- Fluor corporation and other construction companies are struggling with negative cash-flow due to cost overruns and overly optimistic contract bidding.
- Because most construction firms are struggling with negative cash flow today, they are likely to bid higher on new contracts tomorrow.
- Even if COVID causes Fluor's revenue to decline 50%, if its margins return to past levels, it would have a low hypothetical "P/E" today of 5-6X.
- The extreme rise in global unemployment and decline in energy costs is likely to lower Fluor's production costs.
- Fluor appears to have adequate working capital and cash to make it through a lasting period of negative cash-flow.
- Looking for a portfolio of ideas like this one? Members of Core-Satellite Dossier get exclusive access to our model portfolio. Get started today »
Engineering and construction companies have been in deep water for the past few years. This includes the likes of Fluor Corporation (NYSE:FLR), McDermott (OTCPK:MDRIQ)(bankrupt), Granite Construction (GVA), and Jacobs Engineering (J). While a few of these companies have remained profitable, many are taking significant losses due to aggressive bidding on large infrastructure projects. This led to the bankruptcy of McDermott, and many fear that it will soon lead to the bankruptcy of Flour Corporation which had a $5.29 EPS loss on its last quarterly report.
In fact, Fluor's charges were so large that the DOJ recently subpoenaed the company for documents relating to an SEC investigation regarding its extreme 2019 charges. As you can see below, the company is not alone in its steady decline lower:
Clearly, many large construction companies are in a state of secular decline. It is not that demand for infrastructure projects are low, demand is actually decent (as seen in revenue), only that companies appear to be underestimating costs. Construction is a thin margin business, so a small mistake can easily bankrupt a firm.
Still, when bankruptcy risk is high, the value opportunity is often higher. Let's take a closer look at the E&C business with the aim to determine whether or not Fluor can and will recover from its current hole.
Long-Term Trends in Infrastructural Construction
Revenue per share gives us a broad view of the secular trends facing a business. If it is increasing, it is likely that business activity is increasing and vice versa.
As you can see below, RPS increased dramatically for Fluor and its peers from 2000 to 2010 during a major global construction boom. With the recession, RPS declined due to a decline in private sector contracts but subsequently rose due in part to a rise in public sector contracts:
Since 2015, the business activity of most of these companies has stagnated. Fluor has focused its efforts on energy companies and had a backlog of $14.1B at the end of Q4 2019. It also has high exposure to mining and infrastructure with a backlog of $5.4B and $6.9B respectively.
Energy and mining are the riskiest of its business segments. Ongoing analysis regarding the depression in oil prices suggests that energy producers have overbuilt, creating a significant glut. With oil prices still below production costs for many producers, many have slashed 2020 and even 2021 CapEx plans, this will undoubtedly harm Fluor. Still, this is the highest margin section for Fluor at 3-5%.
Still, as you can see below, these margin rates are low by a historical standard. In fact, Fluor generated higher gross margins during the last recession than it does today:
I believe the above chart sums up the core problems in infrastructure construction well. All three of these companies have seen a decline in gross margins that began in early 2019. In general, these companies bid on projects years in advance so if they fail to account for rising costs in their bidding, they will face falling margins. Problematically, this also means low margins will last for a long period of time since.
Fortunately, since the declines are seen in other firms I doubt the SEC will find significant accounting breaches that will harm the company. It is certainly possible, but I'd personally bet against it. The subpoena caused the company to launch an internal review of its costs which caused it to delay its quarterly report. Most importantly, the subpoena and negative profits have scared the company's management, investors, and competitors into not being overly optimistic regarding costs when bidding on construction projects.
Inevitably, this trend will end and may actually result in construction firms assuming costs will be higher than realized, resulting in a sustained period of higher earnings. Over the coming years, I believe Fluror's profit margin will return to historical norms of 2-3%. This equates to $400-$600M in expected annual profits for a very attractive long-run forward "P/E" today of 2.8X-4.25X.
The question is, will Fluor's equity survive to realize these earnings?
A Look at Fluor's Financial Health
In order for investors in FLR to make a solid return, the company must stay afloat during this difficult period. Ideally without selling additional equity or taking on unsecured debt.
As you can see below, the company's balance sheet is quite strong. It has about $1.5B in working capital and $1.8B in cash. This is nearly equal to its total financial debt of about $1.7B (which is equal to its market cap):
The company's CFO is also much better than its abysmal net income. If we assume its CFO will eventually fall to its net income, it will see a significant decline in liquid capital. Its cash-flow does not reflect its earnings which means it is only expected to lose cash in the future. Personally, I believe its current liquidity position is more than enough to keep it afloat through this difficult period.
The next major question is COVID's impact on the company. As seen by its drastic decline from $20-$6 during the March crash, investors clearly expect it to harm the company. In the short-run, it likely will result in even worse cash-flow due to a global productivity slowdown. In the long-run (1-3 years out), it will also likely result in revenue declines (particularly in new oil and gas contracts).
However, revenue is not particularly important when compared to margins. Consider, if FLR's annual revenue declined from $20M to $10M and it was able to return to 3% margins, it would generate $300M a year giving it a hypothetical forward "P/E" of 5.6X which is still extremely low.
The primary issue for the company has been the rapid rise in global labor costs over recent years. As you've heard, U.S unemployment is expected to soon be over 20%, however the same is true in most of the world. India's is currently 24%, Europe's likely around 10-15% (but up to 42% if wage replacement programs were removed). What this will mean is a large global population looking for jobs. When supply increases dramatically, prices fall and the same is true for wages albeit at a slower pace than with goods.
While it may seem paradoxical, the economic impact of the virus may actually benefit fluor in the long-run due to lower labor (and energy) costs. New contracts will likely decline, but not as much as production costs. Additionally, it increases the odds of a major U.S infrastructure bill that results in a surge in new high-paying contracts for Fluor.
Overall, I believe Fluor is a solid long-term deep-value pick with very high turnaround potential. The short-run will be difficult as the company navigates its cost overrun difficulties and COVID, but the long-run margin outlook appears to be much rosier. The company also appears to have the adequate working capital to make it through this period. Obviously, its risk is high due to its negative margins today, but I am bullish from a long-run standpoint.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
Interested In More Long-Term Investment Ideas?
If you're looking for (much) more research, I run the Core-Satellite Dossier here on Seeking Alpha. The marketplace service provides an array of in-depth portfolios as well as weekly commodity and economic research reports. Additionally, we provide actionable investment and trade ideas designed to give you an edge on the crowd.
As an added benefit, we're allowing each new member one exclusive pick where they can have us provide in-depth research on any company or ETF they'd like. You can learn about what we can do for you here.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FLR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.