BWNB - Babcock & Wilcox: Recent Dip Is A Good Buying Opportunity

Summary

• The revenue growth should benefit from the healthy demand trends in the company’s end markets and the Inflation Reduction Act (IRA).
• The margins should benefit from the improvement in the supply chain and operational improvement initiatives taken by the company over the last few quarters.
• The stock is a good buy for medium- to long-term investors.

Investment Thesis

Babcock & Wilcox Enterprises (BW) should benefit from the strong demand for energy security and alternatives to natural gas. The company is expanding its operations both domestically and internationally as a technology leader and solutions provider. The strong demand in its end market has led to an increase in identified global project opportunities, which have increased sequentially to $7.8 bn in the third quarter of 2022. This should help drive growth in 2023 and beyond. Many companies are investing in sustainable technologies to take advantage of tax credits under the Inflation Reduction Act (IRA), which should also benefit BW. The company's margin should benefit from the improvement in supply chain constraints as well as the operational improvements.

Revenue Outlook

The company's revenue saw good growth in 2021 and the first nine months of 2022 due to the higher level of project activity post-Covid as well as the acquisitions of Fosler (September 2021), Voda (November 2021), Fossil Power System (February 2022), and Optimus Industries (February 2022).

In the third quarter of 2022, the higher volume from increased activity levels along with the acquisitions benefited the revenue growth of the B&W Renewable segment. The company faced headwinds due to supply chain constraints and challenges due to the ongoing Russia-Ukraine military conflict. These issues negatively impacted the timing of revenue recognition on certain projects across its business segments. But despite these headwinds, the company was able to post 34.3% Y/Y growth with each of the three segments seeing good revenue growth. The demand level in the quarter remained elevated, resulting in healthy bookings and backlogs. The bookings increased to $227 mn, up 31% Y/Y and the backlog increased 35% Y/Y to $730 mn.

Looking forward, I believe the healthy order rate and backlog levels should benefit revenue growth in the near term. The company's segments should benefit from the strong demand for energy security and alternatives to natural gas. BW is expanding its operations both domestically and internationally as a technology leader and solutions provider. The strong demand in its end market has led to an increase in identified global project opportunities. The potential bidding opportunities have increased to $7.8 bn in Q3 '22 from $7.5 bn in Q2 '22. This should help drive growth in 2023 and beyond. In addition to these healthy demand trends, the global initiatives around hydrogen and decarbonization should also benefit the company in the near term as well as in the long term.

BW should also benefit from the Inflation Reduction Act (IRA). Most of the companies in the U.S. as well as internationally want to leverage 45Q and 45V or some other credits under this act. The first is a substantial increase in the value of the existing tax credit for carbon sequestration (removing carbon from the environment and storing it), which is used to make "blue" hydrogen. The second is a tax credit where the value of the credit is based on life cycle emissions. Additionally, there are various grants coming from different U.S. states, which should have a positive impact on the company. The company should benefit from secular growth trends in sustainable energy, especially in hydrogen. BW's BrightLoop Technology is able to create hydrogen from biomass or biofuels. The company should be able to leverage this product to take advantage of the 45Q or 45V tax credits. BW is working with various clients on the pre-engineering side of hydrogen production.

I believe the company's revenue should benefit from the demand trends in energy security as well as from the increase in identified global project opportunities. Additionally, the company should also benefit from the investments made by companies in sustainable technology under the IRA. The company is well positioned with its products to take advantage of the developments in sustainable technology.

Margin Outlook

The company's margins have benefited from the improvement in volume growth and favorable project execution in recent years. However, of late, the war in Ukraine and supply chain disruptions are presenting challenges related to project delays as well as delays in parts deliveries. This negatively impacted adjusted EBITDA margins in Q3 2022 which declined 570 bps Y/Y to 6.1% in Q3 2022.

Looking forward, the company is working on tackling these supply chain challenges and has made some progress in its parts and services business in North America. Answering a question on its last earnings call , the company's CEO and Chairman talked about rebounding parts and services business in Q4. Below is the relevant excerpt,

So as we go into Q4, in particular, within the parts and services business in North America, we're starting to see the revenue rebound back. It's only because now we're catching up with where supply chain is as it relates to those parts, and we're able to get those parts out the site, meet some of the outage work and service work that's starting to increase."

The parts and services business is a higher-margin business and the improvement in this business should benefit the margins.

Additionally, the operational improvements from restructuring and other cost-saving initiatives should benefit the margins. Through its restructuring efforts, the company has made progress toward making its cost structure variable and reducing costs. While the issue of project delays, particularly in European markets is expected to linger for a couple of more quarters, I am optimistic about the long-term margin prospects as most of the issues BW is facing are transient in nature.

Valuation & Conclusion

The near-term margin concerns have led to a meaningful correction in the stock price after the company reset its EBITDA expectations for the current year lower. The sell-side EPS estimates have also corrected accordingly.

However, I believe as the company makes progress in terms of addressing these challenges over the next few quarters, investor sentiment may improve and the stock will likely see a rebound. The company's growth prospects look good and revenue should benefit from the healthy demand in its end markets. Additionally, the Inflation Reduction Act should provide opportunities for the company, as many corporations are investing in sustainable projects to take advantage of tax credits under the IRA. The stock does not look cheap trading at 23.49x FY23 consensus EPS estimates, but if one has a slightly longer investment horizon and can wait till FY24 when most of the analysts are expecting margin headwinds to wane, the stock may give good returns. The stock is trading at 13.37x FY24 EPS estimates. I believe investors with a medium to long-term horizon can consider buying the stock at the current levels.

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