The Engineering and Construction (E&C) industry is certainly no stranger to volatility. It is normal for the industry to outperform the market during periods of expansion and underperform the market during periods of contraction. The exhibits in this article demonstrate this phenomenon among publicly traded firms participating in the industry pre- and post-recession. Specifically, the publicly traded companies tracked by FMI, comprised of 37 general/specialty contracting firms, significantly outperformed the market in the years leading up to the Great Recession (see Exhibit 1), but woefully underperformed the market during the throes of the Great Recession (see Exhibit 2).
With the U.S. economy in recovery mode, one may expect industry stock prices to be surging. However, that has not been the case. As shown in the graph below, the stock markets have experienced tremendous gains since the end of the recession, but contractors have failed to gain any significant traction in the market. Between June 30, 2010, and June 30, 2015, the S&P 500 outpaced the growth of FMI’s contractor index by 6% (see Exhibit 3). Over that time, the S&P 500 grew by over 100%, whereas, the median share price of the firms in FMI’s contractor index climbed less than 40%. As indicated, the gap in performance has widened over the past couple of years. Specifically, in 2014 stock markets realized significant gains as the Dow Jones Industrial Average increased by 7.5% and the S&P 500 posted a gain of 11.4%. Growth of the S&P 500 cooled in the first half of 2015, with the index expanding by a meager 0.2% through June 30, 2015. In comparison, the median share price of publicly traded contractors dropped by 8.1% in 2014, then tumbled an additional 17.9% during the first half of 2015.
So what is different this time around?
While there is no way to pinpoint the root cause(s) (i.e., the stock market is a fickle beast after all), a number of forces seem to be in play:
1) Inability to increase margins, 2) Weak foreign markets, 3) Anemic public funding levels and 4) A steep decline in oil prices.
As indicated in Exhibit 4, publicly traded construction contractors were able to increase their margins substantially leading up to the recession, with median EBIT and EBITDA margins peaking at 6.6% and 8.8%, respectively. Given the lag time associated with construction projects, earnings performance peaked during the height of the recession, but deteriorated quickly thereafter.
The severe downturn in market conditions, marked by a heightened competitive environment, resulted in a multiyear decline in contractor performance. Considering that markets have started to improve and grow out of the recession, one would think that margins would currently be displaying a strong upward trajectory. Unfortunately, as indicated below, that has not been the case. Margins have remained at reduced levels, effectively bouncing off the bottom for the past three years. Specifically, since June 30, 2012, EBIT margins have moved within a range of roughly 3 percent to 4% (i.e., significantly lower than pre-recession levels).
There are a number of theories as to why margins have failed to recover. One possibility is that it is just a natural part of the construction cycle. Pre-recession, the U.S. construction market was firing on all cylinders, fueled by low interest rates, unsustainable lending practices and investor speculation. Between 2002 and 2006, the U.S. construction market grew by 35%, (i.e., an average annual growth rate of 8.3%), far exceeding its long-term growth rate of 3.4%. Notably, certain segments of the market — housing, for example — experienced much more rampant growth during this period. With the industry on an upswing and opportunity abundant, contractors made substantial investments in people, equipment and systems in order to meet demand. As a result of such investments, there was a large gap created between supply and demand when the market turned. Instead of acting brashly and dramatically trimming overhead, many contractors kept their overhead structures largely intact. With cost structures failing to adjust to market conditions, margins dropped substantially. Even with the construction industry a few years into a new growth cycle, capacity continues to outweigh demand in many market segments and geographic areas. To restore balance, continued growth will be necessary.
Another theory suggests a more permanent shift in the construction industry. Over the last several years, the industry has become increasingly sophisticated. Technology and general advancements have enabled owners to become more knowledgeable about the construction process and, thereby pierce profit pockets and squeeze profit margins. Labor challenges, precipitated by both the downturn in the market and an aging workforce, have further pressured margins, with employers being forced to increase their payroll per capita. If such trends continue, and with evidence suggesting that they will, the margins that we think are low today may just be the new norm.
