In recent weeks, we've looked at some volatile and speculative plays for investors looking to take advantage of the compelling upside offered by small-cap stocks. Stocks such as Dendreon (DNDN) , Force Protection (FRPT) - Get Report, Jones Soda (JSDA) and Buffalo Wild Wings (BWLD) all showcase a combination of risks and potentially huge earnings growth.
Today, we're looking at
( SGR), an established name in the relatively mainstream area of engineering and construction. Weighing in with a market cap around $3.5 billion, Shaw makes for an interesting alternative to larger competitors such as
. But with shares up almost 30% in the first half of 2007, is Shaw a smart play for small-cap investors, or should they look elsewhere?
Kusick: Growth Buyers, Come Forth
Since we started the weekly Small-Cap Spotlight feature here on
, we've looked at a lot of stocks where there's a major catalyst in the works that may or may not develop, with the uncertainty creating a lot of volatility in the share price.
Shaw Group is not one of these stocks. Instead, it boasts everything a growth-oriented investor should look for in a company: a high future growth rate, a catalyst to drive continued upside and an established track record with solid fundamentals.
Some readers may remember that Shaw was one of Jim Cramer's "
Green Market" stocks earlier this year, on the basis of the company's exposure to nuclear power. Nukes have long been a dicey proposition for investment, but the answer is that environmental concerns have finally overtaken much of the stigma attached to nuclear power plants, and we are on the verge of seeing a long-term global boom in nuclear power plant construction.
Last October, Shaw took a 20% stake in the Westinghouse Electrical Company, a global supplier of nuclear plant products. The company's technology is used in half the licensed reactors around the globe. In conjunction with the ownership agreement, Shaw gained exclusive access to engineering work on future Westinghouse AP 1000 plants.
In a nutshell, Shaw has the inside track on construction and servicing contracts in what is looking like a multidecade global renaissance in nuclear power.
The financial implications from this trend for Shaw could be huge. China has announced plans for the construction of 30 reactors over the coming years, and the Shaw/Westinghouse team will be supplying the first four AP1000 reactors.
Currently, the backlog contribution from this announcement amounts to $700 million, but the ultimate financial benefit to Shaw could be greater, as the company stands a good chance to win additional contracting work. Analysts at the research firm Johnson Rice estimate that lead contract work on just one new reactor would generate $1.5 billion in revenue.
Shaw also has significant opportunities in the U.S., where acceptance of nuclear power is also in a steady uptrend because of increasing concerns over the environmental effects of other power sources such as coal. Currently, there are at least 31 planned nuclear plants in the U.S. that Shaw is being considered for work on, and at least 12 of these are expected to utilize the Westinghouse AP1000 design.
But Shaw is not just a nuclear play. The company is a leader in the market for scrubbers, the air-cleaning systems that reduce pollution generated by coal-fired plants. Clean-air regulations are scheduled to become stricter in 2010 as the Clean Air Institute Regulation take effect, forcing plants to cut sulfur dioxide emissions or pay for pollution credits.
Looking at the near-term future, Shaw is set to increase earnings by 90%, to $1.94 in 2008 from $1.02 a share in 2007. In reading analyst reports from major investment banks such as Goldman Sachs and UBS, I noticed that analysts covering Shaw were still extremely uncomfortable with attempting to project the company's future financial results. Remember that the research industry thrives on visibility and being able to put numbers on paper with certainty. In spite of having a growing and visible backlog, the exact size of much of the company's future opportunity can't yet be quantified because of the potential for additional work and uncertain timing of many projects at the current time.
Shares of Shaw were recently trading at $45, or about 22 times what I believe could end up being conservative 2008 earnings estimates. This multiple is ahead of the company's peers, but not by much. Jacobs Engineering currently trades around 21 times a consensus estimate of $2.60, while Fluor is at just over 20 times an expected $4.88 in earnings for 2008.
Having gone over these positives, investors should be aware that Shaw has some problems with its financial reporting and had to delay the filing of its second-quarter 10-Q because of errors in the cost estimates related to a petrochemical project on the Gulf Coast. The error appears to also affect first-quarter results, requiring a restatement of that period as well. The project being reviewed is only a $39 million deal, which won't significantly affect financial results when the review is complete, however it's clear that Shaw has to clean up its act when it comes to its financial reporting.
