Babcock & Wilcox ($BW) — Initiation (8/24/21)

Price: $7 Market Cap: $600m Valuation: 8.2x ‘22E EBITDA Category: Option

For starters, Babcock (BW) was in distress as recently as a year ago (shares got as low as $1). On the verge of bankruptcy and in need of a dramatic turnaround. Today, they’re several innings into that turnaround and close to being out of the woods.

$BW Stock Chart (3YR)

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BW has potential for an option-like payoff but it shouldn’t be your largest position… (Although it is for someone!)

Quick Backstory…

BW was a 2015 spin-off. Actually it was the RemainCo that spun off BWX Technologies ($BWXT), a company that makes and services nuclear reactors for naval ships (a great business!). From a 2015 WSJ article:

Babcock & Wilcox, a 148-year-old company based in Charlotte, N.C., is dividing itself in two under the encouragement of an activist investor. It will spin off businesses involved in making power-generation and pollution-control equipment, to be known as Babcock & Wilcox Enterprises Inc., where Mr. Ferland will be the CEO. The remaining business, to be known as BWX Technologies Inc., will focus on selling nuclear reactors and fuel to power U.S. Navy submarines and aircraft carriers, among other things.

From the BW 10-K, here’s how they describe what they do:

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It’s a mix of parts, service, and installation for power gen and industrial customers… High-margin parts and service make up ~50% of the total business.

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Essentially this is an engineering and construction (E&C) services company (back then, mainly to coal plants). In E&C, a poorly underwritten job can lead to massive blowups and spectacular losses. This is exactly what happened under prior CEO Jim Ferland’s leadership. In early 2018, Leslie Kass, who ran a division for BW, took over as CEO and began the turnaround effort as contract losses were piling up. She left in late 2018 as the restructuring advisors came into the picture…

In late 2018, Kenny Young became CEO. Did I mention that Kenny Young is also the president of B Riley ($RILY) and the CEO of their principal investments division??

How about some of the other actions the company has taken?

  • First they had to complete and exit the projects they quoted at losses (the “Loss Contracts” as they called them) — these wrapped up in 2019
  • Then they had to fix the balance sheet to make up for all the losses they incurred — common stock offerings, high yield debt, preferred stock
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The hope was that underneath the Loss Contracts was a healthy service business.

Turnaround financials…

As you’d imagine, company performance has been terrible since 2017 during the turnaround period. Revenue fell from $1.4bn+ in 2016 to $566m in 2020 and cash outflows were nearly $800m in aggregate from 2017 to 1H21!

2017-1H21 financial summary

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But they slowly turned over each of the Loss Contracts to customers and pushed through with the core business and proprietary technologies while fixing the balance sheet.

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BW is now producing GAAP earnings and a respectable 10%+ EBITDA margin on growing revenue — sales were +40% / +24% YoY in Q2 and the first half of 2021. The pipeline for new bookings is looking good as well with some $6bn in projects to bid on; remember that new build and installation projects are 50% or less of total revenue with high-margin / recurring parts & service making up the other half.

The B Riley aspect…

Here’s the real reason to be interested in this situation.

B Riley is exposed up and down the capital structure including key management positions! Here’s a breakdown of B Riley’s ~$300m exposure:

  • Common shares 27m — at $7/sh = $189m
  • Preferred shares 2.9m — at $25/sh = $73m — exchanged from previous debt issued by Riley
  • Senior Notes — $35m — exchanged from previous debt

Riley even purchased the 10.7m share block owned by Vintage Capital in March 2021 at a price of $6/share:

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CEO Ken Young (also President of B Riley) owns another 960k shares and has made several large open market purchases as well. Bryant Riley himself even made a few open market purchases back in 2020 and owns 176k shares worth $1.2m today.

Why do I weight the B Riley aspect so heavily?

I’ve written about Riley several times in the past (I recommend checking them out). It’s a management team I trust with a knack for creating value. When they’re buying, I pay attention. My initial position in BW came as they were getting started and this remains an option position as they take the business to the next phase.

Notably, B Riley has a current market cap of $1.8bn with $300m in balance sheet exposure to BW. Sure, that’s only 7% of the $4.1bn in total assets but ~17% of the Riley market cap is tied to BW… that’s significant! They have a massive vested in the outcome here.

What’s it worth…

Following the slew of capital raises, the capital structure sports a market cap of ~$600m and an enterprise value of $820m (including preferred stock):

BW capital structure

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Simply using the EBITDA guidance proposed by management gets an 8.2x multiple on 2022 mid-point guidance ($95-105m).

The capital structure has better permanent financing with debt consisting mainly of senior notes (8.125% coupon) due in 2026 and the preferred stock (7.75% coupon) as perpetual (i.e. no near term maturities). Gross leverage is less than 2x EBITDA if you exclude preferred stock. Gross cash of $140m+ can be used for discretionary purposes like M&A at this point — something management has hinted at. Interest expense should dramatically improve from $60m in 2020 to ~$30m or so from debt/preferred coupons going forward.

What do earnings / FCF look like?

Starting with$100m EBITDA(-) $15m for debt interest,(-) $17m D&A expense (not capex),(-) ~$17m for cash taxes using a 25% tax rate$50m in net income [GAAP ignores preferred dividends in net income calculations]

BW could be cranking out $0.58/share in EPS starting in 2022 (12x earnings multiple) with a reasonable balance sheet and a plan to execute M&A and organically grow revenue with a high-quality operating partner in B Riley.

That’s the situation in a nutshell. Guidance of $95-100m 2022 EBITDA and long-term margins of 10-12% suggests revenue at $830m to $1bn.

Should they get back to 2016-2017 revenue levels of $1.3-1.4bn that would suggest $130-170m EBITDA potential (organically). I think they can achieve that target within 2 years with balance sheet improvements (i.e. positive free cash flow). At 85m shares outstanding, that’d be a target price of $13-16/share for a double over a 2-year timeframe.

I’m watching to see that they do indeed start generating free cash flow in 2H21 as indicated and ensure revenue / margins continue to trend in the right direction. I’ll also be keeping a close eye on B Riley activity (buying or selling) and may follow their lead with a portion of my position.