Description

Opportunity

Jacobs Engineering (JEC) presents an attractive long investment opportunity that offers 50%+ upside from the current price on reasonable assumptions.  The opportunity exists from the market’s failure to adequately give credit for 1) material improvements in the core business and 2) a major acquisition that is significantly accretive and further upgrades JEC’s business profile.  Pro forma for the acquisition, JEC trades at 7.9x and 11.7x 2019 adjusted EBITDA and EPS, respectively, well below more front-end engineering & design focused firms and defense IT contractors that are reflective of the company’s mix (~10.5x 2019 EBITDA, ~16.5x P/E)

Because it’s been largely ignored, JEC presents the opportunity to get paid on both the upward revision of forward numbers and a multiple rerating to a more appropriate peer set for the enhanced business.

Background

JEC recently completed a multi-year restructuring and has accumulated strong backlog in higher margin segments as evidenced by large recent contract wins that support upside to the current outlook in its core business.  

Additionally, in early August JEC announced the acquisition of privately held CH2M Hill, which further de-risks the reimbursement portfolio, provides exposure to more high quality government service end markets and offers tangible synergy opportunities. Management has announced 25% expected cash EPS accretion one year following close (expected this quarter).

Shares have underperformed the broader market on relative sector moderation YTD (JEC +3%), with valuation levels based on stale consensus numbers.  As noted, JEC currently trades closer to traditional E&C companies, but the shift to more design and front-end engineering work and mix of high quality government and defense work warrants a multiple rerating more in-line with design focused firms and defense IT contractors.

Business Overview

Jacobs Engineering (JEC) provides engineering & construction services (E&C), including a broad array of design, architecture, engineering & construction, operations & maintenance and scientific and specialty consulting services.  JEC has 54,000 employees globally and operates across four segments, 1) Aerospace & Technology, 2) Buildings & Infrastructure, 3) Industrial and 4) Petroleum & Chemicals.

1. Aerospace & Technology (24% LTM JEC Revenue, 8.1% LTM Operating Profit Margin)

• Services – scientific, engineering, construction, technical support and operations & maintenance, including complex test and evaluation facilities, launch facilities, support infrastructure and remediation

• End Markets – government services, including aerospace and defense (76%), nuclear (11%), commercial automotive & aerospace (5%), telecom (5%), environmental (3%)

• Key Customers – U.S. DoD, U.S. Special Operations Command, U.S. Intelligence, NASA, U.K. Ministry of Defense, U.K. Nuclear Decom Authority (85% government)

2. Building & Infrastructure (24% LTM JEC Revenue, 7.6% LTM Operating Profit Margin)

• Services – transit, aviation, rail, mission critical and civil construction project services, including development and rehabilitation planning and broader infrastructure plan, design and construction

• End Markets – transportation (56%), social infrastructure (38%), water (6%)

• Key Customers – U.S. Navy, U.S. Army Core of Engineers, national government departments globally, private transportation firms

3. Industrial (28% LTM JEC Revenue, 3.4% LTM Operating Profit Margin)

• Services – engineering, procurement, project management, construction, turnaround planning and on-site maintenance for projects such as laboratories, R&D facilities and processing plants

• End Markets – field services (46%), life sciences (36%), mining & minerals (9%), consumer goods (6%) and specialty chemicals (3%)

4. Petroleum & Chemical (25% LTM JEC Revenue, 4.9% LTM Operating Profit Margin)

• Services – engineering, procurement, construction, maintenance, project management and consulting, including feasibility studies and technology evaluation for a wide range of upstream, midstream and downstream facilities

• End Markets – chemicals (43%), refining (41%) and oil & gas (16%)

Key Investment Points

Thesis is driven by 1) improvements in JEC’s legacy core business profile and 2) upside offered from the CH2M acquisition, both of which the market has not given credit to.

1. JEC Core Business

Execution on Strategic Transformation

Management has successfully executed on its strategy of moving JEC away from fixed price EPC work that carries considerably more execution risk towards reimbursable and sustaining services work.  Initiatives to expand higher margin business units through more complex design, engineering and operations & maintenance work have driven substantial backlog growth in A&T and B&I over the last year (+8% and +10%, respectively at Q3 end) with a more attractive customer base on long-term, renewable contracts.  JEC likewise recently completed a multi-year restructuring program that included an annualized cost take-out of $285mm.  

Recent Upswing in Federal Bookings Driving Improved Mix

JEC has announced a string of big wins this quarter, particularly in A&T, where backlog already stood at record levels at fiscal Q3 end.  The increase is consistent with evidence of accelerated DoD spending and provides margin uplift through mix improvement.  When compared to consensus backlog estimates in A&T alone, it seems evident JEC has positioned itself to announce outperformance on the fiscal Q4 earnings release (setting up to improve 2018 outlook on consistent burn rate assumptions).

