Description
While this idea was posted on VIC in early February by will579, I feel that the recent decline of Washington Group’s shares, in conjunction with their ensuing listing on the NASDAQ compelled me to repost the idea.
Summary:
Washington Group International (OTC: WGII) (hereafter, WGII) has recently emerged from Chapter 11 with no debt, strong liquidity, and is extraordinarily cheap. Currently, WGII is trading at a 2003 EV/EBITDA multiple of roughly 2.1x, while the market cap weighted average multiple of its group is 6.0x. Some might argue, the disparity in valuation is justified and a direct result of WGII’s illiquidity and commensurate business risk, however, additional investigation reveals that WGII has far less risk in the power generation business than its peers, and has utilized excessively bleak assumptions in its 2002 guidance. Furthermore, WGII has several catalysts that should assist in the realization of its intrinsic value, among them its plans to be listed on the NASDAQ in roughly 45 days.
Company Overview:
Formerly known as Morrison Knudsen, Washington Group International is one of the largest engineering and construction (ENC) firms in the United States. Though its name has changed WGII is still known for its colorful 100 year history replete with landmark projects including the San Francisco Bay Bridge, Hoover Dam, Trans-Alaska Pipeline, and major features of the Kennedy Space Center. WGII breaks its business in to six segments: 1) Energy & Environment, 2) Defense, 3) Mining, 4) Power, 5) Infrastructure, and 6) Industrial / Process. Brief summaries of each business segment are provided below:
1. Energy and Environment: (18% of Revenues)
WGII’s Energy and Environment division provides ENC services for highly hazardous materials and their respective process facilities. This business unit specializes in long-term operations for the U.S. Department of Energy (DOE), often involving work at nuclear sites.
2. Defense: (14.5% of Revenues)
WGII’s newest division, Defense, has four main operating segments: Threat Reduction, Infrastructure Reconfiguration, Homeland Security, and Defense Projects. The Threat Reduction segment provides demilitarization services to federal clients including nuclear, chemical and biological warfare materials. The Infrastructure Reconfiguration segment provides classified and unclassified services to the US Department of Defense (DOD) and the US Department of State, involving primarily military base closure, construction and management. Homeland Security provides a wide range of ENC services to government customers including real time threat simulations, vulnerability analysis and emergency/crisis response services. The Defense Projects segment provides defense related services including disposing and destroying weapons of mass destruction.
3. Mining: (2.4% of Revenues)
WGII’s Mining division serves the metals, precious metals, coal, and minerals markets through contract mining, technical and engineering services. Some of the projects that WGII works on in this division include an equity participation.
4. Power: (28% of Revenues)
WGII’s Power division is a dominant player in the global power business with experience in the design, construction, maintenance, decontamination and decommissioning of virtually all types of power generation units including: conventional coal, oil, and gas fired generation, combustion turbine and combined-cycle plants, nuclear power, hydroelectric power, waste-to-energy, fluidized-bed combustion, biomass and wind-power units. WGII’s experience in this arena is vast as they have engineered and/or built more generating capacity than any other ENC firm, over 215,000MW worldwide.
5. Infrastructure: (19.6% of Revenues)
WGII’s Infrastructure division is a large player in the global infrastructure market and focuses its operations on various types of projects including: highways, bridges, airports, seaports, tunnels, tube tunnels, railroad, transit lines, water storage, transport, treatment, mine operations, and hydroelectric facilities. An example of a recent project that involved WGII’s Infrastructure division is the $1.1 billion Hudson-Bergen Light Rail System. In this endeavor, WGII led the 21st Century Rail Corporation, a consortium that has a contract to design, build, operate and maintain the Hudson-Bergen Light Rail System for the State of New Jersey’s NJ TRANSIT. After the design and build phase is completed, the 21st Century Rail Corporation will operate and maintain the system for 15 years.
6. Industrial / Process: (17.4% of Revenues)
WGII’s Industrial / Process division provides ENC services to Fortune 500 clients. Services are offered to the pharmaceutical, pulp and paper, automotive, up-stream gas, specialty chemicals, industrial manufacturing, aerospace, food and beverage, buildings, and consumer products markets in various capacities. For example, in the pharmaceutical market, current projects include engineering and construction-management services for a $30-million active ingredient plant for Pharmacia in Puerto Rico; design services for a $25-million active ingredient plant for Pharmacia in Michigan; and front-end engineering for a $250-million bulk chemical plant expansion for Bayer in Missouri.
As of the most recent quarter (reported 8/12/02) all of WGII’s business segments were profitable, despite softer demand in Infrastructure and Industrial Process. As the segment descriptions above demonstrate, WGII benefits from having exposure to “total project life-cycle” services from the planning and design stage, to complete engineering and construction, along with facility management, and maintenance services. Thus, while the cash flow from new projects may get lumpy at times, WGII’s businesses also have a consistent cash flows component from the maintenance and operation of existing facilities.
