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Keeping an Eye on Construction Risk: How to Avoid Losing Money in the Early Stages of an Infrastructure-Spending Upcycle
All indications are that we are entering a new global infrastructure spending cycle. The American Society of Civil Engineers (ASCE) has repeatedly given barely-passing grades to the United States’ infrastructure and estimates that $1.6 trillion will need to be spent on upgrades over the next five years; President Obama recently embraced a new round of domestic spending on roads, bridges, rail, and clean energy projects in his 2011 State of the Union address. Canada, meanwhile, is reported to be running an infrastructure spending deficit of some $120 billion, which will have to be rectified in the coming years. In Australia, Engineers Australia, an outfit similar to the ASCE, estimated that years of under-investment in that country’s infrastructure had caused a shortfall of A$700 billion that needs to be made up rapidly.
Elsewhere in the Pacific rim, China’s rise as an economic superpower will likely require decades of spending on roads, bridges, dams, power plants, seaports, airports, broadband service, water systems, defense installations, oil and gas refining, transportation and storage facilities, and other infrastructure needs, to bring that country’s still laggard national physical plant up to speed with its fully industrialized competitors. Singapore’s bid to become a regional refining and energy transport hub has bumped refinery, storage, and port construction spending in the city-state into high gear. The tiny country has been pouring well over $10 billion a year into public works since 2009. Other countries likely to increase spending in the coming years are fast-growing, but infrastructure-poor Malaysia and India.
All told, analysis by CIBC World Markets estimates that the next 20 years will see some $35 trillion in public infrastructure spending worldwide to modernize developing countries or make up for deferred spending in the industrialized world. This would normally be expected to benefit global engineering, procurement, construction, and management (EPCM) companies, such as Fluor (FLR), Jacobs (JEC), The Shaw Group Inc. (SHAW), Foster Wheeler (FWLT), Chicago Bridge & Iron (CBI), The Babcock & Wilcox Company (BWC), and KBR, Inc. (KBR). Indeed, the share prices of these companies, broadly speaking, have performed well since about the beginning of the second half of 2010 on hopes of a new spending cycle.
Though a large secular increase in demand (as measured by spending on the scale described above) should generally boost backlog, profits, and thus share prices of EPCM companies, there are near-term risks in committing funds to this sector. Investors should be aware of these.
The first thing that investors should be aware of is the nature of the contracts that EPCM companies undertake. Contracts in this industry generally fall into one of two broad categories: lump-sum turn-key (LSTK, sometimes called fixed-price), or cost-reimbursable (sometimes called cost-plus). The latter type is more or less self-explanatory; customers agree to pay the cost of building a project, plus a set profit margin to the EPCM, with certain legal safeguards in the contract for the customer to prevent lax cost-control on the part of the contractor. In LSTK contracts, however, the contractor estimates the cost of the project, and then bids a price that gives the builder some profit. The problem with such contracts is that the risk of cost overruns falls entirely and without limit on the contractor; also, in down cycles, there is tremendous competitive pressure to rebuild backlog and few projects to bid on, which can force EPCM companies to underbid projects, setting themselves up for big problems down the road.
Examining the trading history of companies like The Shaw Group, or especially Foster Wheeler, shows the tremendous losses, and share prices drops, that can follow from exposure to excessive construction risk. To avoid losses, investors should examine, if it is disclosed, the proportion of lump-sum turn-key contracts in a company’s backlog. By itself, taking on LSTK projects does not have to be a bad thing; margins are often wider on such projects to reflect the greater risk being taken by the contractor. Thus a well-budgeted, well-executed LSTK project can be a real boon to an EPCM company. But they are risky, even for the most seasoned, well-regarded companies.
When these projects go wrong, there are often early warning signs on a company’s balance sheet and cash flow statement. Let’s examine Fluor’s statistics; the company provides a good example of the type of analysis an investor should do, because it is the largest U.S. EPCM outfit, has an excellent track record of successful execution of very complicated projects, and takes on a substantial number of lump-sum projects (September-period backlog is about 21% fixed-price). Finally, the company’s results in the second half of 2010 were disappointing because of a number of substantial charges related to cost overruns on fixed-price projects: the most significant were $343 million of charges to earnings related to delays on the huge ($1.8 billion) Greater Gabbard wind farm project offshore of the United Kingdom (the company did record a $152 million tax benefit related to these charges).
The Greater Gabbard project started in 2008. Looking at the current position box on the latest Fluor Value Line page shows that inventory at the end of the September period of 2010 had just about doubled from the end of 2008. Inventory in Fluor’s case refers to contract work in progress. Contract work in progress represents costs incurred by the company for which revenue has not yet been booked (or billed). Thus, it is money owed by the customer to the company, an asset. The problem with the large run-up in this asset is that, should the revenue become uncollectable for any reason, the company would face large potential losses. Not all of Fluor’s contract work in progress relates to the troubled Greater Gabbard contract, but some of it certainly does, and the rapid growth in this balance sheet item should give investors pause, given the problems that have already occurred with this exceptionally complicated project.
Another important metric by which to gauge whether an EPCM company is suffering from bad contracts is free cash flow. Free cash flow, simply defined, is cash flow from operations, less capital expenditures. The measure is favored by those who view it as a more clear picture of a company’s current cash-generating ability, and less susceptible to accounting gimmicks. By this measure, Fluor is having a bad year. In the first three quarters of 2010 (the latest available), it has generated slightly negative free cash flow (and not because it is engaged in a substantial capital expenditure program). In 2009 and 2008, by contrast, it generated more than $665 million and a bit more than $650 million, respectively, figures it has no hope of matching this year.
It would appear, therefore, that Fluor, in its rush to compete for projects and build backlog during the recession, may have departed from its historical budgeting caution and exposed itself to contracts that will hurt it in the next few years. What is worse is that the strong new award totals for 2010 (totaling more than $27 billion) have been driven by strong bidding in the rather narrow-margined mining sector. The tight margins in that construction market mean that there will not be a lot of profit coming from Fluor’s revenues in the next few years to cover potential future cost overruns.
Fluor’s stock price, meanwhile, has floated along, more or less undiminished by the signs of trouble on the near horizon. Investors interested in buying for the coming long-term infrastructure spending cycle should, therefore, conduct similar analyses, in order to protect themselves from experiencing unpleasant near-term price declines.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.