Back in March, when I first wrote about Chicago Bridge & Iron (NYSE:CBI), its stock had just fallen from a high of $89 all the way down to about the $40 mark. To some it was cheap; to others such as myself, the punishment was well deserved, just recompense for a bad acquisition, a toxic contract, and tricky accounting.
But since then the stock has climbed above $50 and is looking very much like the ideal value play -- a rare find in today's market and, at less than 10 times trailing earnings, ready to pop. Powerful investors have bought in to the story: Berkshire Hathaway, they say, is on board, and even the often-bearish David Einhorn.
I would venture a guess that much of the optimism has to do with CBI's formidable $30 billion backlog. Of course, "backlog" is a tricky subject. Nearly all companies that report backlog do so with a standard proviso: don't read too much into it. But for most investors, the bigger the backlog, the better.
Generally speaking, a large backlog indicates strong demand. But what if that demand is stoked by underpricing? And what if it contains a significant number of fixed-price contracts? Then a large backlog becomes a liability rather than a strength.
In a fixed-price contract, the contractor receives a fixed payment and bears the risk of cost overruns. For taking this risk, the contractor receives a higher margin and, quite often, negative working capital. Most EPC firms shy away from the fixed-price contract, which even in its less dangerous hybrid forms, can saddle them with heavy losses. They prefer the cost-reimbursable contract, in which the contractor simply passes along its costs to the contractee while earning a pre-established, though thin, margin. Over the last 10 or so years, the preference for cost-reimbursable contracts has become even more pronounced. Take for instance, Fluor, the largest player in this field. In 2002, its backlog was about 45% fixed-price. Today, this would count as a large fixed-priced weighting. Fluor today is about 81% cost-plus, only 19% fixed-price.
CBI was always unique in that, for many years, it bucked this trend and managed not only to survive but thrive in the fixed-price field. For this feat, the market rewarded its shareholders with a healthy return -- since 2000, about 19% annualized, and that's including the recent fall and not including dividends.
You can see why even the well-trained eye, indeed especially the well-trained eye, is likely to see this as a clear turnaround situation: the stock was hammered by a couple mistakes, but now we have this wonderful backlog. It is mostly fixed-price, and isn't that where CBI shines?
The trouble with CBI's backlog
CBI's backlog is BIG. The following table shows how the backlogs of some of CBI's competitors compare to their revenue.
Fluor has a rather large backlog in both absolute and relative terms, but only 19% of that is fixed-price. In 2002, when that percentage was much larger at 45%, the revenue/backlog ratio was also smaller at 1.3. CBI's ratio, as you can see, is dangerously high at 2.31, or $30 billion of backlog on $13 billion of revenue. Below you will see how the company's backlog has progressed in relation to its revenue over the last 15 years.
From 2007 to 2012, we do see a rising backlog/revenue. But this rise is not particularly worrisome because during this period, CBI, somewhat uncharacteristically, was moving toward cost-reimbursable contracts. In 2012, about 55% of its contracts were cost-reimbursable. In 2013, however, CBI went back to its old bread and butter. Fixed-price contracts became 65% of backlog, and 85% the following year, making it perhaps the biggest fixed-price backlog in the entire history of this industry.
About $16.8 billion of that backlog came from its acquiring Shaw. Remember Shaw, that serial acquirer, which was saved by CBI in 2013? It was in deep trouble then, and its backlog showed it. In 2011, it had a backlog/revenue ratio of 3.4! And let's not forget the now-defunct Stone & Webster, which in 2000 was bankrupt and was acquired by none other than Shaw. Stone & Webster had a ratio of 2.17 -- again, staggeringly high.
These numbers, and this history, should be of great worry to anyone who dare prognosticate the future based on backlog.
Why CBI's backlog is more worrisome than the nuclear contracts themselves
Previously, we focused quite heavily on CBI's troublesome nuclear contracts, mainly its contract with Georgia Power to build Units 3 and 4 of the Vogtle Electric Generating Plant. Here is what I wrote in my previous article:
"In 2013, after acquiring Shaw, CBI reported its highest net income ever in its long, century-old life: $454 million. (It has since been surpassed by the 2014 earnings figure.) It also reported its lowest operating cash flow ever -- a negative $112 million... the cost overruns related to the [nuclear] projects are not being recognized as losses. According to CBI, those are not really losses because contractually, they are entitled to be reimbursed for them, both by the owner [Georgia Power] and, if not by the owner, then by their partner, Westinghouse Electric. In the meantime, costs are being incurred and cash is flowing out, while non-cash earnings are being booked as assets."
