KBR, Inc. (KBR)

aflamm (< 20) Submitted: 5/07/07 2:03 AM : Start Price: $21.80 KBR Score: 10.28

KBR is cheap and misunderstood. Hal, IPOed 20% last November and the other 80% was recently distributed as tender offer exchange to subscribing (former) HAL shareholders in April. The macro argument is simple: World infrastructure is in disarray. World infrastructure has not kept up with the population demands. Even America’s infrastructure is disastrous. The American Society of Civil engineers estimates that $1.6 trillion is needed over a five-year period to bring the nation's infrastructure to good condition. (http://www.asce.org/reportcard/2005/index.cfm) There are similar reasons to own companies including TTEK, WNG, EEI, DY and SGR. Moreover, Energy and chemical capex has been depressed by three, almost four, decades of underinvestment. Clearly, the cycle has started to tip back in the last 18-24 months. But this is 7-14 year cycle, at minimum. Energy companies which spent 8-10% of revenues on Capex in the late 70s and early 80s now spend 2-5% but this is increasing (up from 1-4% only recently). The exact thing can be said for the utility and telecom spaces; there have been 3 decades of under investment in utilities infrastructure, and two in telecom. Additionally, alternative energy technologies create a long term boom in the specialty chemicals businesses engineered materials business. These operations will need new facilities and plants including ethanol refineries, wind farms and clean coal plants.

On the face of it KBR is cheap. KBR is trading at .28 times trailing sales, around 12 times ’08 earnings, and 9 times 2007 FCF (sub 3 Bil enterprise value, Sales of 10 bil, operating cash flow of 300-400 mil, 80 mil in capex). These are below industry comparables of .6, 20, and 20 respectively. KBR entered chapter 11 over asbestos in 2003. During this time it was totally mismanaged. New management was put in place subsequent to the bankruptcy reorganization. During this time the company the company also decided rather boneheadidly to make government contract work it’s primary focus. This had two effects: 1. it missed on the spoils of early energy infrastructure spending in 2004 and 2005; 2. it got a ton of bad press for its Iraq work. The new management plans to shift revenues away from the historically low margin, unreliable government business (75% of revenues today) and towards the high-margin chemicals, energy and construction engineering businesses.

Additionally, there are 2 terrible contracts which have resulted in huge losses for the E&C (energy and chemicals) segment in recent years: the Barracuda-Caratinga off-shore project with Petrobas in Brazil, and the Escarvos GTL plant in Nigeria. Cost overruns related to civil unrest in Nigeria and scope changes led to a $148 million charge in the second quarter of 2006 on the Escravos project. Cost overruns on the Barracuda-Caratinga project led to losses of $785 million between 2002 and 2006. Think about that. About a $1 billion dollars in losses, due to two projects, is tremendous for a company valued at $3 billion in total. These contracts were entered into under old management, and new management has assured to take a stronger stand on contract pricing and terms. Management should be better able to avoid such disasters in the future. I believe lessons have been learned. Moreover, backlogs are exploding in the business. KBR is booked out about 2 years right now. So is WNG, FWLT and SGR. The engineering contractors have all the pricing power. New management is targeting 10+% gross margins for future E&C projects. Moreover, management uses $35 long term oil prices to make their projections so at $55-65 oil, they should be more than okay. Revenues for E&C segment should return to pre-2003 levels of $3.8+ billion in 2007 from 2.6 billion in 2006. By 2008 the revenue mix should be about 50-50, each drawing about $4.7 Bil, as KBR’s Army (LogCAP) contracts expire. Essentially this keeps the sales the same but adds at least +1-4% profitability on sales to operations, using E&C gross margins of 8%, under their goal of 10%, to be conservative. Those are the kind of numbers that allow the company to beat estimates and show serious sequential earnings growth. The macro picture and valuation make this investment especially compelling and the turnaround, a special situation element of KBR, is just icing on the cake.

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