Fluor Company: Statistical Upside Benefit For 1-3 Years Horizon (NYSE:FLR)

Funding briefing

Buyers working cash in equities this 12 months ought to think about the industrials sector as a place to begin in top-down safety choice in our agency opinion.

Our findings from Q3 2023 earnings illustrate the industrials sector held 8% notional worth of the S&P 500 market capitalization weighted index in direction of the tip of ’23 however was poised to ship 16% of the projected 12-month earnings progress (Determine 1). This makes a composite of progress/worth tremendously engaging for industrials in our estimation. Avid readers of mine could have seen the chart beneath advert nauseam as a place to begin for capital allocation in ’24.

Determine 1.

Right here at Bernard Investments, we’ve got been avidly scouring the industrials sector for industry-specific bargains. The sector’s underperformance in opposition to high-beta counterparts within the final 5+ years supplies ample alternatives to filter from.

Inside the industrials sector lies the development and engineering {industry}, closely crushed down at 1.4x EBITDA and 6.5x money movement (Determine 2) because the inflation/charges axis has taken its toll on the capital-intensive area.

Our findings have led us to Fluor Company (NYSE:FLR), buying and selling at a steep low cost vs. {industry} friends at 14.4x ahead earnings and 0.4x EBITDA, while commanding a market worth of two.6x the online property employed to run the corporate.

Determine 2.

The corporate, based in 1912 and headquartered in Irving, Texas, is acknowledged for its experience in small modular reactor know-how, having been a key innovator within the evolving power sector. It has its footprint inside a number of markets, together with engineering, procurement, and building providers. It does enterprise throughout 4 key segments, summarized in Desk 1.

The talk on worth at worth is tremendously necessary right here, as a result of, though FLR sells beneath friends, its enterprise returns and skill to transform earnings into FCF are behind the {industry}. Query is, is the low cost justified?

This report will unpack all the transferring elements of the FLR funding debate. Web-net, we fee FLR a purchase with 12 months to three years funding horizon in thoughts. The traces are blurred trying past this era, given the {industry}’s sensitivity to financial cycles and price of capital. We’re eyeing preliminary goals of $46/share, round 21-22% upside potential as I write.

Desk 1. Description of FLR core enterprise divisions

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Supply: FLR 2022 10-Ok

Crucial funding findings

FLR has rallied off its Covid-19 lows in ’20 and continued inside an ascending channel thus far as merchants proceed to outline clear help and resistance zones (Determine 3). With the transfer extending into the brand new 12 months, we’d like proof on what can prolong the transfer. The case for getting FLR at totally different funding horizons is printed within the arguments beneath.

Determine 3.

• Funding returns coming 12 months

Buyers should acknowledge that returns on company securities within the preliminary 12 months after buy are heavily dictated by beginning multiples. Overpaying can considerably scale back funding returns within the first 12 months.

FLR trades at 14x forward earnings which adjusts to 0.24x earnings when factoring in progress estimates. Distinction to the sector’s 19x P/E and 1.75x respectively, and the {industry}’s figures noticed in Determine 2 earlier.

In our estimation, there’s asymmetrical reward potential in shopping for FLR at 14x earnings for the subsequent 12 months. The ratio of upside to draw back is closely skewed to the previous—exactly the benefit of worth investing within the first place. Shopping for high-quality securities at statistical reductions supplies statistical benefits because it pertains to share returns.

Furthermore, at 14x earnings, the next dislocations are famous when factoring in each asset components and earnings energy:

1. The market values its web property at 2.6x, illustrating FLR’s ROE is larger than its price of fairness. Progress would create shareholder worth if this continues.
2. Paying 2.6x ebook worth equals an ROE of 1.7%, round 1.4x the {industry} median when adjusted by P/Ebook ratio.
3. Adjusted for progress expectations, you might be paying 0.24x earnings—lower than $1 for a $1 of future progress.

Evaluation by Deloitte also projects excessive single-digit progress within the building {industry} this 12 months, including structural tailwind to the corporate’s re-rating prospects:

[L]ooking forward to 2024, there could possibly be a lift to building related to manufacturing, transportation infrastructure, and clear power infrastructure, as funds from three key items of laws handed in 2021 and 2022—the Infrastructure Funding and Jobs Act (IIJA), the Inflation Discount Act (IRA), and the Creating Useful Incentives to Produce Semiconductors (CHIPS) Act—are anticipated to movement into the {industry}”.

— Deloitte 2024 engineering and construction industry outlook

In addition to these points, I would also highlight the string of news catalysts that position FLR well for the coming 12 months. These are summarized in Figure 4. Critically, each of the updates is idiosyncratic to the company and are therefore uncorrelated to the broad market’s return.

These are all bullish points for the coming 12 months in our view.

Determine 4.

• Investment returns 1-3 years

FLR presents with exceptional investment characteristics for the investor considering a 1-3 year horizon. Any corporation’s market value over 1-3 years is heavily dictated by fundamentals, epitomized through sales and earnings growth.

