There’s lots of talk these days about infrastructure, which always sends up a warning signal in our contrarian brains. Investors’ confidence seems to be growing in the engineering and construction industry. The Revere Infrastructure Construction index gained 4.6% on Thursday.
So is this an infrastructure bubble? One of our ways of measuring whether a buble is being created is to look for political influence. President elect Barack Obama’s promises to build America out of a recession certainly qualifies, which is one reason we’re cautiously expecting infrastructure stocks to run up and then plummet.
Andrew Mickey, who writes at StockHouse, thinks that infrastructure stocks are going to break a lot of hearts. The problem, as he sees it, is two-fold:
- Profit margins from public construction programs are poor to non-existent.
- Most construction is done by privately held companies, limiting the investment opportunity.
- The Obama infrastructure boom is likely to be short lived.
Mickey also notes that legendary short seller Jim Chanos is shorting infrastructure stocks these days.
Here’s a glimpse at Mickey’s analysis (to read the whole thing, click here):
I have absolutely no confidence this run in infrastructure stocks can last. In fact, I expect it to end abruptly in the coming weeks and months once reality sets in.
You see, the herd is once again acting irrational. The government funded build-out of U.S. infrastructure is a short-term trend that will not last indefinitely for many reasons.
First of all, states, which normally fund the majority of infrastructure projects, are in terrible financial shape. Sen. Olympia Snowe, “With 41 states experiencing budget shortfalls and unable to make the kind of commitment they traditionally make to infrastructure projects, the federal government must take steps to restore America’s world-class infrastructure.”
Will a practically bankrupt U.S. government be able to build its way out of this hole?
Secondly, the profit margins for these projects are going to be poor at best. It all comes down to supply and demand. And even a two-year, $60 billion boost in demand isn’t enough to tip the scales in the favour of builders. As a result, bidding wars will practically eliminate any profits to be had from these projects. It’s already started to happen.
California contractors are battling it out for work. California Builder and Engineer magazine states, “[There is] a rush by contractors to the public works bids. Caltrans (California’s transportation department), now gets up to 20-plus bidders on projects, where a year ago, the state would be hard pressed to find enough qualified bidders at all.”
It’s happening in New Jersey too. NJ Biz reports, “Competition among [construction] companies has reached a fever pitch, with some firms submitting bids that only cover project costs, Price said. A $10 million highway project might receive up to 20 bids, whereas in better times, such a job would get about eight proposals.”
Only cover project costs!?! That means firms are desperate and are willing to sacrifice any profit just to stay in business. That only happens when supply is far outstripping demand.
Now, a surge in demand could overwhelm the supply of contractors ready and able to take on the additional workload. Yes, it’s a long shot, but it could. Even if it does though, it won’t last long. Eldon Morrison, president of CPM Constructors in Freeport, Maine, says, “We could double the size of our company. We could expand very quickly and put a lot of people to work.”
Finally (and what should be most important to investors) is the majority of the construction industry is private. According to FMI, a construction industry consulting firm, only 9.6% of American construction firms are publicly traded. The rest are private companies which don’t trade on any stock exchanges.
When you break the numbers down, you can really see how little benefit the publicly traded construction companies will get from the stimulus package. If 90% of $60 billion in infrastructure spending goes to private companies, only $6 billion worth of contracts will be available to the publicly-traded ones. That’s not going to amount to much when there are 20 bidders for every project and the heavy construction industry’s net profit of about 4.5% gets squeezed even more