Construction Stocks in Mid-Cycle U.S. Recovery May Outperform
Companies that specialize in engineering and construction may be poised to outperform as demand accelerates for new bridges, power generators and oil and gas refineries in the third year of the U.S. recovery.
Aggregate demand, “the driver of their business,” doesn’t start to rebound “until the expansion is well afoot,” said Andrew Wittmann, a former engineer who is now an analyst at Robert W. Baird in Milwaukee. The lag is caused by “the timing of the construction cycle, which can require several years for approval, planning and design.”
Project backlogs -- or commitments for future work -- at all major U.S. publicly-traded engineering and construction companies rose 3 percent in the quarter ended March 31 from the prior period, according to a June 21 report by Wittmann and other researchers at Baird. This marks the third consecutive quarter of growth and is similar to the rebound that began in the fourth quarter of 2003 following three months of contraction, Baird’s data show.
Backlogs may grow 2.8 percent in the period ending today, according to a proprietary model Baird developed of forward- looking indicators. This bodes well for Fluor Corp. (FLR), Jacobs Engineering Group Inc. (JEC), Quanta Services Inc. (PWR) and other companies that benefit when the U.S. moves into the middle and late stages of a recovery, Wittmann said.
“If you don’t believe the economy is going to ‘double- dip,’ we recommend increasing allocations to engineering and construction stocks,” said Wittmann, who predicts they will outperform industrial shares.
The Standard & Poor’s Supercomposite Construction and Engineering Index has fallen 1.3 percent since Dec. 31, 2010, while the S&P Supercomposite Industrials Index has risen 5.1 percent, according to data compiled by Bloomberg.
Now is a “very opportune time” to invest in these stocks, particularly companies that specialize in oil- and energy- related services and do business in emerging markets, said Andy Kaplowitz, an analyst at Barclays Capital in New York.
A robust pipeline of projects is building, and backlogs should increase during the next year as customers ramp up capital spending, said Kaplowitz, who has covered engineering and construction companies since 2006 and maintains “overweight” ratings on Fluor, McDermott International Inc., Chicago Bridge & Iron Co. and Foster Wheeler AG.
“This is very much a confidence-driven sector, and confidence to spend on large infrastructure projects increases only when the economy is definitively in a recovery,” he said.
The Institute for Supply Management’s manufacturing index peaked at 61.4 in February and has since fallen to 53.5 in May. Even with the decline, it has remained above 50 for 22 consecutive months. That’s more than halfway through an average of 31 months for U.S. expansions since 1960 -- suggesting a transition into more-moderate, “mid-cycle” growth, according to Baird’s report.
The ISM index will likely “hover” in a range between 52 and 55 as the economy shifts, according to Tom Porcelli, chief U.S. economist at RBC Capital Markets Corp. in New York. “We’ve passed the peak in manufacturing activity; it can’t stay at the levels we saw during the initial stages of the recovery.” June data will be released tomorrow.
U.S. gross domestic product grew 5 percent in the fourth quarter of 2009 after the 18-month recession ended the previous June. Since then, it has averaged 2.6 percent. That “choppiness” has meant a slower rebound in some parts of the engineering and construction industry, Kaplowitz said.
Shaw Group Inc. (SHAW), a Baton Rouge, Louisiana-based builder of power plants, lowered its fiscal-year revenue guidance to as much as $6.5 billion from an estimated $7.2 billion after reporting lower-than-expected third-quarter revenue of $1.49 billion on June 28. The company had $19.7 billion in backlogs for the period ended May 31, down 3 percent from the prior year.
“This was an extremely challenging and disappointing quarter,” Chief Executive Officer James M. Bernhard said in a statement.
The number of projects still will grow as customers gain confidence in the recovery’s endurance, Kaplowitz said. In the meantime, many businesses are actively pursuing global revenue diversification. The total backlog for Irving, Texas-based Fluor, the largest publicly traded U.S. construction and engineering company, grew 45 percent to a record $37.2 billion in the quarter ended March 31 from a year earlier, Chief Executive Officer David Seaton said on a May 5 conference call.
More than three-quarters of the total was for non-U.S. business, with future commitments tripling in the Asia-Pacific region and rising 42 percent in the Americas.
Aecom Technology Corp. (ACM), based in Los Angeles, raised its fiscal-year earnings guidance to as much as $2.40 a share from as much as $2.35 a share, citing “an improving global business environment and our exposure to high-growth emerging and natural-resource-rich markets,” Chief Financial Officer Michael Burke said in a May 5 statement.
Asian and Latin American economies in particular will grow “materially faster” than developed countries in the next few years as their productivity improves and populations expand, according to David Hensley, director of global economic coordination at JPMorgan Chase & Co. in New York.
Emerging markets are free of “structural headwinds” that constrain growth and also benefit from government policies that are “quite supportive” of expansion, he said.
Globalization provides a “cushion” as aggregate demand continues to improve, Wittmann said. A majority of engineering and construction companies only recently began reporting sequential increases in their backlogs, suggesting further gains are likely in the second quarter and beyond, he said.
“This is usually an indication the cycle has some duration to its recovery,” he said.
To contact the editor responsible for this story: Chris Wellisz at email@example.com