The following segment is taken from this fund letter.
In the second quarter, we sold our position in Subsea 7. We bought SUBCY in 2019 based on the company’s expansion into offshore wind farms. The 34 ships SUBCY’s property traded below replacement cost. A healthy balance sheet with net cash and a backlog of $5.1 billion provided visibility into future revenues.
Recognizing that the company has gone through one of the most challenging operating environments imaginable, our confidence in the company’s ability to generate meaningful return on assets has diminished. Management continues to suggest that 2024-2025 will see margins normalize. Even if we assume the company returns to its highest margin profile of 15%, it still generates a low ROA for the teens. The company expects its renewables business to have long-term EBITDA margins of around 10% and a return on investment of 9-14%. At the midpoint, 11.5% ROI isn’t bad.
However, given the dynamics of the industry, consistently achieving this performance profile is unrealistic.
EBITDA applies to specific business models and capital structures. SUBCY is not a business where EBITDA makes sense due to ongoing CAPEX needs. In 2022, SUBCY will spend $440 million in CAPEX on a property, plant and equipment base of approximately $7 billion. D&A has accounted for more than $400 million per year for the past five years. These vessels are capital intensive and require ongoing maintenance. Management’s continued use of adjusted EBITDA as a performance measure does not inspire confidence.
Our biggest concern is with management’s capital allocation decisions. Since 2010, SUBCY has taken $2.4 billion in goodwill impairment charges, which is more than the current market capitalization of $2.3 billion. Current CEO John Evan was appointed in January 2020 and therefore has not made the final decision; however, he had been COO since 2005 and played a vital role in these acquisitions. Capital allocation decisions affect us and indicate the competitive and sometimes uneconomic landscape of the industry.
Continuing this trend, in April 2018, Subsea 7 announced a $2 billion bid for McDermott. Two weeks later, the company withdrew its offer, and in January 2020, McDermott filed for Chapter 11 bankruptcy. For one, Subsea quickly withdrew its offer, showing some restraint. On the other hand, it is another acquisition that could have led to significant problems.
In June 2022, SUBCY announced additional provisions on a wind farm installation project due to cost overruns. What is surprising is that they maintain their adjusted EBITDA guidance for the full year. Other lines of business may do better or consider this expense as non-recurring and will adjust it. Anyway, this result confirms our thoughts above. Note that this event occurred after we exited the position and was not a factor in our decision to sell.
To sum up our thoughts. SUBCY operates in a difficult sector. The management team has made some questionable decisions in the past, and operationally the underlying ship economics need to improve to generate decent returns. Although the current stock price looks attractive, it is likely an asset that should trade below its replacement value due to average-at-best economic returns. The current environment allows us to move out of a business that is competing in a tough industry, led by a management team that keeps us up at night and into buying attractively priced, better managed businesses.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.