Fundamentally, to summarize what I wrote in a comment response to the reader earlier, the bear case is these are cyclical companies. Much like with Mastercard (MA), I am taking the opposite to the bear case or "analysts conventional wisdom" for this group - my belief is the customer base for this group is very important - I wrote just last week [Infrastructure Companies Cleaning Up on Contracts] we have 3 sets of customers which are cash rich (a) countries with massive trade surplus (b) countries rich with petrodollars (c) A US government that prints as much money as they need
So I'll take the other side of this "cyclical" trade - I am not saying there are not cycles, but unlike something like dry bulk shipping in which a bevy of ships will be in the seas by 2010, killing that "cycle", I expect quite a long cycle in infrastructure. We have a shortage of companies (and human resources) that can do the engineering and design for power plants, infrastructure projects and the like throughout the world. And a very captive audience flush with cash.
Every 6-8 weeks we get a scare like this in this group i.e. "The End is Near" crowd. And every 6-8 weeks I point to that backlog (slowing or "not") its well over 2 years worth of business for most infrastructure companies. How many business sectors do you know that have pricing power, cash flush customers, and 2 years worth of business already locked in. If you could tell me, feel free to append to this blog entry as a message. Again, the sky is falling crowd is now everywhere as seen by last week's doom and gloom McDonald's downgrade. The world is not ending, there will be winners and losers, even in down market or down economy. I might be correct or incorrect on this call, but this is my rationale so readers (or future investors) would understand why I am high on this group.
Here is Barron's rationale on Foster Wheeler (FWLT) in specific, but what they say for FWLT could apply to all the companies in this sector (and why not a hatchet piece on Fluor which is valued significantly higher, instead of Foster Wheeler? All the same 'issues' apply to Fluor and its valued higher. Hmm...):
- INVESTORS LOOKING FOR A PLAY ON global growth and an escape from U.S. economic doldrums have embraced Foster Wheeler. The company generates about 80% of its revenue outside North America, and its businesses -- designing and constructing industrial plants and equipping power plants -- are thriving. But after a three-year run, we'd suggest taking some money off the table, as the shares no longer appear undervalued.
- At a recent 145, Foster Wheeler's stock had climbed 181% last year and 979% since we first wrote about it ("Survivor," Jan. 31, 2005). Earnings have grown faster than analysts expected as it's enjoyed a boom in new energy projects thanks to the sharp rise in oil prices. And Foster has eliminated the types of cost overruns that almost led to its demise early in this century, dramatically boosting margins.
- Success, however, has made the shares start to look pricey. They trade at 21 times estimated 2008 earnings of $6.96. That's below the 27 multiple sported by competitor Fluor (FLR), but it's slightly higher than Foster's earnings growth of 19%, and substantially above the S&P 500's P/E of 14. Also, this is a cyclical company. Earnings multiples are supposed to contract as profits rise in anticipation of the cycle's downside. But that doesn't appear to be happening. If the cycle runs longer than expected, such exuberance will have been justified. If not, the stock could quickly correct.
- The cycle has at least five more years to run, says CEO Raymond Milchovich. The business isn't affected by the U.S. subprime meltdown, and only a macroeconomic shock in China, the Middle East or India would hurt it. A sharp decline in the price of oil would also bite the company.
- The company still has fans. Vance Brown, a principal at Grisanti, Brown & Partners who was bullish on the stock when it was at $13 a share, remains an enthusiast. He has taken profits to keep his firm's stake from growing too large relative to its portfolio. But Brown remains in the name because he can envision a 2009 where Foster earns $8.50 a share and sports a 25 multiple. That would put the stock just north of $200.
- Still, the company's business backlog may be signaling that the cycle is in the late innings. Investors look to the backlog, though lumpy, to predict future earnings growth. The backlog grew 98% and 47%, respectively, in the third and fourth quarters of '06, and slowed to 25%, 11% and 3% in the first, second and third quarters of '07, notes John Rogers, an analyst at D.A. Davidson & Co. with a Neutral rating on Foster.
- Backlog growth could pop in the fourth quarter, thanks to Foster's new contract to help build a liquefied-natural-gas plant in Australia. But with the backlog at record levels, growth was bound to slow due to the law of large numbers, and that could mean earnings growth will slow, too.
What I highlighted in red is the main concern I'd have with this group. I have mentioned I believe growth WILL slow in China, and India. But down from 11-12% GDP growth to 6% or so; or something reasonable. Crude could drop to $75 or go to $125 - that won't stop projects from continuing.
So if as a bear, one believes China and India are going to negative growth in the coming years, the countries stop their industrialization push, the Middle East countries stop their push, and/or crude is going to $40 again and projects will get cancelled left and right - well then you should be on the opposite side of my trade. I find that scenario a little extreme, and indeed if it does happen, as I wrote this weekend, what exactly can you buy? You can't buy anything in the USA - because last week analysts are saying people will cut back spending at Walmart and McDonald's, and you can't invest in anything overseas because "it's all cyclical and will go to pot" - therefore we have nothing to invest in. Unless there is something between "domestic" and "overseas" I have not discovered. And if indeed this is the scenario as I wrote this weekend, we have a lot worse to worry about than a recession - we are looking at something starting with a D not a R. I am not in that camp - if you are, again I would point you to a 100% gold portfolio because cash will be useless with the type of inflation we will be fighting as the Fed prints money to fight the D word.
As for the 979% return, keep in mind Foster Wheeler (FWLT) was on the verge of bankruptcy a few years ago due to mismanagement (among other things). So it's a bit misleading. I also love how "backlog growth is slowing" but "backlog is at record levels". If you word it one way it sounds "bearish" but I am unclear how one can view "record backlogs" in a bearish light. But I am biased.
Long Foster Wheeler, Shaw Group in fund and in personal account
