Looking At: Chicago Bridge & Iron

Today we’re going to do something a little different.  Instead of just telling you that I bought or sold certain investments, I’m going to bring you along and talk about an investment I’m actively considering.  

This should give you a sense of how I think about investing in individual companies.

Some people will inevitably hate this style of post, but many people have asked me to write more about my investment process.  The best way to do that (in my mind), is with investment case studies.  

So let’s start a little experiment!

We’ll start this experiment with Chicago Bridge & Iron.  

Be sure to give me feedback in the comments.  If the feedback is positive, I’ll continue doing investing posts like this.  If feedback is negative or generates little response, I won’t take this idea any further.

What is CBI?

CBI is the stock symbol for the company called Chicago Bridge & Iron.  Which, oddly enough, is an engineering firm incorporated in the Hague Netherlands.  The company has a long-storied history spanning 125 years, which yes, started with iron bridges.  If you’re curious about corporate history, I suggest checking out that link to their website.

(Note: From here on out, I’m only going to write ‘CBI’ instead of ‘Chicago Bridge & Iron’.)

Today, CBI is an entirely different beast than the original company that made iron bridges.  CBI provides EPC services (Engineering, Procurement and Construction) to petrochemical companies, power generation, and government infrastructure.  Customers include ExxonMobile, Chevron, DOW, Shell, TOTAL, Phillips 66, the U.S. Government, and many more.  At any point int time, CBI has 70 simultaneous projects underway in countries around the world.  

What kind of projects?  Big ones!  Pipelines, huge power plants, fractionators, gigantic storage tanks, and so on.  These projects have contracts that are worth hundreds of millions of dollars to CBI, and worth billions to the end-customer.  BIG projects.

The First Investment Hurdle

Before we invest in any individual stocks, we first need to talk about the basic investment hurdle for any investment.  This ‘investment hurdle’ is the minimum rate of return we expect for taking on the additional risk..  The rate of return is usually a low-risk investment that’s readily available, like bonds or stock index funds.  In this case, we’ll use VTSAX and it’s 7% average long term return to keep things simple.

What does this hurdle mean for individual stock investments?  It means any investment we make must meet or significantly exceed a 7% return.  If it doesn’t exceed a 7% return we shouldn’t invest.  For me in particular, I don’t believe in cutting things close…

I expect a decent premium and look for investments with at least expected returns of 10% (or higher) before I’ll invest my hard earned pennies.

Why Invest Now?

I’ve been looking at CBI as a potential stock investment for awhile, mainly because of valuation.  The business looks like a good bargain against historical metrics.

In years past, the petrochemical boom in the United States fueled a huge earnings boom for CBI.  Revenues doubled from 2012 to 2013,  and it powered the stock price to highs exceeding $80 per share.  Earnings per share was $4.98 at that time, giving the company a PE of 16 at the peak.

Today, CBI’s shares trade at a lowly $35 at a PE of 12.8.  The huge swing in the stock price is a direct reflection of a slowdown in petrochemical construction projects (mainly because of low oil prices).

CBI’s earnings were hit hard as a result.  In 2015 they reported EPS of -$4.72. despite 12 billion in revenue.  The stock price responded by falling to lows of around $28 per share.

Could this be a good time to pick up shares?

To answer this question, we need to understand if CBI is a temporarily fallen angel, or a business permanently in decline.

Oil prices are now starting to rise once again from 2016’s lows.  The petrochemical construction business will eventually pick up again for CBI.  But customers are bound to be more cautious and selective with the projects they take on today.  CBI’s work backlog will probably have difficulty regaining the highs of 2014, and with this means lower revenues than those experienced at 2014’s peak.

Mr. Tako’s Verdict:  Positive.  Some earnings bounce back is to be expected, but not to the same levels.

Earnings

CBI is not usually a company that reports big losses.  Most years they earn a reasonable rate of return.  2015 was something of an exception for the business, and I think it’s important that we keep that history in context:  most of the time the company is profitable…except when it isn’t.  Like most other construction companies, these earnings are subject to big booms when everyone is building, and big busts when they aren’t.

Right now, the company has an earnings yield of 7.8%, using TTM (trailing twelve months) of earnings.  If we assume earnings bounce back to some level higher…say to 2013’s level ($4.23) that implies an upper-bound earnings yield of 12%.

Mr. Tako’s Verdict: Neutral to Negative.  While I like the decent earnings yield possibilities, I prefer companies and industries with steady earnings.  Huge earnings shocks that destroy capital are not a good thing.  There’s no assurance this won’t happen again in 10 years.

