Description

(apologies in advance for formatting on upload)

Opportunity

KBR provides investors an opportunity to generate 50-100%+ returns through a combination of better than expected earnings growth and a valuation re-rating as investors discover this highly misunderstood situation. 

Large market disconnect on valuation:

KBR is not what you think it is.  Investors may associate KBR with the likes of Flour, McDermott, and CB&I.  Instead, they should think Leidos, CACI, Booz Allen.  Because of this misconception, KBR trades at a 30-40% discount to its peers.

Large market disconnect on earnings growth:

Consensus numbers have EPS and cash flow for KBR growing to just under $2/share in 2021 from $1.50/share today.  Meanwhile, the company is pointing investors to >50% upside to these estimates, suggesting $3/share of EPS and FCF is more reasonable.

Business Overview

KBR operates as a diversified service provider through 3 segments

• Government Services (2018 YTD: 67% of total company Revenue, 76% of total company EBITDA)

• Serve defense, space and aviation markets, offering program and mission support and integration for military and government agencies

• Offer a broad scope of services, including R&D, systems engineering, test & evaluation, program management, operations & maintenance, IT and field logistics under the KBRwyle brand

• 2018 Revenue: 64% US, 36% International 

• Hydrocarbon Services (2018 YTD: 27% of total company Revenue, 13% of total company EBITDA)

• Serve onshore and offshore oil & gas, LNG, refining, petrochemicals

• Offer project and program delivery, from front-end engineering & design (FEED) to engineering, procurement & construction (EPC) as well as some maintenance and industrial services

• 2018 Revenue: 42% Downstream, 34% LNG, 10% Upstream, 14% Other 

• Technology (2018 YTD: 6% of total company Revenue, 11% of total company EBITDA)

• Serve refining, petrochemicals, specialty chemicals, gasification, ammonia and fertilizer end markets

• Offer proprietary technologies, equipment and catalyst supply and associated services from early scope planning to project lifecycle support

• 2018 Revenue: 64% License & Engineering, 27% Proprietary Equipment, 9% Catalysts

Investment Thesis

• Business Misunderstood by Market

   Predominantly Government Services Business

  The markets still values KBR as an oil & gas driven E&C, while in reality that’s no longer the case.  As noted above, 2/3 of the top-line and 3/4 of the EBITDA year-to-date have come from the Government Services segment, which is also where 80% of the backlog at Q2 end sits.  This is likewise reflected in the contract risk profile, with 93% of total backlog comprised of cost reimbursable and services contracts.

  The Government Services business has been deliberately built up and diversified into higher value-add services through a series of acquisitions over the last two years in order to “transition to stable, recurring earnings base and attractive cash flow generation”:

• Wyle – May 2016, $570mm

  • Diversified capabilities in systems engineering, program management, space operations, IT and advanced systems and networks, serving DOD, NASA and other federal agencies

• HTSI – Aug 2016, $266mm

  • Honeywell Technology Solutions, leading provider of technical and mission support services across satellite, military logistics and cyber security

• SGT – Feb 2018, $355mm

  • $500mm+ revenue; provide technology, engineering, mission operation and IT services largely for space operations and NASA

• Aspire Defence JV – April 2018

  • Acquired Carillion stake in existing joint venture to assume control; provides maintenance services under long-term services contract with UK (runs for an additional 23 years)

Following the acquisition of SGT noted above, KBR further cemented its position as one of the largest contractors to NASA

Figure 1:

Despite this mix, on a consolidated basis the Company trades at ~8x 2019E EBITDA and less than 12.5x 2019E EPS, which represents a notable discount to Defense Services comps trading at closer to 11.5x 2019E EBITDA and 4 – 5x turns higher on earnings (and 6x below the 14x multiple EGL was acquired for in September)

Figure 2:

KBR is working to potentially change its GICS code to more accurately classify the business as a government services and defense business.  A GICS reclassification requires >60% revenue from a particular industry, and KBR certainly seems to qualify.  While not a fundamental tenet of the investment case, a reclassfication could be an important catalyst for the market to realize the comparable valuation discrepancy.  The CFO, who joined from government contractor Leidos (LDOS) in May 2017, has affirmed an organizational awareness to this rerating lever.

Improved Hydrocarbons Risk Profile

KBR still performs EPC work in commodity driven end markets, but its ultimate fixed price risk has evolved over the last several years, with the current backlog for the Hydrocarbons segment at only 4% lump sum EPC.

Figure 3:

Management has maintained steadfast commitment to avoiding higher risk, fixed price lump sum contracts in high cost labor locations or where they are uncomfortable with project scope, even while chasing large headline projects (a practice that has forever plagued E&C stocks).  While KBR was one of the final two bidders on the large LNG Canada project that FID’d this fall, they were openly unwilling to take certain lump sum risk and willing to lose the project as a result.

