Description

Willbros (WG)
# of shrs o/s: 21MM

Investment Summary

Willbros is an attractive name to play 1) an increasing supply of natural gas from remote/tough locations and non-conventional sources like LNG; 2) a cyclical capital spending recovery in gas transmission infrastructure (identified market size: $2.5-3.0B per year over the next two years).

The pipeline construction industry is very competitive, but WG is well positioned to get its fair share with its brand recognition, global reach, big installed base of pipelines built by WG before and experienced management team. With strong operating leverage (15-20% incremental margin, pretax) in the business, an increase of revenue from break-even level of $300-400MM to its peak capacity of $800MM could take WG’s peak earnings power to $2.25-3.00/shr. With potential acquisitions, which can be funded by its strong free cash flow estimated to be $40-50MM over the next three years plus net cash of $10+MM sitting on its balance sheet today, peak earnings power could be enhanced to above $3/shr, assuming ROIC at 15-20%. At a reasonable peak P/E multiple of 10-12 x, the stock can be worth $30-35/shr in two to three years, nearly a triple from here. The downside risk is quite limited by its tangible book of $10/shr plus $0.50/shr net cash.

The “free call” is on LNG/Iraq, which are not considered to be significant in WG’s current plan for the next two years, but could be gigantic in 3-5 years if these opportunities materialize. In such scenarios, either margin will have to expand on the existing contracts or WG will likely be more aggressive about expanding capacity (pretty much about hiring more people, rather than increasing capex significantly) to meet incremental demand. Each 1% margin expansion on the $800MM peak revenue will add 25 c/shr to EPS and/or each $100MM incremental revenue (beyond $800MM level) at a margin of 15% will add 50 c/shr to EPS.

Peak earnings calculation (core business, without share repurchase or acquisitions)

Breakeven revenue level: $350MM
Peak revenue (at full capacity) $800MM

Incremental margin: 15-20%
Peak earnings
Pretax $68-90MM
Tax rate 30%
After tax $48-63MM

Peak EPS (on 21MM shrs) $2.25-3.00/shr


Willbros is a 95-year old, conservative, well run and the only publicly traded pipeline engineering and construction company in the U.S. The management team is mature with over 20 years experience on average (CEO: 40+ yrs experience), and entrepreneurial, which are both important in this highly competitive business. In total, the management, employees and directors own approximately 9-10% of the company.

Recently, the company is reporting improving new book orderings and increasing backlog, which are precursors to a revenue and earnings recovery that appears to likely occur in 2005, if not sooner. The coming upcycle appears to be driven by
- an increasing natural gas supply from remote locations or non-conventional sources, particularly LNG and gas exports from Canada, which can only be transported by pipelines;
- an improving financial condition of utility operators/owners (some new owners with significantly stronger financial strength, e.g. Berkshire Hathaway/Mid American, etc.);
- an aging gas transmission pipeline infrastructure (75+% built before 1970s) in the U.S. which, for safety reason, has to be replaced as soon as possible and could drive a huge replacement cycle that is well overdue;
- and on the regulatory front, the pending energy bill, if passed, that would encourage accelerations of pipeline asset depreciation.
- Meanwhile, Iraq remains as a wild-card. Despite no near term opportunities around due to the safety concern, if opportunities come, WG will definitely be one of the beneficiaries.

Excluding LNG/Iraq opportunities, which could be gigantic but hard to time and quantify at this point of time, WG has identified qualified prospects it is currently bidding on and planning to bid in a total amount of over $5B. A typical project lasts 1.5-2 years, so annualized revenue opportunities for the industry could be in the neighborhood of $2.5-3.0B over the next two years. The longer these projects get delayed, as they have done so in 2003, the more likley the peak could arrive in ‘05/’06.

Competition is from everywhere, local and foreign, big and small. Willbros, however, does have the brand recognition with its legendary history, e.g. having built the first pipeline in Saudi Arabia and South America, etc., global reach, engineering expertise and know-how for difficult projects, as well as huge installed base of pipelines WG once built before. These strengths make the management believe WG should be able to get a fair share of future projects that are coming. While it is hard to predict WG’s win-rate, it is noted that WG’s peak capacity, without further expansion, is $800MM, which represents 20-25% of total available opportunities that have been identified as of today and continue to grow.

Accumulative free cash flow over the next three years should be in the neighborhood of $40-50MM, or $2-2.50/shr. Plus, WG has $0.50/shr net cash ($20MM cash, $9MM debt) sitting on its balance sheet today. WG can either buy back shares or do acquisitions. Given the small share count and 10% insider ownership, share repurchases might be difficult to implement in any meaningful way. It makes more sense if they can use cash to acquire additional engineering talents and knowledge base, a key to winning bigger and more complex contracts. The management stated that their hurdle rate for acquisitions should be 15-20%, which, if applied on $2.50/shr cash to be redeployed, can generate an incremental EPS of 0.35-0.50/shr - enough cushion to the peak eanrings estimate of close to $3/shr.

The stock is trading at slightly above 1x its tangible book value (approximately $10/shr), excluding net cash (roughly 50 cents per share). Also, it is trading at 12-13x ’04 consensus EPS estimate of $0.95. In comparison, the peer group, represented by larger companies like FLR, JEC, SGR, is trading at just under 2x book and 17x '04 EPS estimates. On an EV/EBITDA basis, WG is trading at 5x ’04 EBITDA estimate while the group is trading at 9x EV/EBITDA.

Catalyst

1) Low valuation
2) A possible success to reclaim revenue: WG appears to believe they could reclaim at least $5MM revenue, or 10% of total claims that are being negotiated with its customers, which reflects the cost over-run from the project delays this year as a result of poor weather. Analysts are well aware of this, but if it really occurs or the amount of ultimate reclaim far exceeds the current expectation, the stock might get a nice pop-up when they report their 4Q03 and FY03 earnings.
3) a recovery of spending on aging gas transmission infrastructure;
4) Stability in Iraq