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Fluor (NYSE:FLR) is the largest publicly traded engineering and construction company in the US and one of the largest in the world, providing engineering, procurement, construction, and maintenance services (EPCM) to mainly companies in the oil and gas, manufacturing, and power sectors and the United States federal government. Fluor's oil and gas segment contributes more than half of the company's operating income. Business is contract-driven and diversified by both geography and business mix.

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Investment Thesis

Over the past two years we have seen stabilization in the capital and commodity markets as the street gains confidence in the economic recovery.

  • Crude oil has risen from trough levels and has stabilized at higher prices, making projects more viable.
  • Favorable credit conditions are allowing project sponsors to get financing for their projects Global economic growth will be led by strong emerging market growth with more modest recoveries in the U.S. and Europe.

In our opinion, a strengthening economic recovery in the developing world and an improving fundamental landscape should translate into strong oil and gas new award activity over the next several quarters. It is clear to us that the improving story behind Fluor will allow for further multiple expansion.

Therefore, we expect FLR to outperform the S&P500 during this economic growth cycle driven by improving backlog growth fundamentals and robust earnings upside. Our view also suggests that the worst is over in terms of margin compression and additional contract charges because of:

  • Backlog continues to grow and will likely surpass prior peak by year-end reflecting the strength in the oil and gas markets, in addition to mining, power generation and government contractual work.
  • FLR signaled margins have bottomed and projects being put in backlog have higher margins versus six months ago, suggesting capacity is tightening.

We believe growth in EPS to stem from better profitability in new backlog and because of this, we believe further upside is likely and a premium valuation relative to the peer group is warranted given that FLR has the potential for margin expansion given an improving business mix (i.e. larger portion of revenues from Oil & Gas Segment) and is increasingly well diversified geographically (i.e. 74% of backlog international). That said, we do recognize two important drawbacks:

  1. Given the strong performance in 2010, we recognize that FLR valuation is not as attractive as it was 12 months ago but neither do we believe that current prices reflect a prohibitively expensive valuation.
  2. The potential for share price volatility and skepticism on the behalf of investors the result of two consecutive quarters of material charges related to the Greater Gabbard Offshore Wind Farm project (the latest was another $180M in Q4). Even so, we do not believe the project is a threat to the long term viability of the company and would use any undue weakness in the share prices as a buying opportunity.

In summary, our viewpoint suggests that FLR can achieve normalized earnings in the not so distant future and that valuation multiples can continue to expand as has been the case in previous cycles. However the risk reward is not as clear as it used to be. Therefore, we have reduced our position in FLR from 8% to aproximately 2.5% of our portfolio. However, we would consider buying at $63/share.

Valuation

FLR is currently trading near its historical average trading multiple on 2011E P/E, but at a premium to its peer group, reflecting its strong growth prospects and solid balance sheet ($2bn in cash, about $13.20 per share and $117m in debt)

Risks

  • Increase in the proportion of fixed-price contracts presents a downside risk to margins
  • Increased competition for new business could cause FLR to bid more aggressively for new work, crimping margins and/or increasing execution risk on future contracts
  • External events such as natural disasters, workers’ strikes or geopolitical issues could create logistical issues at individual job sites, which could lead to project-related charges
  • Regulatory developments could negatively impact demand in a number of FLR’s markets, depending on the outcome
  • Slower-than-expected global economic recovery rally might lead to lower-than-projected capacity investment, including the energy sector
  • Exposure to contracts in high risk geographical areas
  • Potential for arbitration on completed or ongoing projects
  • Negative changes in general economic factors, commodity prices, or input costs could impact demand in commodity-related sectors.
Source: Improving Fundamentals, Robust Earnings Upside: Expecting Fluor to Outperform