In February, Ernst & Young stepped down as the company's independent auditor, giving little explanation for the decision. Although Shaw secured KPMG as its new auditor a month later, it's clear that the company needs to devote more resources to its accounting. With no signs of any wrongdoing, I'm willing to give the company the benefit of the doubt for now, but investors should keep an eye on the company's progress in this respect.
Given Shaw's advantageous position in nuclear plant construction as well as the shift toward cleaner coal-fired plants, I would be willing to pay the premium for this stock. In addition, investors could see a quick boost to the stock if a larger engineering player looks to acquire the company, likely paying a premium for Shaw's unique leverage to nuclear power.
New contract announcements, the resolution of financial reporting errors and a potential acquisition bid could all act as catalysts for shares of Shaw over the next year. Although the future isn't crystal clear yet, long-term investors would be wise to get into this attractive small-cap before the Street analysts, who remain wary of uncertainty, finally see the whole story.
Curzio: Shy Away From Shaw
Infrastructure stocks have been one of the best-performing sectors over the past 12-months. Even the long static
-- a stock that has been an underperformer for years -- has seen its share price move higher in the short term after mentioning in its April quarter that infrastructure is in the early stages of a long-term secular trend.
So it should come as no surprise to see Shaw Group -- a small-cap infrastructure play -- up nearly 100% over the past 12 months. The move is justified, as the company increased its backlog to $11 billion as of last quarter, almost double from two years ago, and its nuclear division -- as Larsen mentioned above -- is expected to bring in revenue for years to come.
But I believe Shaw does not offer investors a favorable risk/reward at the current price. The stock's valuation is one problem, the company's lack of international exposure compared with its peers is another, and Shaw has accounting problems currently that have led the company to switch auditors.
Looking at valuation, Shaw trades at 36 times earnings, according to Capital IQ, according to consensus estimates for the next 12 months. I believe this is a fair estimate to use, given that year-end 2008 estimates are more than seven quarters away -- being that Shaw's recent earnings report was for first quarter 2007.
On the growth end, Shaw is expected to increase revenue about 17% on an annual basis over the next three years. This growth projection does take into account the huge project in China to develop several nuclear power plants.
Shaw's closest competitors -- Jacobs Engineering and Fluor -- are expected to increase their revenue at a slightly slower pace over the same time period, but Jacob's trades at just 23 times earnings, while Fluor trades at 25 times using the same 12-month time frame.
One could argue that Shaw is more levered to the nuclear industry compared with its peers, as this market is expected to generate overseas revenue for the company for many years to come. But nuclear is part of its energy and chemical (E&C) segment, which accounts for only 30% of total revenue as of year-end 2006. The company operates under four segments; environmental and infrastructure (E&I) is its largest, accounting for 44% of total revenue.
In last quarter's conference call, management said it is seeing difficulties in its E&I segment because of lack of bookings. This shortfall was not reflected in last quarter's results since the nuclear deal with China offset the weakness. The company estimates that the first nuclear plant will not become operational until 2013, so I would argue that Shaw will not see additional nuclear orders from China in the short term. If this is the case, Shaw will have to find ways to offset weakness in its largest division in order to meet full-year guidance.
Turning to the international front, where I believe infrastructure has much more potential as underdeveloped countries become more mainstream, Shaw has little exposure compared with its peers, with less than 15% of annual revenue coming from outside the U.S. This includes the $700 million deal from China that the company booked in its $11 billion backlog as of last quarter.
In comparison, Jacobs Engineering received 35% of its 2006 total revenue from abroad, while Fluor received 55% of its revenue outside the U.S. This diversity in revenue should be viewed as a positive for Shaw's competitors, since some economists believe that growth in the U.S. will slow over the next 12 months.
Another risk worth mentioning is that Shaw has delayed its second-quarter filing because of an independent review of a $39 million project -- estimated costs for the project may be in error. The amount is very small when compared with the billions the company has in its backlog, but more important, Shaw changed auditors at the time of this announcement back in April. This review may prove to be trivial, but is it worth it for investors to take this risk?
Shaw has less international exposure and a higher valuation -- with the same growth potential -- as its peers. If you believe that infrastructure is in the early stages of a secular growth trend, I believe you would reduce risk substantially by selling out of Shaw and buying either Jacobs Engineering or Fluor.