BWNB - Babcock & Wilcox: Here's Why The 12% Yielding Baby Bonds Are Too Risky

2023-09-19 06:08:29 ET

Summary

• Babcock and Wilcox's baby bonds are trading at a discount, offering higher yields compared to their peers.
• The company has seen financial improvements in 2023, but interest expenses outweigh operating gains, resulting in a net loss.
• BW's balance sheet raises concerns as its assets are entirely leveraged, potentially eroding the recovery value of the baby bonds.

Babcock & Wilcox ( BW ) is an energy technology and services provider that focuses on clean energy solutions. The company's senior notes trade on an exchange as baby bonds with ticker symbols. The 8.125% coupon bonds due in February 2026 ( BWSN ) are trading at 96 cents on the dollar at 10% yield to maturity while the 6.5% coupon bonds due in December 2026 ( BWNB ) are trading at 84 cents on the dollar and yielding 12.75%. The bonds are not rated by S&P or Moody's, but Egan Jones has rated them BB , placing these bonds at a higher return over their peers. Based on my review of the company financials, I believe investing in Babcock & Wilcox debt is too risky even at these prices.

Babcock & Wilcox has seen financial improvements so far in 2023. Company revenues have grown by $137 million compared to the same period last year. The company's expenses have grown this year by $126 million, led by the variable cost of operations (or cost of goods sold) and increases in selling and general administrative expenses. Either way, operating income swung from an operating loss to an $8 million gain during the first half. Unfortunately, the company's operating income is transformed into a net loss by interest expenses that are three times larger than the gains.

The company's balance sheet raises additional concerns. While current assets have grown nicely without any increase in debt, it's important to note that the corporation's assets are entirely leveraged, led by the $335 million senior notes. While Babcock & Wilcox has borrowing capacity within its loans payable and revolving credit facility, these classes of debtholders fall senior to the senior notes. Should the company need to borrow additional funds from these lenders, it will subordinate the holders of the baby bonds and erode their recovery value.

An examination of the company's cash flow statement confirms that Babcock & Wilcox may need additional financing soon. Despite a financial improvement in 2023, the company burned $22 million in operating cash in the first six months, more than $27 million if including capital expenditures. While operating cash flow is $40 million higher than a year ago, it is a direct result of a $40 million increase in accounts payable, meaning there will likely be further cash flow headwinds in the second half of the year as the company's vendors will want to be paid. The company also has preferred shares accounting for $15 million per year in dividends, an additional cash flow obligation.

Babcock & Wilcox's burning of cash has me hesitant to buy the company's baby bonds. Obviously, I'm also not a fan of the company's preferred shares (BW.PA) currently paying a dividend yield of 10.7%, as they are junior to debt in the capital stack. In order to change my position, I will need to see free cash flow generation that would reduce the company's need for additional debt.

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