Técnicas Reunidas

(Long-dated OOM calls + subscription rights)

I’m an energy bull, particularly with respect to the good old fossil energy sources. That said, I don’t have the slightest idea how oil, gas, coal, etc. will trade over the next months or even few years, and I’m not going to pretend that I know. I don’t follow and don’t care much about inventory levels, draws / builds, DUC movements, OPEC meetings, new mines, the latest China news, etc (*). It’s simply way over my head, and the opportunity cost is too large for me; there are too many interesting companies I can study out here that will provide me with enough of an edge if I do the work.

Nonetheless, I’m bullish energy, and I’m pretty confident that prices have a bigger chance of increasing than decreasing over the medium term. My confidence is a reflection of what I’ve been seeing all around me over the years. During my career, I worked with some very large global financiers of fossil energy projects (mainly oil & gas) that have now completely pulled out of the sector, mostly because of ESG. I have no opinion on ESG (**), but I follow big trends in markets. And MANY financiers have pulled money from the sector over the past years, at an accelerating pace.

This fact, combined with an overall rough decade for many commodities (until recently), has led to very low investments in the space. Meanwhile, demand-related estimates for the next decade continue to be revised upwards. Where is supply coming from, if nobody is willing to invest? I suspect the solution is, as often, higher prices.

In addition to these secular supply-demand imbalances is the push from governments towards lower carbon emission energy sources. I will not comment here on the strategic sense of certain decisions, but whatever we might think of the plans, we can be pretty sure they are here to stay and that the budgets being freed for investment purposes are huge. This trend was particularly strong in Europe already before the Ukraine war and its momentum has only increased since, as Europe suddenly woke up to their reliance on Russian gas. Now Europe has its foot slammed on the pedal as it’s pursuing to secure its energy supply and decarbonize at the same time, all with an almost religious fervor.

The bottom line of this long introduction is that I believe that we are just at the beginning of a long investment super cycle in the energy space. Now, there are many ways to express a view on energy, but I want to be exposed to this overarching investment cycle theme taking into account that 1. I want a broad product exposure (natural gas, petrochemicals, low carbon tech, etc.), 2. I have no clue about timing, and 3. I could be wrong, big time.

This brings me to engineering, procurement and construction (EPC) firms. As the name suggests, EPC companies deliver a complete package of resources to complete infrastructure projects. They are typically a single source for designing and executing large projects in the energy space, such as LNG plants and refineries. These are massive, complicated projects, often in remote places, involving thousands of engineers and construction workers.

As a consequence of the inherent nature of their business, EPC companies are generally tough investments and their earnings dynamic can make most businesses look like utilities. Projects take years to complete, meanwhile (raw) material prices can fluctuate wildly, the many workers in remote locations are difficult to manage, and exposure to cyclical end-markets is always a risk. EPC firms constantly face cost overruns, delays, disputes with clients, as well as geopolitical and regulatory risks. Add to that the highly competitive landscape, with numerous global and regional players vying for contracts. Margins are thin, and extremely so in downturns. In short, one single bad project could kill you.

Needless to say I’ve generally avoided the EPC space like the plague. Indeed, the past decade has been tough for the sector, particularly since the collapse of oil prices almost a decade ago, and many shareholders in EPC companies suffered, a lot.

Técnicas Reunidas, a Spanish EPC company (market cap of ~€480m), was no different. The company entered the sector crisis with a relatively strong balance sheet, which allowed it to survive the challenging period without going bust and even without diluting its shareholders – an impressive feat compared to many peers.

However, while able to survive, the company’s balance sheet greatly deteriorated. Combined with a bad outlook, the impact from covid and inflationary pressures, the share price collapsed and has not recovered since. Indeed, despite many peers having balance sheets in a much more precarious state, many restructured and are now actually in a better shape, sporting higher valuations as a consequence.

That said, as mentioned, the stars seem to be once again aligning for the company and the sector. After a prolonged period of low prices and reduced investments, the oil and gas sector is witnessing a gradual recovery, with investments picking up in both upstream and downstream projects. And as the world moves towards decarbonizing, the focus on low(er) carbon energy sources is increasing. All this is driving demand for EPC services.

