The latest issue of Singular Diligence focuses on the Babcock & Wilcox Co (NYSE:BWC) spin-off. Here’s our overview of the opportunity in Babcock & Wilcox Co’s two businesses (excerpted from our most recent letter):

Babcock & Wilcox will separate into two publicly traded companies in “midsummer” 2015. At that time, investors will be able to choose which of the two newly minted stocks they prefer to buy. One stock will be the power generation on business. The other stock will be the government and nuclear operations business. For now, however, investors can buy shares in the combined Babcock & Wilcox Company and then hold those shares through “midsummer” 2015 when their investment will then be split into two different shares in two different public companies.

Babcock & Wilcox has 5 business segments: nuclear operations, power generation, technical services, nuclear energy, and mPower. mPower loses money. So it does not contribute to corporate profit at all. Nuclear operations contributes 52% of Babcock & Wilcox’s total profit. Power generation contributes 34% of total profit. Technical Services contributes 12%. Nuclear energy contributes 2%. This means that two business–nuclear operations and power generation–account for more than 85% of Babcock & Wilcox’s value. In fact, because mPower loses money, the 3 smallest segments–nuclear energy, technical services, and mPower–account for less than 15% of the group’s earning power. Prospective buyers of Babcock & Wilcox should focus on the two big profit contributors.

The most valuable segment of Babcock & Wilcox is the nuclear operati0ns unit. Nuclear operations has just one end user: the United States Navy. Babcock & Wilcox is the sole provider of critical nuclear components for the onboard nuclear plants that power U.S. Navy ballistic missile submarines, attack submarines, and aircraft carriers. More than 90% of this unit’s profit comes from critical nuclear components such as: core barrels, reactor vessels, closure heads, steam generators, and pressurizers. Each of these components can weigh more than a blue whale (150–250 tons a piece is normal). Babcock also provides control rod drive mechanisms that manage the movement of control rods inside the nuclear reactors. Babcock is the only company in the U.S. licensed to receive, process, and store highly enriched uranium. The company “down blends” highly enriched uranium into low enriched uranium for private sector use. These related activities are a small part of Babcock’s overall business. The single most important line of business for Babcock–contributing about 45% of the group’s profit–is providing critical nuclear components for nuclear powered military ships. This line of business has just one end customer: the U.S. Navy. Babcock is completely dependent on the U.S. Navy as its sole customer for these critical nuclear components. At the same time, the U.S. Navy is completely dependent on Babcock & Wilcox as its sole supplier for its critical nuclear component needs.

Babcock’s second most valuable segment is the power general on group. The power generation group contributes 34% of Babcock’s total profit. About half this amount (17% of total profit) is after‐market products and services. This is maintenance revenue that Babcock has because it built the original equipment. The equipment is custom built on site. For this reason, customers generally purchase all the lifetime needs of the plant–replacement parts and services–from the company that installed the equipment. The other half (17% of total profit) is evenly divided (about 8% of total profit each) among “new build” steam and “new build” environmental projects. Steam generating equipment is used by power plants to convert heat into steam. Power plants that convert heat into steam include coal fired, biomass fired, and waste‐to‐energy plants. Historically, coal power plants were the largest portion of Babcock’s utility customers. Babcock’s steam generating equipment includes boilers, burners, pulverizers, soot blower, and ash handling systems. Babcock sells a roughly equal amount of environmental systems to power plant owners who want to reduce emissions of various pollutants. Regulations often require power plant operators to reduce emissions.

There are a variety of regulated pollutants including: carbon dioxide, mercury, acid gases, and toxic metals. Examples of environmental equipment include scrubbers and baghouses. These are big building jobs that are erecting on site–never in a factory. The third most valuable part of Babcock is its technical services unit. This unit contributes about 12% of total profit. It works in consortiums to manage nuclear fission related sites for the U.S. Department of Energy and National Nuclear Security Administration. Some of Babcock’s most frequent consortium partners are Bechtel (a private company), URS (a public company), and Battelle (a non‐profit). Some of the sites Babcock helps run assemble, refurbish, and dismantle nuclear weapons. Others store uranium and plutonium. Consortium run nuclear sites also oversee the production of plutonium pits, monitor the aging of nuclear weapons, manage the production of critical nuclear components like Tritium–which helps boost the yield in all nuclear weapons and initiate the fission stage in hydrogen bombs–and operate test reactors. Most of the revenue in the technical services segment is not consolidated. So this unit accounts for just 3% of Babcock’s reported revenue but more than 12% of its total profit. The 12% of total profit figure is a much more accurate gauge of the unit’s economic importance to Babcock.

