For the last six months, I have been patiently waiting for an entry into Quanta Services (NYSE:PWR). Often overlooked, this $7.6 bil. market cap. industry leader operates three booming business segments: Electric Power Infrastructure Services, Oil & Gas Infrastructure Services, and Fiber Optic Licensing and Other Services. Think of this company as your builder of anything interconnecting our utility network (electrical transmission, oil/natural gas pipes, and telecommunication).
I have to admit, I missed the run up in the stock from the low 30's in February to its 52-week high of $37.42 in April; a move of ~24% in two months. In the last few months, the stock has pulled back from its high and made a recent low of $32.60 on May 20th. Since then, the stock has been in a clear uptrend making three new higher lows. I would look to start accumulating the stock now in the $34 to $35 range and see it easily above $40 in the next six months.
Why I am so bullish on this stock? A little background on me: I have worked for various competitors to Quanta Services as an electrical construction manager in the Seattle area and can attest to the future growth I see for the industry. I also had the luck and misfortune of working for a 60 year old electrical contractor that went bankrupt as a result of the Great Recession.
For any contractor, there are three key indicators that I look for in determining the company's health: backlog, debt & working capital capacity, and sustained gross margins. How does the company measure up? Let's review:
Quanta currently has record backlog of $9.06 bil. as of recent quarterly filings. Keep in mind, this is larger than the company's market cap. and huge compared to Quanta's record 2013 total revenue of $6.5 bil. Essentially, Quanta has more than enough backlog currently to produce another record breaking year in terms of revenue without booking any further work. In addition, this backlog has consistently grown from $6.8 bil. end of 2011 to where it is today and I see this trend accelerating.
On the last press release on May 1st, 2014 for Quanta's fiscal first quarter, CEO Jim O'Neil stated, "We expect several large contract awards in the coming months which should result in significant backlog growth in both our electric power and oil and gas infrastructure services segments. This further supports our view that opportunities for double-digit growth exist for at least the next two years." He also followed it up in his conference call stating, "We continue to believe that we are in unprecedented times, not only in Quanta's history, but in the history of electric power, and oil and gas industries."
These are strong statements coming from a fairly conservative CEO and I would not take them lightly. The North American electric grid has been under-serviced for years and continues to age. In order to maintain adequate reliability, significant investments are no longer optional, but necessary. Quanta also benefits from favorable government regulations as the administration pushes into green energy, integrating natural gas and renewable electric generation into the grid, while taking coal generation offline. Electric infrastructure services account for 69% of Quanta's 2013 revenue and is clearly in a multi-year uptrend.
Not to be outdone is Oil & Gas infrastructure services, accounting for 29% of Quanta's 2013 revenue and is too, in a secular uptrend. Demand for pipeline engineering and construction is robust, driven by unprecedented development in the North American's shale formation and the Canadian oil sands. It's no surprise that this segment produced 22% year-over-year revenue growth in 2013. I see this segment's backlog continue to grow as the US continues its transition to becoming energy independent.
Debt & Working Capital Capacity
As of last quarter, company currently has $273 mil. in cash and equivalents with $6 mil. in total debt. Company also has $1.1 bil. in unused credit facility bringing total working capital liquidity to approximately $1.4 bil. This is ample liquidity and I don't foresee needing additional working capital to perform its current backlog.
For the first three months of 2014, company's gross profit of $272 mil. was 15.43% of revenue compared with 15.0% of revenue for the first three months of 2013, an increase of 43 basis points. As the year progresses, I see gross margin increasing above the 43 basis point level and could drive repeated earning surprises above the current consensus 2014 estimated $1.92 EPS.
The sustained margin improvement is driven by less competition in the marketplace as consolidation increases throughout the industry and projects becoming larger and more complex. Very few specialty contractors have the working capital or experience to fulfill the requirements of these larger projects, benefiting the more established players in the industry. Hence, the $1.4 bil. in working capital liquidity is a major competitive advantage for Quanta.
One other margin consideration is that a large portion of Quanta's revenue is derived from lump sum contracts, or fixed price agreements that are competitively bid often with price being the most important factor. For 2013, fixed price contracts made up 46% of Quanta's revenue followed by 34% unit price and 20% cost plus contracts.
Unit price and cost plus contracts are favorable for margins as they are bid or negotiated with set margins. Final price on the contract is determined by total cost multiplied by the established margin allowed, and thus provides a stable margin outlook for Quanta.
Where Quanta and all other contractors face the most risk is in fixed price contracts that are aggressively bid. With the potential for cost overruns and delays, fixed price contracts are margin killers should competition in the marketplace be too extreme. However, the opposite is true should the marketplace expand with less qualified contractors able to handle the complex scope and size requirements. Fortunately, this is the marketplace Quanta is currently in. As such, fixed price contracts allow for possible surprise margin improvements rather than a potential risk for margin erosion.
With the company firing on all cylinders with the two main operating segments in a secular multi-year uptrend, one would expect Quanta to be trading at the high end of its valuation. However, the opposite is true with the stock closing at $34.83 last week. Based on the July 11th close, Quanta is trading at trailing PE of 19.61. The historic 10 year average multiple for Quanta is 24. As the company continues to perform and exceed expectations, I believe the current multiple will eventually get back to its historic range. I am putting a conservative multiple of 22 for Quanta by year-end and based on consensus estimates of $1.92 for 2014, my year-end target for the stock is $42.24.
Last week, I decided to go long the stock and plan to hold it in my portfolio for years to come. I also decided to play the stock with options in my trading account with a 6-month outlook. I bought Feb. 2015 38 strike call options and paid $1.46; breakeven on the trade is $39.46. Should the stock hit my year-end target of $42.24, the intrinsic value on these options alone should be $4.24 not taking into consideration remaining time value should the price target be reach prior to Feb. 20th, 2015 when these options expire. With entering any trade or investment, risk management is top priority and a stop loss is essential. Stop loss for this trade is the recent low of $32.60; look for an exit should the stock test and break this level.
Disclosure: The author is long PWR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.