Quality

If one thing stood-out that made me want to research CBI further, it was the excellent returns on capital the business earned in previous years.  ROIC typically exceeded 20% in most years, indicating the company has invested capital in business projects with decent returns.

Is there hope for high ROIC numbers in the future?  Hard to say…

High ROIC numbers are often indicative of business quality.  Good businesses will see good rates of return from re-investing in the business.

Debt levels might be a little high for a company susceptible to big earnings shocks, but interest rates are low.  Under normal conditions these debt levels shouldn’t be a problem for CBI.

Mr. Tako’s Verdict: Positive.  Other than a few bad years, returns on capital have been quite good historically for this business.  It appears to be well managed.  Now that oil prices are improving, I would also expect these numbers to improve.

Competition

While my knowledge of this industry is limited, I imagine a world filled with experienced engineering firms looking to compete with CBI, but relatively few of a similar size and global scale.  

This competition will keep CBI’s profit margins in-check.  We can see the truth of this in their long-term net margins.  

Net Profit Margins averaged 3.15% over the last 10 years.  This indicates significant competition in the industries where CBI exists.  If competition was non-existent,  we would see much higher margins.

Mr. Tako’s Verdict: Neutral. These aren’t super thin profit margins, but they aren’t Microsoft or Google levels either.

Are CBI’s Problems Temporary?

In a word, yes.  The world is going to continue to need fossil fuels, natural gas, storage tanks, and it will be a very long time until all that infrastructure is replaced by SomethingBetter(TM).

The world will continue to need someone to build all that complicated energy and power infrastructure, and they’ll need experienced hands to do it.   I expect CBI will continue to see many large fossil fuel projects of this nature in the future.  We can already see business is picking up in recent quarters.

Mr. Tako’s Verdict: Positive.  The business has already started recovering.

But Will It Grow?

After reading through CBI’s annual reports, I can tell you the company expects to grow through acquisitions and by “being awesome” (my words).

While doing a good job can be a good growth strategy, there’s nothing that says low-cost competitors can’t do the same at lower prices.  “Low-cost and good” always beats “high-cost and good”.

Acquisitions are a far more likely growth scenario, and one I’ve seen repeated in CBI’s past annual reports.  A acquisition growth strategy is fraught with problems, most notably high prices and inconsistent results over time.  

I also noticed that CBI tends to divest themselves of businesses fairly frequently too….I imagine to cherry-pick the “best” business segments and sell off the mediocre ones.

Mr. Tako’s Verdict: Negative.  Growth through acquisition is a possibility, but organic growth would be better.  I’m skeptical of CBI’s growth prospects.

Conclusion

Ultimately CBI is a well-run company with a long storied history of acquisitions and change.  What I don’t see is a great (or consistent) growth story for earnings to be reinvested.

Unlike the petrochemical companies that CBI designs and builds for, CBI doesn’t actually own those assets.  The company must continually find new and bigger projects to maintain and grow revenues.

What I don’t see is a runway of reinvestment opportunities (beyond business acquisitions) to provide liftoff.

CBI is already a global firm, and completes hundreds of large engineering projects around the globe.  It’s hard to imagine rapid growth in the future.  In fact, the petrochemical and power generation industries might see declines as cars and homes become more energy efficient.

For CBI to become a good long term investment, a return of petrochemical construction spending in the U.S.A. would be in order.  As oil prices rise, I would expect some of this business to return.

This highlights one of my greatest problems with CBI — susceptibility to large business shocks as projects are delayed or put on hold.  With the company’s fortunes tied at the hip to the petrochemical industry, big positive or negative swings are a distinct possibility.

Inevitably, the industry is one that can experience big negative “shocks”, and invariably the reputation of the industry is the one that will survive.

CBI looks to me like a value price business that’s just suffered one of those recent ‘earnings shocks’.  There is a good deal to be had here.  I expect its earnings will regain some of their former glory, but probably not to the same level as previous years.  This can still result in acceptable returns for investors.

In the near-term, as earnings improve I would expect the stock price to rise — perhaps into the mid-$60’s to match the mid-$4 per share earnings level that analysts expect.  That’s a huge bump from today’s stock price, and it could be realized in 1-2 years.

Longer term, CBI doesn’t look like a value compounder to me.  Growth will be limited to acquisitions in new industries, and those could be problematic (or sporadic).

Final Verdict:  While there’s good value to be had, I probably won’t be invest my dollars here.

[Image Credit: Flickr]