Construction & Engineering Investment Banking: The Best Way to Build a Strong Finance Foundation?
But before you begin transporting goods or producing aircraft, you need to build the factory, freeway, or entire city in the first place.
And that’s where the construction, technical services, and engineering industry comes in: they deploy heavy construction equipment to build real estate – and even rebuild nations – all the while competing for lucrative infrastructure contracts.
You might recognize these magnificent machines from their bright and familiar yellow trucks or green tractors.
Here’s the blueprint for this group:
- How to find your place in the engineering procurement and construction [advisory] business.
- What’s covered under the umbrella of “engineering,” including the main players.
- Sector and company analysis and how to talk about the industry in interviews.
- Exit opportunities, where to find them, and how to capitalize on them.
Blueprints for a Better Banking Career
Q: What brought you into the industrials group?
A: Way before my bank’s recruiting team ever came to campus, I reached out to a couple of alums to learn more about the investment banking career.
It was a “luck of the draw” kind of thing – I sent a bunch of emails saying that I was interested in learning more about what alums do, and very few responded back… but those who did were very helpful, and I ended up getting placed in this group and sub-group because of the high concentration of alumni here.
The process reminded me a lot of how the sell-side M&A or capital raising process works: you send out a lot of pitch books, a few parties ask for follow up, and then maybe one of the pitch books turns into a mandate.
Q: You mentioned earlier that you’re in the industrials group, technically, but where is the engineering and technical services team in most cases?
A: Most of the time, you don’t see specific groups called “construction” or “engineering.” Instead, Managing Directors in groups such as industrials focus on a handful of areas – and whatever areas are profitable will receive coverage.
In my industrials group, there is a dedicated homebuilding and building materials coverage officer. At another bank, the same coverage is based out of the real estate group.
So it varies based on what the engineering / construction team focuses on, but usually it will be within the industrials group or the real estate and lodging group.
A Deep Dive Into the Foundations of Construction
Q: Great, so how is the sector itself divided up?
A: According to the stock screener, these “engineering procurement and construction” companies fall under an area called “Technical Services.”
Another word for this area is “government services,” otherwise known as government contractors, especially when it comes to structural assignments such as rebuilding Iraq.
If you exclude the defense companies that are involved with energy infrastructure maintenance, this is how I see the world:
Engineering: These firms plan and execute broader construction projects. So if you have to build 200 hospitals, you’ll see these types of companies (partial list): URS (fka: United Research Service), Fluor, Parsons, and Bechtel.
These companies, according to URS, do the following: program management (ex: overseeing a set of subcontractors); planning, design and engineering; systems engineering and technical assistance (SETA, which includes a review of software data and the creation of engineering documentation); IT services; construction and construction management; operations and maintenance (O&M); and decommissioning and closure.
You will also find these companies running and improving power plants’ operations.
Residential Construction: These companies build homes or apartment complexes. Some of the past and present homebuilders include: Lennar, DR Horton, Toll Brothers, and KB Home.
By buyer profile, the market for homebuilders is as follows: Entry level, 1st Move-up, 2nd Move-up, Active Adult (residents aged 55 years and over), and Urban.
These firms focus on acquiring and developing land, and eventually creating entire communities.
Think about how Los Angeles has so many suburban areas such as Palmdale, Lancaster, Santa Clarita, and so on: those are a direct result of these companies going in and building properties with the aim of creating “communities.”
Commercial and Public Construction: On the roadway and more commercial side, you have [in the UK] Balfour Beatty and Carillion. In the US, you have some of the engineering names I mentioned previously.
The list of past and present participants includes: Martin Marietta Materials, LaFarge, Vulcan Materials, and Texas Industries.
Q: So what drives the market for construction?
A: Overall, this is a very cyclical business. Here are some of the factors you look at, by sector:
Engineering: This sector is influenced by the health of other sectors. It’s not so much that everything is connected – it’s just that the clients for the engineering sector come from: chemicals, utilities and power, oil and gas, civil infrastructure, and defense operations.
