A Thorn in Halliburton's Side

The Kellogg Brown & Root unit is putting a big hurt on the stock. Is a parting of the ways likely?

By Stephanie Anderson Forest

Chief Executive David J. Lesar might be right when he describes Halliburton Co. (HAL ) as "the most scrutinized company in the world." The $20 billion Houston giant has taken a public beating in the past couple of years over allegations that its Kellogg Brown & Root (KBR) engineering subsidiary overcharged the government on Iraq contracts and that some KBR executives bribed Nigerian officials, as well as for costly ongoing asbestos litigation. But in the eyes of some investors, the most damning thing about KBR is that it doesn't make any money.

For that reason, investors and analysts are betting that Halliburton will dump KBR within six months to a year. The unit is a poor fit with Halliburton's successful oil-services business, they say, and its weak performance explains why Halliburton trades at a significant discount to its peers. Says energy analyst Jason E. Putman at Victory Capital Management Inc., which holds some 2.3 million Halliburton shares: "KBR has become an albatross for them."


  The 51-year-old Lesar, who took the reins at Halliburton when Dick Cheney stepped down to run for Vice-President in 2000, is being tight-lipped about KBR's fate. He was expected to address the issue at a Sept. 23 investor and analyst meeting, but some investors say that in private conversations Lesar has already admitted that he sees few synergies between Halliburton's oil-services business and KBR, its engineering and construction unit.

Lesar says that while the question has been posed to him in conversations with investors, he does not recall having such one-on-one chats. Through e-mail, he said: "After KBR emerges from bankruptcy and we resolve the asbestos issue, we will take a look at our entire business portfolio."

To many observers, shedding KBR should be a no-brainer. Its problems began long before the Iraq contracts made Halliburton a target of Bush Administration critics. KBR inherited the asbestos mess back in 1998, when Cheney bought Dresser Industries. As lawsuits piled up, KBR was forced to file a prepackaged bankruptcy last December. In July, Halliburton won court approval of its $4.2 billion asbestos settlement plan. The company now expects to emerge from reorganization in the fourth quarter with the asbestos headache gone.


  Meanwhile, though, charges related to the litigation and losses on a huge project in Brazil led to a $292 million operating loss for KBR in the first half, on revenues of $6.8 billion. That comes on top of a full-year 2003 loss of $36 million, on revenues of $9.3 billion.

For all the headlines they've generated, many of KBR's $23 billion of government contracts only barely turn a profit. For instance, in the second quarter, KBR eked out an operating margin of 1.4% on its $1.7 billion of Iraq-related work. All told, KBR now has $11 billion of Iraq contracts. Margins are expected to fall even further in the near term, as a large oil field construction contract ends and work on smaller, less profitable job begins.

The work in Iraq has turned out to be far more complex, and dangerous, than the company envisioned. If KBR decides to bid for other contracts there, it will likely "jack the margins up significantly," Lesar said at a Lehman Brothers (LEH ) conference in New York on Sept. 7. By Stephanie Anderson Forest


  Nevertheless, KBR remains under fire for charges that it has inflated its Iraq billing. The company has powerful enemies in Congress, including outspoken Representative Henry A. Waxman (D-Calif.), who has attacked Halliburton and its missteps in Iraq as "overcharging the taxpayers." Halliburton denies the allegations and, in fact, on Sept. 7 the Pentagon's Defense Contract Management Agency (DCMA) said KBR's purchasing policies and practices are "effective and efficient."

Yet the Pentagon may still withhold 15% of future payments, amounting to about $60 million a month, on a troop support contract until Halliburton provides details to back about $1.8 billion of work already completed. Lesar says that if that happens, the impact on KBR will be mitigated because it will withhold payments from its subcontractors. The Army is also now considering breaking up its multibillion-dollar logistics contract in Iraq among several players. Halliburton says that it has anticipated that possibility, although it may still bail out altogether if too many bidders vie for the work.

The mess at KBR stands in stark contrast to Halliburton's oil-services business. Thanks to stubbornly high oil and gas prices, it's hitting on all cylinders, making drill bits, testing wells, and providing software to help oil companies improve their drilling odds. Indeed, while the Energy Services Group (ESG) accounted for only 43% of Halliburton's revenue last year, it pitched in all of the company's $720 million operating profit.


  Investors believe that KBR's subpar performance is the major reason Halliburton's stock trades at a 20% to 25% discount to other big oil-services outfits such as Schlumberger (SLB ), the industry leader, and Baker Hughes (BHI ). Those companies have price-to-estimated 2005 earnings ratios in the mid-twenties, vs. Halliburton's forward p-e of 19.7. Analyst Robert F. Mackenzie of Friedman, Billings, Ramsey & Co. (FBR ) figures that Halliburton, the No. 2 oil-services player, should be trading at around $40 a share.

He estimates that ESG alone is worth $34.50, and a stand-alone KBR would be worth about $2.5 billion to $3 billion, or $5 to $6 a share. Yet Halliburton trades around $32. To Mackenzie that implies that "KBR is [currently] worth less than zero."

For the time being, Lesar has promoted Andrew R. Lane, a 22-year veteran of Halliburton's oil-services business, to fix KBR's problems. Lane, who is 45, is expected to place bigger bets in the emerging liquefied natural gas (LNG) market -- the business of designing and building plants that liquefy natural gas for shipment and reconvert it at the receiving end. LNG is one of KBR's few bright spots. The unit is the worldwide leader in building the processing facilities, which are in high demand. KBR has built more than half of the existing plants worldwide over the past 30 years.


  KBR also is shifting away from big fixed-cost offshore construction contracts, to contracts where costs can be reimbursed. Such fixed-cost work as the $2.5 billion Barracuda-Caratinga project, which involves converting two supertankers off the coast of Brazil into floating oil production, storage, and offloading vessels, has racked up losses of $762 million over the past three years because of building delays and cost overruns. Says Lesar: "In this business if you have just a few projects with problems it can consume the overall profit margins, and that's what we've seen happen recently."

Analysts say KBR is almost certainly worth more to another engineering outfit than if it was spun off to Halliburton shareholders. "Somebody may buy [KBR] just to get access to its LNG business," says analyst Robert S. Goodof of Loomis Sayles & Co., which owns about 1.5 million Halliburton shares. Prospective buyers could include large engineering competitors such as Fluor (FLR ) and Bechtel Group. Both declined to comment on any potential interest in KBR.

As KBR winds down its work in Iraq, begins using less risky cost-reimbursable contracts for its offshore business, and expands its LNG operations, the troubled unit may crawl back into the black. But the likelihood is growing that by the time KBR gets straightened out, it will no longer be flying the Halliburton flag.

With Stan Crock in Washington

Forest is a correspondent in BusinessWeek's Dallas bureau

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