Raytheon and Chapter 11:
Forced into bankruptcy by its acquisition of Raytheon’s Engineers and Constructors business in July 2000, WGII has recently emerged from Chapter 11. This acquisition added to WGII’s reach in the Infrastructure, Government, Industrial Process market and gave it a huge leap into the Power market, especially the New Generation Power business. As WGII proceeded with the acquisition, they realized that they had acquired some projects that required substantially more liabilities than originally anticipated ($700m greater than the originally estimated amount of $450m) WGII sued Raytheon seeking reimbursement for excess liabilities. In the end, WGII decided the only way to protect the organization was to file Chapter 11.
WGII’s plan of reorganization, approved on November 20, 2001, resulted in the bank debt receiving 80% of the new equity, and the unsecured creditors receiving 20%. In addition, there are warrants and options for the unsecured creditors and management as well. There are 25 million new shares and warrants/options as follows: 2.8M at $24.00, 3.1M at $29.00, 4.4M at $33.00 and 3.8M at $35.50.
Investment Thesis:
There are several factors that will align WGII’s market value with its intrinsic value: 1) awards of new projects, 2) recognition that WGII has no exposure to IPPs, and 3) listing of the shares on the NASDAQ. The investment case for WGII is strengthened when WGII is compared with its group. Furthermore, WGII has several catalysts that should assist in the realization of its intrinsic value, among them its plans to be listed on the NASDAQ in roughly 45 days.
Contract Awards:
While in Chapter 11, it was difficult for WGII to get business because potential clients did not feel comfortable awarding big contracts to a firm in bankruptcy. The ramifications of this slowdown in bookings during bankruptcy, will manifest itself over the next two to four quarters. As Steve Hanks (President and CEO), acknowledged on the most recent conference call, “In this business you can get all the business you want, all you have to do is discount the price, but we won’t sacrifice the future for a strong showing in quarterly bookings.” I believe that management’s discriminatory approach in booking work during the bankruptcy, however, will be offset by awards of work to WGII over the next several months. Some of the potential projects WGII may be awarded in the near term include:
- a $300m Toll Road in Southern California,
- a $800m Chemical Agent Disposal Facility for the Department of Defense,
- a $1B Automobile Facility.
- the Office of Homeland Security has yet to award any mega contracts for the work that must be done to upgrade the level of America’s security, and is likely to do so in the coming months.
Undoubtedly, the award of any new projects of size would be extremely positive for WGII as they have only been referenced on the conference call and have not been mentioned in any press release and are not in the backlog.
IPP Issues:
Uncertainty surrounding power plant construction, which became prominent most recently on the back of NRG Energy’s failure to pay the Shaw Group (NYSE: SGR) for the LSP Pike Energy project, has weighed down the shares of most ENC companies globally. When investigated further, however, it is clear that WGII is in a strikingly different position than any other ENC company. Firstly, WGII has no revenue or working capital exposure to IPPs whatsoever. Secondly, the majority of the current contracts in the Power business are “reformed,” in that they have been converted into “cost plus” versus formerly being “lump sum.” This is a subtle, but exceedingly crucial point as this is what originally put WGII into bankruptcy. Cost plus contracts are contracts in which the ENC company projects how much it will cost to build the project to the given specifications. The “plus” portion of “cost plus” constitutes the fee in which the ENC company charges for its services on the project. A cost plus contract is the most conservative approach to a project from the ENC company’s perspective, as there is little risk to the ENC company in terms of paying for unforeseen project costs---provided that the party that they enter the contract with is of good credit quality. Lump sum contracts, however, are quite different. In a lump sum contract the ENC company provides a lump sum amount that includes all project costs and their fee on the project. Thus, when things go awry in a lump sum contract, and the ENC company realizes it has underestimated the project’s cost, the ENC company is left with the burden of the unanticipated costs, and no profits. Following its emergence from bankruptcy, the majority of WGII’s current projects in the Power business are in the form of reformed contracts with Raytheon, a client with much less credit risk than the IPPs. WGII’s plan for post-bankruptcy was guidance of one to two awards for new generation power facilities this year, and already has two, and is looking at its 3rd.
Nasdaq Listing:
With the second quarter reported, WGII is now focusing on filing three 10Qs from 2001. Along with filing the three 10Qs the only other requirement for a listing of its shares on the NASDAQ, is that they have at least 400 shareholders. Though originally planned to list on the NYSE, WGII believes the NYSE’s requirement of a minmum 2000 shareholders to be prohibitive. WGII’s internal target for filing the three 10Qs is within the next 30days. Apparently, the operational process of getting listed takes an additional 14 days. Thus, within 45 days, WGII should be a NASDAQ listed security—adding to WGII’s liquidity, and Wall Street exposure.