Historically, FLR has grown its top line at 0.14% on average for the last 3 years, producing CAGR operating earnings growth of 97% in the same time—clear evidence of the operating leverage it possesses (keep in mind this works on the way down, too).

Consensus has the firm to grow earnings 218% in FY’23—likely well captured in the company’s market value already—with 8-10% bottom line growth in the subsequent 2 years. Sales are also tipped at 8-14% at this time, ahead of the construction and engineering market’s projected growth outlined earlier. In that vein, FLR is tipped to steal market share from competitors, should it grow faster than the market.

This earnings growth is a critical point to highlight. The market is a conduit between investors and their companies. It capitalizes earnings into an asset value, which changes investors’ net worth over time. It is strikingly accurate in pricing corporate securities based on fundamentals, like earnings growth and return on capital. As seen in Figure 5, the market has done a fair job at pricing FLR based on the trajectory of its earnings power, pricing in changes to growth to the firm’s market value accordingly.

Under this convention, our earnings growth assumptions on FLR estimate its stock price to command a fair value of $45-$46.00. This is constructive for the coming 1-3 years.

Determine 5.

• Investment returns 3 years+

The case for owning FLR beyond a 3-year investment horizon is substantially weaker than the mid-term outlook in our opinion.

As a quick reminder, we judge a company’s long-term (3+ years) investment value by its ability to reinvest surplus cash that is generated from conducting business.

We want corporations that produce incremental earnings growth above what is achievable with similar risk. Companies that have the capacity and opportunity (i.e., the free cash flow and market growth) to invest into additional high-return projects over many years are deemed the most investible in our mandate.

Alas, here is our struggle with FLR. Despite the fact that it is both (i) cheap, and (ii) poised for profitable growth, the propensity to methodically turn this into FCF and reinvest for additional, high-reward projects may be clamped in our opinion.

Determine 6.

Think about the next:

1. FCF per share has been lumpy and generally lower in the last 3 years, due to the capital-hungry nature of the business/industry (Figure 6).
2. These have been compounded by asset inflation, meaning asset replacement costs and maintenance CapEx requirements are indefinitely higher for the company.
3. Like most in the industry, FLR is a low-margin, low return business. Cost of revenues is tremendously high—the COGS margin rests above 96% for the company. Operating margins are equally thin, 100–200bps on average.
4. FLR is, however, a high-capital turnover business. Each $1 of invested capital produces $6–$7.00 in sales for the company, potentially attractive for the company’s planned CapEx moving forward. If the company is to expand its asset base moving forward, this may result in additional sales growth at the ratio of $1 investment: $5–$6 revenue.

Point (3) is tremendously constructive in the investment debate in our view.

But we immediately circle back to point (1) — that FLR does not produce a high rate of earnings on capital employed in the business. It therefore does not spin off high amounts of FCF to reinvest in the first place. Further, it does not methodically rotate earnings into FCF (Figure 8). There is profit, but little cash, as basically all profit must be reinvested to stay competitive—classic economics within the construction industry.

Cash has to come from somewhere, and for FLR, it is not from its operations based on our analysis.

Determine 7.

Determine 8.

Valuation and conclusion

Our investment thesis on FLR looks to the coming 12 months to 3 years as a holding period, as mentioned. Beyond that horizon, we need further clarifications. Subsequently, as seen in Figure 5, our assumptions imply the company is worth $45-$46.00 based on projected earnings growth out to 2025. In our estimation, investment returns and growth are to be driven by:

1. Dislocations in market value to implied value,
2. Related to the above, absolute multiples are thin, providing statistical advantage to the upside,
3. Construction and engineering market growth estimates,
4. FLR forward growth estimates for the next 1-3 years, ahead of market forecasts.

An implied value of $45-$46.00 corresponds to 16–17x forward earnings, substantial value gap of 21.5% from where the market’s priced FLR today.

Desk 2.

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Source: Bernard Investments estimates, Bloomberg Finance LP

Consequently, there is robust evidence that supports buying FLR for a 1-3 year investment horizon in our estimation. We are eyeing first price objectives to $46.00/share or 17x P/E. We advocate owning the company based on the fundamental and structural tailwinds outlined here today. Net-net, rate buy. Risks include the following:

1. Industry and economic sensitivity. FLR does its business in the industry, which is highly sensitive to economic cycles and global economic conditions. We are amid a changing market cycle as I write.

2. Project execution risks. The success of Fluor is heavily dependent on the successful execution of large and complex projects. Delays, cost overruns, and so forth reduce capital turnover of the firm, therefore clamping business growth.

3. Dependency on energy and commodities markets. FLR’s performance is closely tied to the energy and commodities markets. Fluctuations in oil prices, changes in demand for energy-related projects, or disruptions in the supply chain of raw materials can significantly impact the company’s financial results.

Buyers should understand these dangers in full earlier than continuing any additional.