Sunday, September 21, 2014

Dividend Growth Investment Chicago Bridge and Iron


A month has gone by, a new paycheck has arrived meaning more cash to be invested. The latest month was particularly work-intensive, but by keeping the  goal of building up equity in high quality businesses in mind, each paycheck feels twice as rewarding, as it represents one more stone to build my castle. 

My purchase this month was Chicago Bridge and Iron (CBI) which is a very ironic name - The company is not based in Chicago, does not build bridges and does not use iron. This is a somewhat odd purchase for me, as their dividend has a small track record and is only 0.45%. However, for me a stock is just a document that represents ownership in the actual underlying business, meaning that the principles for my investment approach are - "Would I like to own this business if I could purchase 100% of it? If so, how much would I be willing to pay?", the spread between the current business valuation and how much I would be willing to pay, is the driving force for my decision.

CBI is what I would call an oil services and support company as it provides services specifically tailored to the oil industry. This is an industry where I see great potential going forward. As the world population increases and a significant number of people are raised from poverty into the middle classes in emerging economies, we will observe a gradual energy demand increase to sustain this transformation. 

Combine the increased energy demand with the fact that it is getting more expensive to find sustainable oil and gas reserves and renewable energy sources are far from being mature enough to represent a significant percentage of the worldwide energy consumption and we start seeing a promising context emerge. 

CBI is perfectly positioned to capture this market, the main services and products provided by the company are: 

  • Technology for facilities, refineries and processing plants
  • Engineering, construction and maintenance of infrastructure for the oil and gas industry
  • Piping solutions, storage tanks and vessels for oil and gas

One subtle advantage they enjoy, is the fact that they provide services and products accross the whole supply-chain of the Oil&Gas industry. They cover upstream, midstream and downstream. In an industry where many of its clients operate accross the whole supply-chain, this gives them a strong opportunity to cross-sell their services and products. For example, they might win a contract for downstream work and upon building a relationship with the client, they might win further work on the upstream. Currently, they are the only company in this industry with this advantage. The success of this model captured the eye of other similar companies such as AMEC (AMEC), a company I also own, that will go through with the purchase of Foster Wheeler (FWLT) by year-end to be precisely able to offer solutions across the whole supply-chain.

While this indeed draws a nice picture, let's look at actual numbers, and this really shocked me. CBI is a company currently valued at $6.6B market cap, while boasting a backlog of work of $30.7B. That's right, thirty billion dollar backlog for a company valued at roughly 6 billion dollars. Even considering an optimistic estimation from their part, and an and inability to handle some of that work, there's clearly a lot of growth to be achieved just by capitalizing on already "guaranteed" work.

As many of you are probably aware, the reason why this great company is trading at such a significant discount to its usual price is due to accounting concern raised by a short seller called "Prescience Point". They provide their report online in case you are interested in reading their view. The report is quite lengthy so I don't want to focus on its content step by step. The main factor that scared most investors is that CBI currently presents growing earnings but negative cash flow, and so I will provide my view on that issue.

Looking at the cash flow statement from Morningstar we can see that the net income is progressing strongly at roughly 29% CAGR. What's causing the negative operating cash is a significant deficit in the working capital of the company. 



This by itself might mean many things, some of them are worrisome such as the company not being able to collect the payments for its services and some of them are not so worrisome, such as the company keeping a very efficient supply chain. 

In the case of CBI the supply chain efficiency is not a very plausible explanation at all, considering it is mostly a construction services provider. Since the working capital is current assets - current liabilities, the answer to this issue is on their balance sheet where current assets and current liabilities are detailed. 

The detailed current assets for 2013 can be seen in the imagine below:





The area highlighted shows the major cause of the high current liabilities and the reason why working capital is negative. This kind of balance sheet entry is quite typical of a construction company that has contracts on a project completion basis. This works in the following way, a company, like CBI, accepts construction projects and agrees to be payed based on the percentage of project completion, which means, if 20% of the project is completed, the client pays 20% of the total amount of the project cost. Of course gauging what exactly constitutes 20% of a construction project is hard, so more often than not, the construction company ends up either receiving more or less than the percentage of completion. A simple example where this can happen is when the company receives a small percentage upfront before starting the project.

In the case where the company receives less than the percentage of the project completed, that value will go into the assets as "Cost in excess of billings" thus being added to the cash flow, because even though the company did not receive that money yet, it already completed the construction milestone necessary to receive it. In the case the contrary happens, and the company received more payment than it has completed, this will show in the liabilities section "Billing in excess of costs". Even though the company received that money already, it did not yet complete the correspondent part of the work and as such is not allowed to include that cash in the cash flow. 

