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SGR AT A GLANCE

P/E ► 158 HIGH EV/EBITDA ► 19.4 HIGH ROA ► 1.7% LOW ROE ► 1% LOW Debt to Equity ► 2.90 LOW Current Ratio ► 1.15 LOW Interest Coverage Ratio ► 1.44 LOW

 

 

 

 

 

 

The Shaw Group (NYSE:SGR) is an engineering firm that provides comprehensive services in the energy industry, with revenue in FY2007 of $5.7 billion.^[1] The firm builds and maintains nuclear reactors and clean fossil fuel plants, also modifying "dirty" energy plants to match U.S. energy regulations. SGR often contracts with the U.S. Government in environmental and industrial remediation following catastrophes like hurricanes.

Rising worldwide demand for energy has driven the company's growth. SGR has expanded its nuclear energy projects, and on October 16, 2006, purchased a 20% share of Westinghouse, an international nuclear plant construction firm. World energy demand has also increased world demand for environmental services; pollution from coal plants in China, for example, has gotten so bad that some experts believe it is responsible for 750,000 deaths a year^[2], and SGR can retrofit coal plants to reduce pollutant emissions, or build nuclear plants as an alternative energy source. U.S. pollution control legislation, like the 2005 EPA Clean Air Interstate Rule, has stimulated domestic demand for power plant retrofitting services, a market of which SGR controls 25-30%.^[3]

Demand for SGR's services is cyclical because companies and governments usually pay for larger infrastructure projects when times are flush, and cut spending when the economy's not doing as well. Rising commodities prices decrease gross profits, as 52% of SGR's contracts are set at a fixed price, so operating income drops when input costs increase.^[4] SGR's engineering projects are also massively expensive, which makes it more difficult for SGR to bring in project revenues in excess of expenses once they account for working capital. The Shaw Group's main competitors are Bechtel, Fluor, Jacobs Engineering Group, KBR, and URS.

Business Overview and Financials

Shaw Group is an industrial manufacturer with international operations that are divided into five major segments (Fossil & Nuclear, Environmental & Infrastructure, Energy & Chemical, Maintenance, and Fabrication & Manufacturing). The Shaw Group brings in revenue through contracts with both government and private entities in many facets of project-related services. The breakdown and explanation of operating activities by segment is as follows:

• Fossil & Nuclear - Accounting for about 28.6% of FY2007 revenue, the most profitable projects in the Fossil & Nuclear segment are construction-based.^[5] This segment builds nuclear energy plants and clean coal-firing plants for energy providers, while retrofitting existing power plants with pollution control equipment (like scrubbers and smokestack control). The F&N segment's services help refineries match clean coal specifications and meet the requirements of the Clean Air Act.

• Environmental & Infrastructure - The source of about 25.7% of FY2007 revenue, this segment includes services that help restore contaminated air, water, and soil. The projects can fall within a considerable range. In the past, SGR has worked on waste management projects including landfill design and construction, wetland restoration, and drinking water treatment.^[6] It frequently contracts with the U.S. government, and in particular is working with the Department of Defense to help decontaminate former nuclear weapons.^[7] The Environmental and Infrastructure segment was also contracted to drain water out of residential areas following Hurricane Katrina. Frequently projects in the Environmental and Infrastructure segment are directed at waste management, as the company offers technological expertise in water-treatment processes demanded by municipal governments.

• Energy & Chemical - This segment processes energy products and makes chemicals, working primarily in the gas, petrochemical, refinery, and chemical industries. Most important are its refining operations for crude oil and synthesis of plastic polymers. Within refining, SGR uses "Fluid Catalytic Cracking" to produce propylene, a compound demanded by plastics manufacturers. SGR has also established itself as a builder of ethylene plants, a compound used in manufacturing a variety of higher-value chemical products. The Energy & Chemical segment accounts for 18.6% of FY2007 revenues.^[8]

• Maintenance - 18.9% of FY2007 income, this segment renovates and fixes nuclear, fossil, and chemical plant facilities.^[9] SGR performs routine safety checks for nuclear, chemical, and fossil plants. In the case of an outage or needed repairs, SGR provides services ranging from painting to construction to get energy and chemical plants running again.

• Fabrication & Manufacturing - Despite weighing in at only 8.3% of FY2007 revenue, this segment is one of the world's largest suppliers of fabricated piping systems, mainly demanded in the electric power, chemical, and refining industries.^[10] SGR started as a pipe fabrication company and continues to sell piping systems to construction and engineering firms, operating plants, and other SGR segments. The piping systems are used in energy plants to transport materials, and are the essential components of the pathways that raw materials (mostly gas or liquids) and other inputs follow as they are converted to finished products.

