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Industry Analysis: Heavy Construction
The Heavy Construction Industry is comprised of companies that provide a broad array of engineering, planning, design, consulting, construction, and management services for a wide variety of infrastructure and facility undertakings. Projects range from highways, bridges, mass transit systems, and airports to commercial buildings, power transmission grids, oil and gas exploration sites, and water and wastewater infrastructure.
Customers include federal, state, and local governments, as well as private enterprises. Clients are located around the globe, though North America, Europe, Asia/Pacific, and the Middle East are the largest geographic markets.
Spending on construction-management services is cyclical. Many commercial clients will increase investment during the middle and late stages of an economic expansion; they usually cut spending in downturns. The opposite holds true for municipalities. Governments, when possible, spend heavily on infrastructure projects during recessions to stimulate recoveries.
Heavy Construction stocks are suitable for investors seeking above-average appreciation. The majority of companies in this sector do not pay dividends, and distributions that are made tend to be modest. Yields rarely exceed 2%. Investors in this industry should focus on a stock’s valuation and its relationship to the current business cycle (trough vs. peak).
Those with a long-term view may buy into this sector when the stock market appears to have bottomed. Momentum investors may find appeal when the economy is on an upswing. The companies under our review typically have Average (3) Safety ranks, with most having Financial Strength ratings of at least B++. Thus, Heavy Construction balance sheets are typically strong. This industry holds appeal for a relatively broad population of investors.
Revenue and Net Profit Streams
Companies in this industry compete for management contracts around the globe. The types of contracts vary in accordance with each stage of the business cycle. In the early part of an economic upswing, transportation demand will pick up, raising infrastructure spending. Once a recovery has taken hold, commercial businesses gain confidence and release cash for expansion. Late in the cycle, energy and commodity prices will rise, lifting spending on exploration and mining. The largest, most diverse companies can produce steady revenue and earnings streams through much of the business cycle.
In challenging times, competition in this sector can be fierce. When both government and commercial business is scarce, contract price competition heats up, pressuring profit margins. Operating and net margins are usually in the low double and single digits, respectively. A number of Heavy Construction firms specialize in just a few segments of the industry. Nevertheless, managements are cognizant of the benefits of diversification. Too, the companies also have to determine whether fixed or variable price contracts will yield the most income. Volatility in raw materials expense can make such determinations difficult. Managements may also boost profitability by improving productivity and efficiency. Acquisitions, divestitures and, among other actions, facility consolidations are common.
Mergers and Acquisitions
The barriers to entry in this industry are high, given the size and complexity of projects and capital funding needed. The sector is also mature. Companies expand through mergers and acquisitions; the most frequent transactions are of the bolt-on variety. M&A deals offer better diversification of the service base, improved end-market and geographic coverage, and maintenance of favorable competitive positions. Bigger scale helps to assure ample, steady cash flow. Even though the industry has undergone considerable consolidation, pricing power will come under competitive pressure in severe economic downturns, when the number of projects in development sharply declines.
Most of the Heavy Construction companies under our review have been able to maintain healthy balance sheets and keep plenty of cash on hand. Bolt-on acquisitions are rarely funded with debt. Large deals are often financed with equity, especially when share valuations are at favorable levels. Savvy managements, with a long-term view, pursue deals during weak business periods, when purchase prices tend to be more modest. M&A has helped companies better tap into the lucrative energy and infrastructure sectors.
The majority of members of the Heavy Construction Industry are capital intensive. But the companies do not generally carry heavy debt burdens. Managements are quite conservative. Indeed, debt ratios are typically under 30%. A few companies, mainly focused of providing management and engineering services, are more labor intensive. Most construction projects are long-term, and cash flow is fairly easy to predict, as are earnings, through the business cycle. Rich cash flow assures the funding of day-to-day operations.
In good times, excess cash is set aside for internal and external expansion. During challenging periods, some cash may go toward debt retirement and common stock buybacks in support of the share price. Generally, these companies are not known to be generous payers of dividends. We caution conservative investors that Heavy Construction stocks can be rather volatile in times of uncertainty.