Friday, August 03, 2007

Infrastructure Frame-up






Hathaway Bridge
Panama City, Florida


The tragic failure of the bridge in Minnesota puts into stark relief the precarious condition of the U.S. transportation infrastructure. The bridge was a known weak link across the Mississippi River that cuts between Minneapolis and St. Paul, two populace towns in the country’s heartland where business and commerce depend upon the river and the bridges that span it.

The revelation that this bridge and many more are badly in need of repair or replacement was heard up and down Wall Street, which has a few “bridges” of its own in the credit markets. However, if investors are anything it is resilient. The losses of last week, the worst since the market “repriced risk” following September 11, 2001, can be shrugged off if there is another opportunity in the wings.

Infrastructure stocks! Construction companies will be the big winners if the country rebuilds its roads and bridges. Right?

Fluor Corporation (FLR: NYSE) and Michael Baker Corporation (BKR: NYSE) are the first that come to my mind. Both are leaders in the design and building of transportation infrastructure in the U.S. and around the world. Fluor is already working on Highway 52 in Rochester, Minnesota. Baker provides engineering and management services and has worked on replacement of the Ford City Bridge over the Allegheny in Pennsylvania and the replacement of the Fulton Road Bridge in historic section of Cleveland, Ohio.

Some might take the name
Chicago Bridge and Iron (CBI: NYSE) as a description of their work. CBI is an engineering, procurement and design firm, but the only bridge in their world is in the name. CBI focuses on the oil and gas industry and water and waste water projects. On the other hand, bridges, tunnels, roads and airports are the forte of Granite Construction (GVA: NYSE), a heavy civil construction company based in California. Granite recently finished the elegant Hathaway Bridge in Panama City, Florida and is currently working on the Woodrow Wilson Bridge in Alexandria, Virginia.

On the small-cap side of the sector, there is
Meadow Valley (MVCO: Nasdaq), a heavy construction company based in Phoenix, Arizona. Meadow Valley is working on bridge improvements for the Interstate 15 Beltway in Nevada. Another heavy construction company, Perini Corporation (PCR: NYSE) is based in the east. Perini is currently working on deck replacement for the Bronx-Whitestone Bridge in Queens, New York and was a member of the consortium that built the AirTrain connecting the local transit with JFK Airport in New York.

Wrong! Take a few deep breaths before entering buy orders for any of these stocks.

First, as taxpaying citizens we should all realize that catastrophic events do not always lead to action in the right place or even any action at all. The financing for transportation infrastructure is in the hand of politicians. Elected officials even manage to play shell games with national and state gasoline excise taxes earmarked to pay for road building and repair. This means the pace of decision making and the timing of funding are far from predictable even though the taxes motorists pay are quite predictable. Just so you know, total excises and other taxes collected at the gas pump by state and federal authorities average $0.458 per gallon.

Consequently, the financials of any of these companies shows considerable variability in quarterly and even annual results, often times because of the unpredictable flow of project financing and contract awards.

Another key risk for investors in construction stocks lies in their contractual relationships. Most projects are undertaken with fixed-price contracts that put the construction company at risk for unexpected costs and delays. While it is possible to get “change orders” that would increase payments from customers to cover cost-overruns, negotiations with are not always successful. What may begin as a promising contract with lucrative margins can ultimately end in a net project loss.

To make matters even more unpredictable, revenue is recognized under percentage of completion accounting methods. There is plenty of room for error along the way and for losses to go undetected for several quarters. This can be a great source of disappointment for investors who dislike quarterly variances in results.

Of the five “bridge” players, Meadow Valley is the best bargain on all three earnings, cash flow and book value bases. However, this regional construction company is least likely to be able to capitalize on any national spending on infrastructure replacement and repair. On the other hand, Granite Construction has a string of bridge projects behind it and a national presence. Its trailing PE of 28-times is well below the prevailing 62-times multiple for the heavy construction industry. It is also below the industry averages in terms of book value and cash flow multiples.

Since Baker is an engineering firm and not a heavy construction company it does not bear some of the risks inherent in fixed-price contracting. BKR is trading at par with its engineering services peer group at 23-times trailing earnings, but at 16 times cash flow it is well below the average of the group.

If you embark on a trip through the construction sector, read the map carefully. There could be many detours.



Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.




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