So if you need a new oil refinery, you would look at oil sector drivers before you call an engineering company to complete the work.
Even the department names for one such engineering company, URS, tell you which sectors the individual departments’ health depend on: Infrastructure & Environment, Federal Services (serves: Dept of Defense, Dept of Homeland Security, and National Aeronautics and Space Administration), Energy & Construction, and Oil & Gas.
There’s some seasonality as well; winter enables business in the oil and gas sector, while spring reduces business in the oil and gas sector (think: road bans in the Northern US and in Canada).
Commodity prices will definitely influence the price of transporting equipment or even the raw materials that go into the deliverables of an engineering company (ex: roadwork, buildings, etc.)
I know you covered oil and gas drivers, but these items are also important here and include: domestic and foreign oil and gas supply; cost of exploring, developing, and refining; and available pipeline capacity.
These items influence which oil and gas services can be performed, and lower prices or high price volatility lead to decreased drilling activity.
On the government side of things, the type of contract work influences top-line numbers and growth:
- Cost-Plus: You are reimbursed at a fixed or performance-based rate. If costs go over, you may not be reimbursed for all costs incurred.
- Fixed-Price: You are paid an upfront amount that covers your work budget.
- Target-Price: Fee applied to budget, and the fee can be changed later.
- Time-and-Materials: Hourly billing rate with out-of-pocket expenses reimbursed.
There are more variations, but you mostly care about the percentage of revenue contributed by each type of contract above: it’s always in the company’s interest to be reimbursed for cost overruns and additional expenses.
Speaking of which, revenue is often recognized by the “Percentage Completion” approach – you earn revenue only after you produce work.
Sometimes you also see revenue earned in proportion to the costs incurred relative to the costs remaining… so revenue recognition is not quite as straightforward as it is for normal companies.
Finally, interest rates will influence the price of revolvers and term loans, which many engineering companies rely on. Foreign exchange can have an impact on the bottom line as well.
Q: Great, thanks for explaining all that. What are some key indicators in the sector?
Other indicators include: employment, immigration (think: people moving into specific geographies), household formation, consumer confidence, lending, real estate taxes (including deductions for mortgage payments), and the Case-Schiller Index.
On the commercial side, I look at the government budget announcements for any changes in infrastructure spending; I also look at military activity because where there are troops, there will be a need for logistics (forts, barracks, etc.). You can look at construction spending data made available by the US Census.
Outside of this, there are some other indicators worth taking a quick look at: office vacancy rate, municipal bond issue volume, and capacity utilization. You might find those types of indicators in a sector update.
Financial Analysis and Valuation Approaches
A: Of course. Here you go, by sector:
- Technical Services: Cerberus Capital Mgmt / DynCorp: by Goldman Sachs (search for ‘April 9, 2010 and is not necessarily indicative of current market conditions’)
- Aggregates: Blackstone / LaFarge North America: by Merrill Lynch and Rock of Ages: by Covington Associates
- Residential Construction (Homebuilding): Gafisa / Tenda : by Banco Itau
Q: What are some important financial and operating metrics to look at?
A: For these types of companies, you pay a lot of attention to a company’s pipeline and what types of assignments and new contracts are coming in.
You can break up the book of business by backlog, option years, and indefinite delivery contracts:
- Backlog: Signed, committed contracts that the company has to produce and deliver.
- Option Years: Years of potential work in addition to the base (or minimum) term covered by the backlog.
- Indefinite Delivery: Think of it like this: you are waiting to receive an assignment from your staffer… but until you receive a task, you don’t get paid. It’s sort of like that.
In-line with these metrics, you pay special attention to the “book to bill ratio.”
If it’s greater than 1x, this metric reflects growth; a ratio equal to 1x reflects stability; and a ratio of less than 1x reflects decline.
You may have seen this ratio in the semiconductor industry, but it is also applicable for any company that works with an orders backlog.
