Describe the thesis behind another energy-related holding, KBR, Inc. [KBR].
VB: KBR is the former Kellogg, Brown and Root subsidiary of Halliburton. It was spun off earlier this year and operates in two primary areas that each make up roughly 50% of its business. It provides engineering and construction services to large customers in the energy industry, managing projects like building refineries or liquid-natural-gas facilities. The more controversial business is in governmental services, which does things like operating military bases in Iraq or running supply lines there. Underpinning our interest here is another big secular trend: low energy and electricity prices for much of the last two decades led to a serious underinvestment in energy infrastructure that is now being addressed. Demand for this infrastructure will continue to rise as the global economy expands, and we think we’re only in the early innings of that trend. KBR’s backlog of energy projects has tripled over the past four years and is now close to $8 billion.
How do you see that backlog translating into earnings growth?
VB: The key issue, of course, is the probability one attaches to the signed projects happening. Here we think the visibility into this cycle is strong. Oil companies today are using $40-50 per barrel prices to justify capital-spending projects, so it will take a dramatic fall in oil prices from current levels to see disruptions in KBR’s signed projects.
CG: We’ve actually reduced our exposure to oil-and-gas production companies, because we’re seeing a more favorable risk/reward in energy infrastructure and alternative fuels (like ADM’s ethanol business). If oil prices go from $90 to $50 per barrel, the big oil companies will make considerably less money than they would otherwise. With that same price decline, KBR’s earnings prospects should not really change.
VB: The company’s book earnings will be messy this year because of charges related to the spinoff, so they’ll earn maybe only $1 per share. We see that tripling by 2010, to around $3 per share, driven by the signed backlog and an expectation that operating margins rise from around 4-5% to closer to 7%. These energy projects are very complicated and require experience in difficult parts of the world that only a handful of companies have, so we see much better pricing as demand stays strong.
What about KBR’s government-services business – are you expecting that to be more of an asset or liability?
VB: We basically expect it to remain steady, without a lot of growth, making it only 30-40% of the business a few years out as the energy side grows. We don’t believe the headline risk from Congressional inquiries into the Iraqi operations will result in any material business risk. Making no judgment onwhat may have gone on with certain contracts there, it’s inevitable that that work would be controversial.
KBR shares have doubled since the spinoff – at $41.10, how are you looking at valuation?
VB: Taking out the $12 per share of net cash on the balance sheet, the stock is currently trading at less than 10x our $3 per share estimate of normalized earnings. That’s half the multiple at which comparable companies like Fluor and Foster Wheeler trade – for a company that we think will triple its earnings. If KBR executes, there’s no reason it shouldn’t also get that 20x multiple, resulting in a share price of more than $70 after adding back the cash.
Are you confident here that they’ll spend cash wisely?
VB: We wanted them to buy back shares when the price was lower, but they’ve been slow to do that. They say they’re looking for acquisitions, which we hope would be smaller buys to expand into new markets – like the building of nuclear power plants, for example – rather than anything too big.