Thursday, August 03, 2006

Halliburton Corp: Windfall of War

"In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military industrial complex. The potential for the disastrous rise of misplaced power exists and will persist."

First described on January 17, 1961, former President Dwight D. Eisenhower warned of the irresponsible power of the military-industrial complex in his Farewell Address to the Nation.

Historians consistently rank Eisenhower among our top 10 presidents—and we “Like Ike, too!” The prescience in Eisenhower’s warning could not be better articulated than looking at Halliburton Company’s (HAL-$33.72) 2Q:06 filing with the SEC last week.

Oil services giant Halliburton is making money on more than drill bits and cement. Halliburton is the largest private contractor in Iraq. The Company’s Government and Infrastructure segment provides support services to military and civilian branches of governments throughout the world. The Government and Infrastructure segment's most significant contract [surprise!] is the worldwide United States Army logistics contract, known as LogCAP (Logistics Civil Augmentation Program).

Additionally, the Company is helping to rebuild the oilfields in Southern Iraq, with contracts like PCO Oil South (Project and Contracting Office, a Defense Department agency brought in to oversee the “RIO-2” construction after allegations of
“significant deficiencies” in Halliburton’s cost-estimating systems for prior billed work).

[Ed. note. The LogCap contract to provide support to our troops is the most recent of three mega-contracts awarded to the Company. First, there was the original $2.4 billion “Restore Iraqi Oil” (RIO) contract, which the Company received in secret without competitive bidding in March 2003; followed by the $1.2 billion RIO-2 contract, which was awarded to the Company, in January 2004, to continue with the restoration and servicing of the oilfields in Southern Iraq.

In his July 1970, chart-topping Vietnam War protest song, “War,” Edwin Starr wrote: "War! What is it good for? Absolutely nothing….”

Sadly, war is good for profits. From the rebuilding of the Balkans in the mid-1990s to the Middle East today, war has been good for Halliburton. For the first six months of FY 2006, Iraq-related work contributed approximately 22.4%, or $2.4 billion to consolidated revenue of $10.7 billion and $74 million to consolidated operating income of $1.47 billion.

Top-line contributions from the United States Government, resulting primarily from work performed in the Middle East, represented approximately 31%, or $6.5 billion, of consolidated revenue of approximately $21.0 billion in FY 2005. Iraq-related income totaled $175 million, primarily due to income from the award fees on definitive LogCAP task orders, settlement of ‘Dining Facility’ Contract (DFAC) problems, and other issues.

[Ed. note. In an earlier draft of his Farewell Address, President Eisenhower had originally called the cozy, cooperative relationship between defense contractors and the Government, the “military-industrial-congressional-complex”. Readers ought to take note that we have made it almost through this posting without mentioning Vice-President
Cheney, Halliburton , and White-House secret deals, in the same paragraph.]

Investment Analysis.

Albeit doubtful that Halliburton will be found in the portfolio of any “socially responsible” mutual fund (such as Domini Social Investments), the 10Q Detective believes that the stock holds investment merit at its current price:

  • The stock is off 19.7% from its (split-adjusted) 52-week high of $42.00 per share (April 20, 2006), as investors looked in the rear-view mirror at decreasing Government and Infrastructure backlog(s) in Iraq-related work and the material impact on future revenue when (speculation became fact) the U.S. Army announced that it would rebid the LogCAP III contract for logistical support that the Company’s Kellogg-Brown & Root division (KBR) previously provided in Iraq. However, KBR is eligible to bid on the future work, as the Army has determined it wants multiple service providers to perform the work.
  • Of interest, Halliburton has announced its intention to completely separate KBR, Inc. from Halliburton as expeditiously as possible through a tax-free dividend distribution of KBR, Inc. stock to Halliburton stockholders. Winnowing KBR from the Company will mitigate the risk of being too dependent on WAR for profits and—we believe--will also help to unlock the true value of the Energy Services and related-products units.
  • In our view, too, political unrest the world over, from Nigeria to the Middle East, will drive gas and oil prices much higher in coming months—look for of light, sweet crude oil futures to top $80 a barrel in the coming weeks. The demand for oil services and drilling industries (in other global locations) are in the beginning stages of a renewed, sustainable business upturn.

    During the first half of 2006, the Energy Services Group segment produced revenue of $6.1 billion and operating income of $1.5 billion, reflecting an operating margin of 25.1%. Revenue increased $1.4 billion or 30% over the prior year period, primarily driven by higher drilling activity in North America, the Middle East, the North Sea, and Russia.
  • In our opinion, the KBR – Iraqi issues are already reflected in the price, for the Common Stock currently trades at only 13.2 times its FY 2007 consensus estimates of $2.56 per share (which is well-below its average monthly, five-year P/E multiple of 23.84).
  • Foreign Corrupt Practices Act investigations, KBR bidding practices investigations, and allegations of misdoings in Iran —if investors can stomach the stench—there is the potential for a profitable trade in the Common Stock of Halliburton.

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