Valuation Multiples Trend Upward
Despite the downturn in performance levels, valuation multiples have been trending upward. Exhibit 5 displays median valuation multiples, on a monthly basis, for publicly traded construction contractors between June 30, 2005, and June 30, 2015. The multiples displayed are total enterprise value (TEV) to operating cash flow (EBITDA), TEV to operating earnings (EBIT), price to historical book value (P/BV) and price to earnings (P/E). As shown, valuation multiples, excluding P/BV, plummeted in the latter half of the 2000s, ultimately bottoming in late 2008/early 2009. Since then, multiples have been on the rise, suggesting that investors believe that stronger earnings performance is likely in the relative near term. However, over the last couple of years, publicly traded contractors have failed to deliver on such expectations, repeatedly missing earnings estimates. In 2014, for example, Aecon Group, Inc. missed earnings per share (EPS) estimates each quarter, the largest, occurring in the quarter ending June 2014, was $0.38 below estimates, or a 319.78% surprise. A number of other contractors have missed earnings estimates in recent periods as well. For example, Tutor Perini’s EPS during the fourth quarter of 2014 was $0.56, registering $0.15 below estimates. Further, Primoris Services’ EPS during the same period came in at $0.17, thereby missing estimates by $0.32.1
Many of the publicly traded contractors included in FMI’s contractor index are foreign-owned and have significant exposure to international markets. Thirty or 40 years ago, little construction in the U.S. was performed by foreign-owned firms. Further, relatively few U.S.-based contractors had operations in foreign markets. Today, circumstances are quite different, whereby the largest contractors in the U.S. are performing work on a much more global scale. In fact, the top-20 general contractors in the U.S. derived nearly 40% of their revenue from international activity in 2014, based on information obtained from Engineering News-Record. The U.S. construction market continues to be highly attractive, given its enormous size and relatively strong growth prospects and stability. In recent years, a common theme in the E&C space has been foreign companies penetrating the U.S. market through mergers and acquisitions.
Here are a few notable transactions:
WSP Global Inc. acquired Parsons Brinckerhoff Group Inc. from Balfour Beatty plc for approximately $1.4 billion in cash on September 3, 2014. Parsons Brinckerhoff is a global consulting firm for various infrastructure projects for both public and private clients. In 2013 Parsons Brinckerhoff generated just under £1.6 billion in revenue.
Obayashi USA, LLC acquired Kraemer North America, LLC on November 12, 2014. Obayashi USA, a member of Obayashi Group, headquartered in Tokyo, Japan, agreed to terms to acquire a controlling ownership interest in Kraemer North America. Headquartered in Plain, Wisconsin, Kraemer North America provides heavy civil and industrial construction services.
Andrade Gutierrez of America, Inc. acquired The Dennis Group, Inc. on July 2, 2015. Andrade Gutierrez, headquartered in Brazil, agreed to terms to acquire a controlling interest in The Dennis Group. The Dennis Group offers a wide array of engineering and construction services to food and beverage industries throughout North and Central America as well as Europe.
The U.S. vs. Other Countries
While the U.S. has recovered meaningfully in the wake of the Great Recession, foreign economies have been much less fortunate. Exhibit 6 contrasts the performance of the S&P 500 versus the FTSE 100. Comprising the 100 most highly capitalized companies listed on the London Stock Exchange, the FTSE 100 is generally considered to be reflective of the financial health of the European Union. Historically, it has trended in conjunction with the S&P 500, indicating relatively high levels of correlation between the economies of Europe and the U.S. However, that trend has not followed suit over the last few years, as the European economy has lagged that of the U.S. For example, Germany, which is widely considered the driving country in the Eurozone, had annual GDP growth of 0.4%, 0.1% and 1.6% in 2012, 2013 and 2014, respectively. By comparison, the United States experienced GDP growth of 2.3%, 2.2% and 2.4% over the same period. The lagging European economy can be attributed to a number of factors. Many point out geopolitical pressure, specifically the Ukraine conflict, as well as the European debt crisis as the main drivers behind the sluggish economy.
Regardless of the reasons behind the delayed recovery, both foreign companies and U.S. companies with material international exposure, are being adversely affected. Nearly half of the firms in FMI’s contractor-index are headquartered abroad or have significant operations outside of the U.S. Such exposure significantly influences the performance of the publicly traded contractor group as a whole.
