McDermott on Its Back Brian Graney (TMF Panic)
November 12, 1999
Investors who had figured on a quick recovery this year for beaten-down oil and gas industry subsea contractor McDermott International (NYSE: MDR) have received a rude awakening over the past two days as the company's shares have sunk to new depths. Despite rising oil and gas prices and improved investor sentiment toward the energy sector in general, McDermott's core J. Ray McDermott marine construction services business has seen dismal results. Yesterday, the company said fiscal Q2 EPS was $0.06, down from last year's $0.85 and substantially below the First Call mean estimate of $0.19. In turn, investors have unloaded the stock, sending its share price down a wrenching 55% in the last two trading sessions.
Even though McDermott's stock was considered dirt cheap by many observers before the drop, it's a whole lot cheaper now trading at about 5 times trailing earnings and a mere 0.6 times book value. Sounds like a value investor's dream come true, right? Maybe, but the company currently finds itself in a big hole. While analysts are quick to point out that the macro outlook for McDermott is rosy thanks to a strengthening oil services sector, McDermott is different from other oil services companies.
Contract offshore rig operators such as Global Marine (NYSE: GLM) and Ensco International (NYSE: ESV) are up big this year as production companies have resumed exploration and production (E&P) spending amid higher oil and gas prices. However, the spending hasn't carried over into the kind of large E&P projects upon which McDermott so heavily depends. Marine construction revenues are down 53% year-over-year for the first half of the fiscal year, while operating profits from the business are down 77%. Last year, marine construction accounted for 41% of total revenues and 46% of operating profits.
A 6-month to 12-month lag between higher general E&P spending and subsea spending by oil and gas producers is not uncommon; McDermott expects the lag to extend out into the first quarter of calendar 2000 at the very least, which will test investors' patience.
While waiting for the increased spending to kick in, another problem has reared its ugly head. McDermott has been dealing with liability claims for the past 20 years related to cancers and other health conditions allegedly caused by asbestos in commercial boilers and other products that used to be sold by its Babcock & Wilcox subsidiary. The company has been systematically settling these claims for some time, but plaintiff lawyers have recently started to demand larger-than-usual settlement payments. As a result, the company has cautioned that paying higher settlements or future litigation could have a "material adverse impact" on the company's results.
McDermott's management didn't attempt to quantify the higher settlement risk, so the market did it for them. In the end, the downward pressure applied to the stock over the past two days because of the asbestos liability may end up being an over-reaction, as 63% of the liability claims paid out in the last year were covered by insurance. But with the weakness in its core business not going away soon, calling the market's bluff on the liability front would be a gutsy move. Unless they bring a considerable amount of industry knowledge to the table, investors hunting for value in McDermott should tread cautiously.