• Sell-side consensus on backlog for the segment implies bookings in the quarter of $738mm, below suggested announced bookings

• The Missile Defense Contract announced 8/30 should add ~$500mm ($250mm annualized for the first two years, with potential for more going forward)

• While sizing for O&M and IDIQ (indefinite duration indefinite quantity) contracts is speculative, large headline new wins (not just rebids) are indicative of positive trajectory
  

Select FY 2017 Q4 Announced A&T Contract Wins

2. CH2M Acquisition

Acquisition Reinforces Strategy

CH2M boasts several attractive attributes for JEC:

• Best-in-class water business, less susceptible to macro spending fluctuations relative to commodity driven commercial markets

• Tier 1 Nuclear services provider, a stated goal of JEC management at their analyst day last December

• Limited number of competitors and high-skill nature presents very attractive contract structures

• Projected at $115bn market in the U.S. alone through 2021

• 90% reimbursable contract portfolio

• ~81% of YTD operating profit derived from government customers
  

While the sticker purchase price (10.1x LTM EBITDA) appears high on first read, CH2M has been undergoing its own internal transformation.  In seeking growth historically, the company took on several fixed-price EPC contracts at aggressive bids it was unable to execute on.  A similar strategic shift towards a higher quality reimbursable portfolio of specialty engineering and design work has dramatically improved the outlook over the last 3 years; however, as a private, employee owned firm, cost structures have been less in-focus relative to JEC’s recent trajectory.  Although an investment by Apollo in 2015 (clearly an impetus for this deal) and stricter management focus have driven some gains, JEC management asserts CH2M remains a few years behind on tangible improvements that make cost synergy estimates ($150mm run-rate) likely conservative. Furthermore, with the MOPAC highway design-build project in Austin reaching a settlement in late September (transferring over clean, where JEC management had underwritten resolution in Spring 2018), the JKC joint venture in Australia remains the only legacy project overhang. A timeline to resolution is now estimated at 4 – 5 years away (went tools down in January, arbitration initiated in August), so it’s additionally likely investors don’t ascribe a meaningful impact to valuation until the path to settlement becomes clearer.

As evidence of improving momentum, CH2M achieved a 1H 2017 awards increase of 25% over last year.  While JEC management is underwriting 15% EPS accretion and 25% cash EPS accretion in the first full year after deal close, CH2M’s management forecasts in the proxy imply far more value.  These figures obviously need to be taken with appropriate skepticism given the deal dynamics in-play but still underscore a potential conservatism on the part of JEC management (i.e. avoiding historical overpromise / under-deliver on sector M&A).

The table below outlines the terms of the deal and shows illustrative valuation metrics based simply on both standalone consensus numbers and announced EPS / Cash EPS accretion as well as on CH2M projections disclosed in the S-4 (which are clearly more aggressive).  While outlined in further detail in the following valuation section, these illustrative multiples on a pro forma basis show JEC as undervalued.

Reasonable Synergy Targets

Conversations with management indicate very high conviction in the targeted $150mm cost synergy target.  The figure was derived on a detailed, bottoms up build and is primarily driven (~2/3) by overlap in real estate and IT (likely upside to real estate as management has identified 50 locations in announced target figure but see a higher realizable number as likely).  Additional cash flow improvement exists on bringing down CH2M payable days in line with JEC (targeting low 70s from mid 80s).

Although not factored in to reported projections, management has consistently asserted that the opportunity to achieve revenue synergies as a part of the combination is “material” (”the real story here is the growth opportunity of leveraging that complementary skills and capabilities” – Q3 FY17 Earnings Call).  Management believes CH2M’s expertise in water and environmental services will allow for further customer integration by adding consulting and remediation services to Jacob’s existing relationships in petroleum & chemicals and mining & minerals customers.  The complementary nature of this combination does make it far more attractive than other large-scale historical E&C M&A; however, given the enhanced government customer profile there are likely fewer opportunities for integration into the customer strategic planning process as public projects are approved and planned on a more one-off basis and am therefore unwilling to give them any credit at this point.

Consensus Estimates Not Updated for Merger and Recent Backlog Wins

Sell-side analysts have yet to update estimates pro forma for the acquisition of CH2M.  The initial deal announcement received a lukewarm response from the sell-side community, praising the strategic fit and congruency with management’s stated goals; however, the higher than anticipated purchase price and failure of large scale E&C deals to materialize announced synergies historically pushed consensus to wait-and-see mode.  Previously discussed anticipated backlog growth on recent federal bookings and greater transparency into the pro forma outlook should drive upside to FY 2018 outlook on fiscal Q4 earnings in November.

