Fluor: Why Turnaround Is Difficult Despite Experienced New Management Team
- Fluor is under SEC investigation after taking huge charges in Q2 last year.
- The company's problems do not arise from its execution capabilities but unrealistic estimates while bidding for projects under its previous management.
- Until there is more clarity on future charges, I remain on sidelines.
Fluor's (NYSE:FLR) stock price has corrected ~50% over the last couple of weeks after it announced an SEC investigation into the company's accounting and financial reporting. The hefty $714 mn in pre-tax charges which Fluor took in the second quarter of 2019 has attracted SEC's attention. Fluor is not the only E&C company which has taken significant charges in the recent past. Recently bankrupt McDermott (OTCPK:MDRIQ) took $485 mn in charges in the first nine months of 2019 before filing Chapter 11. Granite Construction (GVA) also reported significant negative revisions in its project profitability estimates last year (see my article on Granite here).
In order to understand what is causing these charges, one should understand the percentage-of-completion accounting method these companies are using. Fluor and most of the other E&C companies recognize revenue using the percentage-of-completion method, based primarily on contract cost incurred to date compared to total estimated contract cost. The percentage-of-completion method of revenue recognition requires the company to prepare estimates of the cost to complete for contracts in progress. In making such estimates, judgments are required to evaluate contingencies such as potential variances in schedule and the cost of materials, labor cost and productivity, the impact of change orders, liability claims, contract disputes and achievement of contractual performance standards.
In addition to risks and resulting variance due to project delays, cost overruns or other problems, there is also risk from overly optimistic assumptions particularly on lump-sum or fixed-price contracts. Sometimes, in order to secure a project, a contractor like Fluor may come up with an unreasonably low bid. This is particularly true if there is intense competition and the end market is not seeing much project activity. Those incorrect assumptions then find their way to the company's P&L while using the percentage-of-completion method. At the end of the project, when it becomes apparent that the actual cost of completion is much higher than initial estimates, the company ends up taking charges.
Fluor's former chairman and CEO, David Seaton, himself accepted that the company (and its competitors) had gone too aggressive in bidding in one of its end market - gas-fired power projects. On Q1 2018 earnings conference call, he had commented:
"...I also stated that we were in the process of assessing the gas-fired market to determine if there are opportunities for risk-adjusted returns that are consistent with our expectations and long-term experience. I'd like to share with you the outcome of our review and the further actions that we are taking. I'm going to ask everyone to pay close attention.
The U.S. power consumption growth rate is less than 1%. Power producers do not really need additional capacity other than satisfying regional needs. We, the industry, and the entire E&C community have led our clients to believe that a gas-fired power project costs approximately $650 per kilowatt, although virtually no one has delivered one for that value.
The customers start at that figure, negotiate it downward and there's always some contractor that is willing to say okay to the lower number using some excuse to justify the win, Fluor included. We have had 12 gas-fired power projects since 2003. 10 of the 12 have underperformed our as-sold expectation with three suffering losses. Competition, both public and private, have had similar experiences with no current projects performing as expected."
David Seaton resigned as chairman and CEO last year. The company brought back its previous chairman and CEO, Alan L. Boeckmann, as executive chairman. He had served as chairman and CEO of the company from 2002 to 2011 and the company posted impressive growth during his tenure with its net earnings increasing to $593.7 mn in 2011 from $163.6 mn in 2002. Its stock price also saw a significant increase during this period. He soon appointed Michael Steuert who has previously worked as Fluor's CFO from 2001 to 2012 as CFO and Carlos Hernandez as CEO. The new management team is well regarded and I have little doubt about its project execution capabilities. However, the problem here is not project execution. If a gas-powered project cannot be completed for $650 per kilowatt, no matter who is involved in executing the company would have to take charges. Unfortunately for new management and Fluor's investors, the problem was not restricted to the power market alone.
After the current management stepped in, it scrubbed through the backlog and booked $714 mn in pre-tax charges across business segments in Q2 2019. This clearly is a case of aggressive estimates/financial projections gone wrong across the board rather than execution issues on a couple of projects.
What remains after taking these charges is projects at break-even margin in backlog which the company has to deliver to clients. If there is even a slight execution issue or externalities, these projects can easily go into losses and the company has to take further charges. For example, if coronavirus pandemic gets worse and Fluor has to take some downtime, some of these projects can easily turn red.
Further, the question still remains if new management has reassessed all the project estimates and if it was conservative enough. Given what previous management and other companies have done, there seems to be quite a leeway in terms of estimating the cost to complete projects. Even after taking huge charges in Q2 2019, management is still examining projects for more charges. In its recent earnings call, management talked about potential charges in two big projects. While it has declined to provide more details saying its books are still open and we will probably know about these charges when the company files its 10-K, I believe this signals there might be more pain ahead.
Management also has a reason to not be conservative. These are not normal times for Fluor. After taking charges in Q2, in addition to reversing previous profits, the company will have to incur $500 mn additional cash expense in 2020 and 2021 to complete the problem projects. Things are already not going well for Fluor and more charges would have added more questions to the viability of its business. So, if management has some leeway in terms of its profitability estimates, there is a chance that it would not have gone conservative enough in taking these charges.
It seems like Fluor's fixed-price contracts really have a bad reputation in the market. Last year, when the company kept its government business on the block (before reversing the decision last month), it excluded two troubled fixed price projects: Radford and Warren. I believe investors would not have been comfortable with the forecast of these two projects and worries regarding any further charges would have turned off the potential bidders.
The company's balance sheet looks ok with cash and marketable securities worth ~$1.85bn and long-term debt at ~$1.64 bn at the end of Q3 2019. But I believe one should also account for $500 mn in cash expense Fluor will have to incur to complete some of the problem projects over the next two years. If there are any major charges, it can worsen the balance sheet. At the end of Q3 2019, the company had a backlog of $30.3 bn out of which 62% was fixed price or lump sum. So, there is a risk of further charges. E&C companies need to maintain a strong balance sheet as they need cash to execute large projects and clients prefer to deal with companies with a strong financial position as most of the projects are multi-year in duration.
I believe there is a lot of uncertainty around further charges in fixed priced projects which are making investors nervous. If it was just an execution issue, I would have placed my bet on the current management. However, there is very little it can do about aggressively bid projects with unrealistic estimates. I believe we will have some clarity over the next year as Fluor completes some of its problem projects and results of the SEC investigation help investors better judge the company's financials. Until then, I remain on the sidelines.
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