Construction And Engineering Sector Likely To Outperform On The Way Up

Although the industrial sector had a rough year in 2008, there were some sectors,  like conglomerates, rails, and aerospace and defense sub-sectors, that were able to help boost some of the lagging sub-sectors that relied heavily on residential construction and business spending. The net effect was an out performance in the first three quarters of the year.

In Q4 2008 and the beginning of 2009, we’ve seen the performance of the Industrials ETF, the XLI (XLI),  significantly underperform the S&P 500 (^GSPC) as the more attractive sub-sectors in 2008 began to plummet based on economic factors such as the expected 2010 defense report for the defense sector, and lower volumes for the railroad companies. Since March 9th, stocks are 18% off their recession lows, and some analysts are even bold enough to predict an earlier-than-expected recovery in the second quarter of this year.

Whether or not  this is the case, it is time for investors to start thinking about removing some of their defensive holdings and swapping them with ones in the construction and engineering sub-sector, which is extremely likely to outperform the rest of the market on the way up.

Construction and engineering companies saw an early run-up in 2008 as energy prices skyrocketed until the commodities bubble had burst. It then took a deserved beating as businesses curtailed spending to keep up with the decline in consumer expenditure. To do this, the first thing companies wanted to do was to cut their expansionary plans for a rainy day. Construction equities like Flour Corporation (NYSE:FLR), Jacobs Engineering (NYSE:JEC), Foster Wheeler (NASDAQ:FWLT), and McDermott Int. (NYSE:MDR) were decimated due to the expected cuts in future orders and customers backing out of their contracts, which would kill the companies’ backlog orders. In 2008, the industry showed some resilience and recorded year-over-year double-digit growth in the backlog category, as Flour’s and Jacobs’ backlog orders grew 10.2% and 22.9% respectively.

What has investors worried now is this expected decline in backlog orders is on the verge of taking place. McDermott estimates that 2009 and 2010 backlog orders will fall 51% and 74% from 2008 highs. The rationale here is that falling energy prices will deter oil companies from beginning new projects. On average, 54% of construction and engineering companies’ revenue comes from the oil industry, so why would anyone want to expose themselves to an industry with a terrible macroeconomic outlook?

Because these expected cuts in new orders are already priced into the industry’s stock prices. Investors understand that this industry won’t return to the glory days of 2007 and 2008 until oil prices rise once again. Oil prices have now stabilized, and oil is trading roughly around $50 per barrel. This is significantly higher than many oil companies have anticipated, yet  still lower than the threshold of $60 per barrel that companies oil companies would like to see.

Regardless, this new stability will result in fewer cut backs in new infrastructure projects. Oil price stability will also allow construction companies to be able to increase, or at least maintain, expected profits that will now be driven by other customer groups.

Customer diversification will now be the key for companies to outperform their peers. Relying too heavily on one customer can be detrimental to profits when the economy is injured. With one of the most diverse client bases in the industry, Jacobs Engineering would be the most likely candidate to gain new contracts. They have made it clear through their mission statement and their repeating business that they are able to maintain strong relationships with their customers. Jacobs is also extremely likely to become a major target of infrastructure spending from the stimulus package. The US government has allocated over $111 billion from the $787 billion stimulus passed earlier this year. With leading market positions in transportation and water industries, there is a high probability that Jacobs will be alloted many of these pending contracts.

While the industry might not return to the glory days for quite some time, it has been heavily discounted due to the lower energy prices and curtailed spending. I still believe that a company like Jacobs will be able to outperform the market during a recovery. For those of you with the long-term buy-and-hold strategy, picking up an E&C company at such a discount will undoubtedly result in extreme capital gains in the future if for no other reason than that energy prices will once again increase. Additionally, a construction company like Jacobs, who has international exposure in Asia, Europe, and the Middle East, will definitely be able to capitalize on the higher-growth economies like China and India. When the world is ready for a turnaround, the construction and engineering sector will be ready to begin rebuilding.

Disclosure:  None

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