By James A. Anderson
A slowing economy may put a dent in homebuilding, but it probably won't hurt the engineering and construction companies that build the big projects. Federal, state, and local governments are finally loosening purse strings and spending budget surpluses on infrastructure.
And giant oil and gas companies, eager to cash in on high gas prices -- and high demand -- have upped their budgets for exploration and production expenditures by 10%, according to Salomon Smith Barney. That's good news for the companies that design and build oil refineries and power plants -- Fluor (FLR ), Foster-Wheeler (FW ), Jacobs Engineering (JEC ), and their competitors.
In fact, the engineering and construction group has been on a tear since late in the fourth quarter. A Standard & Poor's index that tracks a dozen stocks in the group climbed 12.4% in the last three months of 2000. But that only partly made up for a retreat in the first nine months that knocked the group down 10.7% overall for the year. But consider this: In a market that has severely punished earnings miscues, Fluor saw its stock appreciate 12.1% in December, despite having warned analysts that earnings estimates for the company were too aggressive.
But if you're tempted to tie the sector's run to nothing more than the kind of market rotation that steered money out of tech stocks and into rusty Old Economy stocks, think again. What some call the waning days of the economic expansion are turning out to be a godsend for engineering and construction outfits. Their stocks traditionally take off just when an economic upswing is peaking, since that's when government and private-sector coffers are most full. It's also when CEOs feel most free to ink deals to add production capacity and legislators start slinging pork.
"This is a late-cycle group," says Fritz Von Carp, an analyst with Merrill Lynch. "Historically, these companies have outperformed after industrial production has peaked, when businesses start putting cash flow back into equipment to expand capacity."
True to form, spending on big projects has just started to take off. One indication: new-order backlogs, the number Wall Street uses to gauge the fortunes of companies like Fluor or Jacobs. The latter all but reported a Santa sighting at the end of 2000 in a fourth-quarter earnings release that indicated backlogs were up 31%, vs. the same time a year ago. Fluor, while cautious about its earnings prospects, also had good news: In late November, it said its orders -- $1.9 billion worth -- were double the figure a year earlier.
"Industry backlogs had declined 13 consecutive quarters up until the end of 2000," reports Von Carp. "At that point, coming out of a very bruising downcycle, this group turned the corner." Adds S&P analyst Stewart Schaarf: "Don't be surprised if some companies in the sector post new-order growth on the order of 20% year-over-year in 2001." Such lofty expectations are due in part to a 1998 law that's scheduled to boost spending on U.S. highways by $200 billion over the next few years and a $28 billion allotment for the Federal Aviation Administration to upgrade airports.
Such positive signs probably have you thinking engineering and construction stocks would be overvalued by now. They aren't, if only because they've been disappointments for so long prior to the current boom. In the early and mid '90s, the group was a Wall Street darling, based on expectations that hefty overseas contracts would trigger outsized earnings growth. The optimism pushed engineering and construction sector multiples as high as the S&P 500's.
Things changed in the late '90s, when revenues suddenly became less predictable and the industry fell from the Street's favor. Then, in 1998, the economic crisis in developing countries sapped overseas revenues. As the group's stocks fell, the number of Wall Street analysts who followed them dwindled to a handful. While some 30 analysts still spend their waking hours trying to decide if Amazon.com has a valid business model, Fluor is tracked by just four analysts. It's little wonder, then, that the construction crew has seen its valuations dwindle. As of Jan. 26, the group commanded a price-earnings ratio of just 15.7 times forward earnings, vs. 26.6 for the S&P 500.
Now that the contracts are rolling in, look for the group to rebound. One stock analysts say should benefit is Jacobs Engineering, a company that would interest even the most skittish of investors, thanks to its dependable earnings growth, even during down times for the sector.
"With the exception of Jacobs, every publicly traded company in the sector had at least one earnings debacle in the mid and late '90s," says ING Barings analyst Richard Rossi. The secret to Jacobs' success: rock-solid business relationships. In fact, when the company recently reported results for its first quarter ended Dec. 31, 78% of its bookings were from previous clients. Zacks Investment Research reports two of the three analysts who follow Jacobs rate it a strong buy or buy, and consensus estimates are the company's earnings will grow an average of 15% annually over the next five years. ING Barings' Rossi thinks the stock, which closed on Feb. 2 at $50.76, could reach the mid 50s in the next 12 to 18 months.
One beneficiary of increased public sector spending will be Granite Construction (GVA ), which generates about 60% of its revenues from building highways, dams, bridges, and mass-transit systems. Not only does Granite stand to harvest revenues from the federal government's push to upgrade highways and airports it's also in line to snare more business now that California, aims to fix its roadways.
ING Barings' Rossi says backlogs are growing handsomely, and Granite appears to be on its way to 15% or more average annual earnings growth over the next two years. All five analysts who follow it rate the company a strong buy or buy, and Wall Street consensus estimates forecast 12.5% average annual earnings growth for Granite over the next five years. Rossi believes the stock, which closed on Feb. 2 at $31, could reach the mid to upper $30s in the next 12 to 18 months.
While no mutual fund sticks to engineering and construction shares exclusively, Lord Abbett Small Cap Value (LRSBX ) had stakes in Jacobs (1.2% of its portfolio) and Granite (1%) as of last Sept. 30, according to the latest Morningstar data. The Small Cap Value portfolio posted a 2000 total return of 32.6% and has recorded a 2.4% gain so far this year. Over the past three years, the fund has averaged an annual total return of 10.9%.
It looks like an economy past its having peak could pave the way for some good investments in the engineering and construction sector.
Anderson teaches journalism at the City University of New York. Follow his twice-monthly Sector Scope column, only on BW Online
Edited by Patricia O'Connell