KBR’s Portfolio Transformation Should Lead to a Higher-Margin and Lower-Risk Business Profile

Equity Analyst

Krzysztof Smalec

Under the leadership of CEO Stuart Bradie, who took the helm in 2014, KBR has focused on shifting its portfolio toward differentiated government solutions. The portfolio rebalancing, which included the acquisitions of Wyle and HTSI in 2016, SGT in 2018, and Centauri in 2020, has already started to bear fruit and led to improved results in recent quarters. In 2020, KBR restructured its portfolio into two segments: government solutions and sustainable technology solutions.

The government solutions segment accounted for roughly 74% of the firm’s backlog as of December 2022 (compared with only about 16% as of December 2014), and we expect the shift to long-term government contracts to result in a more stable portfolio. In our view, the segment has some moat-forming potential based on switching costs, as many of the firm’s government contracts are multiyear agreements that generate relatively stable cash flows.

The sustainable technology solutions segment (roughly 26% of KBR's backlog as of December 2022) includes the legacy technology solutions business (which has a unique portfolio of licensed technologies and offers consulting services across a variety of markets, including refining, petrochemicals) as well as the advisory consulting business from the legacy energy solutions segment. Management believes the segment can expand its margins through cost reductions by roughly 100-200 basis points per year, to the high teens by 2024.

KBR’s portfolio transformation is the culmination of the firm’s shift away from more cyclical and lower-margin end markets. The company has exited lump-sum engineering, procurement, and construction (including LNG) projects, which we believe will result in a less risky and more profitable portfolio.

Business Strategy & Outlook

We assign KBR a no-moat rating. The company has transformed its portfolio by shifting away from more cyclical and lower-margin end markets (including lump-sum engineering, procurement, and construction projects), which we expect to lead to more stable results. Nonetheless, although we see some moat-forming potential in certain areas of the business from a qualitative perspective, we forecast KBR to earn average returns on invested capital, roughly in line with its cost of capital throughout the business cycle. As a result, we believe KBR lacks an economic moat.

KBR is a leader in the LNG and fertilizer industries, having been involved in the design and construction of roughly a third of the global LNG production and roughly a third of the world’s ammonia plants. KBR’s unique portfolio of technologies and track record of completing large, complex projects are meaningful intangible assets that could help the company forge an economic moat in certain niches.

Additionally, there are switching costs in parts of its business, including government services and maintenance, where long-term contracts generate a relatively stable cash flow. For instance, KBR was awarded an 18-year privatized financing initiative contract with the U.K. Ministry of Defense for the acquisition and maintenance of 38 new aircraft. The company also has strong relationships with government agencies in the U.S., such as NASA, with which KBR has had a contract since the beginning of the space program.

However, despite this niche potential, KBR has to contend with high cyclicality, significant customer power, as well as 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. These factors have historically made it difficult for KBR to maintain consistently attractive returns on invested capital throughout the economic cycle, and we do not expect that to change over our explicit forecast horizon.

None

Economic Moat

KBR, Inc. engages in the provision of differentiated professional services and technologies across the asset and program life-cycle within the government services and hydrocarbons industries. It operates through the following segments: Government Solutions, Technology Solutions, Energy Solutions, Non-strategic Business, and Other. The Government Solutions segment provides full life-cycle support solutions to defense, space, aviation, and other programs and missions for military and other government agencies. The Technology Solutions segment combines KBR's proprietary technologies, equipment, and catalyst supply and associated knowledge-based services into a global business for refining, petrochemicals, inorganic, and specialty chemicals as well as gasification, syngas, ammonia, nitric acid, and fertilizers. The Energy Solutions segment provides full life-cycle support solutions across the upstream, midstream and downstream hydrocarbons markets. The Non-strategic Business segment represents the operations or activities which the company intends to exit upon completion of existing contracts. The Other segment includes corporate expenses and general and administrative expenses not allocated to the business segments above. The company was founded on March 21, 2006 and is headquartered in Houston, TX.

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