Thursday, May 29, 2008

Another one poised to rise: SGR

SGR, an engineering, procurement and construction (EPC) firm has significant exposure to nuclear power plant projects in the U.S. and China. The stock has traded relatively flat so far in 2008 because the timeline for nuclear projects in the U.S. remains uncertain, but I see significant long-term potential for investors as the nuclear story evolves both domestically and abroad. Shares were recently trading at $59.36.

Shaw offers a combination of solid near-term business momentum in its domestic engineering business, along with an outstanding long-term catalyst based on its 20% equity stake in Westinghouse Electric, a leading global designer of nuclear power plants. This relationship provides Shaw with exclusive access to engineering work on Westinghouse- designed reactors. This is significant because the company's AP1000 pressurized water reactor is considered a leading contender for new projects around the world. Shaw and Westinghouse are already in the initial stages of work on four new AP1000 reactors in China, with substantial potential for additional work based on China's plans to construct numerous additional reactors over the next decade.

In the near term, Shaw's non-nuclear businesses are generating solid momentum. The company's primary strength is in coal-fired power plants, providing services ranging from new plant construction to installation of scrubbers, which are key components necessary for reducing emissions of sulfur and other pollutants. Environmental concerns are on the upswing in the U.S., and Shaw's management has said that environmental and scrubber projects should remain plentiful in the U.S. for another three to five years.

Shaw also services natural gas-fired plants, providing it with some diversification away from coal. Its Energy & Chemicals segment has shown progress on the international front over the past 12 months, announcing projects in India, China and Korea, as well as a polysilicon manufacturing plant in Idaho for Chinese solar company Hoku Scientific (HOKU:Nasdaq). The plant is expected to be completed in 2009. Military-related projects have also provided a steady source of revenue in recent years, particularly in environmental remediation at U.S. military bases that are in the process of closing.

Shaw recently announced a deal with the U.S. Department of Energy to proceed with full construction of a mixed oxide (MOX) fuel fabrication facility in Aiken, S.C. The $2 billion deal had been much anticipated by analysts heading into the latter months of 2007, but, as is often the case with large contracts, negotiations dragged on longer than expected.

The company also made headlines earlier this week after announcing that it has been awarded EPC contracts for two AP1000 nuclear units to be built at the V.C. Summer Nuclear Station near Jenksville, S.C. The contract is with Scana Corp.'s South Carolina Electric & Gas unit and Santee Cooper, a state-owned electric and water utility in South Carolina. However, the process for securing a COL (construction and operating license) to begin work will take years, and Shaw's management commented that it expects the COL, which was submitted in March, to be approved in 2011.

Timing is a key concept for investors to remember when taking a position in an EPC company because catalysts develop more slowly than at most other businesses. Because of the significant time between project bids, negotiations, per-construction preparation and completion, a new deal announcement does not necessarily translate into a big jump in the company's stock price on the day it is first announced.

In a similar way, it's uncertain how quickly the full nuclear power opportunity will develop. Although there are four AP1000 reactors being constructed in China, it's hard to pin down the size of the opportunity for the Westinghouse/Shaw combination, or how long it will take before subsequent new projects are announced. However, uncertainty creates upside potential for investors, and we're obviously bullish on Shaw's position in China. I believe that shares of Shaw are undervalued relative to the long-term opportunity afforded by the company's early entry into the developing Chinese nuclear market.

One of the reasons for the aforementioned uncertainty is that nuclear power has significant competition from traditional fuel-based plants, as well as alternative energy plants like solar and wind power. China is expected to invest heavily in alternative energy over the next 10 years, but nuclear offers its own advantages and reasons for significant long-term success in both China and the U.S.

As a refresher, there's a big difference between certain power sources such as wind and solar, which only produce power part of the time (when the wind is blowing or the sun is shining) and baseline sources that reliably generate power 100% of the time. While there is enough room for many technologies to have a place in power generation, nuclear power is known for being the low-cost solution in terms of fuel and other operating costs. In fact, the only technology that can produce power on the same scale at a similarly low cost is hydroelectricity (which obviously has limitations caused by geographic requirements). The tradeoff is that nuclear power has some of the highest startup costs in terms of plant construction, and no permanent solution has been found for safely disposing of spent nuclear fuel. On a long-term basis, however, the return on a nuclear investment is very attractive.

The continuing rise in energy demand around the world, combined with increasing concern over the environmental effects of carbon emissions, create a favorable setup for nuclear power. In the U.S., concern over dependence on foreign oil is another factor that could accelerate the uptake of nuclear and other energy alternatives.

The four reactors in the early stages of construction in China could also provide a blueprint for future success in the U.S. New commercial nuclear projects in this country have been virtually nonexistent since the 1970s, so a solid showing in these early projects could serve as an effective marketing tool for new plant projects. Shaw's stock currently trades at 26 times 2008 consensus earnings estimates. However, relative to 2009 earnings expectations, Shaw appears downright cheap, trading at 18 times the Thompson Reuters consensus. It's also useful to note the company's valuation relative to larger competitors like Fluor (FLR:NYSE) and Jacobs Engineering (JEC:NYSE), which both sport price/earnings multiples above 23, based on 2009 estimates.

Shaw's smaller size accounts for part of the reason for the discount as does the recent success of competitors in projects such as building and expanding oil production capacity, which isn't one of Shaw's specialties. Another notable point: Shaw's most recent quarterly earnings (announced in April) were a disappointment, coming in below expectations due to a number of small negatives, including weaker-than-expected results in its Environmental & Infrastructure segment, the push-back of the MOX deal signing, and some one-time charges. In addition, management provided lower guidance based on an anticipated higher tax rate. My view on the results is that they helped bring investors' near-term expectations down, which is a positive for investors with a long-term view of a company's potential. None of the issues that affected last quarter's results are what I would consider a red flag for investors, and I see additional potential for upside based solely on the market's lower expectations for upcoming quarterly results.

disclosure: none

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