It is very common for companies who have a lot of new projects or just starting projects to have high current liabilities (Billings in excess of costs) because they tend to take a percentage upfront to help supply capital to ramp up the construction. There is obviously no guarantee that CBI will be able to deliver on these construction projects and so, it is indeed possible that not all of the cash currently billed in excess of costs will actually be received. However, let's assume that CBI actually fails to deliver (which I do not consider a likely possibility), and let's assume that Prescience Point is actually right and CBI failure results in the -$1.6B loss they propose. So, we assume that out of the $2.7B that CBI would be allowed to declare as cash, they will only receive the remaining $1.1B. I also assume that the projects accounted for in "costs in excess of billings" will also be successful, so I will count that cash as current assets. This would lead us to a positive working capital of around $250M. 

So, assuming CBI was allowed to account for this cash, finished their projects successfully as they historically have, and was indeed masking a -1.6$ loss, it would still lead to around $800 operating cash flow, which in my opinion is more than enough cash to proceed with operations and I don't see this as being an issue.

Disclaimer: I am not an accountant nor am I a specialist in this field. This article expresses my view after extensive research. There is still a probability of this being wrong or incomplete and you should not take this as professional advice.

Even though I do not particularly appreciate appealing to authority, I find it reassuring that Berkshire Hathaway (BRK.A) has a sizable stake in the company. When Berkshire invests in a company of this size, they actually send people to the physical offices to see how things are done and to ask questions directly to the management, and while they might be wrong about the company's long term perspectives, I strongly doubt they would let such an accountancy issue go unseen.


Stock Price: 62$
Dividend Yield: 0.44%
Dividend Raise Streak: 1 Years
Typical Yearly Dividend Growth (5yr): Doesn't increase every year
CAGR Dividend Growth (10yr): 13%

This company was more of a buy based on valuation than for the dividend itself, I just felt it was too good of an opportunity to pass on. Would you consider buying a big bargain if the dividend history is kind of wonky?

20 comments:

  1. Thanks for sharing your recent purchase of CBI. This is a stock I have heard of but never really looked into before. I appreciate you highlighting your recent purchase and stats about this company. It's definitely a name that is not popular among any of the dividend bloggers out there. Look forward to your updates about your dividend income and seeing how this investment works out for you. Thanks again.

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    1. Hi DivHut,

      Thanks for stopping by! I was in the same boat as you until recently, the sharp drop really caught my eye. It's not a common dividend investment for sure, but I have great expectations for them, let's see how it pans out.

      Best,
      DividendVenture

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  2. What a great write up and explanation of percentage of completion accounting. Not too many folks can wrap their head around it and you've explained it quite well. While CBI is not a position on my watchlist, I hope it works out well for you moving forward!

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    1. Hi writing2reality,

      Thanks for the feedback! I became acquainted with this method while analyzing CBI, I always find incredible how much I learn as I study different industries and companies.

      I'm not surprised that you don't have CBI on your list, it's a very unconventional pick for a dividend-based portfolio, let's see how this goes.

      Best,
      DividendVenture

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  3. Interesting stock and thanks for introducing it to me. Seems pretty solid. Good that Buffet is behind it as well

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    1. Hey Asset-Grinder,

      Thanks for stopping by! In my case I took notice of it because Berkshire disclosed an investment in it, but after I did my due diligence I was very impressed with what I was seeing and with the valuation of the company. Glad you enjoyed it

      Best Wishes,
      Dividend Venture

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  4. I've heard of CBI when Buffett disclosed his stake, and again when the accounting issues were made public. I never really did research on the company because of the lack of dividend streak though. I do have to say, your analysis was solid, so I may look at the company in more detail myself. And similarly, I just looked at FAST Graphs, and CBI looks solidly undervalued based on its "normal"/market premium and intrinsic P/E ratios.

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    1. Hi DividendDeveloper,

      Thanks for dropping by! I also heard of CBI for the first time when Berkshire disclosed an increased stake in the company. It really took me by surprise because I usually scout for opportunities and the company had such impressive metrics of ROE, EPS growth and a P/E of 12.

      I was put off at first because of the lack of dividend streak, but it stayed in my head until I finally did some research and ended up being tolerant about that, because even though they didn't increase every year, they never cut their dividend and their growth is equivalent to yearly increases of 13%.

