KBR is a Halliburton (HAL) spinoff that has attracted much negative press due to circumstances surrounding the awarding of contracts for Iraqi reconstruction and support. Do not let media reports detract from KBR’s ability to execute, however; the bidding process for contracts is very competitive, and KBR has been deemed the company best suited to meet the Army’s needs. About 63% of KBR’s revenues come from its Government & Infrastructure (G&I) segment, with 78% classified as US Government Operations – Middle East. This means that roughly 50% of total revenues come from work in the Middle East, although only 24% of operating income is attributable to that.
Another significant profit driver is upstream work in the energy complex (23% of revenues but 36% of operating profit), and KBR is also involved in downstream work with refining oil, petroleum products, and chemicals.
I find the stock attractive because of two main points: the balance sheet, which creates a favorable risk-reward, as well as the customer base, which has given KBR a substantial backlog of work to complete.
From a business perspective, a company that handles large-scale, asset-intensive capital projects might be in a position of uncertainty during a credit-driven recession. There are certainly many stocks that I wouldn’t want to own right now because of that affiliation, but KBR does not fit in with, say, solar stocks.
As was recently discussed on their conference call, KBR’s customers are some of the largest entities in the world – governments, national oil companies and the integrated majors. It’s often forgotten that despite the (slightly diminished) market caps of leading oil names, the largest oil companies are all state-run. Having a customer base that’s comprised of cash-flow-rich oil companies and governments means that financing projects is much less of a concern, and CEO Bill Utt indicated there have not been any cancellations or delays of KBR’s $15 billion backlog (compared to roughly $10 billion in annual revenue).
Additionally, KBR has an excellent balance sheet – probably the best of all the heavy construction companies – with over $1 billion in cash and no debt, for a company with a market cap under $2.5 billion. The potential to make add-on acquisitions to diversify KBR’s business lines via acquisition, or to return capital to shareholders, provides a cushion for the patient investor. All in all, the solid balance sheet and backlog create a favorable risk-reward, with $6.65/share in net cash (50% of the stock price) and $9.50/share in net tangible assets (65% of the stock price). While irrational markets make me hesitant to say those figures will hold, taking a reasonable view of the risks relative to the upside presents an intriguing picture.
Backing out the cash, KBR trades for about $8/share. That’s less than 5x current earnings, and about 4x next year’s projected figures. On a 10x or (dare I say) 15x earnings multiple plus cash, this stock should go for $25-$34/share (+70% to +135%), and considering a reasonable price-to-book relative to adjusted return on equity, I figure this is roughly a $36 (+150%) stock
There could be an argument that the political uncertainty surrounding the military’s future role in Iraq could hurt results, but even backing out those earnings and applying a 10x multiple plus cash, I still arrive at a $20 stock price. How did KBR get to these levels? Jeff Gendell’s hedge fund, Tontine – which is supposedly liquidating holdings – was a major holder of KBR. I believe they had a good thesis, but other bad bets on the market caused them to become distressed sellers. One of the informal rules: look to buy good assets from distressed sellers.
See the slides from the presentation.