Babcock: The Market Did Not React To The Decline In The Oil Price

Babcock & Wilcox Enterprises (BW) is executing a turnaround, and the market expects profitability in 2020 and 2021. However, minority shareholders may not benefit from the expected EBITDA increase. I am worried about the recent increase in the share count and new convertible securities. Additionally, the market has not reacted to the decline in the oil price, which will most likely damage Babcock’s sales. Finally, I sincerely hope that the company finds new financing to continue its operations.  

The Decline In The Oil Price Could Damage The Business Model

In April, most investors sold shares of oil companies when the oil price collapsed. That’s not all. With a diminishing demand for gasoline, oil and gas companies expect a decrease in 2020 sales. They are selling less and at a smaller price than in 2019.  

The market did well by selling oil & gas stocks. However, in my view, not many investors executed due diligence on other industries and corporations suffering from the decrease in oil prices. One of these stocks is Babcock & Wilcox Enterprises. As a result of the coronavirus, in March, the share price declined from $4 to $1. Notice that the company was seriously impacted by the spread of the coronavirus: 

“Our business has been adversely impacted by the measures taken by local governments and others to control the spread of this virus. Our headquarters and the headquarters of our Babcock & Wilcox segment in Akron, Ohio, the headquarters of our Vølund & Other Renewable segment in Denmark and the headquarters of our SPIG segment in Italy (among other locations where we and our customers, vendors and suppliers operate) are currently subject to lock-down or shelter-in-place orders under local ordinances, with employees continuing to work remotely if possible. While some of our employees can work remotely, many of our customers and projects require our employees to travel to customer and project worksites.” Source: 10-k 

With that, I am unable to explain why the share price did not decline one month later. Oil futures went to negative territory, but the company’s share price stayed at $1.9-$2.05.  

Babcock & Wilcox offers custom technologies, aftermarket services, and engineered solutions to various power generation and industrial clients. The company’s most relevant clients operate in the energy, oil, petrochemical, and renewable industry.

In 2019, Babcock & Wilcox segment generated 80% of the total amount of revenue. This segment offers services for power generation. Given the most recent oil price collapse, I expect that the power generation industry will suffer a decline in revenue. As a result, Babcock & Wilcox Enterprises will most likely suffer a decline in sales. 

In its most recent annual report, Babcock & Wilcox Enterprises noted that volativel oil and natural gas prices would push demand for the company’s products down. Taking into account this fact and the decline in the oil price in April and May, I believe that there is downside in the share price:

“Demand for our products and services has been, and we expect that demand will continue to be, subject to significant fluctuations due to a variety of factors beyond our control, including macroeconomic and industry conditions. These factors include, but are not limited to, the cyclical nature of the industries we serve, inflation, geopolitical issues, the availability and cost of credit, volatile oil and natural gas prices, low business and consumer confidence, high unemployment and energy conservation measures.” Source: 10-k

Diminishing Sales, But Massive Cost Cutting

Babcock & Wilcox Enterprises is undertaking a turnaround of its business, which started way before the coronavirus hit. The income statement shows a decline in sales since Babcock sold several business units. 2019 sales were 19% less than 2018 sales. In the same time period, costs of operations declined by 26%, and restructuring activities were equal to $11.07 million. Babcock & Wilcox is really working hard to push its profits up. As a result of the company’s efforts, the operating loss increased from -$426 million to -$29 million.       

A quick look at the bottom line reveals that interest expenses increased significantly in 2019. It may be a concern for conservative investors. With that, the company is still not reporting positive net income. Babcock lost $121 million in 2019, $3.87 per share.

The market consensus is that sales will decline to $567 million in 2020, and EBITDA will creep up to $21 million and $62 million in 2020 and 2021 respectively. Given the efforts made in 2018 and 2019, I do believe that the company could be profitable in two years. Even if the oil price does not increase from its current level, in my view, Babcock & Wilcox will most likely be profitable. Keep in mind that the company is selling non-performing business units. With that, perhaps, shareholders may not profit from the turnaround. Shareholders should monitor the share count, the amount of debt, and the actions of management. That’s what matters on this name.    

The Financial Position Is Worrying – The Coronavirus Did Not Help 

As of December 31, 2019, cash and cash equivalents were equal to $43 million. The most significant assets are accounts receivables, equal to $165 million, and contracts in progress worth $91 million. Babcock doesn’t seem to be paying very fast. Thus, the company had to finance its operations with a significant amount of debt.  

Including the revolving credit facilities, the term loans and the pension liabilities, I get a total sum of $571 million. It is way below the current amount of cash. Besides, notice that the company’s asset/liability ratio is under one. Conservative individuals may pass on the company because of the current financial position.

