Description

KBR (KBR US): Opportunity to own two great businesses trading at a discount to intrinsic value and to slower growth inferior peers.  KBR offers nearly 60% upside over the next 12-18 months if it can get back to its 1yr forward P/E of 18x, which is a conservative multiple given double-digit organic top-line growth and ~20% EPS growth. We believe the recent pullback in the stock creates a phenomenal opportunity for investors and for management to create significant value via warrant settlement and share repurchase.  If the stock does not re-rate in a similar timeframe, we believe management will split the businesses and force the market to place a multiple on STS, a business with >20% organic top-line growth and healthy operating leverage.  Further, following successful outcomes at peers Jacobs and Aecom, we would not be surprised to see activist intervention.

Background and Company Description: This idea was written-up in early 2021 and while the stock is up >60% since the write-up, earnings power has kept pace, and the quality of the business has improved tremendously (as evidenced by revenue growth, margins and ROIC).  When Knicks2121 outlined the thesis, the business looked like this: “The Government Solutions (GS) business represents ~70% of revenue and ~90% of EBITDA. KBR has replaced its legacy Energy Solutions (ES) business (low-margin, fixed price EPC work) with a Technology Solutions (TS) segment that provides proprietary technologies, catalysts, digital solutions and consulting services to the refining, petrochemicals, and specialty chemicals end markets.” 

For 2023, Sustainable Technology Solutions (STS), which focuses on solving the “energy trilemma” of energy security, energy transition and climate change / sustainability will account for ~25% of revenue and nearly 40% of EBITDA.  While GS should grow organically by ~6-8% per year (some lumpiness from large, short-term contracts) with stable 10-11% EBITDA margins (cost-plus-ish), STS is and should continue growing top-line 15-35% per annum with >20% EBITDA margins currently, and with material operating leverage (largely an IP-license business with an increasingly large recurring tail).  Overall, the company currently generates an ROCE (tax-adjusted EBIT/net debt + equity) of ~19% (2023E), which we think will rise to 30%+ in 2025.

I am not going to spend a lot of time going through the details of either business.  I would encourage interested investors to review their annual report, website (especially recent awards) their most recent investor decks (March 2021 analyst day and their April 2021 STS deck) and BAML’s December 2022 initiation report.  These charts are dated and will be updated next spring at KBR’s next analyst day (last one was 2021).

Dislocation #1: Business Quality

STS should be the ESG darling of the market.  It’s one of the few “energy transition” businesses with significant profitability, massive growth and minimal capital required to realize that growth. KBR is the market leader in hydrogen production (>50% share), green and blue ammonia production (>50% share), top 5 in LNG terminal design (firstin terms of margins), will be the #1 leader in plastic recycling as well as large scale carbon capture and storage.  While many companies that touch these end markets are unprofitable, KBR's ESG division (STS) will generate >$350M of EBITDA in 2024 and grow 15%-35% for the foreseeable future. The Company's ~$600M EBITDA Government Solutions business grows ~10% per annum as well.  KBR will improve its communication surrounding STS over the coming quarters and investors should appreciate that the growth inside this business is structural, profitable and acyclical (customers are predominately sovereigns, NOCs and the largest IOCs; only 30% US).

Further, there are several businesses within STS that will likely each be worth billions.  For example, Digital Solutions and Mura Technology are two exciting businesses that investors seem clueless about. The former is a digital platform that provides clients with a digital twin of their facility, allowing them to monitor, optimize and operate remotely.  This is on the opex side for clients and helps KBR provide an end-to-end solution for plants.  Revenue and EBITDA is in the single-digit millions per year per plant but continues for the life of the plant.  This is a recent offering bundled with other STS products and services, which differentiates KBR and keeps them close to the customer.  Mura is quickly becoming the leading plastic recycling company.  While KBR “only” owns 18.5% of the company, they a) have the exclusive global license, b) design the modules (own the IP) and c) will win virtually all of the ancillary engineering and consulting work that comes with contract wins. For every $~50M, 20kTA module, we think the revenue split is roughly 50% to KBR.  Customers include GS Caltex, Dow, CP Chem (Chevron Phillips), Mitsubishi Chemical, Igus and LG Chem.  We believe Mura can achieve $100M-200M+ of EBITDA by 2026-2027 (~8-15 modules) and will likely IPO in 2025.  Some analysts believe this business will IPO with a 20-30x EBITDA multiple given its growth profile.  While these estimates are very rough at this stage, we believe increased disclosure early next year and the market will begin to value the equity stake as the IPO chatter begins.

Dislocation #2: Homesafe Isn’t Gone. It MAY not generate $150M of EBITDA in 2025.

