FLR - Fluor Corporation: A Hedge Against Hurricanes And Inflation

2023-10-31 01:35:04 ET

Summary

• Fluor Corporation focuses on energy, urban solutions, and mission solutions, positioning it well for long-term trends.
• Climate change is increasing the frequency of extreme weather events, providing a natural hedge and upside opportunity for Fluor.
• Fluor's infrastructure focus and US presence make it relevant to infrastructure trends and macroeconomic activity.

Fluor Corporation ( FLR ) focuses on engineering services in three areas for its services: Energy, Urban solutions, and Mission solutions. We will see in the valuation that the company has slim margins, variable revenue, and fluctuating cash expenses. Nevertheless, it is well-positioned to benefit from long-term trends and might be a fantastic hedge against tail events from an ESG and Macro perspective.

The pandemic severely impacted the company, as construction was stopped or limited, and private spending shrank. Because of this impact, the company stopped distributing dividends. Although it has slim margins and variable revenue composition, its balance sheet is solid, and it has very little debt while holding a substantial cash reserve, which should ease these fluctuations.

Fluor received revenue from the seven stages of construction: design, engineering, procurement, fabrication, construction, startup, and maintenance. While Procurement fabrication and construction may bring higher revenue, they get slimmer margins than Engineering, startup, and maintenance.

Hurricanes - Not a black swan

Climate change is one of the seven most important trends I focus on, and one of its most notable consequences is that extreme weather events, like hurricanes , will become more common and less predictable. A timely but unfortunate example is Hurricane Otis , which devastated Mexico Pacific just a few days ago. The Hurricane changed from a mild tropical storm to a hurricane in hours and, with minimal warning, devastated the Pacific coast of Mexico.

One of Fluor's main activities is infrastructure, and these events will require governments to spend more on rebuilding infrastructure damaged by hurricanes and other weather events. For this reason, Flour could be a natural hedge in many portfolios. Extreme weather events negatively affect most stocks as they disturb economic activity, while Flour is inversely correlated and benefits from these events.

While many would call these occurrence types a Black Swan, it is not. Black Swans are extreme events for which a probability cannot be calculated or adequately measured. While we cannot accurately predict when and where these extreme weather events will occur, we have substantial evidence that their frequency will increase.

Infrastructure and green tech

The company receives a substantial portion of its business from the US, so infrastructure trends and macroeconomic activity are relevant.

The US has a substantial infrastructure deficiency. The American Society of Civil Engineers estimated a $2.6 trillion infrastructure cap for the decade. While Biden's infrastructure bill addresses some of this with its $1 Trillion plan, a significant gap will still exist. The infrastructure spending falls directly on Fluor's core competencies, like Dams, electric infrastructure, Water treatment, and transportation.

Besides the natural infrastructure repair due to the lack of investment in past years. The transition to electric vehicles will increase energy consumption, and the current infrastructure, even if repaired, is not enough to handle this change.

This should increase spending on energy production, storage, and distribution, which Fluor also does well, as it is clear from its recent contracts with the Nuclear Propulsion Lab, where Fluor just received a 5-year contract extension, or the Ion Battery production facility in Sweeden. While this is likely considered in the price, it is a decisive factor for the company's stability in the future.

Inflation & Macro Economics

Inflation has been a dominant theme of the post-pandemic era. To understand the current predicament of the central bank and the possible consequences for the economy and the company, we need to understand how inflation, bonds, interest rates, and government spending are correlated. So, bear with me for a brief, oversimplified explanation.

The central bank controls the interest rates, which is the interest rate that government bonds pay. It shifts the rate depending on how it wants to manage the economy. Lowering the rate makes borrowing cheaper, so spending and investing becomes easier, increasing consumption and economic activity. This is an expansionary monetary policy. Rising rates do the opposite; saving becomes more attractive, and borrowing becomes increasingly tricky, reducing consumption and investment. This is a contractionary monetary policy.

A common analogy is that lowering rates pushes the gas on the economic car, and hiking the rates is equivalent to hitting the brakes.