Without a doubt these are money-draining projects. Just take a look at the rise in CBI's short-term debt, shown below quarter by quarter.
Although these numbers indicate a company in pain, I do not believe the nuclear projects themselves, injurious though they may be, will deal CBI the death blow that we all fear.
The benefits of moral hazard
The history of nuclear projects is checkered by cost overruns, brought on by regulatory delays, supply issues, and just the unforeseeable. The longer, the more difficult, and the more complicated a project is, the greater becomes the contractor's leverage over the owner, and this leverage only becomes stronger the further the project progresses. This is because after a certain point, the cost of switching to another contractor is pretty much impossible for the owner to bear. The nature of this relationship invites a considerable amount of "moral hazard."
For a prime example of this, look no further than the nuclear plants at Vogtle Units 1 and 2. These were predicted to cost $660 million and ended up costing $8.9 billion by the time they were completed in the late 80's-a miss of more than 1,200%! Nuclear projects are unpredictable -- but are they really that unpredictable?
Difficult as it is to project the cost of a nuclear plant, it might be impossible if the contractor has an incentive to understate that cost, and the contracting utility, which is usually regulated, has an incentive to tell its shareholders, and the public that, well, all this will be cheap enough.
And if the cost projections turn out to be wrong -- if bankruptcy threatens owner and contractor alike? Then, enter the state regulator – in this case, the Georgia Public Service Commission (PSC). This is the part of the story in which the regulator approves a rate hike, as Georgia PSC did in 1975 when Georgia Power faced bankruptcy while constructing Vogtle Unit 1. Sitting on that commission are commissioners, elected by the people of Georgia, and how dare they bankrupt Georgia Power, provider of jobs and energy? So it is very hard to be right if there is no penalty for being wrong.
What this amounts to is a sort of bailout that must in the end trickle down to the vendors: CBI and Westinghouse. The vendors will submit a change order (basically, asking for more money). The owner will vehemently refuse, and while refusing, petition the regulator to approve a rate hike. Then comes a flurry of lawsuits between the vendors and the owners, the owners and the vendors, and even the vendors themselves. It is a dance that has been repeated many a time, across many a project. But at the end of the day, the regulator cannot afford to bankrupt the owner and the owner cannot afford to bankrupt the vendor.
The nature of fixed-price contracting
What may eventually take down CBI are not the wounds brought on by the nuclear projects but its reaction to them. When a company endures the ordeals that CBI has experienced over the last couple years, there is an enormous temptation to disguise and deny the loss, first by accounting magic and then by writing more business -- by adding to the backlog.
The market likes a rich backlog, and CBI knows it. The market acknowledges CBI's prowess in the fixed-price field, and CBI knows that, too. It knows the market knows that it has always done well with the fixed-price contract, and that is why it never loses a chance to mention that fixed-price backlog, the very thing that might be its greatest liability.
The business of EPC contracting is similar in many ways to the business of insurance: the fixed-price contractor is a bit like an insurer who has chosen to forgo reinsurance. Both companies are unique in that they are primarily bet makers. Now, you may say, well, all businesses are bet makers. And you would be right. But some businesses can thrive on a single bet that was made for them in the past, usually by some dead genius, of whose creativity and luck, stakeholders now benefit. The contractor and the insurer, on the other hand, must make multiple bets, often, and in size. If they fail big, they have no brand or steady stream of cash to fall back on. They have only their capital. And more cash only comes from more bets.
In such a business, big mistakes often bring about bigger mistakes. Like a losing gambler who doubles down after losing a hand, management tries to recoup its loss by taking a risk it would have never taken had it not been injured in the first place. The logic of this is more inexorable in that it is not driven by logic, but nature.
There is a very high chance that CBI's management has already taken this unfortunate route. Interestingly enough, the nuclear contract with Georgia Power may end up prolonging CBI's life, propping it up at the public's dime. . But once it ends, then the deluge.