You also look at capital expenditures and how they relate to the backlog… having incoming business is great, but you also want to deploy capital efficiently both to win new business and to service existing clients.
According to Vertical Research: “Working capital accounts, including accounts receivable and cash and billings advances, are typically the largest asset classes on an E&C’s balance sheet.”
So you’ll pay special attention to these accounts in any type of analysis involving cash flow and/or FCF projections for use in a DCF analysis, and groupings such as the Change in Working Capital take on special importance.
When it comes to commodity prices, pay attention to these: aluminum, copper, nickel, zinc, and rebar (and see our coverage of metals & mining investment banking).
There is also a strong correlation between the performance of E&C (engineering and construction) equities and the WTI (West Texas Intermediate) spot price.
Lastly, the composition of the contracts mentioned in the very beginning is still important: what percentage of an E&C (engineering and construction) company’s work is Fixed Price vs. the other categories?
Q: So it sounds like there are a lot of new and different metrics, but what about valuation?
Do you see new methodologies or multiples, or variations on the well-known ones?
A: A lot of the valuation side is very standard: you still use future share price analysis, a traditional DCF based on Unlevered Free Cash Flow, and traditional comparable company analysis, precedent transactions, and LBO analysis.
The difference is that you may pay more attention to certain metrics, particularly when reviewing operating benchmark comps.
For example, you might highlight gross margins a bit more than you would in other industries since these projects and contracts are often based on hourly labor rates.
You may also use what is known as ‘Multiples Compression Analysis’ to chart Enterprise Value / LTM Revenue or Enterprise Value / LTM EBITDA over time , to discern whether valuations are going up or down.
This method is different from comparable companies analysis, since you’re comparing relative valuations over time instead of just looking at the numbers at one specific point in time.
In equity research, I’ve seen these approaches and metrics as well: Return on Equity, Return on Assets, Return on Invested Capital, and Economic Value Add (ROIC – WACC).
For more on these metrics, please see our tutorial on ROIC vs ROE and ROE vs ROA.
Deals, Firms, Reading, and More
Q: What kind of deal flow can our readers expect going into this sector?
A: Homebuilders typically focus on raising capital. You should expect the much larger and well-established engineering companies to be fond of corporate banking products (ex: term loans, revolving lines of credit, etc.).
Depending on what year it is, you can see a bit of activity among these titans when it comes to advisory tasks.
Activity tends to go in waves, similar to how US REITs (Real Estate Investment Trust) tap the equity markets nearly in unison; there was a set of months where you saw the large engineering companies make acquisitions in the cyber-security sector, for example.
Q: Great, and what are some of the leading boutique banks in this sector?
A: Zelman Associates covers land brokers, homebuilders, construction and developers.
It must be the capital intensive nature of the business, but the usual suspects that compete in the homebuilding space include: Bank of America Merrill Lynch, Citi, and Deutsche Bank.
Further Reading and Exit Opportunities
Q: What should our readers take a look at when it comes to staying in the top bucket for bonuses?
A: Vertical Research Partners has produced a report covering several companies in the space.
Engineering News Record keeps a tab on the top contractors annually, while Financial Times’ RSS feed focuses more on the construction sector, with an emphasis on residential and public sector (ex: roads and bridges).
Finally, UBS has a presentation on the engineering sector saved here from the Rice Global E&C Forum.
Hanley Wood publishes a set of real estate development [and construction] magazines depending on what areas within the business you’re interested in.
Finally, on the report side of things, this construction outlook from FMI might be of interest to you.
Q: And where do you go after advising companies in the engineering and construction sector?
A: Defense or industrial-related funds are a very popular destination because of where these funds recruit from, and less because there are a huge number of these funds.
Real estate private equity funds tend to look more for real estate backgrounds, and less so for industrial ones, mostly because many RE PE funds invest directly in individual properties and are less involved with home-building firms.
Q: Awesome! Thanks for your time.
A: Glad to be helpful.
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