Wednesday, February 24, 2021

Technip Energies: FTI Spinoff, Forced Selling, Asset-Lite Business

Technip Energies (THNPY, ADR in the U.S.) is a recent spinoff of TechnipFMC (FTI). Technip Energies is an engineering firm that specializes in large downstream energy infrastructure project management, think multi-billion dollar LNG facilities in remote areas, floating LNG megaships and refinery buildouts. This is far from my area of expertise (if I really have any), I've had a few missteps in energy related spins before, but I think it presents an interesting special situation opportunity because:

  • Forced selling by both index funds (FTI was dropped from the S&P 500 index earlier in February ahead of the spinoff) and U.S. domestic oriented managers that can't hold the Paris listed/headquartered Technip Energies.  One data point around forced selling, the shares closed today at €11.26 in Paris, but $12.01 in the U.S. ADR.
  • Complicated percentage of completion accounting that makes the business difficult to analyze that may lead to some valuation errors, or obscure the attractive economics of the business.
  • Technip Energies is a surprisingly asset-lite "people business" despite the cyclicality of mega projects, their backlog (€13B) for the next several years is in place, they're guiding to mid-single revenue digit growth over the medium term and thus have no immediate concerns about growth trailing off, yet it trades for a ~15+% FCFE yield with what's essentially a zero net debt balance sheet.
Pre-spin TechnipFMC was the result of a merger between U.S. based FMC Technologies (original FTI) and French based Technip in 2017, primarily done to formally combine the two's subsea business that they had previously tied together in joint venture. That subsea business is now the parent, TechnipFMC, which retains the name and FTI symbol, along with the dual listing between the U.S. and Paris. The spinoff, Technip Energies, is almost entirely a legacy Technip business and will be headquartered and primarily traded in Paris. Originally, the spin was only going to trade overseas, but in the end the company decided to also include a sponsored ADR that would be distributed to U.S. holders of FTI. But the ADR shares will trade over-the-counter and generally won't be eligible for U.S. based indices. I've covered some merger-spin combination in the past, they tend to be interesting, might be worthwhile to frame this in a similar way even though the spin was 4 years after, but strategically its similar.

Following the spinoff, TechnipFMC retained 49.9% of the ownership of Technip Energies with the intention to monetize that stake over the next 18 months to reduce debt and shore up the parent's balance sheet. While there will be some short term overhang, it also highlights that the parent didn't want to saddle the spin with debt as is typical lately in order to pay a dividend back to the parent -- FTI wants the spin to trade well to maximize the eventual sale proceeds.

To give some scale to the types of projects Technip Energies works on, here's their flagship Yamal LNG, one of the largest construction projects ever in the Artic. It was built to transport LNG from a remote Siberian peninsula, which didn't previously have road or sea access, to China.

Another is the Shell Prelude, a mega floating LNG facility that is longer than the Freedom Tower is tall, WSJ had an article about it last summer highlighting some of the difficulties of operating something the size of a mini-floating city during a pandemic.

With multi-year projects of this size comes some complicated accounting, Technip Energies operates with a large (~$3B) negative net working capital position.  Their clients pay them partially upfront but mostly along the way as milestones are met, but each periodic milestone payment is always ahead of work to be completed.  As a result, the company has a large "net contract liability" line item on the balance sheet that makes it difficult to analyze the company, one could take a view that as long as the company is growing that the NCL should be semi-permanent and give the company credit for much of the cash on the balance sheet.  I'm guessing some data sites and screeners will take this approach when coming up with an enterprise value for Technip Energies.
But for simplicity and conservatism, I'm going to say the balance sheet is basically in a zero net debt position, now if they stopped accepting new business tomorrow and put the business in run off that would be a bit too aggressive, but at the same time it is probably too conservative of a stance given their backlog and projected growth.

To put a valuation around the company, I took a free cash flow to the equity (FCFE) approach to neutralize the cash vs NCL:

15+% FCFE yield for a near zero net debt company with a strong backlog seems too high, I haven't spent a ton of time on comparables, but I think for an asset lite business like this it should be more around 10% FCFE yield, which works out to a $18+ stock price (for the ADR in USD).