Técnicas Reunidas’ management is bullish, putting it mildly:

…we have left back such [a difficult] scenario and we are seeing a quick reactivation of bidding activity. In fact, in just two months [in 2023] we have secured major awards that are an example of the positive commercial trends. But this is the tip of the iceberg. Our pipeline of projects keeps growing and getting closer to the bidding stage. We have little doubt about what lies ahead: a multiyear investment super-cycle in the energy sector, in both the traditional and the low carbon sector…The market is giving us the opportunity to grow and we will.

This confidence is starting to show in results, with c. €1.5bn awards to-date in 2023, practically the same level of awards reached over the first half of 2022. Sales growth seems to have inflected and is now accelerating.

The company has a healthy backlog and is experiencing strong order growth. Its project pipeline is at an all-time high (roughly €70bn), with roughly two-thirds of these projects expected to be awarded in 2023; 2023 and 2024 promise to be very solid so far. Of the big pipeline, the group is focusing on projects worth €22bn and aims to win around €8.5bn.

The accelerating activity combined with efficiency measures implemented over the past few years has led to a relatively strong guidance for this year: €4bn revenues and an ebit margin of 4%, implying a level of operating profit not achieved since almost a decade.

While the fundamentals are clearly moving in the right direction, this improvement is not company specific and is visible throughout (almost) the entire sector. Since Técnicas Reunidas is one of many listed EPC players, why am I looking at this one, given that its clearly not the best out there? There are a few reasons.

First of all, Técnicas Reunidas has long-term options, out to 2027.

Keep in mind the three points I mentioned earlier. Anything can happen in this sector and I could be way off. Losing the entire position is not an unimaginable possibility if the market turns south again. Hence, to counter that, and of course to play the possibility that I might be right, I want multi-bagger upside. Operating leverage works both ways; the company’s outlook for 2023 is good and is definitely a sign of the much improved bidding activity. However, the targeted 4% ebit margin is ‘ok’, and mainly reflects contracts signed in less favorable conditions. Should we indeed enter a multi-year super cycle, pricing will gradually improve. In such a case, I expect margins to exceed the 6% achieved in 2008-2012, particularly as the company’s cost base is now more efficient. A 6% margin on, let’s say, €4.5bn revenues is €270m ebit looking out a few years – an amount never achieved by the company. Keep in mind that cyclical markets can move rapidly, while most sell-side analysts think linearly.

Another reason I’ve been looking at Técnicas Reunidas is that despite being able to survive without diluting shareholders, the balance sheet drastically deteriorated. Note that ECP companies have wildly swinging working capital positions, and most liquidity is tied to working capital. Working capital deficits need to be added to the net debt position, and companies need to have plenty of room to absorb any setbacks and to invest should markets (quickly) recover.

Técnicas Reunidas does not have the necessary flexibility and is definitely ripe for a restructuring / equity raise, which was a big reason why the valuation was much lower compared to the average of its peer group. Indeed, the 2021 AGM already hinted at this possibility with the approval granted to raise capital. And as we have seen over the past few days, the company is now seeking to raise €150m (24.4m shares at €6.15/share, or a whopping ~44% of shares outstanding). You can find more details on the proposed capital increase here.

Given the already depressed valuation and the need for a lot of equity, I was hoping the massive dilution would smack the share price down to even more attractive levels (relative to the dilution). Also, the 2021 AGM proposal stated the possibility of a capital raise with pre-emptive subscription rights, potential creating an additional interesting event-driven opportunity.

The rights are trading separately as of today and I’m keeping an eye out. These things tend to get smacked around every now and then, which could create a good entry point into the shares.

The bottom line of all this is: there aren’t many EPC companies with options outstanding out almost five years, basically spanning my uncertainty period and providing enough of a cushion should my timing be off. The thesis could not play out, but far out of the money calls provide plenty of upside leverage should we indeed embark in a prolonged investment super cycle. In such a case, earnings will continue to rise, along with the company’s valuation. Reaching the pre-2015 share price (adjusted for recent dilution) is possible just based on achieving the current guidance and maintaining it over a few years, implying 10-15x upside. However, I would expect more as a new investment super cycle would push Técnicas Reunidas’ earnings generation to record highs over an extended period. Energy security, decarbonization and simply meeting growing demand are going to be major driving forces over the next years.

As always, this is not advice. Always do your own due diligence.

* Not true. I do care and follow.

** Also not true. I have a strong opinion on ESG, which you can find in some very early posts.