Babcock’s nuclear energy group is its least important money making business. The nuclear energy group contributes just 2% of Babcock’s total profit. It supplies commercial nuclear steam generators and components to utility customers in Canada. This is a legacy business for Babcock. Babcock was one of the suppliers to virtually all 104 commercial reactors built in the U.S. However, U.S. utility companies stopped building new nuclear reactors after the Three Mile Island accident in 1979. In 1989, Babcock sold its U.S. nuclear energy business to Areva. Babcock kept its Canadian business. The total market for nuclear reactors in Canada is small. However, Babcock dominates the Canadian nuclear reactor market. For decades, Babcock was banned from re‐entering the U.S. market as part of its agreement to sell its U.S. nuclear energy business to Areva (thus protecting Areva from competing with Babcock in the U.S.). That ban has now lapsed. If a new commercial nuclear reactor is ever built in the U.S., there is nothing stopping Babcock from bidding for the contract.

Babcock’s fifth business unit–and the only one that loses money–is mPower. Babcock has cut annual spending on mPower to $15 million a year. The company has already sunk more than $400 million into mPower since 2009. The unit will have no commercially available products until before the early 2020s. It is a highly speculative start‐up. mPower is a small, modular nuclear power plant. Each modular 125 megawatt nuclear power plant is just 70 feet long by 10 feet wide. It has a five-year fuel cycle. So, it can be moved by a railroad and run for 5 years without anyone ever having to touch the fuel. mPower was a production departure for Babcock. Most of what Babcock does is steam-related on-site custom construction jobs using heavy components in high priced jobs. For example, the nuclear operations group–which supplies critical nuclear components to the nuclear power plants onboard U.S. navy ships–spends about 5 to 9 years building a component which is then installed and run by the navy for more than 30 years before being retired.

Babcock & Wilcox has a more than century long record of working on the biggest steam and nuclear projects in United States history. Babcock & Wilcox was founded in 1867 by George Babcock and Stephen Wilcox (inventor of the water tube boiler). It manufactured water-tube boilers during the 1800s. In 1902, Babcock & Wilcox provided boilers to New York City’s first subway system. In 1903, the Commonwealth Edison Company of Chicago used Babcock & Wilcox as its supplier when it pioneered the use of steam turbines exclusively for utility power general on. Babcock & Wilcox boilers were installed on the ships in Teddy Roosevelt’s Great White fleet in the early 1900s. During World War 2, Babcock & Wilcox participated in the United States’ Manhattan Project (which built the world’s first nuclear fission bombs). In the early 1950s, Babcock designed and built components for the world’s first nuclear powered submarine (the USS Nautilus). From the 1960s till the Three Mile Island accident in 1979, Babcock made many of the heavy nuclear components for the 104 commercial nuclear reactors built in the U.S. Babcock also designed and built components for the Nimitz‐class nuclear powered aircraft carriers first built in 1966. Since then, Babcock has supplied heavy components to every nuclear powered ship in the U.S. Navy. Babcock was acquired by McDermott International for $750 million in 1977. United Technologies was the next highest bidder. McDermott had to spinoff Babcock & Wilcox in 2010, because McDermott was an inverted company–incorporated in Panama–and the U.S. changed a law to ban the awarding of government contracts to inverted companies.

Three of the world’s big nuclear component makers can trace their roots to Babcock & Wilcox: Doosan Babcock, Babcock Power, and Hitachi (originally “Tokyo Babcock”). Other competitors–with no historical ties to Babcock & Wilcox–include Alstom and Foster Wheeler. About 85% of the value of Babcock & Wilcox comes from the nuclear operations business that serves the U.S. Navy as its end customer and the power general on business that serves mainly U.S. coal power plants. Those are the two business units an investor in Babcock needs to understand. And they are the only two units that we discussed in this issue of Singular Diligence.

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