Risks/Other Thoughts:
  • Building mega projects is an inherently difficult business, the work is often performed in remote areas, takes many years to complete and your clients tend to be politically exposed state run entities.
  • Some of their contracts are fixed price, which means Technip Energies takes a significant amount of risk in the projects coming in under budget and on time.
  • Client concentration is also high as you'd expect with projects of this size, 5 clients make up 73% of their backlog.
  • With TechnipFMC retaining a significant ownership position in Technip Energies, there could be a share overhang, so we might be only be partially through two of the three forced selling events.  First was the S&P 500 deletion pre-spin, then the ADR selling off from spin dynamics and U.S. mandate deletion, third will be when TechnipFMC fully exits their stake.  TechnipFMC has pre-sold €200MM worth of Technip Energy shares to BPI based on an initial VWAP, an investor in the business already.
Disclosure: I own shares of THNPY

19 comments:

  1. Thanks for the great writeup. I agree this looks cheap, though I happened to be looking at SNC-Lavalin today and it's a great example of this business model (big, long-term infrastructure construction projects) going bad.

    A couple of questions on your FCFe model:

    1) I believe they are going to have $750 million in debt (bridge facility to be taken out by a bond offering), so in addition to taxes and CapEx, there will be some interest expense between EBITDA and FCFe.

    2) I understand you're doing a back-of-the-envelope, steady-state FCFe model in which NCL essentially stays flat. But do you have a sense of how the actual FCF is going to be over the next few years? From looking at the January 2021 investor day presentation and reading the transcript, I got the impression that the next few years may be a bit light on FCF as, among other things, the big Yamal project closes out. In addition, the analysts tried to get at this issue a few different ways, but management refused to answer it directly. See pages 60, 63, 65 here: https://investors.technipenergies.com/static-files/eeb0d958-6c7b-4e24-8014-37784cd19c66

    My concern about medium-term cash flows was also heightened by management's repeated statements during the presentation that their medium-term plan was to dividend out 30% of profits and retain the rest to, among other things, "strengthen the balance sheet." If NCL is actually float that will be replenished by new contracts as older ones roll off, and you already have 2.9 billion in cash against only 750 million in debt, then why do you need to further "strengthen the balance sheet"? Indeed, the whole discussion of capital allocation was a big concerning, though this is all may be somewhat irrelevant if the point here is simply that spin dynamics have pushed this down too far.

    --KJP

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    1. Thanks for the thoughtful comments.

      1) Yes, they will have some interest expense but at the same time they'll have some interest income on the asset side, think this largely evens out. And yeah, more of a back of the envelope calculation, didn't run a big DCF on this business.

      2) I don't have a good sense of FCF in the near term, I share a lot of your reservations around the analyst day and some wish washy comments from the CFO. The NCL is fairly short lived versus say insurance float, so I'm guessing you need to build in some cash cushion in case of overruns on their fixed price contracts, etc. The company probably wants to over reserve in the early years of a big contract like their recently announced win in Qatar when the uncertainty is the highest.

      But you could be right, maybe this could be shortened to just a forced selling thesis and play the quick bounce, avoid all the business risk that comes with it.

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  2. Thanks for writing up this idea. Have you happened to see FRTT? Much smaller, but similar dynamics (spin-off on the OTC, parent was in the Russell 2000 but FRTT is not). The spin actually happened back in December, but the shares only started trading on Friday.

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    1. I haven't, but sounds interesting, I'll take a look thanks.

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  3. Management evidently thinks they need to keep the cash. In past years from the prospectus its free cash flow was mostly sent up to the parent Technip/FMC. It's interesting that unlike other spinoffs (e.g. Oxy/California Resources) the parent did not extract a lot of cash on the spinoff, in fact it looks like it didn't take any. So both the parent and spin seem to agree the cash is needed on the balance sheet. I did a rough calculation of operating cash flow minus payments to its Yamal partners for 2017 through 6/30/2020 and got roughly 1.20 euros/year in cash flow (which is almost all free cash). Technip Energies also works on some hydrogen production projects so this could be one of Cathy Wood's disruptive technologies (somebody send her an email).

