The collapse in May of an interstate bridge north of Seattle provided a sharp reminder that North American infrastructure, particularly in the United States, is in urgent need of investment.
No one was killed in the incident, but two vehicles dropped into the water and traffic was disrupted for weeks – dramatic proof of the crumbling condition of much of the U.S. highway system.
With the political gridlock in the U.S., however, the conventional wisdom is that no major spending on public works is on the horizon.
Share prices of major engineering and construction firms (E&C in the industry jargon) reflect that downbeat outlook. These companies may grow by expanding their operations in emerging markets, or by catering to the energy sector, but investors seem to hold little hope that their domestic businesses will benefit from robust infrastructure construction.
And that may present an opportunity for patient investors who are willing to bet that the need to invest in bridges, highways and other public works cannot be ignored much longer. Cash-strapped governments in the U.S. could take a lead from Canada and engage more in public-private partnerships, arrangements where E&C companies partner with investment funds and local governments to create for-profit projects, like toll roads.
“I think that will be next, and will get a lot of this infrastructure built,” says Trevor Johnson, an analyst for National Bank Financial, who covered infrastructure stocks before recently transitioning to the real estate sector. “Traditionally, you had just the governments spending the money and running the assets themselves. But their balance sheets are to the point where it isn’t as easy to do that, and you’ve got a lot of [for-profit] companies with cash. They’re in a better position to finance and run these things.”
Todd Wenning, an analyst with Morningstar, concurs. “I think you’ll see more [public-private partnerships] in Canada and the U.S. in the next 10 years, more so than any massive government spending bill. It seems like the most natural opportunity for large-scale investment in infrastructure in the U.S. and Canada.”
Clearly, there is a need. The American Society of Civil Engineers, in its 2013 Report Card on America’s Infrastructure, gave the United States a D+ grade on its infrastructure, and estimated $3.6-trillion (U.S.) in spending is needed by 2020.
Canada is faring better, but still has its issues. The inaugural Canadian Infrastructure Report Card released last September by a coalition including the Canadian Society for Civil Engineering, gave a “good” rating to drinking-water systems and waste water networks, but only “fair” to municipal roads.
To be sure, the potential payoff from investing in infrastructure stocks is not going to come overnight.
Andrew Wittmann, an analyst at Robert W. Baird & Co., says all the E&C companies he covers have “ample opportunities” should U.S. infrastructure spending come through, but he’s not looking for it in the short term. Although President Barack Obama’s 2014 budget proposals including an “infrastructure bank” that would provide federal subsidies and matching dollars for local projects, he sees “more negative headlines than positive” as the U.S. wrestles with its fiscal issues.
Investors who are willing to wait for the mood in Washington to change can choose from a list of major E&C companies that begins with giant Fluor Corp., which trades at a price-to-earnings ratio below 14, according to Standard & Poor’s Capital IQ. Mr. Wenning of Morningstar says the Texas-based company, with $28-billion in annual revenue, is now getting a smaller proportion of its sales from the United States than at any time in its 100-year history.
Its industrial and infrastructure division makes up nearly half of sales, but the company has been buoyed in recent years by projects in the energy and mining industries.
“There are only a handful of companies that can service multibillion-dollar projects,” Mr. Wenning says. “With a long and distinguished track record, a healthy balance sheet, and global capabilities, Fluor is one of these select firms.”
The recent cutbacks in the mining industry are a headwind to the company, but there are still plenty of positives. Mr. Wenning assigns a fair value of $63 to the shares, which traded this week around $58.
In doing so, he assumes annual revenue growth of 4.5 per cent through 2017, versus the 15.7-per-cent sales growth of the last 12 months, which was aided by contracts in the energy and mining sector. But his “bull case,” which builds in revenue growth of 6.5 per cent, yields a fair value of $89, he says.
Mr. Wittmann of Baird is most positive on AECOM Technology Corp., a Los Angeles company that is trading at less than 12 times its projected earnings for the year ahead. (It is not to be confused with Toronto’s smaller TSX-listed Aecon Group Inc. )
Mr. Wittmann says the company, which engineers and manages the construction of roads and bridges, as well as mass transit and wastewater systems, has profit margins below industry averages. He has an “outperform” rating on the stock. “The profits they’re earning today could be higher from managing their business a little bit better.”
He also likes Jacobs Engineering Group Inc. of Minnesota for its exposure to the energy industry. More than $3-billion of its nearly $11-billion in revenue in its most recent fiscal year came from projects for oil and gas exploration companies or refiners.
Morningstar’s Mr. Wenning is concerned about Montreal-based SNC-Lavalin Group Inc., which is one of the more expensive E&C companies, with a forward P/E ratio approaching 18. At $44 (Cdn.), the stock has reached his estimate of its fair value. While praising its experience in public-private partnerships, he’s worried that the corruption scandals that have “plagued” the company “could adversely impact the business at least for a few years as the new management team seeks to right the ship.”
“Despite the cloud that hangs over the company, it continues to win its fair share of meaningful projects including a metro-rail line in Vancouver and a gold mine in Quebec, but weaker demand outside of Canada is a concern.”
The potential for weaker demand drags on all E&C firms. If governments confound expectations with a fresh willingness to solve their infrastructure challenges, however, it could provide these shares with an unexpected lift.