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Stock Strategist Industry Reports

We Think the Recent E&C Rally Is Unjustified

We think the operating environment will remain challenging in the near term.

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Investing in engineering and construction (E&C) firms is one way to play the growing global need for energy, power, and infrastructure. However, at this time we do not think E&C firms are attractively valued. The companies are adjusting to a period of slow growth following a strong boom in E&C activity over the last few years, and we expect competition among E&C firms for new projects to be very fierce, which will lead to lower pricing and lower margins. Outside the United States, we think pricing for some large-scale projects, particularly in the Middle East, could be low enough to discourage many of our E&C firms from bidding. In the U.S., we expect demand to be tepid in the near term, as energy infrastructure project flow remains weak due to reduced demand for fuel and power. As for public spending on infrastructure, we expect the boost from the stimulus package will be somewhat offset by slower spending by state and local government due to budget issues.

While we expect the near-term operating environment for E&C firms to remain challenging, the stocks have rallied strongly over the last few months. A final investment decision for a handful of multibillion dollar LNG projects in Asia is expected to be made over the next 12-15 months, and we think increasing optimism that some of these projects will move forward has helped drive this recent sector rally.  KBR (KBR) has the front-end engineering and design (FEED) contracts for the two that are likely to move forward--the Gorgon project in Western Australia and the Papua New Guinea LNG project--and therefore is well-positioned to win additional work. We expect both of these projects to move ahead, as the project sponsors have signed a long-term LNG supply agreement for most of the planned production capacity. Other projects that may move forward include the Ichthys LNG project in Northwest Australia and the Gladstone project in Eastern Australia. KBR has a FEED contract for the Ichthys project, and  Foster Wheeler (FWLT) and  Fluor (FLR) have FEED contracts for the Gladstone project.  Chicago Bridge & Iron (CBI) also has strong LNG capabilities, both as an E&C contractor and as a manufacturer of gas storage tanks, and it is also a likely beneficiary from increased investment in LNG projects.

Patricia Oey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.