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    1. I think if FTI intended for this to be a garbage barge it would have been structured differently as you suggest, a lot of spins will be loaded with debt, but here FTI retained equity to later sell. Wouldn't do that if you expected the business to quickly fall off a cliff.

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  4. Glad to se someone with essentially the same analysis. Good thorough analysis. The European accounting threw me off for a bit. I was a CFO at a firm that used % of completion accounting - there are offsetting assets and liabilities when employed correctly. any way I appreciate your work here.

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    1. New report out today. Appears some of my assumptions were on the conservative side. Minimum PT = $19-21.

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    2. Thanks, yeah I made a mistake and stated '21 estimates in my valuation math when I quoted their '20 numbers. '21 revenue guidance is 6.5-7.0B euros.

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  5. 1) Project management companies typically hold large cash balances (think Fluor (FLR) for example) and significant 'net cash' positions. I really don't see why but I consider all this cash is restricted and can't be used in debt extinguishment. It's likely debt is covered by project cash flows which makes the company dependant on its customers. In other words, TNHPY may even default if customers delay their payments significantly (and customer concentration is high). In that case 750 mln in debt is a serious risk + it must be excluded from FCFE. Any thoughts on that matter?
    2) ADRs correlate with EUR/USD rate and EUR is on the high end of its 5-y range. Should we correct PT by currency risk?

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    1. 1) I think I agree with you in spirit, its somewhere in between and I'm not sure where, but by going with $0 net debt, I'm giving them credit for 750MM of 3B Euro cash balance. I think that's fair for a going concern with a growing backlog?

      2) I don't think I would. Euro is the reporting currency, but roughly half of their cash (and maybe their revenue?) is USD.

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  6. good analysis ..even sell side analyst are divided on this this with BoFA being too sell rating if i remember. what is not clear is the original motives for first merging and then this spinoff. If the business is really capital light and carries neg working capital, it should hv helped the parent's balance sheet as i suppose that the subsea activity should be cyclical

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  7. After spinnoff, the parent's company shares (FTI) hv been in alot of pressure too. Anyopinion on the valuation of parents company which still has almost half of spinoff

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    1. Two comments:
      1/ you have to factor in the value of Technip Energies that was "carved out" of the FTI market cap upon the spin (technically they only carved out 51.1% of the value). But there is probably some forced selling now that FTI is no longer in the S&P 500.

      2/ The subsea market currently has too much capacity, so competitors are locking in multi-year projects today at low margins (sub-10% EBITDA margins). Many think that FTI will continue to earn ~10% EBITDA margins for the next few years as a result. You can see the reverse of this in 2017 when the company's margins last peaked in the mid- to high-teens because they were working through a final year of lucrative contracts struck at the peak of the oil boom in early 2014, when oil was >$100/bbl. Furthermore, FCF conversion from EBITDA is very poor due to corporate overhead, interest on debt, and the asset-intensive nature of this business.

      I've spent a lot of time looking at FTI (the parent), and whether the stock is cheap truly comes down to whether you see the subsea market tightening sooner rather than later. I really don't know.

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  8. Here are my two cents on the calculation of net debt: one should assume that Technip is in a net debt position to be conservative. THNPY has a €2.6bn net contract liability (NCL) (€3bn contract liabilities less €0.4bn contract assets), €2.9bn in cash, and €0.75bn in debt. The calculation of net debt is thus €2.6bn NCL + €0.75bn debt - €2.9bn cash = €450m net debt.