On November 2^nd, KBR’s stock fell by ~14% despite solid earnings and confirmed guidance.  However, they stated that their $4.75 2025 EPS target may not be achievable due to delays with their Homesafe project.  For reference, in late 2021, KBR’s HomeSafe JV (72% ownership) won the Global Household Goods Contract by the US Transportation Command (TransCom). This $20bn 9.5-yr contract covers ~325,000 annual household relocations for the US Armed Forces globally. The program was not cleared until late 2022 following protests by ARC and CGS.  Relocations were supposed to begin by now, but there have been further delays due to poor IT on the TransCom side, which led the government to recently change providers to CACI.  There has been no new schedule provided, but only the timing of the contract is in question, not the scope or scale of the business.  Analysts estimated ~$150M of EBITDA (EPS ~$0.55-$0.75 of the $4.75 target).  From speaking with management, we believe nothing short of Armageddon would prevent some contribution from this contract in 2025.  Given that the stock fell by an equivalent amount of the actual contract (and we’d argue the stock was undervalued prior to November 2^nd), the market reaction suggests that this contract simply won’t materialize.  More likely, the market reaction likely reflects what happens in the current market environment to any whiff of bad news from any company.

Dislocation #3: Management Quality

Stuart Bradie clearly articulated and successfully executed the transformation of KBR's business away from legacy Energy E&C contracts characterized by lump sum, turn-key projects that were extremely capital intensive towards a more stable Government Solutions business that includes operational support (e.g. training), information operations (e.g. data analytics), program management, engineering services (systems and platform integration) and scientific research…AND STS.  This business transformation was achieved intentionally via M&A, divestitures, business line closures and organic investments.  Our checks on Stuart from his days at Smiths and WorleyParsons were also very strong.  He currently owns ~670k shares with >200k options and RSUs.  Anyone who knows Stuart appreciates his current level of frustration and acknowledges that a) there are no sacred cows in the portfolio and b) he appreciates how siloed institutional investors are.  We think KBR will provide a lot more disclosure on STS at the Company’s analyst, likely early next year.  If that does not serve as a major re-rating catalyst, we believe that he will pursue a break-up.

Finally, in addition to potential delays to HomeSafe, the environment for levering up and shrinking the share count has changed dramatically since March 2021.  To blame management for this seems foolhardy to us.  That said, while the math for levering up and buying back stock was not very accretive when the 10-year was 5% and the stock price was at $60 just a couple of weeks ago, the math is different at 4.6% (let’s say 200bps spread for 5-year paper) and the warrants are much more affordable ($1 move in the share price = $11M in savings).  KBR is a corporate client of the warrant holders (three banks).  The negotiation should not be a long or contentious one.  We also think they could accelerate a 2-4M share buyback here, which would shrink the share count to ~130M heading into 2024 (~4M from the warrants).  We believe another 6-8M shares could easily be bought during 2024.  For 2025, we think the share count will be ~120M-125M, which would make >$4.75 very achievable with half of the expected $150M of EBITDA from HomeSafe.  Lastly, KBR will greatly exceed the 2025 target of >$800M of EBITDA in 2024 with minimal contribution from M&A.  This is the result of STS, which will already hit the 2025 target of $300M in 2023.  Leverage is not the 3x envisioned in early 2021, but rather 2x, given the change in the financing environment.  We believe management has executed brilliantly thus far and will take advantage of recent share price weakness to create long-term shareholder value via warrant settlement and buybacks.  We also wouldn’t be surprised to see top management personally purchase stock.

Summary Model and SOTP

Risks

Sequestration / cuts to the US Government budget, containing cost inflation, significant project cancellations, something severe happens with Saudi-US relations, NOC / IOCs stop spending money

Catalyst

1. Buybacks: We think over the coming weeks, KBR will reach a cash settlement on the warrants and buyback stock. We think the company will buyback 5-8% per year through 2025.
2. Analyst Day: in spring of 2024, KBR will likely host an analyst day with a lot more disclosure on STS and the rest of the business. We think it will become clear to the market that both businesses can stand alone.
3. M&A: We think Jacobs will sell its government services business for a higher multiple than where KBR trades despite KBR’s GS being quantifiably superior.  We believe there could be more M&A in the sector as well. Carlyle announced the acquisition of Mantech in May 2022 for ~17x/16.3x 2022/2023 EBITDA and 26.9x/24.6x P/E.  Mantech was demonstrably inferior with MSD revenue growth and <10% EBITDA margins.
4. Homesafe visibility: we think Homesafe will ramp by spring of 2024 and the market will get more comfortable that $100M+ of EBITDA in 2025 is probable.
5. Mura IPO: we think Mura will IPO in 2025 with a lot more information and a preliminary roadshow in 2024.
6. Earnings: we think growth will accelerate for KBR while peers that face civil construction and/or “the real economy” languishes.
7. Spinoff/spit: We think KBR will communicate that the STS business will be spun-off if the market does not appreciate its value by the end of next year.  KBR trades at <12x 2025 P/E.  This is an absurd multiple for a company with significant revenue visibility and accelerating 15-25% per annum EPS growth.