SGR Annual Report^[12]

SGR Annual Report^[16]

Though gross profit increased in 2007, losses in other business activities contributed to an overall loss in net income. Net income has historically been positive; prior to the loss of $19 million in 2007 SGR reported net income of $50.2 million and $15.7 million in 2006 and 2005.^[17] The loss in net income in 2007 was largely due to a $33.2 million charge related to foreign currency translation adjustments on interest expense for Japanese Yen-denominated bonds.^[18] This adjustment is subtracted from gross profit along with income taxes, other general expenses, and losses from peripheral investments. Gross profits and revenues were at their highest in 2007, but currency fluctuations and losses from unconsolidated subsidiary entities of $25.9 million led to a loss for net income.^[19] Also, in the energy industry, design and construction projects are often so large that they can cost hundreds of millions or even billions of dollars. Increased use of debt to finance these projects makes debt more risky, though SGR has historically maintained a strong credit rating.

Key Trends and Forces

• Strategic Acquisitions in the Nuclear Sector are Helping the Shaw Group Expand its Operations: SGR purchased a 20% stake in Westinghouse, whose technology is used in over 40% of nuclear reactors built internationally. ^[20] Domestically, Westinghouse AP1000 reactor designs are being considered at least 12 reactor construction projects. If Westinghouse wins these contracts, it will be the first time they have built this type of reactor in the U.S.^[21] As alternative energy sources have become more popular and the price of fossil fuels has increased, Westinghouse has increased its backlog of construction projects. Demand for nuclear energy as an alternative energy source has grown stronger in the past five years, especially in response to climate change legislation.

• Demand for Environmental Restoration Services is on the Rise: Following such catastrophic disasters as Hurricane Katrina, many state and local governments are installing new damage control and prevention measures. SGR earned revenues of about $1.0 billion in 2006 from work done in the aftermath of Hurricane Katrina and Hurricane Rita draining water out of New Orleans and providing temporary housing services for displaced residents.^[22] Though revenue growth in the Shaw Group's Environmental and Infrastructure segment has declined since these disasters, the American government is actively pursuing infrastructure restoration and protection efforts. This has traditionally been a neglected area when budgets are tight, but SGR uses a number of strategies that lead it to win contracts over its competition. The company sets a fixed price for many of its projects rather than asking its clients to reimburse costs, which can escalate quickly for larger tasks. Also, the firm's wide range of services and history of successful projects with the Department of Energy, Army Corps of Engineers, and FEMA often lead to repeat business. SGR's most recent repeat was won on April 4th, 2008, when it was awarded a $700 million contract to build flood gates and a barrier wall in Lake Borgne in Louisiana.^[23] SGR's task focus has shifted to catastrophe prevention from catastrophe response in the last two years, with major projects in levee and irrigation canal construction.

• Reduced Emissions Technology is a Growing Industry: Demand for cleaner energy sources is rising, especially amidst public pressure for tighter U.S. Energy Regulations. Following issuance of the Clean Air Interstate Rule (CAIR) on March 10, 2005, sulphur dioxide and nitrogen oxide emissions in 28 eastern states are required to drop to 70% and 60%, respectively, of their 2003 levels.^[24] SGR controls 25-30% of the market for retrofitting domestic coal plants to make them compliant.^[25] As a result of CAIR and other environmental legislation, air quality control is becoming a much bigger contributor to SGR's revenue. Pollutant emissions abroad are growing, as foreign, emerging economies industrialize, especially visible in Chinese air pollution. Though current emissions reduction initiatives in China have been limited at best, there is potential for the demand for SGR's services to grow as pollutants become more dangerous (over 750,000 deaths a year are caused by air pollution and other environmental damages^[26]).
  

  

  Air Pollution (thousand metric tons) by Pollutant Type from Heat and Power Plants^[27]

• Cyclicality in End and Factor Markets is a Risk to Engineering Firms: SGR's customers mostly function in the energy and petrochemical industries, which are susceptible to cyclical changes in demand. Especially with respect to oil prices, energy company revenues (and, correspondingly, their ability to pay for contracts) are relatively volatile. Oil is a commonly used factor of production for the Shaw Group and many of its customers. For SGR in particular, rising oil prices increase the cost of petrochemical manufacturing and, thus, the cost of goods produced. This introduces volatility in revenues to SGR's manufacturing segments. With its construction and design clients, SGR's revenues come from fixed-price contracts (a fixed payment for an entire project is agreed upon) and cost-reimbursable contracts, (the client agrees to pay for project costs as well as a value-added premium). With fixed-price contracts, SGR is not reimbursed for over-budget spending on resources like oil if prices rise quickly. A little over half (52%) of SGR's projects are fixed-price and the remainder are cost-reimbursable. Therefore, the company can even take a loss on a project if factor costs increase sharply, though price volatility can also increase profit margins if production costs drop.^[28]
  

  

  Oil Price per Barrel by Oil Type over the Last Ten Years ^[29]

• Foreign Energy Demand Drives Growth in Overseas Operations: Growing economies abroad have lifted energy demand over the last ten years. China in particular expects to increase nuclear power generation by five-fold in the next 12 years.^[30] SGR's Fossil & Nuclear segment has grown as energy demand has surged. Aside from increased crude oil and petrochemical consumption abroad leading to more projects for SGR, alternative energy sources are becoming more popular. After acquiring a 20% equity stake in Westinghouse, one of the two major global nuclear reactor builders, the Shaw Group has benefited from industrial growth in China and South Korea. In addition to 30 new domestic reactors, Westinghouse has been contracted to build 6 reactors in South Korea and 4 reactors in China.^[31]

Competition

The Shaw Group's main competitors include Bechtel (privately held), Fluor Corporation, Jacobs Engineering Group, KBR, URS, and Washington Group International.