The most worrying about Babcock’s financial situation is the sale of business units. I believe that the company is very desperate to obtain cash. In 2019, the company sold a material handling business in Germany for $11.4 million. According to the 10-k, the business sold generated $30 million in revenue. In my opinion, selling businesses for 0.38x sales does not look good.

“Effective May 31, 2019, we sold all of the issued and outstanding capital stock of Loibl, a material handling business in Germany, to Lynx Holding GmbH for €10.0 million (approximately $11.4 million), subject to adjustment. Prior to the divestiture, Loibl was part of the Vølund & Other Renewable segment and had revenues of approximately $30 million for the year ended December 31, 2018.” Source: 10-k

In the last annual report, Deloitte, the auditor, noted that the company would continue as a going concern. It was clearly stated by Deloitte that from May 11, 2020, the company would need to refinance its financial obligations.

As of May 12, 2020, Babcock & Wilcox Enterprises communicated that it was preparing an announcement of an agreement with creditors. In my view, even with a new debt agreement, the total amount of debt is very significant. Bankers are taking over the company. Minority shareholders will most likely lose money on this stock.

Risk Of Dilution And A Reverse Stock Split

When bankers take over a company, many times it does not go bankrupt straight away. Instead, the company issues a significant amount of convertible securities like warrants, convertible debt, or equity rights, which gives the company a small amount of time. However, it reduces the intrinsic valuation of each common stock. Babcock & Wilcox Enterprises appears to be exactly at this point in time. 

The company issued warrants and non transferable subscription rights to acquire a significant amount of shares:     

“On July 23, 2019, 1,666,667 warrants were issued to certain entities affiliated with B. Riley in connection with the Equitization Transactions described in Note 19. Each warrant can be converted to one share of our common stock at an exercise price of $0.01 per share. As of December 31, 2019, all 1,666,667 warrants remain unexercised.” Source: 10-k

Notice also that debt holders are receiving shares in return. The company commenced to convert debt into equity. It is quite worrying. Minority shareholders may see an increase in the share count in the next few years. Yes, it does not matter that EBITDA increases in 2020 and 2021. If the total amount of shares increases, the share price will most likely decline.

On the top of it, in 2019, Babcock & Wilcox Enterprises executed a reverse stock split. Instead of focusing on building a better business model, Babcock pushed the share price up by reducing the total amount of shares outstanding:

“On July 11, 2019, the Company’s board of directors approved a reverse stock split of one-for-ten on the Company’s issued and outstanding common stock which became effective on July 24, 2019.” Source: 10-k

Shareholder Class Action Litigation And SEC Investigation

I also discovered a shareholder class action litigation against Babcock & Wilcox Enterprises, which shareholders need to know. The plaintiff alleged fraud, and misrepresentation. As a result, the company paid $19.5 million to several investors. I wonder whether many more shareholders may receive money if they start an additional class action   

The SEC is investigating the case, in which Babcock & Wilcox decided to pay $19.5 million. If the SEC decides that the company needs to pay more money, the share price may decline even more:

“The U.S. SEC is conducting a formal investigation of the Company, focusing on the accounting charges and related matters involving the Company’s Vølund and Other Renewable segment from 2015-2019. It is reasonably possible that the SEC may bring one or more claims against the Company and certain individuals. Due to the stage of the investigation, we are unable to estimate the amount of loss or range of potential loss of any claim. However, there can be no assurance that such claims will not have a material impact on the Company.” Source: 10-k

Related Party Transactions – Debt Holders Took Control

Investors need to study carefully who appointed the directors in the Board. In this particular case, it is very relevant. One shareholder owns approximately 17% of the share count and a significant amount of debt. This large shareholder pushed the company to hire the current CEO. Please notice that the CEO of this financial institution is also the CEO of Babcock & Wilcox Enterprises. I see a lot of conflict of interests arising from the current situation.

Another financial institution is holding 33.9% stake in the company and is also owning term loans. Minority shareholders should be aware of the clear conflict of interest. I wonder whether the company’s debt agreements with these institutions were in the best interest of Babcock & Wilcox Enterprises and its minority shareholders:

Conclusion

Minority shareholders may be in trouble. Firstly, the decline in oil price didn’t create a decline in Babcock’s share price. It may happen in the following months. Additionally, the market believes in the company’s turnaround. The EBITDA may increase in 2020 and 2021. However, with the increasing share count and the current debt level, minority shareholders may not see an increase in the share price. Finally, two large shareholders own a significant amount of debt. I believe that many conflicts of interest can arise from this situation.  

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Babcock_ The Market Did Not React To The Decline In The Oil Price

Disclosure: I don’t hold shares of Babcock

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