      Best,
      Dividend Venture

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  5. Hi Dividend Venture,
    I just found out about your site today, very good review and well put together. I put CBI on my watchlist ever since BRK purchased stocks on this company, I would love to invest in this company but it doesnt qualify on my entry criteria yet, hopefully in few years down the road. I am very impressed with your age and knowledge, you already looking towards the future! Most young people are living the most at this stage in life. I wish I started investing as early as you are! Good luck in your journey!

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    1. Hi Ogie,

      Glad you enjoyed the article! I also appreciate the compliment, and I tell you, I feel like I am living the most . I do not have particularly expensive habits and I really enjoy buying stocks, stocks for me, are like a new Iphone for most people, so that leaves me pretty happy :)

      Best,
      Dividend Venture

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  6. DV,

    Interesting pick!

    I like the infrastructure/energy play, as that's my line of thinking in regards to GE. Totally different businesses, but same long-term theme.

    The yield here is too low for me to personally get interested, but you have to acknowledge the value. The stock is down some -40% YTD, which has led to a P/E ratio of ~10. If you're even half right, that's a coiled spring. And having Buffett on your side with his enormous DD resources means you're probably closer to 100% right. Looks like a solid play! :)

    Best regards.

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    1. Hi DM,

      I feel you on the low yield. I just received a dividend from CBI and it was so low it really made me think twice about holding this stock long term or just wait until it reaches fair value and sell it. Let's wait and see how this pans out!

      Best,
      DividendVenture

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  7. Hi DV,

    Very good pick. I have enjoyed reading it was so detailed. I can understand why you bought it.

    Wish you the best of luck.

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    1. Hi I Will Be Done By 50,

      Thanks! Glad that it was so clear, I'm hoping this article clears some of the doubts around CBI for many people.

      Best,
      DividendVenture

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  8. In the case where the company receives less than the percentage of the project completed, that value will go into the assets as "Cost in excess of billings" thus being added to the cash flow, because even though the company did not receive that money yet, it already completed the construction milestone necessary to receive it. In the case the contrary happens, and the company received more payment than it has completed, this will show in the liabilities section "Billing in excess of costs". Even though the company received that money already, it did not yet complete the correspondent part of the work and as such is not allowed to include that cash in the cash flow.

    Can you explain this further? I'm having trouble wrapping my head around it. How does an item that does not involve cash get added to the cash flows while an item that DOES involve cash get excluded? This seems counterintuitive to me.

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    1. Hi Anonymous,

      Sure! I also had trouble grasping the concept at first because it seems so counter-intuitive and some of the sources about this are actually wrong and confuse both terms.

      The reason for this is that even though cash flow has "cash" in the name, it doesn't really represent how much cash you have at that point, instead it represents how much cash you will have as a result of that year's business activity.

      Since you are payed based on percentage of completion it means that when you complete 20% of the work you should have 20% of the payment. But let's say that you completed 20% and already charged 30%. While you indeed have the money already, in the future you will have to complete the remaining 80% of the work for only 70% of the total pay (because you already received 30% of the total) and so you are forced to mark those 10% extra as a liability until you actually complete that extra 10% work.

      The same thing happens the other way around, if you have done 20% of the work and only received 10% of the pay, you can be confident you will receive the extra 10% as it relates to work already successfully completed. So it is added as an asset and increases your cash flow. Remember that cash flow, is not the exact amount of cash you have at the time, but represents how much cash you are expected to generate from that year's activities (hence why accounts receivable are taken into account in working capital and thus in cash flow).

      This is the main reason why CBI has strong earnings and negative cash flow, they are receiving a significant amount of money in advance for their projects that is then discounted as a liability until they progress their projects. This is very normal in a company that is getting a lot of new work and receives a small lump sum upfront.

      Regarding construction companies, when it's the other way around is when you should get concerned. If they have a bad earnings and a huge cash flow it means they are either not getting payed for the work they do, or they are not getting any new work.

      Hope it helps,

      Best Regards,
      Dividend Venture

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  9. I know you say you're not an accountant and neither am I but I don't think what you said is right. I'm long CBI and have been reading the footnotes. I'm not trying to stir the pot or create an argument I just want to reason it out so we both have a correct understanding. I think basically everything you said is the opposite. First of all cash flow is basically a reconciliation of the start of the quarter cash to the end of the quarter cash, therefore it absolutely represents how much cash you have. If you read the 10-k it says they basically have two types of projects. Reimbursable and fixed price. Fixed price they get the cash upfront as is cash flow positive therefore to align with your examples they do 0% of the work and get 20% of the cash. So that's cash flow positive not negative. And reimbursable is just the opposite. Let me know if this makes sense as after digging into the 10k and 10q's I feel pretty confident on this (just did this the past few days after I posted my first comment).

