Comparing Two Engineering and Construction Stocks
One useful exercise when scanning the Magic Formula® Investing (MFI) screens is comparative analysis of stocks in the same sector, or that are direct competitors.
MFI is as much of a sector ranking tool as it is for individual stocks. It is common to see many companies from the same industry sector enter the screen at almost the same time, as macro-economic factors weigh on all participants. A few examples currently are: for-profit education (Apollo (APOL), Capella (CPLA), ITT (ESI), and DeVry (DV)), semiconductors (KLA-Tencor (KLAC), Kulicke & Soffa (KLIC), and Marvell (MRVL)), and defense (Raytheon (RTN), General Dynamics (GD), and SAIC (SAI), among others).
For this article, we'll focus on a smaller set: engineering and construction, or "E&C", companies. While in the past there have been more, right now there are two in the screen: Fluor (FLR) andFoster Wheeler (FWLT).
Which one would be a better choice for an investor wanting exposure into the E&C sector?
The E&C business model is relatively easy to understand at the sketch level. These companies bid on jobs for new construction, procurement, engineering, and maintenance jobs for facilities to a wide variety of customers. Contracts can be on a fixed-cost basis (the E&C firm offers to do the job for a set price) or "cost-plus", where pricing is determined by an agreed-upon markup on project costs. Some E&C firms also concentrate on winning maintenance contracts, which provides a nice stream of recurring revenues.
Fluor and Foster Wheeler both do a large amount of business for the oil and gas industry, although FWLT is far more concentrated there (nearly 80% of sales vs. 34% for FLR). The bulk of these jobs involve building, upgrading, or maintaining refineries.
Foster Wheeler also has a sizable business (20% of sales) building fuel boilers that are used in electric power plants. These boilers allow the power plant to burn a range of fuels from coal, oil, gas, biomass, and even waste products.
Fluor, on the other hand, is far more diversified. 41% of sales come from the Industrial and Infrastructure segment, with projects in mining, transportation, healthcare, telecom, and other end customers. Government (15%) services the Departments of Energy, Defense, and Homeland Security, with two major ongoing contracts at the DoE's Savannah River nuclear site, and the DoD's LOGCAP IV military logistics contract in Afghanistan. 7% of sales are from the Services unit, and another 3% from electric power customers.
Both firms are in very good financial health. FWLT carries 4 times as much cash on the balance sheet as debt, while for FLR the ratio is 5 times. Both companies have current ratios (current assets / current liabilities) around 1.4, and both earn more interest then they pay out. Both firms consistently generate free cash flows margins of 3-5% on sales. FWLT's 5-year average return on invested capital is about 32%, and FLR's is almost exactly the same! Financial health is excellent for both companies, in this comparison we have an even push.
These two firms approach the return of capital to shareholders slightly differently. Foster Wheeler concentrates on share buybacks, and they have been aggressive, with an average share count decline of 5.7% per year since 2007. Fluor buys back shares too, but to a lesser extent, with an average 1.2% annual reduction in the same period. On the other hand, Fluor also pays a 1.3% annual dividend yield, while Foster Wheeler pays none. Another close call here, but Fluor gets a slight nod for committing to a regular dividend.
Fluor has performed better from a growth standpoint than Foster Wheeler over the past 5 years, with a compound annual revenue growth (CAGR) rate of 8%, while Foster's sales have actually declined. Additionally, recent trends favor Fluor, with that company reporting a 14% increase in backlog in the most recent quarter, vs. a 7% decline for Foster Wheeler. We also saw a more steady performance for Fluor during the 2008-10 recession, where revenues declined at a far slower pace than for FWLT. FLR's diversity has served it well, limiting the impact of major declines in individual industries and allowing the firm to invest where the growth is at any given moment.
Foster Wheeler carries a EBIT/Enterprise Value of 16%, vs. 3/5 year averages of 9.9/11.4%. Its price-to-sales ratio is 0.42 (3/5 year avg. of 0.82/0.94) and the price-to-book is 2.49.
Fluor's EBIT/EV is 14.2% (10.6/11.0%), price-to-sales is 0.34 (0.48/0.50), and price-to-book is 2.66.
The nod here clearly goes to Foster Wheeler, which is straight up cheaper even with similar historical valuation ranges to Fluor. But it bears mentioning that both stocks trade at meaningfully lower valuations than they normally do.
As is often the case, this is a close call, and MFI investors can probably do pretty well with either stock over the next year or so.
That said, MagicDiligence will give the nod to Fluor. The primary factor in this decision is Fluor's diversity and scope, which really paid off for the firm during the recession and allows them to focus on whatever industry or project is most attractive at present. Consider that, in 2008-09, Fluor earned nearly 60% of sales from Oil and Gas when that industry was in a boom period. Then, Fluor lost some gigantic refinery contracts, saw half their oil and gas backlog disappear, and yet still performed relatively well as their other segments picked up the slack. A similar occurrence for Foster Wheeler could have decimated that company, considering the lack of options. While FWLT is a slightly cheaper stock, the difference isn't enough to make up for what seems like a bigger downside risk.
Steve owns no position in any stocks discussed in this article.