Description

Opportunity:

Fluor (FLR) is one of the world’s largest engineering, procurement, and construction (EPC) companies. The market gives FLR a negative sum-of-the-parts value and substantially lower multiples relative to peers because of an overreaction in coronavirus fears, worries from a SEC investigation and poor earnings. However, the latter two are from previous management and new management is selling assets, expected to grow the business through 2020 despite problem projects and aligning themselves with shareholders by changing all long-term incentives from as-sold margins to stock. Also, a private equity, activist firm in this sector was rumored to possibly buyout the company when it bought shares in the high teens to low twenties per share. The stock now trades around $9/share. Having a volatile but profitable history tracing back to 1890, FLR could double, triple or more over the long-term. FLR has a 4% dividend and expects to have more than $18B in revenues over FY20.

Throwing the Baby out with the Bath Water:

At Friday’s (2/28/20) closing price of $8.80/share, the company has a market cap of $1.24B. FLR has ~$320M in net cash as well as $124M in non-controlling interest and $626M in investments. This results in an enterprise value (EV) of ~$418M. FLR was going to sell its government (excluding two fixed price projects) and equipment rental (called AMECO) segments, for ~$1B, which was viewed as very conservative. During last week’s earnings call, the company decided to keep the government business but still sell AMECO. As of last week’s earnings call, government is generally considered to have produced ~$1B in proceeds (review of recent transaction for support later on*). This is greater than EV by $582M, meaning the market values FLR ex-government at negative $582M (government is expected to be ~14% of revenues over FY20). This also does not include future proceeds from selling AMECO (will review its valuation later on**). It is conservative to assume the cash burn (expected ~$330M in FY20) and current contract capital position (~$100M) could be higher than expected and eat all of those proceeds.

Alternatively, FLR has roughly $1.2B in tangible book value. FLR trades for 5.5x-6.3x consolidated adjusted EPS basis (given FY20 guidance range of $1.40-$1.60), just 0.7x FY21 EBITDA (using $585M sell-side consensus expectations), 1.7x FY21 FCF (using $246M sell-side consensus expectations), and 1/4 to 1/3 of working capital. Adjusted EPS is very cheap considering ~12x in 2008, which was the cheapest since 2005, and peers currently trading around the mid to high teens, and above twenty times before the coronavirus market impact. More valuation analysis later on.

Background:

FLR has underperformed for several reasons. Previous management increased risk taking with more megaprojects and has not executed well while the industry faces secular headwinds. They also increased exposure to fixed price contracts. New management was officially instituted in May 2019, but issues continue to persist. During Q4’s earnings call, management revealed 8-10 projects with cash outflows, majority of which will be completed this year “with a few rollover in 2021,” an SEC investigation into past revenue recognition, specifically focused on Q2 charges, a delay in reporting 4Q earnings and 10K, and unspecified adjustments on two projects in Q4.

This caused the stock to trade down to ~$15/share from ~$19/share. About two years ago, the stock was just above $60/share. This is a cyclical company in a 6+ year trough period. Coronavirus news sent shares down to ~$9 from ~$15.

Overreaction, Change, and Where I could be Wrong:

In the most recent earnings call on Feb 18, CFO Steuert said, “Our [China] yard got back to work on Feb 10. And at this point we don’t see any delays.” Additionally, FLR’s 2018 10-K shows Asia Pacific (including Australia) represented ~8% of revenues in FY18. FLR’s Chinese and Mexican fabrication yards ship to markets around the world.

FLR’s Chinese fabrication yard’s central, oceanfront location in Zhuhai is roughly 1,146.6 kilometers from Hubei in central China or approximately 12.5 hours car drive according to Google Maps. Research shows the majority of cases are still in China, close to 95%, with 94.3% in Hubei as of Thursday morning. 84% of Chinese confirmed cases and 96% of Chinese deaths are in Hubei. Contrary to doomsday headlines, if you are young and healthy, there is a ~0.2% case fatality rate if you are infected, however moral panic and fear may continue to be a self-fulfilling prophecy regarding the stock market.

FLR has a strong balance sheet and carries a net cash position while peers have net debt positions. ACM sold its government business because of its debt load and peers are becoming more services-oriented (ACM, KBR, J, etc). This is because they do not have the balance sheet capacity. As a result, FLR has less competition in an already small group of competitors and thus even higher barriers of entry for this cyclical, low capex business. This industry dynamic has resulted in a history of producing FCF. In FY08, FLR produced $951M in cash flow from operations and $578M in FCF.

FLR is keeping the government business because they claim to now have better visibility into their cash flows and given their liquidity position. The stock is implying that they kept it since they need strong, reliable cash flows. However, the cash burn has improved significantly. In Q2 earnings call, an analyst asked "are we looking here at $700M, $800M cash burn as we move into 2020 on these projects that have negative contract capital position?" Management responded with "that's a little high." This quarter they said $500M with 2/3 in 2020 (~$333M vs. $700M-$800M) and the rest in 2021.

Also, new management is reducing the backlog’s risk by negotiating terms and conditions. Alan Boeckmann returned to the company in May. He was the successful, former CEO who is famous for flying out weekly to visit certain problem projects in order to make sure they succeeded. Replacing Bruce Stanski, Michael Steuert returned to FLR as CFO, which was his previous role before retiring seven years ago. These two leaders are credited for the company’s strong 2002-2011 stock price appreciation, tenfold at its peak. Pushback here is that macro was a strong tailwind during this time. Boeckmann and Steuert are supporting the new CEO, Carlos Hernandez.

