phillip Asherman recently increased the company’s guidance for 2015 revenue to a range of $14.4 to $15.2 billion and projected this year’s earnings to come in between $5.55 and $6.05/share. If this business were to simply reflect the long-term average valuation of the broader market index with a P/E multiple of 15 times earnings, the share price would rise to between $83.25 and $90.75, an increase of between 83% and 99.5% from the current level.

The company’s announced order backlog of $30.4 billion at the end of 2014 provides them with a 2-year cushion of existing business even if they fail to book any new order during that time. That eventuality would seem to be a virtually impossible outcome. Commenting on CB&I’s outlook for 2015, Mr. Asherman stated, “We project less than 5 percent of our revenue from new bookings could be affected by timing risks associated with lower oil prices.

Present Value Is Fine But Investing Is About The Future

While it is always encouraging to find a business that is misunderstood or has experienced some short-term event that has caused it to become undervalued, investing is about producing long-term gains and that requires the business to produce positive long-term results. CBI reported a strong 4th quarter along with record bookings for new contracts

Again in the same press release cited above, CB&I reported strong 2014 fourth quarter and full-year results. New bookings were up 33%, Revenue up 17% and operating income was up 31% from 2013.

The statement quoted Phillip Asherman as stating: “New awards of $16.3 billion for the year highlight the breadth and reach of our offerings.” This indicates that the company is continuing to win new business at a pace faster than the one at which it is completing existing orders. While we can never be absolutely certain as to what the future might hold, the next two years are locked in and the company continues to expand sales at a torrid pace.

In determining present fair value and future stock price growth, one of the favorite metrics used by many investors is the price to earnings growth ratio or PEG Ratio shown in the table below.

Growth Est CBI Industry Sector S&P 500
Current Qtr. 36.80% 140.10% -99.30% 8.70%
Next Qtr. 5.90% 96.60% -20.60% 14.30%
This Year 8.30% 21.50% 22.20% 2.80%
Next Year -3.20% 14.50% 5,745.00% 13.20%
Past 5 Years (per annum) 28.01% N/A N/A N/A
Next 5 Years (per annum) 8.40% 16.24% 13.13% 7.71%
Price/Earnings (avg. for comparison categories) 8.06 21.11 8.97 19.19
PEG Ratio (avg. for comparison categories) 0.96 1.35 1.01 2.13

This ratio is simply a measure of the current price to earnings multiple of the stock divided by the long-term projected earnings growth rate. In the case of CB&I, 8.06% divided by 8.4% which produces a PEG ratio of 0.96. What constitutes a fair valuation based on this particular methodology varies among individuals. I prefer a number of 1 or less when I am buying but use the industry average figure to determine fair value and for estimating the discount at which I can acquire the shares.

CB&I currently carries a PEG ratio of 0.96 against the industry average valuation of 1.35. If we assign a range of fair value as being the industry averagePEG valuation of 1.35 and use the company’s most recent guidance range of $5.55 to $6.05 for 2015’s earnings, we are left with a range of fair value between:

1.35 X 8.4 X $5.55 = $62.94/share; 38.4% above the current price

And

1.35 X 8.4 X $6.05 = $68.61/share; 50.86 above the current price

Based upon recent results, the current projected earnings growth rate appears to be on the conservative side. However, I prefer using numbers I believe to be conservative when attempting to determine my expected rate of return on any investment. It tends to reduce my downside risk to evaluate my capital allocation decisions that way.

Final Thoughts And Actionable Conclusions

After so many years of a bull market with very few corrections in the indexes, it is becoming more and more difficult to find truly compelling opportunities in which to put new capital to work. I believe I have overcome that hurdle with CB&I at the current valuation. While the current share price offers an excellent point of entry into this stock, I believe there are also two alternatives that would provide excellent potential returns while also lowering the risk profile of the position.

In reviewing this business, I noticed that the April 17, 2015 expiration call options for these shares with a strike price of $50 can be sold for a premium of about $0.65 which produces an immediate return of 1.43% against the current share price for a 5-week obligation to sell 100 shares of the stock for each contract sold at $50/share any time between now an April 17th. Should the stock trade above the strike price and the shares be called away by the buyer of the options, an additional capital gain of 9.9% would be recorded and bring the total return to about 11.3% over 5 weeks.

For the most risk averse among us, the April 17, 2015 expiration put options with a strike price of $42.50 can be sold for about $1.25/share ($125/contract) which represents an immediate return of 2.94% on the $4,250.00 that would be required to purchase the 100 shares of stock (at the option of the option buyer) covered by each option contract sold. The strike price of these options represents a discount of 6.55% to the current market price of the stock and would result in a net price of the new position of $41.25/share ($42.50-$1.25) or a 9.3% discount to the current share price. Should the share price of CB&I remain above the $42.50 strike price of these options, the seller of the contracts would keep the premium collected for an annualized return on the capital committed to the position of about 30%.