Tickers in this Article: SHAW, JEC, FLR, KBR
It's hard to maintain a lot of enthusiasm for engineering and construction (E&C) companies like Shaw Group (NYSE:SHAW). By their very nature, large projects take a long time to design, permit and execute, and there is enough competition in the industry to prevent anyone from making especially attractive economic returns for a long time. That said, I do not believe Shaw's valuation reflects the steps that the company has taken to reduce the risk of its operations, nor the long-term realities of electricity demand.

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Muddled Third Quarter Results
Shaw's results are muddled with a variety of charges and so forth, but the bottom-line results didn't look exceptional. That said, quarter-to-quarter performance is arguably not the best way to evaluate a company like Shaw. Revenue rose 5% this quarter (and above expectations), as growth in Environmental and Infrastructure (up 5%) and Plant Services (up 2%) helped offset a 9% decline in recognized revenue in Power. Gross margin improved fairly meaningfully, though, and the company did eek out a positive EBITDA for the quarter. Stripping out all of the charges ((related to the sale of the E&C business, a project for GenOn (NYSE:GEN)), and overruns on a coal project), Shaw appeared to miss by about 20%. Nevertheless, management sounded pretty optimistic and the guidance suggests both a strong fourth quarter and pretty meaningful earnings potential for fiscal 2013.

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A Good Enough Price for E&C
Shaw announced a little while ago that it reached an agreement to sell its Energy and Chemicals unit to Technip (OTC:TKPPY) for $300 million. That's not an especially robust price for a business that once achieved $200 million in gross profits during the peak, but Shaw was in a no-win situation. Shaw really didn't have the scale to compete with a company like KBR (NYSE:KBR), and its small presence in markets like petrochemicals was a profit-limiting issues. It wouldn't have shocked me if Shaw had held on to it, but now the question is whether Shaw can find worthwhile deals in segments like power and make better use of its balance sheet.

SEE: How To Evaluate A Company's Balance Sheet

Power Is a Must-Have, but It's not Easy
Nobody doubts that a modern economy like the United States needs electricity to function, and likewise nobody doubts that there needs to be additions and upgrades in generation and distribution infrastructure. The problem, though, is that there is still no agreement on what America's power future ought to look like, and the permitting and approval process for individual projects is time-consuming and uncertain.

To wit, while Shaw was able to add a SCANA (NYSE:SCG) nuclear power project into its backlog, the company removed a Duke Energy (NYSE:DUK) project (formerly a Progress Energy project) in Florida due to ongoing delays.

Shaw does have a worthwhile business in keeping existing nuclear plants running ((it serves about one-third of the U.S. plants and companies like Exelon (NYSE:EXC) and American Electric Power (NYSE:AEP)), and new nuclear plants are getting permits. What's more, Shaw does have a presence in combined-cycle gas plants. But competitors like Fluor (NYSE:FLR) and Jacobs (NYSE:JEC) limit the upside to margins and returns, and uncertainty about financing and the regulatory environment is leading many utilities to drag their feet on building new plants.

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The Bottom Line
Shaw looks undervalued on both a long-term discounted cash flow model as well as on more conventional metrics like EBITDA/EV. This is a company with legitimate capabilities and a sizable maintenance/service component to its revenue. But this is also a company that is sensitive to political and regulatory developments that it cannot control, as well as the capital market's enthusiasm for underwriting large-scale power and infrastructure projects. I do believe there will be a point in the next few years where investors will look back at today's price as a bargain, but the road between those two points is not only rocky, but of an unknown length as well.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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