In FY14, contracts were 81% reimbursable versus 19% fixed, lump-sum and guaranteed. Fixed work jumped to 49% of contracts as of Q2 2019 when new management took over. Fixed work represents 62% of contracts as of Q3 2019. Part of this increase is due to new management converting some reimbursable contracts to lump-sum. For the past 6+ years, reimbursable projects have been safer as we have been in trough cycle periods for most commodities. During peak periods and when executed properly, fixed contracts produce higher margins.

In April 2019, Jacobs Engineering (J) sold its equivalent energy and chemicals (E&C) and mining and industrial (M&I) segments to WorleyParsons for $3.3B, 15x OI or ~75% of revenues on FY18. Removing a $935M pre-tax gain lowers these ratios to 11x and 53%. WorleyParsons CEO Wood said, “All of this is happening as hydrocarbons and minerals and metals are both coming off the bottom and are well below their peaks of 2013. We think this is an exciting time for the sector.”

Applying 33%-50% towards consolidated E&C and M&I FY21E revenues of ~$12.4B would result in $4.1B-$6.2B of value. Applying 8x-10x to consolidated FY21E OI of ~$450M would result in $3.6B-$4.5B. This is without contributing any value to Infrastructure and Power, Diversified Services or nuclear, which is expected to profitably contribute in 2021.

At the same time, FLR has also become less reliable on oil and gas. In FY14, 67% of the backlog was oil and gas versus 45% in FY18.

The SEC investigation is still a worry, but they are focused on past management issues. If new management was concerned about liquidity and cash flows, then they would still plan to sell the government business for additional proceeds. The pushback here is that they might not be seeing the multiples they wanted. The SEC is looking into prior revenue recognition, Q2 charges when the company announced a strategic review, and Radford and then Warren, two fixed government contracts with less than $700M in sales.

New management expects FY20 to have “modest growth over 2019.” In H2 2018, FLR saw book-to-bill ratios above 2.0x for the first time in the last 10 years. This can be an indicator for a strong beginning of a new cycle, after 6+ years in a trough period. This makes me less worried about revenue recognition as FLR should be able to generate more than enough revenue. Management has recently claimed “a movement to the right in a number of projects” as reasoning for lower than expected revenues in Q4.

Private Equity, Activist Stake:

If operations worsen, Bernhard Capital may provide a floor for the stock. In Aug and Sept, the PE firm built a 5% stake by buying in the high-teens and low-$20’s. They have no current plans to acquire FLR but left open that option. Located in Baton Rouge, Jim Bernhard and his young, eponymous firm may not be household names, but many know The Shaw Group, his former company. He founded it in 1986, investing $50K with two friends to acquire a bankrupt pipe fabricator while nearby oilfields were struggling to recover from a major downturn. He grew it into a F500 company, eventually selling it to CB&I. Referred to as Shaw 2.0, the burgeoning PE firm plans to invest $15B compared to its current ~$2.0B AUM.

Approximately 13 days later after the announcement of their stake, FLR said they will sell assets and Peter Fluor said he is stepping down and will not stand for re-election. The latter may be a red flag.

Management Aligned and Incentivized:

Management is also aligning themselves with shareholders by changing all long-term incentives from as-sold margins to stock. The largest portion will be structured as RSUs with a TSR modifier. Management will receive a 30% deduction if FLR’s future stock price performs in the bottom third of the S&P 500 and a 30% kicker if they are in the upper third. Short-term incentives will mostly be adjusted to focus on cash flows and earnings.

$100+/Share Stock Case:

The big bull case is $100+/share by mid 2020’s. This is not unreasonable when considering a modest 50% of ~$25B of revenues, a 10x multiple on 6-8% overall OI margin from said revenues, or both. Applying an USD revenue growth rate from FY21 to FY25 gives ~$23B in revenues. Add the possibility of nuclear becoming a multi-billion dollar revenue business around 2025, and we are there. 

Risks:

The main risks are continued poor execution and unexpected operational mishaps. SEC investigation comes back with substantial negative issues. Continued increased fixed price contacts exposure. It could be a red flag that Peter Fluor stepped down in Sept 2019. A macro cycle would weigh down on performance.

*Government Business Worth:

AECOM (ACM) is currently selling its management services business for ~$2.4B, almost all of which is serving governments worldwide. FY19E valuation was ~60% of revenues and 12x operating income (OI). Both government segments are similar in size, growth, and margins. After removing ~$700M in sales for two kept projects, 8x-12x OI multiples imply $800M-$1.2B and ~33% of revenue results in ~$1.0B.

**AMECO Analysis:

The market seems too focused on adjusted EPS, but selling AMECO may shift this attitude (management says by the end of Q2). AMECO is more appropriately valued on original equipment costs (OEC), EBITDA or revenue multiples and represents >50% of FLR's capex. AMECO original equipment costs are $700M to $1B, based on its sales numbers.

Catalyst

Main catalysts are sheer value, asset sales by the end of Q2, aligned and incentivized insider ownership and activist/PE involvement. Additional catalysts are screeners correcting EV, macro improving, earnings, and buybacks (FLR: “definitely consider share repurchases”). Also, please note that deferred tax assets have been taken off the balance sheet but are still at the company’s disposal.