Whatever happens with the rates, if the supply of goods can adjust to the new conditions, the market follows some adjustments. In expansionary monetary policy, more goods will be sold at a slightly higher price, and GDP will grow.

However, prices will increase if supply is constrained and there are insufficient goods to sell. The GDP grows very little, and prices rise. This is why we are experiencing such a crisis with inflation.

During the pandemic, interest rates were lowered to increase the money supply and economic activity. The supply chain suffered significant disturbances, which have not been resolved, and as the pandemic resided and economic activity increased, inflation increased. So, the Central Bank increased the interest rate to control inflation.

Now, there is one "person" who does not follow the pattern we have described and has sufficient money to move the needle: The Government. It may increase spending or decrease taxes, which increases money supply, economic activity, and inflation. The government is doing this for many reasons, including that 2024 is an election year.

So, while the Central bank is hitting the brakes, the government is pushing the gas, and the proverbial economic car may drift safely past the curve, spin out of control, or crash.

One might assume that the Central Bank can hit the brakes harder, but there is a catch. Bonds. Bonds, or at least fixed-rate bonds, pay a fixed amount typically once or twice a year. If newer bonds yield more than old bonds, old bonds will depreciate. Banks hold enormous amounts of bonds to balance their lending activities. With all the rate increases, banks have substantial unrealized losses, and increasing rates might be the last drop some banks might bear before crashing.

What does this have to do with Fluor? In the short term, its contracts are typically multi-year, as can be seen by its Naval observatory deal extension or the UK nuclear site's 3-year contract , and also are, in many cases, not sensitive to fluctuations in macro forces once awarded. Increasing government spending should be a positive trend for its revenue. In the medium term, if the proverbial car were to crash, reactivating the economy usually means increasing government spending, especially infrastructure, as it provides jobs.

Valuation

For the valuation, we will use an FCFE valuation. The gross margin is projected to be between 3 and 4%, and the resulting profit margin is slim. Because the natural business has low margins, the low scenario is especially acid to test the financial viability of the company and its prospects.

One important note is that Fluor holds cash per share of about $11, so about a third of the price is cash and a relatively low debt. Which may allow the company to sustain significant hits or prolonged losses without risking bankruptcy.

So, while the low estimate may have very little value in FCFE, its fair value will be higher.

With this valuation, the stock has a 20% upside and downside from the current price, considering the high and mid scenario—the low scenario, in this case, a stress test. Has a much steeper 60% downside. In this stressful scenario, it may be argued that the liquidation value of the company would be higher.

When this stabilizes, the company may distribute dividends, as it has done, which may also prove to be a mid-future catalyst.

Conclusion

Fluor's rocky performance during the pandemic and recovery is creating a period of higher uncertainty for its valuation, which is why the low scenario is needed and may result in being overly pessimistic, while the potential upside remains. Of the tail, the horizon is complex to estimate as a revenue per year, but its trend is there. For this reason, the valuation is, by design, pessimistic. The main objective for this stock in most portfolios should be risk reduction.

In the past article, I introduced the animalistic portfolios of the Tortoise and the Cat.

Tortoise Portfolio: Include the stock in the portfolio. Not only the ESG exposure is mixed and a key objective of the portfolio, but the relatively low risk of the company and the hedge it would add to the portfolio is reason enough to include a position. In the long term, it is more likely that the company will resume providing a dividend, and with a long time horizon, that is a possibility that is welcomed.

Cat Portfolio: No inclusion of the stock in the portfolio. If a drastic event occurs or a sharp price decrease occurs, the inclusion of the stock could be revisited, but in the meantime, the stock does not present enough upside to justify an allocation.

Taleb's book, Antifragile, speaks of the quality of objects or systems opposite of fragility. Instead of large shocks destroying it, they make it stronger, like the crab. Claws that grow bigger and stronger each time they break. This stock reminds me of this property as it is priced around the fair value if nothing happens, while if tail events hit, it may have a substantial upside.

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