New CEO, New Approach for Chicago Bridge & Iron

No-moat global engineering and construction firm

Chicago Bridge & Iron CBI has announced that Patrick Mullen will replace Philip Asherman as CEO effective June 30. We believe new leadership will begin to reverse negative sentiment following a rocky stretch of poor execution, cash shortfalls, nagging lawsuits, and sizable share price declines.

Asherman has been CEO for 12 years, but in recent years he had become something of a lightning rod for investors, in our opinion. His growth-first approach to project bidding and capital deployment has had mixed success. His $3.9 billion acquisition of Shaw Group in 2013 ($2.2 billion net) led to a $1 billion write-down and high-profile lawsuits involving the sale of Shaw's nuclear construction unit to Westinghouse. Project execution has been erratic as well, as reliance on subcontractor-heavy workforces boosted revenue at the cost of weak productivity, including multiple upward cost revisions on certain projects.

Mullen came to CB&I via the 2007 acquisition of technology licensor Lummus Global. He ran the technology and E&C segments at CB&I before being named COO in September 2016. We suspect Mullen will attempt to reduce risk and improve execution while retaining the company's core competitive strengths.

Some low-hanging fruit may be found in lowering reliance on potentially volatile fixed-price contracts and nonemployee labor, the primary sources of recent cost overruns. We think execution can be addressed via careful project selection and reliance on captive labor. An estimated $700 million in proceeds from the imminent sale of CB&I's capital services unit will comfortably address all covenant issues and pare debt. And while the dispute over the 2015 sale of its nuclear construction unit to Westinghouse is unlikely to end soon, our base-case estimate is that the settlement value of post-closing adjustments is $0.

We believe Mullen will keep CB&I's integrated services model, which combines technology, engineering, fabrication, and construction services as a single offering. It's a one-stop-shop model increasingly popular with customers that are uncomfortable dispersing contractor responsibilities too widely on their major capital investments.

An E&C firm's chief asset is its ability to win contracts in its core markets, and here energy-focused CB&I is performing well. In recent weeks, it has won significant awards in petrochemicals, power generation, and technology licensing for refining and chemicals production. The $2.8 billion value of first-quarter new awards was an 18-month high. While energy prices remain in the doldrums, demand from cheap-energy beneficiaries seem poised to more than offset weak exploration and production demand.

Intense Competition Prevents a Moat
We believe Chicago Bridge & Iron lacks an economic moat overall. A fragmented industry structure and transparent bidding process for many standardized projects often lead to multiple bidders and intense price competition, especially during periods of slow project demand.

We believe CB&I's smaller technology licensing business and parts of its fabrication unit possess an economic moat, mainly based on intangible assets built on its patent estate, favorable reputation and record, or customer switching costs for larger and more complex projects. We judge that there is no economic moat in the firm's more traditional E&C areas, where smaller and less technically proficient rivals compete successfully on price or speed of completion or simply by leveraging existing relationships.

The order backlog of an E&C firm is one of its prime assets, with characteristics such as quantity, project type, risk assumption, and customer/partner relationships all important factors in assessing the overall quality of its book of business. It is also viewed as a measure of an E&C firm's ability to drive organic growth and, in turn, its overall competitiveness. CB&I's year-end 2016 backlog is roughly 1.8 times its annual adjusted revenue over the past year, which places it comfortably between peers Fluor FLR (roughly 2.5 times) and Jacobs JEC (roughly 1.5 times).

We believe this reflects CB&I's favorable reputation (certain customers may delay commencing a project if the delay means that CB&I can play a role) and its specialized skill set for handling complex multiyear projects in energy infrastructure. We think this trend is poised to continue as CB&I leverages its well-honed strengths in U.S. shale petroleum development and in the downstream refining, midstream, liquefied natural gas, and petrochemical sectors.

Direct global competitors for major energy and petrochemicals projects include privately owned Bechtel and publicly traded Fluor, Jacobs Engineering, SNC-Lavalin SNC , and AMEC Foster Wheeler AMFW . Competition also comes from the engineering units of many potential customers and partners, including global energy and chemicals producers, industrial gas suppliers, and technology licensors.

We believe customers with a complex or showcase project often prioritize execution skills and construction quality in an E&C firm over pure cost or speed of completion. In the case of an offshore oil production platform, LNG terminal, new ethylene cracker, or petroleum refining complex, the project may represent a multi-billion-dollar investment expected to operate 24/7 at high efficiency for decades. Once the facility begins operating, unexpected or extended downtime can prove costly or even halt production. This preference for reliability and quality of execution contrasts with that for many simpler, less critical, or incremental construction projects, where speed of completion and absolute project cost may take priority.

CB&I emphasizes its vertical integration and array of in-house value-added services. Success with many of CB&I's larger projects often requires a range of skills and tight collaboration among several different groups. Strategies that CB&I has implemented over time include broadening its fabrication capabilities and expanding its skilled labor force, elements that aid in its ability to coordinate and control work flow and thereby keep large projects on schedule.

