Why McDermott International Shares Dropped 11% This Morning

What happened
Shares of McDermott International (NYSE:MDR), an engineering and construction firm that specializes in building undersea oil pipelines and floating production facilities, are tumbling today.

News that the company will purchase its troubled onshore peer Chicago Bridge & Iron (NYSE:CBI) in a deal valued at $6 billion — including the combined debt of the two companies — sent McDermott shares down nearly 11% in early Tuesday trading, before the stock clawed its way back to a 7.8% loss as of 11:50 a.m. EST.

Falling stock chart superimposed over digital map of the world

So what
McDermott International is structuring its acquisition of Chicago Bridge as an all-stock transaction. McDermott will acquire each of Chicago Bridge’s 101.4 million shares currently outstanding for 2.47221 shares of McDermott’s own shares. That makes the purchase price of this deal roughly 250 million McDermott shares, which at a recent share price of $7 each values the acquisition at $1.75 billion, plus another $1.7 billion in Chicago Bridge’s net debt.

(This value will obviously fluctuate with the value of McDermott’s own stock.)

Now what
Is that a fair price to pay? It certainly seems so. A $7 share price times 2.47221 works out to about $17.30 for each share of Chicago Bridge & Iron being acquired — a tidy discount to the $17.92 at which Chicago Bridge stock closed last night. This suggests that McDermott shareholders are getting a steal of a deal.

But if that’s the case, then why are McDermott’s own shares sliding on the news? Partially, one imagines, it’s because Chicago Bridge itself has had a lot of problems cropping up lately with meeting construction deadlines and cost overruns. It could be a factor of investors worrying about McDermott — which has historically burned cash — taking on a debt-laden subsidiary in the form of Chicago Bridge.

On its own and prior to this transaction, McDermott sported nearly as much cash on its books as debt, and was generating enough free cash flow to manage its debt load. After the merger, I see these two firms together carrying a combined net debt load approaching $1.8 billion — and instead of generating cash to pay off the debt, burning through a combined $522 million in negative free cash flow over the past year.

Maybe investors are right to be selling today?

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