Oil Profits Could Benefit Engineering Stocks

Oil Profits Could Benefit Engineering Stocks
By IAN MCDONALD and RUSSELL GOLD
WSJ, August 23, 2006

In today's energy-stock sector, investors might want to borrow a credo from Watergate-era reporters: Follow the money.

Thanks to soaring energy prices, the world's biggest oil and natural-gas companies are sitting on mountains of cash. Exxon Mobil Corp. had more than $32 billion in its coffers at the end of June -- nearly equal to the combined stock-market value of General Motors Corp. and Ford Motor Co. At the same time, Royal Dutch Shell PLC, Chevron Corp. and BP PLC had a total of more than $26 billion in cash.

So, where will that money go?

While shareholders likely will benefit from higher dividends and share repurchases, a big chunk of the cash will go toward building infrastructure projects required to get the next generation of oil and gas out of the ground, refined and brought to market. That is good news for engineering companies such as Jacobs Engineering Group Inc., Foster Wheeler Ltd., Chicago Bridge & Iron Co. and McDermott International Inc., which are seeing a buildup in backlogs of multiyear projects.

"We're going to have to spend more capital to increase energy supplies," says John Segner, manager of the $1.5 billion AIM Energy Fund. "And I think we're in the very early innings of doing that." This thesis led him to add Chicago Bridge stock to his fund's portfolio last fall.

Stocks like these aren't for the faint of heart. These companies take on complex projects in remote -- and often dangerous -- parts of the world. But even critics admit that as the economy slows, these companies' multiyear projects may churn out earnings growth when it is hard to come by.

Yesterday in 4 p.m. composite trading on the New York Stock Exchange, Jacobs edged down 45 cents to $85 a share, giving the company a market value of $4.92 billion. Chicago Bridge, with a market value of $2.59 billion, added 2.8%, or 72 cents, to finish the session at $26.40 a share. McDermott International, with a market cap of $5.4 billion, edged up 14 cents to $49.44 a share. On the Nasdaq Stock Market, Foster Wheeler's shares edged up 15 cents to $42.21 each, giving the company a market value of $2.81 billion.

So far this year, engineering and construction stocks are up 15%, compared with 5.8% for the Dow Jones Industrial Average.

Why so much excitement? The energy industry recently has emerged from an extended period of underinvestment. Major companies are starting a slew of infrastructure projects: refineries, liquefied-natural-gas plants, offshore-drilling platforms and other expensive undertakings.

Energy projects account for about 40% of Jacobs's revenue -- most of the rest comes from pharmaceutical, federal and chemical clients. The Pasadena, Calif., company reported a record $9.4 billion backlog last quarter, up 12% from a year earlier. The company reported $7 billion in revenue for the year ended June 30.

Project backlogs are growing even faster at companies with greater reliance on energy clients. Last quarter, excluding certain costs and fees, Foster Wheeler reported a $2.84 billion backlog, up 83% from a year earlier, while McDermott International, based in Houston, reported a $7.8 billion backlog, more than double from the start of the year.

While this glut of new projects seems like a spree, the assumptions behind the buildup are relatively conservative, says John Rogers, an analyst with D.A. Davidson & Co. who covers engineering and construction firms. He said most projects he has discussed with clients and vendors assume oil prices of about $40 a barrel -- more than 40% below current prices.

Mr. Rogers and others suggest two schools of thought when it comes to investing in this niche. One is to own shares of diversified firms such as Jacobs or Fluor Corp. for the long term.

Thanks to years of stable, growing profit in a cyclical business, Jacobs is widely seen as the industry standard. The company has a diversified, loyal customer base and consistently has averaged a 15% return-on-equity over the past decade.

"It's just a good, well-run company and over the long term we think this is the place to invest in the group," says Ed Han, manager of the $143.9 million Transamerica Premier Growth Opportunities Fund, which has owned shares of Jacob for more than two years.

The other strategy, for more aggressive investors, is to load up on shares of more energy-focused engineering and construction companies such as Foster Wheeler, which has operational headquarters in Clinton, N.J., and corporate headquarters in Bermuda, and Chicago Bridge, which is based in the Netherlands. The idea: Their results might spike higher and faster than those of a more diversified firm.

Mr. Rogers of Davidson says buying shares in McDermott is a lower-risk path to execute this strategy. Offshore energy projects are the company's main focus, and its ownership of terminals and other facilities in key Gulf Coast, Middle East and Asian ports gives it a competitive advantage, Mr. Rogers says. He rates McDermott a "buy." His firm expects to receive or seek investment-banking work from the company in the next three months. Mr. Rogers doesn't own shares of McDermott, but he or a family member owns Jacobs Engineering shares.

These stocks trade at varying multiples of their expected per-share earnings next year, from a 22 price/earnings ratio for Jacobs to a P/E of 17 for McDermott, according to Thomson Financial. Analysts expect Jacobs to increase its earnings at a 15% clip over the next five years and more energy-focused firms like Chicago Bridge and Foster Wheeler to increase theirs more than 20%. The stocks are near the top of their historical valuation range, which is reason for concern, but not if they boost profits as expected.

Of course, investors should remember that numbers themselves have been a problem for many companies in this sector. The firms typically use "percentage of completion" accounting, which requires estimates of a multiyear project's costs and earnings. Poor estimates have led to big restatements from time to time.

But a strong market for construction doesn't always lead to stock-market success. The strength of the market helped convince Halliburton Co. it was time to spin off its KBR division -- an acknowledged leader in the energy-construction field. The spinoff is planned in coming months, but plans for an initial public offering of stock in the unit were pushed back recently after the overall IPO market weakened and a construction project in Nigeria faced unexpected cost overruns.

That said, bulls believe these firms might be one of the few pockets of growth in a slowing economy, even if oil prices slip.

"Once they start these big projects, they usually don't shut them off," says Mr. Han of Transamerica. "A half-built refinery isn't much good to anyone."