    So the cash flow really is bad there is no way around that. Why I am long is because they claim this is due to the mix of reimbursable vs fixed price projects they are doing. I wish they gave more details but they don't so that's the info I have to decide on. 1. This as happened before and the cash flow eventually recovered so that gives me some confidence. 2. The backlog is heavily fixed price projects compared to prior times so that should help return to positive cash flow.

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    1. Hey Anonymous,

      I very much appreciate this debate. Since I am not an accountant and I do have a position, I have all the interest in figuring this out.

      Regarding cash flow, in the quarterly example you provided, it represents the net cash position resulting from business activity in that quarter, but it doesn't mean that the company already has that cash in its possession. Working capital is factored in the cash flow calculations and it includes both accounts payable and accounts receivable, which represent cash that the company will have to pay and cash it will will have to receive in the short-term (usually around 90 days).

      Regarding the contracts, what you describe are two different kinds of long-term contracts they engage in.
      Percentage of completion like I described is an accounting standard that is independent from the kind of long-term contract they are in, and is used to allow them to recognize the revenues of on-going projects.

      The refer that in their report:

      "Revenue Recognition—Our revenue is primarily derived from long-term contracts and is generally recognized using the percentage of completion (“POC”) method, primarily based on the percentage that actual costs-to-date bear to total estimated costs to complete each contract. We follow the guidance of Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Revenue Recognition Topic 605-35 for accounting policies relating to our use of the POC method, estimating costs, and revenue recognition, including the recognition of incentive fees, unapproved change orders and claims, and combining and segmenting contracts."

      The "Billings in excess of costs" and "Costs in excess of billings" are well defined standards of POC accounting. While in my post I might have not succeeded in making sense out of them, they do work the way described, even if it's counterintuitive. The best source I found that sums this up is http://www.wikinvest.com/stock/Manitowoc_Company_(MTW)/Revenue_Recognition_Percentage-of-completion_Accounting . They cite official documentation only including the relevant part.

      They cover a bit of this in their report as well, although in a fairly convoluted language: "Cumulative costs and estimated earnings recognized to-date in excess of cumulative billings is reported on the Consolidated Balance Sheet (“Balance Sheet”) as costs"

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    2. Just a few definitions to start:

      "In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities."

      "Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities and commercial paper."

      And you are correct that working capital is included in cash flow calculations but it is not included as cash. It is used as an adjustment from NI to CF. If they have NI but it was from an increase in accounts receivable then it will be deducted to show the actual CF. So when Other working capital is (1147) on the cash flow statement that means that that account increased 1147 which shows up in the income statement, but no cash was received. Eventually that money should show up in the cash flow statement but it wont be added to the income statement when it does. This is occurring because of timing of payments and also as a company grows its working capital usually grows.

      For example, my understanding is that if CBI completes 20% of a project but has gotten no payments nor billed the company then it will show up as an asset in "Costs and Estimated earnings in excess of billings". When they bill the company, but before they pay, this $200 gets moved to accounts receivable. And once they finally pay it shows up in cash.

      Costs and Earnings.... Accounts Receivable Cash
      Changes to NI 200 0 0
      Changes to CF 0 0 200

      Hopefully that table shows up alright. But basically when they say they've done 20% that is when they get to recognize the revenue and earnings. However they do not get to recognize the cash flow until they actually receive the cash. That is where their contract types come in. If they are heavily in reimbursable projects right now then they are going to be recognizing all this revenue and earnings without having being paid the cash. This situation shows up in the cash flow statement.

      As this relates to the investment thesis, we do not really have a way to confirm that this is the case. If this is true and it just has to do with the timing of the contracts then eventually CF will exceed NI.

      Wish we had an accountant to settle this...

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    3. Hey DividedVenture, I didn't quite settle our discussion but I made my first post on seeking alpha about CBI and discuss the negative cash flow to some depth if you want to check it out. http://seekingalpha.com/article/2660735-chicago-bridge-and-iron-temporary-negative-cash-flow-leads-to-golden-opportunity

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