Investing in turnaround stocks can be quite profitable if you follow one simple rule: Only focus on companies that have identified the source of their woes and have delineated clear and workable solutions to stabilize and rebuild operations.
For struggling global construction firm McDermott International (MDR), the path to a turnaround has been spelled out for investors. Now it's time to execute on that plan.
A quick glance at McDermott's business model suggests this company should be flourishing. It has deep expertise in the construction of massive offshore energy platforms. In recent years, major oil companies have waded deep into the Atlantic Ocean as they seek to replace the output of fast-depleting onshore oil fields. For example, the Lula oil field off the coast of Rio de Janerio might hold up to 8 billion barrels of oil and is currently being developed by Brazil's Petrobras (PBR).
But McDermott has stumbled badly, thanks to a series of managerial missteps. Most notably, the company has been unable to complete contracts under budget, turning potentially profitable deals into money losers. That was the result of a decision to pursue deep water projects, straying from its core competency of shallow water projects.
Though McDermott has been underperforming for quite some time -- missing profit estimates in the final two quarters of 2012 and the first quarter of 2013 -- the recently released second-quarter results were bad enough to send shares down roughly 20% in just one trading session.
That was enough to lead to a shake-up at the company. A raft of senior executives, many of whom had oversight for regional projects in Asia and elsewhere, has been replaced. The company expects to take roughly $50 million in restructuring expenses, which should "mark the peak of near-term charges," according to analysts at UBS.
The company said it intends to revisit its past strengths. Referring to recent quarterly results on the Q2 conference call, CEO Stephen Johnson said, "We found that our processes and procedures were somewhat inconsistently applied throughout the organization and that management needs to improve adherence to our proven processes and procedures," adding that "more experienced and more skilled personnel are now being recruited, being trained and assigned to projects by our global operations management."
More importantly, McDermott has abandoned the practice of pursuing projects at any price to retain market share. Instead, the company said it plans to pursue new contracts that are priced to better reflect potential cost overruns. It will take 12-18 months for bad projects to roll off the books, but the move should lead to a rebound in profit margins.
According to Morgan Stanley, McDermott's EBITDA margins slid from 19% in 2010 to 12% in 2012, and thanks to a dismal first half of 2013, are likely to be slightly negative this year. Notably, these analysts think that newer contracts with sounder pricing will help EBITDA margins rebound to 8% in 2014 and 9% in 2015.
Of course, the only way to ensure solid pricing is a willingness to cease pursuing market share. That's why Morgan Stanley's analysts also see the company's order book falling from $4.8 billion in 2012 to just $3 billion this year and again in 2014. In effect, the company is willing to shrink to grow stronger.
If these changes yield the net result of improving cash flow in 2014 and 2015, look for investors to focus on what has become a deep value play. The company's market value of $1.8 billion is not far above tangible book value of $1.7 billion. And the company still carries roughly $400 million in net cash on its books.
As a solid vote of confidence, CEO Johnson recently plunked down $500,000 of his own money to buy the beaten-down shares.
I don't expect this stock to move back up into the mid-$20s, where it stood in early 2011. Not if management intends to shrink the company a bit in order to grow stronger. Still, a move up to $12, which would reflect a 2014 price-to-sales multiple of around 0.75, is quite reasonable. That's a fair price to pay for a company with broken but fixable problems that still faces a sizable market opportunity as offshore energy exploration trends continue to strengthen.
Recommended Trade Setup:
-- Buy MDR at prices up to $8.60
-- Set stop-loss at $6
-- Set initial price target at $12 for a potential 40% gain in six months.