Multiple Material Award Catalysts on the Horizon

Government Services

While Government Services improves earnings stability, the segment still offers the potential for high growth (as evident in the 11% organic top-line growth YTD).  The National Defense Authorization Act, signed before fiscal year-end for the first time in a decade, with base defense and OCO spending growth in FY19, represents the second consecutive year of large scale growth and provides greater near-term visibility / award flow potential.

• Space – KBR focus and positioning in space sector noted above, with several potential / pending awards

  • NASA Kennedy Space Center

    • SGT awarded $609mm 5-year contract (JV w/ PAE) on a takeaway from AECOM (ACM protesting, expect resolution by end of October)

  • NASA SENSE (Space Exploration Networks Services and Evolution)

    • Potential platform win representing over $1bn; expected in next 6 – 9 months

  • NASA Marshall Space Center

• LOGCAP V – multi-billion dollar logistics support contract with the US Army

  • KBR’s largest singular contract and an expanded recompete that has been pushed to April – June of 2019

  • LOGCAP V will be structured on a regional basis (whereas IV and previous has been per country), with KBR bidding to maintain its longstanding position in Iraq (CENTCOM) and Europe (EUCOM)

  • The CENTCOM portion would include Kuwait, an expansion from its current position that would offer upside to its current total LOGCAP IV exposure even when including Europe

Hydrocarbon Services

KBR posted a book-to-bill of 2.6x in Hydrocarbons in Q2 2018, anchored by a number of awards that reflect the momentum management has discussed seeing in bookings moving forward while still maintaining prudent risk discipline.

• CEO, Q2 Call: “During Q2, we also announced multiple reimbursable awards from key clients. That included three FEEDs, EPC and construction management and program management services, all of which have predictable stable backlog for KBR and position us for the next phase of these projects. To highlight this, the methanol plant I talked about above at the specialty chemicals facility, expansion for Tier 1 customer we talked about last time in Texas and the Trinidad refinery project, all are expected to be reimbursable EPC projects with the exclusion of Arkema which is a lump sum conversion. But all in line with our risk profile and all are expected to deliver solid revenue and stability enabling a return to growth in the Hydrocarbons Services business into 2019 and beyond.”

While bookings growth in Hydrocarbons should continue into 2019 across a number of end markets, growth potential is undoubtedly most pronounced in LNG.  Supply / demand curves indicate global markets will be in a supply shortfall well before 2025, with estimates continuing to move left, implying the need to begin capacity buildouts.  Following the official FID of LNG Canada, a slate of additional projects are closer to moving forward over the next few quarters, of which KBR is positioned around several major awards.

Figure 4:

• Woodfibre

  • Potential for this project to get awarded in 2018

  • KBR negotiating EPC sole-source, with a potential award value in the $1 – 2bn range

  • Woodfibre has funding in place and the majority of offtake agreements signed up

• Magnolia

  • JV – 70% KBR / 30% SK E&C

  • KBR has contract in place, FID expected in early to mid-2019

  • FERC approved, still working through binding off-take agreements

• Venture Global

  • Offtake agreements signed, awaiting FERC approval

  • KBR one of two parties negotiating for EPC

  • FID potentially in mid-2019

• Nigeria Train 7

  • Currently working on FEED with Technip and JGC (another FEED team of Saipem and Chiyoda also competing)

  • Involved in trains 1 – 6 with Technip and JGC, management has noted conviction moving forward

  • EPC award potential in 2H 2019, would be $4 – 5bn award for KBR

There likewise exist additional opportunities for capacity expansions in both the US Gulf Coast and Australia. 

In mid-September, KBR also announced a JV with ConocoPhillips to develop new low-cost modular LNG technology.  This provides access to COP technology that had previously been exclusive to Bechtel, broadening the Company’s ability to participate in both greenfield and capacity expansions globally.

• Consensus Estimates Remain Too Low

   

  At its Investor Day in May 2017, KBR introduced a new set of financial targets via a “Base Case” and an upside outlook called the “Breakout Case.”  Part of these cases included 2019 – 2021 compound growth targets for both Revenue and Net Income as well as additional margin and segment level detail.  As can be seen below in the latest outlook KBR has provided, management is calling for a Base Case of 5 – 10% Revenue growth and 10 – 15% Net Income growth for the total business. 

