Engineering and construction (E&C) companies are generally considered late-cycle in that their performance lags the broader economy by several quarters. So far, profits have held up very well as they work through the project backlogs accumulated in past years, even as current order win rates remain rather anemic. Going forward, as customers move out of capital conservation mode and begin posturing themselves for sustainable growth, backlog will eventually grow again. However, companies will be reluctant to commit to sizable new projects until the economic recovery gains stronger footing--making growth elusive as the economy totters along. Moreover, new backlog probably won't translate into sizable revenue for some time, as E&Cs don't book revenue until the projects get underway. Lastly, due to increased competition during these lean times, backlogs booked during this period can carry a slimmer margin which will impact E&C's earnings for many quarters, or even several years in some cases.
Against this challenging backdrop, E&C companies accumulated sizable cash piles during the last two years in response to the extremely uncertain economic climate. Due to their low capital intensity, and the fact that many projects booked during fatter times were reaching completion, E&C companies had very strong cash-generating capabilities. We expect companies to counter the lack of organic growth with bolt-on acquisitions in order to reach their targeted growth rate, fill in technical competencies that they lack, or expand into geographies they don't serve. Historically, E&C companies have relied on acquisitions for a third to half of their growth, and we expect more intensive M&A activity in the next several years.
The Developed Markets vs. The Developing Market
Recovery in developed markets is likely to be choppy. In the U.S., E&C companies are facing fierce competition with more companies chasing small project pipelines. The public debt crisis circling European countries is putting a damper across the Atlantic, as sovereign countries become more reluctant to use their national balance sheets to stimulate the economy in order to support the sanctity of the Euro. Companies that have operations concentrated in these regions, such as Granite Construction (NYSE:GVA), Jacobs Engineering (NYSE:JEC), and URS (NYSE:URS) will likely experience lower margins and slower growth, unless they aggressively enlarge their service territories and shift their mix of offerings.
Things look much different in Eastern Europe, the Middle East, and Australia. Australia, being the only developed country that didn't really encounter the global recession (and much that comes out of the ground is exported to China), sprung back much faster. Opportunities in these regions abound, and companies serving commodity exploration and production facilities, infrastructure, and nuclear power generation will likely see their backlog improve more rapidly.
How does M&A Compliment Existing Operations?
At the end of the day, the E&C business is a people business. Companies are trying their best to maximize utilization of their technical professionals, particularly in the downturn. The ability to move people out of the U.S. and the U.K. to capture opportunities in countries such as Libya or Hong Kong (or out of California to New York) is crucial to maintaining corporate growth and profitability. A broad footprint enables companies to take advantage of the peaks and the valleys of the global economy. In general, it is much easier to grow into geographic regions through acquisition of an established platform than it is to grow from the ground up. Recently, we have seen Jacobs Engineering JEC and URS URS both making inroads to expand their service territories into the Middle East, India, and other promising regions.
The other driving force of M&A is gaining specific niche service expertise. Industries do not recover from recessions at the same speed or magnitude. For example, mining and upstream oil and gas production, particularly front-end work, can produce juicy profits for E&C companies while downstream refineries and petrochemicals sectors are likely to still be in hibernation. For government services, companies that have expertise in global rapid-rail services or intelligence and IT support generate healthier margins than companies that rely heavily on state and local government for small road maintenance projects. AECOM's (NYSE:ACM) $1 billion acquisitions of McNeil, Davis Langdon and Tishman are prime examples of this. Foster Wheeler also made a few small deals to spruce up its offshore deepwater offerings.
Do acquisitions ultimately benefit the shareholders of E&C companies? That becomes a key issue for long-term valuation. When large E&C firms embarked on the spending binge in the last decade, they accumulated significant human capital. We noted that during this downturn, they competed fiercely to undertake low-margin businesses in keeping their employees' utilization high, rather than reckon with industry overcapacity and eliminating what they consider difficult-to-replace engineers. Now as things begin to roll around, are we looking at history repeating itself?
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