While SGR may be among the smallest of the large engineering firms (by revenue total), it is among the most diversified. The scale of operations for many of its competitors, notably Fluor Corporation, are larger. After its expansion into nuclear design and construction with the 20% purchase of Westinghouse, however, SGR is positioned to provide a variety of services. This variety of businesses exposes SGR to competitors in other markets as well. The main competitors for the Westinghouse segment are Areva, General Electric, Mitsubishi, Hitachi, and Atomstroyexport.

• Backlog - This is the value of contracts received for projects that have not yet been completed. Below are the figures for the backlogs of SGR and its competitors in 2007. A fixed-price contract is one where the client agrees to pay a set amount before the project begins, while a cost-reimbursable contract requires the client to cover production costs as they are incurred.

*Percentage as Portion of Revenue

URS has a backlog of about $18.7B but uses different types of contracts than the other companies.^[42]

SGR has accepts a greater proportion of fixed-price contracts than its competitors. This exposes the Shaw Group to greater risk in factor cost variation, though it helps the company to compete for project contracts.

References

1. ↑ SGR FY2007 10-K, Item 8, Page 73
2. ↑ The Wall Street Journal, Blog by Mark Gongloff, July 3rd, 2007
3. ↑ SGR FY2007 10-K, Item 1, Page 5
4. ↑ SGR FY2007 10-K, Item 1, Page 3
5. ↑ SGR FY2007 10-K, Item 1, Page 6
6. ↑ SGR FY2007 10-K, Item 1, Page 6
7. ↑ SGR FY2007 10-K, Item 1, Page 6
8. ↑ SGR FY2007 10-K, Item 7, Page 41
9. ↑ SGR FY2007 10-K, Item 7, Page 41
10. ↑ SGR FY2007 10-K, Item 1, Page 9
11. ↑ SGR FY2007 10-K, Item 7, Page 41
12. ↑ SGR FY2007 10-K, Item 8, Page 73
13. ↑ SGR FY2007 10-K, Item 7, Page 42
14. ↑ SGR FY2007 10-K, Item 7, Page 42
15. ↑ SGR FY2007 10-K, Item 7, Page 42
16. ↑ SGR FY2007 10-K, Item 7, Page 42
17. ↑ SGR FY2007 10-K, Item 8, Page 73
18. ↑ SGR FY2007 10-K, Item 8, Page 129
19. ↑ SGR FY2007 10-K, Item 8, Page 73
20. ↑ SGR FY2007 10-K, Item 1, Page 10
21. ↑ Wall Street Journal - "Toshiba Unit Nears Nuclear Deals"
22. ↑ SGR FY2007 10-K, Item 7, Page 38
23. ↑ CNN Money - "Shaw Group Wins $700M Inner Harbor Navigation Canal Hurricane Protection Project," Apr. 4th, 2008
24. ↑ EPA: Clean Air Interstate Rule
25. ↑ SGR FY2007 10-K, Item 1, Page 5
26. ↑ The Wall Street Journal, Blog by Mark Gongloff, July 3rd, 2007
27. ↑ Energy Information Administration
28. ↑ SGR FY2007 10-K, Item 1, Page 13
29. ↑ Energy Information Administration
30. ↑ The Economist - "China's Quest for Resources: A Ravenous Dragon," Mar. 13th, 2008
31. ↑ SGR FY 2007 10-K, Item 1, Page 10
32. ↑ Bechtel Corporate Fact Sheet 2006
33. ↑ Fluor Corp. FY2007 10-K, Item 8, Page F-3
34. ↑ KBR, Inc. FY2007 10-K, Item 8, Page 64
35. ↑ Jacobs Engineering Group, Inc. FY2007 10-K, Item 8, Page F-4
36. ↑ Yahoo! Finance - Competitor Profile for SGR
37. ↑ SGR FY2007 10-K, Item 8, Page 73
38. ↑ Fluor Corp. FY2007 10-K, Item 1, Page 8
39. ↑ KBR, Inc. FY2007 10-K, Item 1, Page 11
40. ↑ Jacobs Engineering Group, Inc. FY2007 10-K, Item 1, Page 8
41. ↑ SGR FY2007 10-K, Item 1, Page 3
42. ↑ URS FY2007 10-K, Item 1, Page 13