A Sturdy Blueprint at Jacobs Engineering
By Stewart Scharf
Even in the midst of a faltering global economy, Jacobs Engineering Group (JEC ) continues to thrive. A provider of engineering, construction, maintenance, and project services, Jacobs is expanding its worldwide presence, broadening its offerings, and strengthening its balance sheet. This well-managed company has a solid financial track record, and we at Standard & Poor's expect Jacobs to continue its consistent 15% earnings growth rate. The shares carry S&P's highest investment ranking of 5 STARS (buy).
Jacobs is poised to benefit from its diverse customer and geographic base, and from positive trends in its key business segments: defense, petroleum, infrastructure, federal programs, buildings, and biopharmaceuticals. It generates more than 85% of its revenues through its preferred-relationship-based business model, where Jacobs develops long-term alliance contracts and local partnerships. It uses this strategy to limit its exposure to risk, as long-term relationships with clients help reduce sales costs.
This approach's benefits are substantial. Unlike other contractors that take on riskier, one-time projects, Jacobs enjoys a high percentage of repeat business. This allows it to maintain tight control of its marketing costs and avoid price competition, which helps both the revenue and expense side of the income statement.
Jacobs started 2003 in pretty good shape. Its contract backlog was a solid $6.7 billion at December 31, 2002, up 4.7% from a year earlier. Of that total, 54% was derived from field services (mostly construction), and the remainder from technical services (engineering, design, and architecture), conducted through home offices in various geographic regions.
Bookings also have been strong in recent periods, reflecting favorable prospects for publicly funded infrastructure and buildings (15% of total revenues) and federal programs (22%). Jacobs should get a boost from stepped-up federal funding for military and homeland-security projects, as well as increased spending over the next 10 years to upgrade roads, rail systems, airports, schools, and prisons.
Furthermore, as a large new-drug pipeline and an aging population boost demand for treatments, Jacobs' pharmaceutical-industry customers should step up outlays for plant projects. Spending by Jacobs' chemicals and pulp and paper customers, which account for 12% and 1% of revenues, respectively, should gradually recover toward the end of fiscal 2004 (ending September). In the petroleum market, new clean-fuel regulations should boost client spending on projects for the removal of sulfur from gasoline, and eventually from diesel and aviation fuel, over the next decade.
Jacobs has reduced its exposure to industry cycles over the past 10 years by diversifying its customer base. It has increased the share of revenues from its pharmaceutical segment to 19% from 3%, and its federal programs revenues to 22% from 10%, while decreasing its percentage of revenues from chemicals to 12% from 32%, and petroleum to 25% from 35%.
Operating margins should get a boost as Jacobs derives a greater proportion of revenue from more profitable projects. Margins should also benefit from lower field-services costs and synergies from acquisitions. Jacobs will likely expand its network via acquisitions both domestically and abroad, focusing on areas that it's familiar with and where it has existing operations, such as Singapore, where $1 billion of work is available.
It should continue to keep a lid on general and administrative expense through low-cost engineering centers in places like India. Its strong cash flow ($145 million in fiscal 2002) should help fund further debt reductions (Jacobs' 9% debt-to-capitalization ratio, at December 31, 2002, remains one of the lowest in the industry) and allow for niche acquisitions, as it focuses on balance-sheet improvements rather than share buybacks.
GOOD UPSIDE LEFT.
While the shares have already enjoyed a nice run-up, having risen 40% since October, 2002, S&P believes further gains are in store because of Jacobs' favorable growth prospects and an established management team. The stock trades at approximately 16 times our fiscal 2003 earnings-per-share estimate of $2.30, on par with the projected multiple for the S&P MidCap 400 Index, and at less than 14 times our fiscal 2004 projection of $2.65, a discount to the expected 2004 p-e for the index. In addition, the stock's PEG ratio (p-e-to-EPS growth rate) is only 1.1, and its return on equity (ROE) of 17% is above the industry average.
After applying a multiple of 20 to 22 times our fiscal 2003 estimate, we're targeting a stock price of $46 to $51, representing potential upside of 24%. Based on S&P's Core Earnings model, earnings per share, including 28 cents per share for stock-option expenses and 7 cents for pension costs, are projected at $1.95 in fiscal 2003. Although Jacobs' three pension plans (two in the U.S.) were underfunded by nearly $73 million at fiscal 2003 yearend, one is frozen, while the U.S. government is funding another.
Given Jacobs' superior earnings-growth record and relatively low-risk profile, and S&P quality ranking of B+, we believe the shares have potential for further capital gains.
Analyst Scharf follows engineering and construction stocks for Standard & Poor's