With more than 330 billion in capital expenditures to be conducted over the next four years in oil and gas construction markets, the energy infrastructure construction market will continue to boom. Many firms demonstrated record earnings performance in 2013, and for many firms 2014 is set to match if not exceed 2013 performance. With labor markets constricting and earnings improving, are oil and gas infrastructure firm valuations growing?
Valuations of businesses typically utilize several approaches, but one of the commonly used valuation methods is the capitalization of earnings method. This methodology utilizes an earnings figure, typically operating earnings, and divides it by a capitalization rate. A capitalization rate will incorporate the appropriate risk factor for the industry and business, and will subtract growth. For example, in the construction industry a common private company capitalization rate is 20 percent. If operating earnings are $100 annually, the value of the business, (referred to below as enterprise value), would be $100 divided by 20 percent, or $500. If the expected growth rate is 5 percent, the value of the business becomes $667, or $100 divided by 15 percent.
The inverse of the capitalization rate is typically referred to as a “multiple.” In our first example above, the multiple is five, or one divided by 20 percent. The public market is an excellent place to look at trends in market multiples, and that is where we have turned to analyze the question on oil and gas infrastructure valuations.
The nearby chartshows the Enterprise Value to Operating Earnings (EV/EBIT) multiple of the large, public, energy EPC firms as a percentage of the S&P 500’s. From June 2012 until October 2013, the group’s EV/EBIT multiple grew from 6.7 to 11.25, an expansion of 68 percent in just 17 months. During that same period, the S&P 500’s EV/EBIT multiple expanded just 29 percent. As a result, the energy EPC firms EV/EBIT multiple as a percentage of the S&P 500’s increased from about 65 percent to about 85 percent. In other words, all things being equal, the market saw much stronger future growth in our constituent oil and gas infrastructure firms than they did in the overall S&P 500.
However, since October our constituent group’s multiple has declined by 8.2 percent versus an S&P multiple decline of just 0.8 percent. This story is telling, especially as the two most oil and gas focused members of the group, KBR and Fluor, saw their multiples decline by 30+ percent. The reason: the market believes that the growth rate of energy infrastructure markets is likely to slow.
FMI is seeing similar trends in the market for private oil and gas infrastructure firms. With so many firms having seen record 2013 financial performance, multiples are stabilizing. Buyers do not believe that companies in the energy infrastructure market can continue to grow at the rapid pace that they have been for the past few years.
While the “energy infrastructure” growth story may be losing some of its momentum with same investors, it remains one of the more attractive sectors in the United States. While we anticipate multiples to remain steady or even decline slightly, we expect valuations to remain high primarily as a result of the following:
1) Earnings will remain strong. As discussed, valuations are often conducted by multiplying operating earnings by a market multiple. If a firm’s operating earnings have grown substantially over the past few years and the multiple has grown as well, the value of the firm has increased dramatically. As multiples stabilize, as long as earnings remain strong enterprise values will remain strong.
2) Labor constraints will grow. As noted heavily in this issue, tightness in labor markets remains a real challenge for the construction industry. As construction volumes increases, labor strains are likely to give competitors with training programs, recruiting and retention programs, and larger workforces with an advantage. If acquirers begin to see this trend, greater market consolidation could be the result.
3) The regulatory environment will expand. The government continues to expand regulatory requirements on both owners and contractors in oil and gas markets, which drives up compliance costs. While inefficient, this provides an advantage to existing players and will continue to create barriers to entry.
In summary, we believe the market for energy infrastructure firms continues to be strong, and the conditions may be ripe for further consolidation in certain sectors. Valuation multiples, however, are likely to stabilize or even decline slightly in 2014.