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Investment thesis McDermott Engineering

NYSE: MDR Engineering and Construction: Offshore oil rigs, Power stations Market Cap: $5.42B SPECIAL SITUATION - DIVESTITURE

Precis:
On July 2nd 2010 the McDermott Engineering (MDR) board approved the final plan to divest the organisation of The Babcock & Wilcox Company (B&W), its nuclear power generation and operations group. The divestiture is scheduled for July 30th 2010. This special corporate situation has potential to create a profitable investment opportunity, for various reasons set forth herein.

The Parent:
MDR is an engineering and construction company, with a focus on offshore oil and gas construction and power generation systems. MDR has been in operation since the 19th century, with many pioneering industrial achievements throughout the Cold War era. The firm employs people worldwide, with offices throughout the continental United States, as well as Europe, the Middle East and Asia. Though the firm maintains a set of corporate headquarters in Houston, TX, it is legally headquartered in Panama for tax reasons. The engineering and construction industry for oil and power is intimately intertwined with both the larger engineering and construction industry and the energy industry. MDR is strongly positioned within its industry segment, with both McDermott Engineering International (MII) and B&W leading companies in their respective fields. Financially, MDR has been somewhat adversely affected by the recent global economic crisis. Net earnings have decreased for 3 consecutive quarters, assuming accurate guidance by management for the most recent, unreleased, quarter's earnings. Though the firm was not unharmed, it is still in a sound position overall. Total assets have increased 5% to $4.89B since 2009, mainly due to a net cash flow increase of $727M. This cash flow increase is primarily the result of the firm's drastic reduction of investment losses in 2009 from 2008. Additionally, liabilities have been reduced by $244M overall,

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___________________________________________________________________________________ despite the firm's addition of $50M of new long-term debt. Of MDR's $6.4B in equity, $6.37B is held by institutional investors and mutual funds. A large number of these funds are index funds, particularly multiple funds of Vanguard's. The majority of these index funds have restrictive limits on types of businesses in which equity must be held, setting thresholds for market capitalization, earnings and debt. Therefore, a significant potential exists for institutional investors to trade the situation based on preset rituals rather than fundamental financial analysis. The main reason behind MDR's divestiture of B&W is that MDR's Panamanian incorporation status does not sit well with United States officials in positions to provide considerable patronage to B&W by way of new nuclear reactor projects and alternative energy installations. With the divestiture completed, B&W will be a wholly US-incorporated business, and thus will be able to pursue government business free from the offshore taint of MDR. B&W has already won a $10.8M contract from the Department of Energy to design modular solar power plants on news of the divestiture.

The Child:

The Babcock & Wilcox company B&W is a leading technology innovator in power systems, nuclear component manufacturing and power system servicing. B&W has two main segments which carry out this business: Power Generation Systems and Government Operations. It is the stifling of the Government Operations segment owing to MDR's tax-refugee status which is the main agent provoking this divestiture. B&W has operating income of ~$270M off revenues of ~$2.9B, and employs more than 13,000 worldwide. B&W has increased revenue whilst paying down long-term debt for the past three quarters. Additionally, B&W has a backlog of prepared yet unassigned government contracts worth $2.7B immediately on departure, of which $2.696 has been funded. As an as-yet uncreated entity, B&W has no official ownership as of yet, but institutional investors will receive a distribution of share in B&W for each share of MDR they hold. As institutional investors are the largest equity shareholders in MDR, they will be likewise at the creation of B&W. Certain B&W subsidiaries have recently lost trial in an asbestos-hazard case. The liabilities for the case have been fully funded, but publicity has been extremely negative. Aside from this, most current news is positive, such as the aforementioned solar power module design contract, large revenue backlog, and

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___________________________________________________________________________________ increasing revenue. At equilibrium, B&W should perform similarly to MDR, trading at a 14-17x multiple.

Thesis
At divestiture, B&W will come under intense selling pressure. This is a foregone conclusion, as every index fund holder of MDR will be forced to divest themselves of their B&W shares immediately by fund charter. The other major class of institutional MDR holder, mutual funds, will also most likely rapidly divest themselves of their B&W holdings soon after acquisition. This selling pressure is no reflection, or even judgement, on the underlying business merits of B&W. It will be entirely mechanical, owing to the holding requirements of the institutional investors who own MDR. Additionally, it can be expected that market technicians will catch the obvious downtrend and exacerbate the situation with aggressive leveraged shorting. However, the long-term prospects for B&W based on business fundamentals is very bright. The firm has a solid reputation and good earnings prospects for the future, while it carries a light debt load. The new business lines in research and backlogged government contracts guarantee a steady earnings stream for the immediate future. Additionally, the new B&W board will be highly incentivized to focus on the development of business opportunities because of their significant holdings in the firm, both from their grants of B&W stock as MDR shareholders, and additionally from their stock options. Ergo, the following two broad developments can be forecast for the market price of B&W: 1) The stock will undergo severe price depression beginning at the divestiture date (July 30), and continuing throughout a period of 2-5 weeks thereafter. 2) Following phase 1, the stock will undergo a dramatic recovery as the market moves to recognize the underlying solidity of the B&W business. This should peak with a multiple between 14-17x earnings.

Summary Plan of Action

As the movement of the price for B&W will have two main phases, there should be two accompanying phases for the fund's course of action regarding this security. Phase 1: As the B&W stock comes under severe pressure from institutional sell-off, it will undergo a drastic reduction in price. This should be exploited by levered puts on B&W, beginning immediately upon divestiture. This position can be hedged by an accompanying purchase of MDR, although that will potentially reduce returns to a suboptimal level. All short positions should be closed out after three weeks, a 40-60% return, or a firm technical bottom, whichever comes first. Phase 2: At bottom, B&W should prove to be a solid value on purchase. The fund should gradually move to a full long position, while being mindful of the potential for further runoff selling. This position should be maintained until there is a return in excess of 50%, or the B&W stock reaches a P/E

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___________________________________________________________________________________ multiple of 14.5-15.5x. Forecasted return cases: 1) Nightmare: Immediate strong performance of B&W, jeopardizing the short position. Long position abandoned before adoption due to capital damage. Likelihood: Infinitesimal Short returns of -30 to -35%, long abandoned, overall returns -30 to -35% 2) Bear: Weak sell-off in initial phase, mediocre return for long phase. Likelihood: Low Short returns of 5-10%, long returns of 0-5%, overall returns of 5-16% 3) Base: Phases undergo predicted market action, with non-extreme results. Likelihood: Probable Short returns of 20-25%, long returns of 20-30%, overall returns of 44-63% 4) Dream: Phases undergo predicted market action, perfect trading execution. Likelihood: Moderate Short returns of 30-40%, long returns of 60-100%, overall returns of 108-180%

Conclusion
The July 30th divestiture of B&W from its parent, MDR, poses a singular opportunity to profit by ineluctable market activity by institutional participants. This will yield two main phases to the movement of the stock price of B&W, which are amenable to exploitation by basic options positioning and bottom purchasing. This has the prospect of yielding high surplus alpha owing to the reduced risk afforded by the margin of safety the institutional selling will create. I recommend the above actions prescribed in this Thesis as the firm's most appropriate course of action. I put it to my Partners to veto or approve.

Bishmer J. Sekaran Chief Investment Officer Scorpion Rock Capital