Description

URS is a diversified engineering & construction company with underestimated earnings power from legacy loss-making contracts and merger synergies with recently-acquired Washington Group, trading at a steep discount because of confusion over the earnings power and growth profile of the combined company that should resolve with ’08 guidance and several potential contract wins over the next 12 months.

 

Merger Background

 

On 5.29.07 URS, an engineering & design services firm, announced the acquisition of Washington Group Int’l (WNG), an engineering & construction firm, doubling their size and transforming the company from a gov’t-focused design firm into the 3^rd largest E&C company offering single-source design, procurement, construction, and management services to a broad range of end markets, including 40% exposure to the rapidly growing power and infrastructure markets.

URS successfully closed the acquisition on 11.16.07 at the bargain price of $95, or 10.6x ’08 EBITDA, despite opposition from Washington Group shareholder Greenlight Capital, who voted against the deal and argued that WNG was worth as $124 / share on a standalone basis because (A) WNG should realize 100 to 200 bps of gross margin expansion on new work given the favorable demand environment, (B) the offer gave no credit to an estimated $6 / share of tax assets, and (C) WNG recent earnings were depressed by non-recurring charges on legacy contracts that were finished in the fall of ’07.

 

Thesis

 

At 7.1x ’08 EBITDA, 13.3x ’08 EPS, and 10x ’08 FCF, we believe URS presents an extremely compelling opportunity to buy a leading fully-integrated E&C franchise at discounted prices:

 

1) Merger Synergies

 

URS should reap substantial revenue and cost synergies from the acquisition of WNG that may be underestimated by the Street. First, the acquisition broadens URS’s expertise from primarily design services to a fully-integrated portfolio of design, construction, and management services with which to win new contracts and expand contracts with existing customers. For example, URS currently provides planning and design services to the DoD for the reconfiguration of military bases – adding WNG’s construction expertise allows URS to fulfill the construction side of those contracts as well. This integrated single-source offering will prove increasingly important as customers move from design-bid-build contracts, with different firms specializing in the design and construction of a project, toward design-build contracts with a single firm to improve execution.

Second, the merger consolidates both companies’ oil & gas businesses and increases their resources with which to win a greater share of the growth in energy spending. Until now both companies had been relatively small players in oil & gas without the critical mass or portfolio of services to win major contracts. For example, URS has long-term Master Service Agreements (MSAs) with several multinational oil & gas companies, but these services have been limited so far to engineering and environmental clean-up work. With the acquisition of WNG, however, URS can now lever these MSA relationships to cross-sell procurement and construction services as well and potentially become a major player in oil & gas E&C.

Third, URS expects to reap $50-55M, or 50 bps of pro forma revenue, in cost savings in 2008 from eliminating redundant overhead, such as IT departments, insurance, and public company expenses, and further cost savings beyond ’08 from eliminating redundant regional offices. This estimate will likely prove conservative as URS has a strong track record of integrating large acquisitions and achieving much higher cost savings as a percent of revenue, such as the 150 bps of savings from the acquisition of Dames & Moore in 1999.

The Street may underestimate the impact of these synergies as URS has provided very little guidance thus far and in fact had a strong incentive to downplay the potential benefits to avoid further opposition from Greenlight and others who argued that the merger did not fairly share the benefits with WNG shareholders. Now that the acquisition has closed, we expect URS to become more forthright and highlight the strategic benefits of the merger going forward.

 

2) Underestimated earnings power at WNG

 

On their last earnings release WNG management guided 2007 results to $4.0B of revenue and implied EBIT margins of 4.2% (ex gain on sale). However, this guidance also included pre-tax charges of $29.7M – or $0.22 / pro forma share – in Q2 and Q3 from SR-125, a legacy fixed-price California highway project, which are non-recurring since the project should be completed this year and WNG no longer bids on these fixed-price construction-only contracts. WNG also expects to recover the bulk of these charges through later claims adjustments. On a normalized basis then excluding these charges or any potential recoveries, WNG actually expects to achieve an EBIT margin of 4.9% in 2007. We conservatively estimate that WNG can at least maintain this margin, not to mention exceed it, through 2009 given (A) very positive language from WNG management on the E&C demand environment and contract pricing power, (B) expectations across the E&C industry for 50 – 150 bps of gross margin expansion over the next 2 years, and (C) historical EBIT margins of 5.5% at WNG in 2003 before these highway charges began. Assuming 15% CAGR in revenue through 2009 – which should also prove conservative given their $6.7B backlog at year end, 17% y/y bookings growth and 1.3x book / bill in the first nine months of ’07, the favorable macro environment for energy and infrastructure capital spending, and estimates across E&C competitors for 15-25% revenue growth – we estimate WNG should generate at least $4.7B in revenue and 4.9% EBIT margins in ‘08, and $5.3B in revenue and 4.9% EBIT margins in ‘09.