   

  Figure 5:

  

   

  Since the Q2 call, management has increasingly framed the Breakout Case potential as highly achievable. Commenting on a segment level basis for both Government Services and Hydrocarbon Services:

• Q2 Call, July 30, 2018: CEO: “…we feel the breakout potential is achievable in both segments. With the growth that's happening in our Government Services business, we achieved 11% organic growth for the second quarter, and we've got substantial bids out there, the $9 billion pipeline and an award in something like LOGCAP V that went in our favor, we would achieve that breakout case. So that's very much within reach if things go our way and we continue to perform. And then again on the Hydrocarbons side, the breakout case is really related to really sort of winning probably a fair share in the downstream sector, which we're doing and then one of the LNGs going ahead in the time frame that we're working on and I think that's all achievable”

   

   

   

Discussions with management have reiterated this view, affirming that LOGCAP V and one large LNG project alone take each segment to their respective breakout cases.  Depending on the cadence of awards, KBR could be in position to meaningfully reframe its growth targets in 1H 2019 and potentially as early as the Q4 call in February.

Given management conviction, visibility from the aforementioned stability of the government business and growth opportunities across the business, these targets seem reasonable.  However, consensus numbers currently reflect an earnings outlook below the midpoint of the Base Case.

Figure 6:

There exists further upside to earnings numbers from several potential cash events that would accelerate deleveraging and meaningfully reduce interest expense that are not captured in management’s current guide.  Following a refinancing in Q2 in order to fund working capital payments while completing the Ichthys project in Australia, KBR will focus on paying down debt to reach a gross leverage ratio of ~2.75x by 2019 year-end from ~3.5x currently.  Management’s forecast at this point includes no cash inflow beyond regular operations, though several potential cash events could dramatically accelerate this paydown.

• As Ichthys comes to completion, KBR is in position to get collect on outstanding change orders

  • Several hundred million dollars in total, exact amount to be determined between KBR and client

  • Likely scenario is project is fully finished in Q1 next year, begins generating economics and the client look to settle some time in 1H 2019

• Settlement with consortium (JEC / CH2M, GE, UGL) initially subcontracted on the job who walked off the project in January 2017

  • JKC filed $1.7bn claim, with KBR holding 30% ownership interest amounts to over $500mm

  • Arbitration hearing set for October 2019, with expected decision in 1H 2020; potential for earlier settlement

• Advance payments on large scale Hydrocarbon Services award(s)

  • Generally advance payments ~10% of total awards value, so for multi-billion dollar awards offers several hundred million dollars of upfront cash, allowing for greater flexibility

While the two Ichthys related items may not be realized in full, KBR is near guaranteed some cash collection not accounted for in management’s targets.  The ability to paydown $300mm of the Term Loan B is worth ~$0.02 - $0.03 of EPS per quarter, indicating an early 2019 cash event could drive real value when annualized for the year.

As it further relates to FCF, it’s worth noting that the long-term Net Income targets do not account for potential EPS accretion via buybacks or M&A, which further deflates comparable consensus EPS estimates on flat share count assumptions.  With targeted operating cash flow conversion of 90 – 110% of net income, KBR can start deploying sizable cash flow by 2020 if not earlier, and management has expressed a willingness to do so.

• …the cash flow prospects of the Company are very good and we think we can delever fairly quickly. We can see hitting the sub-3 zone in late 2019, possibly early 2020, after which we would be more liberal in our capital deployment alternative. Relative to M&A, certainly that would be one alternative. Buybacks would be another or some combination of the two we are very comfortable with.

Valuation

Price Target Range

1-Year Price Target Range of $30 - $40

Based on the management cases outlined in Figure 5 above, the bottom end of the Base Case assuming 10% compounded net income growth would imply 2021 earnings of $2 (with no buybacks).  Applying a 15x multiple, slightly below the FY2 multiple of Defense Services comparables presented in Figure 2, would imply a $30 price target and 50% upside.  At the midpoint of the Breakout Case, which as noted management has spoken to a clear path to achieving, a 15x multiple on 2021 earnings would imply a $44 price target and 120% upside.

Figure 7:

Figure 8 below outlines more conservative scenarios where Hydrocarbons earnings remain flat for the next few years (as opposed to management's growth estimates), and the company only achieves its Government Services Base Case and Growth Case scenarios.  KBR should still be able to generate $2-3/share of EPS and FCF in this case, and still comfortably ahead of consensus estimates.

Figure 8:

Figure 9 below highlights the power of KBR free cash flow generation.  KBR should generate greater than $700-900mm of cumulative FCF from 2019 – 2021, or ~30% of its current market cap in free cash flow for debt repayment, buybacks, and M&A.  Productive use of cash flow provides upside to EPS and FCF estimates.  However, even ignoring this, at a 7% yield on 2021 numbers, KBR provides staggering upside.

Figure 9:

Risks

Broader macro risks cancel potential awards or push to the right

Catalyst

• Award catalysts outlined above

• GICS code reclassification

• Ichthys change order resolution, cash settlement with consortium