Construction Stocks: A Case for CAT, Not the Dogs

In 2010, I owned a number of the engineering & construction companies. The bull case was simple: global recovery will lead to improving business conditions allowing for non-residential construction to increase. I concentrated on companies well-positioned in the energy sector with reasonable valuation metrics and good prospects for increased backlogs and earnings.

While on the Fast Money Prop Desk on November 10, 2010, I recommended buying FWLTand others in the group noting that the Architectural Billing Index (ABI) had crossed 50 for the first time in 30 months indicating improving and positive business conditions in the US. However, I was more attracted to companies that also had significant ROW exposure. he group performed well in the absolute and relative to the market. As of this writing I have no position in the sector.

Here is why I now suggest avoiding the sector. Credit remains tight limiting the ability to finance projects; the ABI declined below 50 for the first time in 6 months indicating that business is likely to contract; the companies, almost without exception, disappointed when they reported earnings, and backlog for Q1 (and some disappointed in 4Q 2010); and global competition has increased. This is the most important point.

When the industry blew up in the last cycle, it was because work dried up and fixed cost contracts led to massive losses and near bankruptcy conditions.

Variable contracts allow the E&C companies to charge the customer for increased costs such as raw materials and construction overruns not reflected in the original agreement. The companies had sworn off fixed contracts, but guess what? They are back with a vengeance because of excess capacity in the marketplace and increasing global competition; the negotiating power is now with the customer.

At current levels, I see no reason to own: Foster Wheeler , Fluor , Jacobs Engineering, McDermott, Babcock & Wilcox or Shaw Group . You can better participate in this cycle owning CAT because it is not entirely dependent on new non-residential construction or rehabs.

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Trader disclosure: On May 20, 2011,Weiss Owns (MSFT); Weiss Owns (QCOM); Weiss Owns (BRCM); Weiss Owns (AKAM); Weiss Owns (DVN); Weiss Owns (DE); Weiss Owns (COP); Weiss Owns (CNX); Weiss Owns (ETP); Weiss Owns (NS); Weiss Owns (UUP); Weiss Owns (MRK); Weiss Owns (KO); Weiss Owns (HK); Weiss Owns (VZ); Weiss Owns (TEVA); Weiss Owns (KO); Weiss Is Short (X)