Fluor's Price Drop Unwarranted

We believe the recent drop in

Fluor reported a cost overrun at a gas-fired Florida power project and a $1.00 reduction in its 2018 earnings per share outlook to $2.10-$2.50. We believe the cost issue is specific to the project and the region and does not impair Fluor’s broader project portfolio.

A second issue is the trend in Fluor’s order backlog, which fell to $29 billion at March 31, a sequential decline of 6% and a steep 30% drop versus a year ago. We believe a rebound in project demand is already underway, with Fluor announcing a string of awards in recent months in refining, offshore energy, petrochemicals, and liquefied natural gas that we consider harbingers for renewed backlog growth in coming months.

The signature big project win to date is the multi-billion-dollar engineering, procurement, and construction award in late April to a Fluor-led joint venture for the new LNG export terminal in western Canada being built by LNG Canada (Shell is a 50% partner). Fluor’s share of the project award, at an estimated $6 billion-$7 billion, makes it the largest single project by value in company history.

The first phase of the LNG Canada project includes the development of infrastructure to support an eventual doubling of LNG export capacity at the site, suggesting the potential for another major contract award for the Fluor joint venture within several years.

Cost overruns surrounding gas-fired power project work have hampered a number of engineering and construction companies the past few years, including CB&I (which fired its CEO and has agreed to be acquired by McDermott) and privately held CH2M (which surrendered its independence and was acquired by Jacobs in December). While we believe Fluor’s issues are qualitatively similar to those of CB&I and CH2M, we believe the magnitude and impact on financial and managerial flexibility are smaller. Fluor will exit the gas-fired power market entirely upon completion of the Florida project, which is now more than 86% done.

Size of Projects Limits Competition Fluor is one of a handful of global engineering and construction companies specializing in larger and more-complex construction and development projects for major industrials, miners, utilities, and government entities. It targets multi-billion-dollar projects where competition is inherently more limited. We believe the company possesses a narrow economic moat mainly based on intangible assets built upon its favorable reputation and lengthy record, as well as customer switching costs for the projects it specializes in. We judge that there is no economic moat in more-traditional E&C areas, where smaller and less technically proficient companies compete successfully on price, speed of completion, or simply by leveraging existing relationships.

Fluor’s competitive strengths include its lengthy record, vertical integration, diversified project mix, sophisticated support services, and financial soundness. Vertical integration means it performs services from pre-construction feasibility studies and front-end engineering and design work to detailed engineering, procurement, construction, and project management, as well as post-construction commissioning, operations, and maintenance.

Awards for early-stage work help Fluor establish client relationships, provide insight into a project’s risks and opportunities, and allow it to assess profit potential. 2015-17 were years of declining organic revenue and operating income driven by weaker commodity prices and delays on major projects. Order backlog ebbed amid mixed economic signals and political uncertainty.

Fluor’s project portfolio is diversified across geography and industry. Its $31 billion backlog includes ethylene crackers at the heart of the U.S. petrochemical renaissance, the single-largest global petrochemical complex (Sadara joint venture in Saudi Arabia), and the largest single support services contract for the U.S. military (LOGCAP IV in Afghanistan). High-visibility projects in turn tend to attract motivated project managers and a preferred group of technology providers, subcontractors, and suppliers with whom to collaborate. One example is Fluor’s partnership with ethylene technology provider TechnipFMC to secure lead roles in three recent multi-billion-dollar ethylene cracker projects in the U.S. Gulf.

Commodity and energy prices have strengthened in 2018, and U.S. tax and regulatory reforms have brightened the outlook for cyclical recovery in project demand. We look for Fluor to exploit opportunities across the energy chain, petrochemicals, LNG, and other healthy niches to recharge growth and profitability.

Many Risks Out of Company's Control Fluor merits a high fair value uncertainty rating because E&C companies regularly confront a broad array of risks and uncertainties from multiple sources in their normal business, many beyond direct control. While Fluor employs a full menu of traditional risk-management techniques such as contractual provisions, insurance, financial hedging, and risk-shifting to subcontractors or partners, it remains exposed to large losses or revenue declines from a number of sources, often for years after the physical completion of a project.

Market volatility and cyclicality are one straightforward threat. Fluor generates 70%-80% of sales from two segments: oil and gas (exploration and production, downstream, and chemicals) and industrial and infrastructure (mining and metals). Volatile and declining prices for crude oil and industrial commodities often result in project delays, suspensions, or cancellations. Prolonged bouts of weakness raise issues of customer commitment and even solvency. Project and customer selection is critical because Fluor specializes in larger and costlier projects that are more dependent on long-term forecasts.

“Termination for convenience” provisions permit an otherwise valid project contract to be canceled after it has been awarded and additional commitments signed. Exercising TFC requires only minimal advance notice, a lack of bad faith or fraudulent intent, and the payment of damages that do not typically reflect sunk costs or lost profits.

Fluor’s competitive advantages are often clearest when contemplating larger projects containing new or challenging elements. However, these also carry greater execution risks and loss potential, particularly regarding contractual recovery of cost overruns. Overruns often derive from factors not under Fluor’s direct control, including permitting and approval delays, volatile materials costs and availability, or sudden project modifications. Fluor took a $416 million pretax charge in 2012 tied to unreimbursed costs on the Greater Gabbard U.K. wind project.

Fluor's Financially Fit Fluor strategically maintains an investment-grade credit rating in order to boost competitiveness in securing new business. At year-end 2017, its balance sheet held $2.1 billion in cash and securities against roughly $1.6 billion of debt.

Fluor regularly generates operating cash flow well in excess of its operating requirements. Operating cash flow averaged $725 million annually during 2013-17, compared with annual average capital spending during the same period of $274 million. Fluor repurchased a significant amount of its stock in 2009, when most companies were hoarding cash, and completed a $1 billion buyback program in 2015. With the benefit of hindsight, we consider this to have been a reasonable capital-allocation decision. The company’s policy is to pay a relatively modest dividend, which it has sustained through downturns. In 2017, dividends totaled $118 million.

We expect Fluor will continue to stress organic growth and utilize bolt-on acquisitions to add complementary technology and capabilities where needed. A recent $489 million investment in a China-based fabrication joint venture with a unit of CNOOC aims to significantly upgrade its remote fabrication capabilities. The $700 million purchase in 2016 of Dutch-based privately held construction and maintenance provider Stork possessed both opportunistic and strategic elements.