Energy and Construction Stocks Looking Good -- For Now
Andrew Leckey

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While there are solid prospects for stocks of engineering and construction firms in 2011, they won't come from efforts to rebuild a devastated Japan.

The primary drivers will be high oil prices, general economic revival and U.S. government spending programs.

Major American engineering and construction firms do very little work in Japan because that country has a large and loyal contingent of homegrown contractors that do most of its building. Yet there is an indirect effect from what has happened there.

"If contractors from Asia will now be spending more time in Asia instead of the Middle East, it will indirectly benefit U.S. contractors," said Will Gabrielski, senior equity analyst with Gleacher & Co. in New York. "That's because Asian contractors have been increasingly competitive and putting pressure on the Western contractors in the Middle East region."

Investors in these companies' stocks must keep fundamentals in mind:

Oil prices are important because international and national oil companies are the top customers for engineering and construction services. The awarding of contracts is what counts, and there has been an increase in agreements the past three quarters.

"These firms will benefit from a good capital expenditure story for the next few years," said Robert Connors, equity analyst with Stifel Nicolaus in Baltimore, Md. "That makes me believe we are going to see continued strength in the sector."

Contracts inked before recession kept these companies out of harm's way when much of the world was mired in recession.

"When the economy went into its trough in 2008, the engineering and construction companies had already booked a backlog of projects, so they didn't take a big hit in 2009 and 2010," explained Min Tang-Varner, analyst with Morningstar Inc. in Chicago. "This industry generally lags the economic cycle by four to six quarters, or even longer."

For the past two years of rocky economy, companies have had to compete for projects and reduce their expenses, Tang-Varner noted. Profit margins should be compressed for at least a couple more quarters, she expects.

Experts believe 2012 and 2013 will bring large awards and profits for engineering and construction firms, an expectation that is fueling their stocks. Higher profits for oil companies mean more spending on major projects to produce more oil. The greatest demand is in the Middle East, Latin America, North Africa and some former Soviet Union states.

"The big focus isn't on the ExxonMobils of the world, but rather the big national oil companies such as Saudi Aramco and Sonatrach in Algeria," said Gabrielski. "The majority of the spending and production growth driving the need for new refined products comes from the Middle East and Asia and not the U.S."

There are investments worth making in the industry.

Fluor Corp. (FLR) is a global company that Connors and Gabrielski both consider especially well positioned. It provides engineering, construction and maintenance services to customers in oil and gas, manufacturing and power, and to the U.S. government. More than half of operating income comes from oil and gas, with nearly three-fourths of revenue coming from outside the U.S. Few companies can handle projects on the scale Fluor can. It benefits from large U.S. government projects and has a strong balance sheet with little debt and plenty of cash flow.

"Fluor has the ability to participate in many geographies and different energy end markets, whether refining petrochemicals or upstream production," said Gabrielski, adding that a drop in oil prices would be negative for the industry.

Jacobs Engineering Group (JEC) is another top Connors stock recommendation. This major engineering and construction company derives its revenue from oil and gas, the chemical industry, and government agencies. With a network of professionals in North America, Europe, the Middle East and Asia, it has a reputation for complex planning, design and execution. Long-term client relationships and pricing discipline are some of its strengths.

"I like the stock of both Fluor and Jacobs because they are good at executing projects and have a solid operational history," said Connors.

Here are some other companies whose stock is worth watching:

--Chicago Bridge & Iron Co. (CBI), which derives about half its revenue from construction of liquefied natural gas facilities, also builds refineries, offshore structures, storage tanks and pressure vessels.

--KBR Inc. (KBR), which primarily serves the U.S. government and energy companies, obtains 80 percent of its sales from outside the U.S. Operations in Iraq accounted for more than one-fourth of its revenues last year.

--Swiss-based Foster Wheeler AG (FWLT) has a power generation manufacturing business that builds boilers for utility companies, in addition to engineering and construction. The company's client base is primarily in Asia, Australia and the Middle East.

--McDermott International (MDR), builder of power-generation equipment and offshore-industrial facilities, makes steam production and pollution control equipment for use in electricity generation and industrial processes. Its government operations division makes nuclear reactor components.

Remember that political upheaval, decisions in energy generation and unforeseen events can affect these stocks.

"Before the events in Japan, I'd have told you the companies with nuclear power exposure would have done better," concluded Tang-Varner. "But Shaw Group (SHAW) took a stock-price nosedive on the news because it is the large company that undertakes large nuclear power plant contracts."

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