Some preliminary signs are emerging though that the analyst community is awaking to the more attractive relative end market exposure associated with JEC’s book (even without adjusting for CH2M) and that the greater specialty government services mix requires a more nuanced SOTP breakdown.  Specialty government IT contractors (BAH, LDOS, CACI) command over 3x turn premium on 2018 EBITDA relative to traditional E&C names, which for JEC at ~25% of estimated operating profit is a meaningful multiple expansion story.

Valuation

Multiple Expansion on Attractive Relative Risk and Service Mix

Prior to the merger, management had actively focused on improving the relative portfolio risk from a fixed vs. reimbursable contract mix.  Following the merger, JEC will expand its reimbursable backlog mix to 85%, well above most E&C peers, providing for a more stable outlook by mitigating project-specific execution risk that has long plagued broader industry performance.

Similarly, following the deal the company’s mix of generally higher margin, lower risk front-end design and engineering work will compose a greater portion of revenue as compared to most diversified E&C peers.   

Comparable Trading Multiples – Based on Consensus Estimates

After closing, JEC will be the largest North American design firm by revenues, yet it currently trades well below the four other largest North American design-focused competitors (AECOM, WSP, Stantec, Tetra Tech).  Furthermore, the A&T sector provides specialty government services work that should further command a premium to traditional E&C.  On a pro forma basis relative to recent disclosure, JEC should derive roughly 25% of its segment operating profit from A&T government services work. On base case FY 2019 EBITDA estimates, a rerating to the below multiple would yield over 50% upside to the current price in a year.  

Price Target Range

One-year price target range of approximately $75 - $105, anchored on a multiple to FY 2019 EBITDA estimates.  Detailed in the table below, the range reflects a base case and bull case, with side-by-side comparisons of the implied price under both scenarios based on 1) JEC’s current standalone FY1 EBITDA multiple of 9.2x and 2) the blended design / defense IT FY1 multiple above of 11.0x.

These base case figures present a conservative outlook, with JEC achieving ~$1,280mm of FY19 adjusted EBITDA and $5.00 of adjusted EPS (adjusting for deal related costs, which the company has indicated they will report next quarter).  As a point of reference, current consensus median JEC standalone EBITDA for FY 2019 is $780mm, which combined with no growth on CH2M reported LTM EBITDA of $324mm and $150mm of target synergies is ~$1,250mm.

A $75 target on base case assumptions at the current JEC standalone FY1 EBITDA multiple implies JEC trading at approximately ~15x adjusted earnings of $5.00, which would be cheap on a one-year forward basis.  Just based on an earnings multiple in-line with standalone 17x FY 2018 consensus EPS, this would indicate a share price of ~$85 in a year and be supportive of some upward rerating on the current EBITDA multiple.

Path to Bull Case

The bull case below outlines a path to ~$200mm of additional FY 2019 EBITDA, driving further value creation

1. A&T growth outpacing consensus estimates

• JEC standalone consensus assumes growth of 3% in 2019, well below the company’s organic target of 5 to 7% that is more in-line with where recent contract wins and management commentary has aligned

• Additionally, the recent tuck-in acquisition of Blue Canopy, a specialty defense IT contractor ($100mm top-line, low double digit operating profit margins) provides further upside opportunity
  
  

2. Rebound in Industrial and P&C segments

• Industrial: growth in Life Sciences verticals and a recovery in mining capex present upside to current low growth consensus estimates

• P&C: double digit declines in yoy segment revenue over the last 7 quarters present easier comp profile; backlog growth of 5% yoy in FY17 Q3

3. Upside to $150mm cost synergy target and pro forma margin profile

• Management has reiterated conservatism in the quoted $150mm cost synergy target with tangible opportunity for greater capture on both the cost side (especially as it relates to CH2M’s real estate profile) as well as enhanced revenue opportunity from selling CH2M services (i.e. environmental remediation) to existing JEC customers

• Assuming a 32% tax rate and ~143mm pro forma shares, an additional $25mm of cost synergies translates to ~$2 of equity value on a 17x forward earnings multiple

• Similarly, management has discussed new backlog wins / pipeline carrying higher margins as well as better execution on achieving margin booked relative to margin sold across all segments in recent months

Risks

• Integration issues – lack of full synergy realization, revenue dissynergies on overlap (i.e transportation business), CH2M engineering talent defection

• Macroeconomic downturn, more pressure on macro driven end-markets (chemicals, oil & gas, mining & minerals)

• CH2M Australia Ichthys JV settlement outcome unfavorable

Catalyst

• FY Q4 earnings – Continued project wins in A&T and B&I drive backlog growth and margin mix improvement, FY 2018 outlook gives insight into CH2M pro forma

• Merger close and near-term synergy realization announcements become recognized by analyst community and drive higher consensus and multiple rerating on recognition of improved business mix