While the U.S. has emerged from the recession in better shape than most countries, conditions remain far from ideal. Activity in certain segments is substantially constrained by anemic public funding levels. Federal construction put in place has fallen for each of the last three years, dropping from $31.7 billion in 2011 to $22.7 billion in 2014. This reduction generally stems from budget issues, increased deficits and surging debt levels. For example, between 2008 and 2014, the U.S. has run deficits ranging from $458.6 billion to $1.4 trillion. Although, the annual deficit has been on a downward trend, dropping from $1.4 trillion in 2009 to $484.6 billion in 2014. Nevertheless, running such deficits, which have driven national debt over $18 trillion, has had an impact on the country’s appetite for continued spending. State and local agencies have also suffered from funding concerns. As an example, California’s budget has been stressed in recent years, with one outcome being the underfunding of its highway/road system, among other issues. In fact, in its five-year budget that was prepared in 2014, California estimates that the total deferred maintenance for roads is $59 billion.
The Oil Factor
A more recent phenomenon attributing to the underperformance of contracting companies is the steep decline in oil prices. According to Nicole Friedman of the Wall Street Journal, “Brent crude oil and gasoline futures both posted 48% losses in 2014.”2 Oil prices are not expected to bounce back any time soon, given the current coupling of strong supply level with lackluster demand.
Prior to the downfall, publicly traded E&C firms had become much more immersed in the oil and gas sector, given the level of opportunity, marked by countless projects relating to the extraction, transportation and refinement of oil. Several publicly traded firms had made it an initiative, both through organic and inorganic efforts, to increase their exposure to serve the oil and gas market. Some of the larger transactions that have occurred recently follow.
Amec Plc acquired Foster Wheeler AG for approximately $3.1 billion in cash and stock on January 13, 2014. Foster Wheeler is a worldwide engineering and construction company specializing in oil and energy. For the year ended December 31, 2013, Foster Wheeler had revenues of approximately $3.3 billion.
SNC-Lavalin Group Inc. acquired Kentz Corporation Ltd. for roughly £1.1 billion in cash on June 23, 2014. Kentz Corporation provides engineering and construction services to oil and gas, petrochemical, and mining and metals companies. Kentz Corporation had revenue of $1.7 billion for the year ended December 31, 2013.
URS Corporation acquired Flint Energy Services Limited on May 16, 2012, for C$1.25 billion in cash and the absorption of C$225 million of Flint’s debt. Through roughly 80 locations in North America, Flint provides construction services to several companies in the oil and gas sector. At the time of the transaction, Flint generated roughly 80% of its revenue in Canada, with the remaining 20% attributable to the United States.
As result of such activity, the performance of publicly traded contractors has become more intertwined with the movement of the oil and gas sector. The steep drop in the price of oil has led to a curtailing of capital expenditures and a postponement/cancellation of projects. For example, according to Carolyn King and Chester Dawson of the Wall Street Journal, “Suncor Energy Inc. said it would cut its 2015 capital spending program by 1 billion Canadian dollars,” and Canadian Natural Resources Ltd., said “that it would trim its 2015 spending budget by C$2.4 billion to C$6.2 billion, citing the recent drop in oil price.”3 With companies worldwide cutting projects, there is a heightened sense of concern for engineering and construction companies with exposure to the oil and gas industry.
Historically, the stock prices of publicly traded E&C firms have trended with the market, albeit with more amplified movement. This trend stopped after the Great Recession, as publicly traded contractors continue to underperform the market during a period of expansion. Key factors behind this phenomenon are the continued depression of margins, global economic weakness, inadequate funding levels and the contraction of oil prices. Only time will tell whether the divergence is temporary or more lasting in nature.
Curt Young is a managing director with FMI Capital Advisors, Inc., FMI Corporation’s registered Investment Banking subsidiary. He can be reached at 303.398.7273 or via email at email@example.com.
Cameron Larabee is a valuation analyst with FMI Capital Advisors, Inc., FMI Corporation’s registered Investment Banking Subsidiary. He can be reached at 303.398.7204 or via email at firstname.lastname@example.org.
2 Friedman, Nicole. “U.S. Oil Prices Fall 46% This Year, Steepest Loss Since 2008.” Wall Street Journal. December 31, 2014. Web.
3King, Carolyn, and Chester Dawson. “Suncor Cuts Capital Spending Due to Low Oil Prices.” Wall Street Journal. January.