Jacobs Solutions' Portfolio Transformation Should Lead to More Stable Returns

Equity Analyst

Krzysztof Smalec

Under the leadership of former CEO Steve Demetriou, Jacobs transformed its portfolio to increase recurring revenue and reduce cyclicality. In 2017, Jacobs acquired CH2M for $3.3 billion to bolster its presence in the transportation, water, nuclear, and environmental services end markets. In April 2019, Jacobs completed the sale of its energy, chemicals, and resources, or ECR, business to WorleyParsons for $3.3 billion. Jacobs operates four business segments: critical mission solutions, people & places solutions, divergent solutions, and PA Consulting.

We view Jacobs’ portfolio transformation favorably. As the ECR segment had high exposure to volatile oil and gas prices, and its operating margins have long lagged those of the firm's other segments, we think the divestment will lower the risk and boost the margins of Jacobs’ portfolio. Furthermore, we like the strategic fit of the CH2M acquisition, as the deal has bolstered the firm's nuclear business, allowing it to become a Tier 1 nuclear services provider, and increased Jacobs' exposure to end markets that we think will benefit from favorable long-term trends, including water and transportation.

In the long-run, we believe the company is poised to capitalize on multiple favorable secular drivers, including infrastructure modernization, space exploration, intelligence analytics, energy transition, supply chain investments (particularly in the semiconductor and life sciences end markets), and the 5G buildout. We also think Jacobs is well-positioned to benefit from the $1.2 trillion infrastructure bill in the U.S., given the firm’s strong position in areas such as water and transportation infrastructure.

In May 2022 Jacobs announced plans to spin off the critical mission solutions business in the second half of fiscal 2024. We believe that critical mission solutions has the potential to build an economic moat based primarily on switching costs. Around 85% of the segment’s portfolio comprises contracts with durations of over four years, giving it significant revenue visibility.

Business Strategy & Outlook

We assign Jacobs a no-moat rating. We believe that most engineering & construction (E&C) firms lack moats as intense competition, significant customer power, and the relatively standardized nature of most projects hamper economic moat creation. Furthermore, E&C firms have to contend with high cyclicality and event risk, such as legal disputes and cost overruns (which could be caused by a number of factors including labor shortages, subcontractor performance, and inclement weather). As a result of a fragmented industry structure, high historical volatility, and the potential for large losses on individual projects, it is difficult for E&C firms to maintain consistently attractive returns on invested capital throughout the economic cycle.

Although we think that most E&C firms derive the bulk of their revenue from no-moat activities, we acknowledge that the potential for moat creation exists within certain niche sectors. For instance, Jacobs’ critical mission solutions segment has the potential to forge a moat based on customer switching costs and intangible assets. Critical mission solutions has a portfolio of long-term contracts (typically 3-10 years) to perform mission-critical services to government agencies, such as operating the Missile Defense Integration and Operations Center for the Missile Defense Agency, operating and managing the Nevada National Security Site for the U.S. Department of Energy, and providing IT services and infrastructure support on several projects for NASA. Roughly 95% of the segment’s revenue is recurring, and the unit boasts an impressive rebid win rate of over 94% that we think could become the foundation for an economic moat in the segment.

We view the people & places solutions segment as inherently less conducive to forming economic moats. Jacobs has a strong reputation and track record, having been involved in numerous signature projects, such as California WaterFix, restoration of the Palace of Westminster, and the LaGuardia Airport expansion. However, we think that fierce competition, the prevalence of projects with standardized specifications, and lack of customer switching costs will make it difficult for the people & places solutions segment to consistently outearn its cost of capital. 

Despite some moat creation potential in certain niches, we view most of the design and construction work that E&C firms engage in as relatively routine. Industry cyclicality has historically driven relatively volatile returns on invested capital, and we do not expect that to change. We forecast Jacobs to earn average returns on invested capital roughly in line with its cost of capital throughout the business cycle. As a result, we believe that Jacobs lacks an economic moat.

None

Economic Moat

Jacobs Solutions Inc

Jacobs Solutions, Inc. is a holding company, which engages in the designing and deployment of technology-centric solutions. It operates through the following business segments: Critical Mission Solutions, People and Places Solutions, and PA Consulting. The Critical Mission Solutions segment offer broad sectors, including U.S. government services, cyber, nuclear, commercial, and international sectors. The People and Places Solutions segment provides end-to-end solutions under the climate change, energy transition, connected mobility, integrated water management, smart cities, and vaccine manufacturing industries. The PA Consulting segment includes the investment in PA Consulting Group. The company was founded in 1947 and is headquartered in Dallas, TX.

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Jacobs Engineering Group Inc.'s (NYSE:J ) Q2 2023 Earnings Conference Call May 9, 2023 10:00 AM ET Company Participants Jonathan Evans - Vice President of Corporate Development & Investor Relations Robert Pragada - Chief Operating Officer Kevin Berryman - Chief Financial Officer Conference Call Participants Jamie Cook - Credit Suisse Andy Kaplowitz - Citigroup Michael Dudas - Vertical Research Partners Sean Eastman - KeyBanc Capital Markets Bert Subin - Stifel Financial Corp. Steven Fisher - UBS Chad Dillard - Bernstein Michael Feniger - Bank of America Gautam Khanna - Cowen Andrew Whitman - Robert W. Baird Operator Good morning ladies and gentlemen and welcome to the Jacobs Solutions Second Quarter 2023 Earnings Call and Webcast.

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Operating Profit up 74% Year-Over-Year, Adjusted Operating Profit up 7%1 People and Places Solutions Operating Profit up 21% Year-Over-Year Second Quarter Revenue up 6% Year-Over-Year; 9% in Constant Currency1 Narrows Fiscal 2023 Outlook Range; Reiterates 100% Cash Flow Conversion Target Announced Plans for Spin-off of Critical Mission Solutions Business DALLAS , May 9, 2023 /PRNewswire/ -- Jacobs Solutions Inc. (NYSE: J) today announced its financial results for the fiscal second quarter ended March 31, 2023. Q2 2023 Highlights: Revenue of $4.1 billion up 6.4% y/y; net revenue1 increased 5.2% y/y and up 8% in constant currency1 Backlog1 of $29.0 billion, up 4% y/y; gross margin in backlog up y/y EPS of $1.70, up 149% y/y; Adjusted EPS from continuing operations1 of $1.81, up 5% y/y Cash provided by operations of $132 million; continue to expect 100% fiscal year underlying cash conversion Jacobs' CEO Bob Pragada commented, "We have delivered a robust second quarter focused on disciplined and rigorous execution.

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