Among analysts that have published pro forma URS estimates, however, the mean estimates for the WNG segment are $4.6B in revenue and $200M in EBIT in ‘08, or 14% growth and 4.4% margin, implying a 30 bp decline from the normalized level already expected this year. Most of these analysts did not cover WNG previously and have only a cursory understanding of WNG’s book of business or margin structure. When pushed on their estimates, all analysts defended themselves by arguing that URS had provided very little commentary so far and they were awaiting more guidance from the company before doing more work. Relative to these estimates then we see at least $0.29 of upside to EPS. Ultimately, we believe the value opportunity Greenlight observed at WNG may simply manifest itself now through URS.

 

3) Discounted Valuation

 

URS historically traded at a 10-20% P/E discount to the E&C group because of its concentration in the slower growing defense sector and its lower exposure to energy-related end markets. Additionally, URS underperformed the E&C group by 30% (+13% vs. +43%) from deal announcement to close because of the uncertainty and “hairiness” of the acquisition. Anecdotally, investors focused their attention elsewhere in the E&C space where they could find cleaner exposure to the energy investment cycle, rather than wade through the uncertainty of disgruntled shareholders and a potentially broken deal. Moreover, despite a +10% move on 11/15 with the positive news of the WNG shareholder approval, URS has since underperformed the E&C group by another -6% (-18% vs. -12%) as 29M new shares were delivered to former WNG shareholders less familiar with URS. This 55% increase in the URS float in the hands of new shareholders likely drove technical pressure on the stock in a spinoff-like dynamic, creating the opportunity present today.

As investors gain greater visibility into the outlook for the “new” URS, however, we expect this valuation gap to converge as the deal overhang disperses and investors recognize the improved growth profile of URS, with strong positions in the design and construction of nuclear and coal-fired power plants, highways and bridges, oil & gas facilities, and nuclear clean-up services. Additionally, the merger doubles URS to the 3^rd largest E&C firm by revenue and EBITDA. The stock could therefore benefit from increasing sponsorship as new sell-side and buy-side coverage highlights the upside to earnings and valuation. Six sell-side analysts, including Citigroup, Lehman, and Bear Stearns, currently do not cover URS and could initiate coverage now that URS rivals its largest competitors in size.

 

Valuation

 

We estimate URS should generate cash EPS of $3.27 and $4.06 in 2008 and 2009 (see end). At $45.53, URS trades at only 11.2x ’09 EPS (before tax assets) versus E&C comps trading in the 17x range. Given the improved end market exposure and growth characteristics of the combined company, including 7% oil & gas, 13% power, and 15% infrastructure, as well as the likely upside from greater than expected revenue and cost synergies, we believe the new URS should trade in-line with its E&C competitors. Additionally, URS will have the most attractive risk profile in the group with only 10% of its backlog under fixed-price contracts, reducing the risk of cost overruns facing its competitors. Finally, URS also inherited an estimated $227M, or $2.75 / URS share, in tax assets from WNG, all of which should be fully utilized. Once the dust settles from the recent acquisition and investors gain greater clarity into the revenue synergies and ’08 performance, we believe URS should trade in-line with comps at $65, or 19.9x ’08 and 16.0x ’09 EPS, and 10.3x ’08 and 8.7x ’09 EBITDA.

 

Catalysts

 

1) 2008 Guidance – URS will issue ’08 guidance and provide more detail on the strategic synergies of the merger on their Q4 earnings call in late February. As investors gain clarity into the potential of the new company, we expect shares to meaningfully appreciate toward our price target.

 

2) Contract Wins – New contract wins in the power and nuclear clean-up markets, including potential wins in the Sellafield and Hanford Plateau clean-up projects in Q2 to Q3 ’08, would underscore the capabilities and end market profile of the new URS, further driving valuation convergence.

 

3) Strong Quarterly Performance – The stock should continue to work through 2008 as URS delivers strong performance and capitalizes on the opportunities from the merger, transforming investor perception of URS from that of a slower growing gov’t focused design firm to a fully integrated E&C provider with premier power and infrastructure franchises.

 

Risks

 

1) Integration – As the acquisition of WNG nearly doubles the company and brings URS into new businesses, such as the power market and construction services, integrating WNG may present some complications. However, URS has a strong track record of integrating acquisitions, including four major acquisitions in the past 11 years, three of which each doubled the size of URS. Additionally, Tom Zarges, former COO of WNG, will continue to lead Washington Group as a separate subsidiary out of Boise, minimizing the risk of any missteps during the integration.

 

2) E&C De-rating – Multiples for the E&C space have expanded significantly over the past year given the surge in backlogs and demand for E&C services. While we believe this re-rating is warranted given the long term global demand for energy-related construction, transportation infrastructure, and environmental clean-up services, a slowdown in capital spending or significant decline in energy prices could dampen the growth outlook and market sentiment for the space.

Catalyst

(1) 2008 Guidance and more detail on the strategic synergies of the merger on their Q4 earnings call in late February.

(2) Contract wins in the power and nuclear clean-up markets, including potential wins in the Sellafield and Hanford Plateau clean-up projects in Q2 to Q3 ’08.

(3) Strong Quarterly Performance should transform investor perception of URS from that of a slower growing gov’t focused design firm to a fully integrated E&C provider with premier power and infrastructure franchises.