Risks:
1. Power Market: As IPPs continue to experience turmoil in almost every facet of their business, WGII’s shares have continually been misinterpreted as having great exposure to power plant construction. Given that WGII remains one of the largest global ENC companies in the Power Generation business---having built over 200,000MW of power in the world, with 4,000MW currently under construction---confusion is understandable. As discussed above, however, the majority of WGII’s exposure to the Power market is through reformed contracts with Raytheon and has exceedingly low collection risk.
2. Illiquidity: Currently, WGII trades over the counter and is exceedingly illiquid on a normalized basis, making for a high amount of volatility. I do believe, however, that as we approach the listing of the securities on the NASDAQ and interest in the story increases, volatility should go down, volumes should increase and a two-way market should develop.
Financial Guidance:
As WGII is coming out of bankruptcy, the company has been quite conservative with its guidance.
2002E:
Revenue $3.2 – 3.5B
Gross Profit $150 – 160m
Net Income $32 – 35m
EBITDA $115 – 125m
Ending backlog $2.6 – 2.9B
New Work $2.8 – 3.1B
Given that as of the second quarter ending June 28, 2002 the company has already generated the following results:
1H2002
Revenue $1.932B
Gross Profit $91.4m
Net Income $22.1m
EBITDA $64.6m
Ending backlog $3.1B
I find it highly likely that they will be able to achieve their guidance, especially considering that WGII has just emerged from bankruptcy and is being overly cautious. In fact, to miss its revenue estimate WGII would have to generate less than $709m in both 3Q and 4Q, which would roughly constitute a 25% sequential revenue decline over WGII’s 1st and 2nd Quarters of 2002. Furthermore, as shown above, management incentives have been structured via options and warrants that have a significantly higher strike than the current share price.
Comparables:
The main publicly traded comparables for Washington Group International as I see them, are Jacobs Engineering (NYSE: JEC), Shaw Group(NYSE: SGR), Fluor Corp(NYSE: FLR), URS Corp(NYSE: URS), Granite Construction (NYSE: GVA) and SNC-Lavalin Group (TSE: SNC).
Ticker-----------JEC----SGR---FLR----URS----GVA----SNC----Average*---WGII
EV/EBITDA 02-----10.4x--3.8x--6.2x---6.1x---6.0x---10.5x---6.9x-------2.4x
EV/EBITDA 03-----9.1x---2.9x--5.2x---5.6x---5.1x----9.6x---6.0x------2.1x
EV / FCF---------21.9x--4.1x--15.4x--15.2x--15.1x--26.3x---15.8------5.3x
P/E--------------15.9x--5.5x--12.3x--7.9x---12.5x--19.0x---11.9-----10.6x
Price/Sales------.45x---.27x--.25x---.19x---.49x---.64x----.40x------.08x
Debt/TC-----------9%-----73%---3%-----52%----18%----69%-----37%------0%
*Average reflects the average of the companies listed above excluding WGII.
On almost every valuation metric WGII trades at a discount to its peers. Moreover, WGII has no debt, and no exposure to IPPs---both factors that call for a multiple premium to the group, not a discount.
Intrinsic Value:
I believe Washington Group International has an intrinsic value of at least $28 a share assuming a cost of capital of 10.6% In my model, I make the following assumptions:
- extremely modest revenue growth of 5.0%
- terminal growth rate of 2.0%
- ultra-conservative risk premium of 8%(historically the risk
premium has averaged 3.5%)
- changes in net working capital and capital expenditures are 1%
of revenues
- ignores the sales of equipment bought for use during specific
projects
My estimated intrinsic value is equivalent to a 5x multiple of 2003 EBITDA, which is very reasonable considering its peers currently trade at a weighted average 2003 EV/EBITDA multiple of 6.0x.
At current price levels of roughly $15.85 per share, the stock market has misinterpreted WGII’s exposure to the power market and the risk of emerging from bankruptcy and the engineering and construction industry’s misfortune creating a 50%+ disparity. Based on my estimate of $44m in free cash flow for 2002, and 25m shares outstanding, WGII has about $1.78 in free cash flow per share. At a price to free cash flow of 6.5x on my estimates for this year, WGII’s current valuation creates an attractive investment opportunity.
WGII’s Capital Structure:
Market Cap $ 387.5
+ Debt $ 0.00
- Cash $ 105.00
---------------------------------
EV $ 287.5
Free Cash Flow:
____________2002________2003
Revenue_____3350________3518
EBITDA ____117.5________139
- TAX_______14.3_______12.9
- CAPEX_____25.0________35.2
- CHG NWC___33.5_______35.2
-----------------------------------------
= FCF_______44.7_____55.66
Catalyst
Catalysts:
I see three primary catalysts: 1) Nasdaq listing and Increased exposure on Wall Street, 2) New “Mega” contract awards, and 3) Upside to guidance