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Stock Strategist Industry Reports

E&C Outlook: Government Gives, Competition Burns

The engineering and construction industry survived 2009 in fine shape, but the future is murkier.

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Contrary to what might be expected for a sector leveraged to the capital spending and fixed asset investment cycle, the engineering and construction (E&C) industry survived the recession generally in fine shape.

For many companies, falling input costs, a slack labor pool, and good project management allowed margins to expand in 2009 for previously signed contracts. This, when combined with some working capital reductions, produced very strong free cash flows at previously indebted companies like AECOM and URS, strengthening their balance sheets considerably. These companies are now on the prowl for more acquisitions to expand their areas of expertise or geographical reach.

Going forward, we think two big themes will dominate the space.

Government, Government, Government
The first is that although private-sector (industrial, commercial, power, petrochemical, refining) demand is still generally very weak, the government has picked up the slack and then some. We had feared earlier that weakness in state budgets would darken this bright spot, but this appears to not be the case. Build America bonds, when combined with federal largesse, allowed E&C companies with heavy government exposure to grow their backlogs in 2009. The largest beneficiaries were probably  URS (URS) and  AECOM (ACM). Granite Construction may end up in a good spot too if the new highway appropriations bill is eventually approved. Lucrative federal contracts extend past the stimulus-inspired projects and include everything from flood control, to cleaning up nuclear waste, to supporting the wars in Iraq and Afghanistan.

On the other hand, companies that rode the boom in the refining, power, and petrochemicals industries in 2003-08 suffered the most in 2009. During the boom years, economic growth was strong and these industries invested heavily to comply with federal environmental rules. The refining industry especially earned above-average margins during that time, allowing it to invest in capacity to utilize heavier and sourer crude oils and sulfur control equipment. The power sector invested in new capacity and in "scrubbers" to mitigate mercury and sulfur emissions as well.

These investments are nearing completion, and the revenues will be hard to replace in the near term.  Jacobs Engineering (JEC),  Foster Wheeler (FWLT), and  Fluor (FLR) are all in this camp. Nevertheless, even these companies are looking forward to 2010 and 2011. They are optimistic that federal pollution standards will tighten even further, bringing another bonanza. In particular, the sky is the limit if we greatly tighten control on carbon dioxide emissions.

Tough Competition
We regard competition as the biggest threat to industry profitability in the next several years. In a razor thin margin industry like E&C, even giving up a point or two of operating margin can be devastating to the bottom line. From virtually every company in the space, we hear that competition has become fiercer, both at home and abroad. Especially in places like the Middle East, where megaprojects are still on the drawing board, capable firms from all corners of the globe are converging. Large Korean and Japanese firms--sophisticated and powerful competitors--are especially ambitious. Even at home, with weakness in many vital end sectors, E&C firms are becoming more desperate for business. For example, Granite Construction recently stated that they are being outbid on smaller projects by smaller competitors coming out of the woodwork, and their strategy is to go after larger projects that these small firms cannot touch.

The reason for this aggression is simple. The E&C firms' institutional memory dictates that recessions, though painful, are short. When the recovery happens, the rebound is sharp and long-lasting. This is what happened in the 2000-02 recession. Many large E&C firms spent the last decade acquiring smaller competitors for their expertise and human capital. They are extremely loath to get rid of hard-to-replace engineers in bad times only to be caught short in good ones. However, retaining these engineers is expensive and is largely a fixed cost even if no projects are rolling through. So the current imperative is to keep the utilization rate on engineering staffs high, even if it means taking a smaller margin on the construction front.

This is a dangerous game to play. The E&C industry contends with numerous risks, the largest of which is cost overruns. A major overrun may cost hundreds of millions of dollars. With firms taking on more risk, the chances of overruns increase, which may stress income statements and balance sheets for several years--the time it takes major projects to move from the drafting board to completion.

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