There aren’t that many industries these days with years of visible sales and profits ahead of them. Munitions, perhaps, although you are always at risk of an outbreak of sanity. The best industry bets right now are the large engineering and construction (E&C) companies.
I have spent time among energy people lately, all of whom seem to have sheaves of plans for big projects. What they don’t have are the people to carry them out. Almost a generation of engineers, geologists, and other specialists is missing, thanks to the 20 years of lean time. The companies who already have the engineers, managers and patents on hand are in a seller’s market.
But which are the best prospects? E&C is a cyclical business, so towards the end of a cycle you should probably look at the well-capitalised companies that never seem to get into trouble. At this point, however, a different strategy may make sense.
The Iraqi reconstruction programme has been a classic example of companies failing to exercise discipline in contract administration. KBR, the Halliburton subsidiary, took on every possible task thrown at it by a profligate (and incompetent) US controlled Coalition Provisional Authority.
It seemed as if it would be easy money: a desperate customer, plenty of cash, and laughable audits. It did not turn out that way. KBR and Halliburton wound up with a very bad public relations problem and a cash flow squeeze.
The lack of control by the customer had infected the contractor. And KBR did not have the people with the skills necessary to take on all that was asked of it.
The secret to being a profitable engineering contractor is not just to know the technology but to stay within the original scope. That is easy to write in a mission statement but when times are lean it is tempting to take on task after task hoping that things will turn out well.
Which is what happened to Foster Wheeler. In the 1990s FW managers had a “can do” attitude to projects such as giant waste-to-energy plants that were technically difficult and economically marginal. A number of these required the company to put up a lot of its own money to complete.
It was not just the financial commitment. Foster Wheeler had good technology for specific parts of power stations but it had reached beyond those skills. “We took on entire power projects rather than the ‘boiler island’, where our real expertise is,” says a company official.
A number of very big power plants went well over budget, with Foster Wheeler on the hook for the difference. The result was a billion-dollar debt by the start of the decade, a negative net worth, and the prospect of a court-ordered restructuring. This happened in the middle of the 2000-02 crunch. Instead of filing under Chapter 11, however, a new management team under Raymond Milchovich, chief executive, was able to persuade lenders to go through a series of out of court debt for equity exchanges. The last of these was completed in April, leaving $191m in long-term debt.
Given that even now Foster Wheeler has a negative net worth of $239m, after taking the project write-offs and a series of asbestos reserves, this was not necessarily an easy sell. But in 2002 Mr Milchovich appointed an internal tsar to review FW’s “project risk management” and gave him the power to kill potentially uneconomic deals.
The lenders-to-be-shareholders believed the company had got the message about staying disciplined on project scope and pricing, so they gave FW the necessary breather.
E&C companies often incur negative cash flow at the beginning of projects, before the progress payments and completion bonuses start to roll in. Profits have a tendency to bounce around from quarter to quarter.
Still, the industry’s preferred metric – operating earnings before interest, taxes, depreciation and amortisation – has been turning up quickly for FW. In 2004 that came in at $214m, which rose to just under $280m for 2005. The backlog was up to $4.55bn by the end of the first quarter, more than twice last year’s revenues of $2.26bn.
FW has a promising set of core technologies. Still, why buy into a company that, to be blunt, has a past? Why not buy stock in Fluor, a process engineering company with good technology and management that never seems to get into trouble?
Look at the charts of the two companies. Industry and market conditions that lead to a blip in Fluor stock create dramatic swings in Foster Wheeler’s paper. That is what you would expect with a thin to non-existent equity base in an edgy market. But the upside is going to be more dramatic for FW – it may have a history but it sure has beta.
What about a fall in energy prices? What would that do to the backlog and future orders? The company says that even higher cost customer projects are economic with oil at $35-$40 a barrel.
As it happens, that is my base assumption for oil two years out. Prices will not stay in the $70s – not with substitution, demand destruction and new supply – but if they fall below $40 that new supply will slow or stop. So there is a good floor under the demand for energy E&C.
The International Energy Agency estimates at least $3,000bn is needed for oil and gas capital expenditure during the next 25 years, or about 1,000 times FW’s annual sales.
I don’t buy the “peak oil” theory. There are plenty of hydrocarbons to be found. They will, however, be more expensive to produce. You are already paying the price. Why not profit from the trend?