Labor shortages have proved to be a limiting factor at energy and petrochemical projects in North America and elsewhere in recent years. The option for an E&C firm to use proven in-house services increase a customer's confidence in a project's successful completion. The benefits frequently grow over time as satisfied customers with demanding requirements return to CB&I when considering further developments.

Ethylene Cracker Expertise Benefits CB&I
Ethylene is the largest-volume petrochemical and is the key building block for a broad range of downstream derivatives. Success in securing and executing cracker projects often leads to further opportunities in downstream projects, debottlenecking/upgrading, and ongoing maintenance and supervisory services. We believe CB&I and Fluor are the two leading E&C firms in North American ethylene plant construction.

New U.S. Gulf and Middle Eastern crackers are largely based on feedstock ethane sourced from natural gas, as opposed to the larger and more complex crackers that run on crude oil-based naphtha prevalent in much of Europe and Asia. This is an example where the competition among E&Cs involves building less complex crackers, a skill in the wheelhouse of AMEC Foster Wheeler, Bechtel, Jacobs, and many others.

Apart from reputation and a history of successful cracker completions, CB&I's successful formula involves bundling its engineering, procurement, and construction services with the licensing of its leading ethylene cracking technology. Most other competitors, including Fluor and Bechtel, are partnering with independent technology licensors, potentially raising the potential for miscommunication or differing agendas. We expect that many ethylene producers would be naturally attracted by the bundling of a leading E&C firm with leading technology licensed by a captive provider.

CB&I's prefabrication units can manufacture certain portions of a project offsite for later delivery. Rising demand has driven the cost of a typical 1 million-metric-ton ethane-based ethylene cracker in the U.S. Gulf Coast from approximately $1.0 billion just before the shale boom to $1.5 billion-$1.8 billion currently, in part owing to a shortage of skilled labor at work sites. For projects involving space limitations either onsite or in areas where skilled labor is scarce and expensive, CB&I can access its own dedicated remote construction sites. In many cases, large portions of a final project can be prefabricated remotely and shipped in modules to the work site for final installation.

This strategy offers potential savings in labor costs and, where specialized skills are required, improved reliability. The technique appears especially well suited to brownfield expansions (for example, adding a second cracker to an existing complex with a cracker already in operation) as it can limit interference with a customer's existing operations.

In 2015, CB&I won EPC awards to build cracker and derivatives complexes for Shintech and the Lotte-Axiall joint venture in Louisiana. It was also awarded a FEED contract and technology process license by Total Petrochemicals in Port Arthur, Texas. CB&I now has three active cracker projects plus one FEED award; for comparison, there are four new crackers now under active construction by all other E&C competitors combined. Outside the United States, CB&I was awarded a leading role in the large Orpic cracker complex being built in Oman, a potential catalyst for additional non-U.S. project awards.

The U.S. petrochemical industry is undergoing a renaissance based on the availability of cheap and plentiful natural gas and natural gas-sourced ethane. Volatile crude oil prices have little effect on surging domestic demand to develop new ethylene crackers, methanol units, and nitrogen fertilizer plants, as well as LNG facilities and upgrades to existing refinery operations. In total, dozens of new world-scale projects in these areas have been proposed for the U.S. Gulf alone, each representing investments of $1 billion or more to complete. Not all will be built, in our view, and certainly not all will be built according to the original timetable. However, U.S. shale petroleum development promises to create substantial long-term demand for many of CB&I's leading capabilities in one of its prime markets. We expect CB&I to win its fair share of this substantial stream of new business.

Uncertainty Is High
E&C firms regularly confront a broad array of risks and uncertainties from multiple sources in their normal business, many beyond their direct control. While CB&I employs a full menu of traditional risk-management techniques, it remains exposed to large losses or revenue declines from multiple sources, in some cases for years after the physical completion of a project.

CB&I generates 70%-80% of sales directly from energy (exploration and production, refining, petrochemicals) and LNG. The large project scale and industry cyclicality create uncertainty regarding growth, profitability, and timing of cash flows. Volatile and declining prices for crude oil and industrial commodities can result in project delays, suspensions, or cancellations. Prolonged bouts of weakness raise issues of customer commitment and even solvency. Project and customer selection is critical, as CB&I specializes in the larger and costlier projects more dependent on long-term forecasts.

CB&I's Colombian refinery project illustrates the consequences of cost overruns. In February 2016, Colombian President Juan Manuel Santos called for a full inquiry into the $4 billion cost overrun at state-controlled oil firm Ecopetrol's Cartagena refinery, Reficar. CB&I has been the sole contractor for the upgrade and expansion of Reficar since roughly 2009. The original $4 billion budget has roughly doubled since then to $8 billion. Reuters noted that the extreme cost overruns threatened to become a national political scandal and tarnish the administration of Santos, who in turn requested information about Reficar project expenses from CB&I and another E&C firm involved in the project.

While CB&I contracted to perform the work on a cost-reimbursable basis (the contractor is not responsible for all or most cost overruns), we are uncertain about the direction the national investigation will ultimately take and whether CB&I will face any legal liability, or if it will consent to givebacks.