    However, the NCL includes Technip's future profit from contracts for which the customer has paid an advance (which creates the contract liability in the first place). Assuming a company-average 15% gross margin on the €3bn of future revenues to be recognized from the contract liability, then roughly €450mn of profit is "baked into" the contract liability on the balance sheet. Some analysts choose to count some or all of this €450mn as Technip’s cash. As I'll show below, including anything less than the entire gross contract liability in the calculation of enterprise value is effectively "double counting" profits. The reason is simple: if you assume that future profits are ours today to subtract from net debt, then you cannot capitalize these same profits with a multiple of EBITDA later.

    As others have pointed out, E&C companies are paid up front by clients for each stage of a project. Built into that up-front payment is the company's estimated profit on the project. Estimated is the key word here because the project revenue is often fixed (many of THNPY's contracts are fixed price), but costs are not. And cost overruns in this business are common.

    Here's a simple example: I agree to build you a house for $100k, and you agree to pay me $50k on day one and $50k on day 181, with the house expected to be complete on day 360. I, as the contractor, estimate that I will earn a $10k profit on the job assuming that lumber prices, wage rates, and the number of labor hours needed to complete the project come in at or below my estimates.

    On day one, my balance sheet will show $50k of cash and an offsetting $50k contract liability. The "net worth" of my venture is still $0 as I have recognized no revenue or profit because I have yet to start building. Technically, my net worth could be $10k in the future (my baked-in profit on the project), but this is by no means guaranteed.

    I will recognize revenue ratably over the 360-day contract term or in chunks based on certain easily-observable milestones, e.g., the foundation is poured, the house is framed, the sheet rock is hung, etc. I will expense my costs as they are incurred, and any difference between the revenue recognized in a period, say, a quarter, and the costs recognized in that same period becomes my profit or loss for the period.

    My cash flow statement will be quite different. I will have two large cash inflows: $50k on day one and $50k on day 181. If I have estimated the project well, I will never be in a negative cash position on the project, i.e., my costs in the first 180 days will not exceed the $50k cash advance from you, my client. However, the cash is never really mine. It belongs to the client until day 360, when whatever is left in the project bank account is mine to take.

    So how do we value my project or a portfolio of similar projects? If we assume a positive net worth of $10k on day one (my estimated future profit based on the terms of the contract) AND we capitalize the future "flows" of the project - my $10k profit, recognized over the period - then we are double counting my profit: once in the calculation of initial net worth and again in valuing the flows from my portfolio of similar projects.

    If you read sell-side notes on THNPY and other E&Cs you'll see that the calculation of net debt for valuation purposes is somewhat of a debate in the industry. There is no right answer. It's just a matter of exercising your own judgement when valuing one of these businesses.

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    1. Thanks Colin, very thoughtful comment, enjoyed the example. While I agree with the example, the complication comes when you have 100s of projects at various stages, but you're probably right, best to completely offset the cash and treated it as restricted cash or as you put it, the clients.

      Fixed price contracts for a business like this is very risky, I mentioned it briefly in my write-up but probably should have emphasized it more. To use your house example, when doing a rehab project how many times does the estimate come down when you rip open the walls or floors? Almost never.

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    2. I mostly agree. I was the CFO for a construction firm for nearly 40 years. Percentage of completion accounting for fixed price contracts is so full of estimates that rarely, if ever, prove to be true when a project is completed. Just estimating the percentage completed is an exercise in guesstimating letting alone figuring profits for a 5 year project into the future. There are two types of forecasters - those that don't know and those who don't know they don't know. I am gradually talking myself out of this holding for other than a quick profit turnaround as it and the parent were clearly indiscriminately sold on the spinoff.

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    3. PS. Forgot to add there is a nasty little thing called retention. It is 10% and is not payable until the owner has filed a notice of completion and then paid days thereafter. As most profits turn out to be less than 10%, there will be a time where profit is fully recognized but the cash flow related to that profit is not received yet. Now factor that in for 100's of projects. The house CF scenario was too simplistic.

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    4. Thanks Jim for your perspective, appreciate the insights. Yeah, maybe this is a shorter term special situation trade and don't confuse it with a long term hold that exposes you to all the business risk.

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