Description

Conrad Industries constructs, converts, and repairs marine vessels at four facilities on the US Gulf Coast.  The company builds Jones Act barges, tug boats, lift boats, crew/supply boats (for the offshore oil industry), ferry boats, etc.   Roughly 2/3 of revenues are derived from new construction and the remaining third from the repair business, which is higher margin.

                What makes this company interesting is that it earned $2.46 per share for the last twelve months (through Q3 2011) and I don’t believe earnings have peaked for this cycle.  With the stock at $15.00 per share this represents a P/E ratio of only 6, but the valuation is actually much cheaper than that due to a significant net cash position on the books.  As of September 30^th, Conrad had $24.2 million dollar of cash on the balance sheet, net of debt.  After backing out this $3.81 per share in net cash, Conrad trades for a P/E ratio of only 4.5 times.  Conrad is both growing and diversifying its business, and I believe gross profits and net income will continue to grow for as long as oil stays above $85 (due to their exposure to the Gulf of Mexico E&P business)

                I believe that net of cash and excess working capital, Conrad is currently trading for between 3-4 times earnings, and that management is aggressively buying back stock at this point.

                Before going any further, I should mention that the founding family controls 49.1% of the stock.  95 year-old J. Parker Conrad is the founder and co-Chairman of the board.  His son, John P. Conrad Jr. is 68 years old and is Co-Chairman, President, and CEO.  The stock is also illiquid, trading an average of only 6,500 shares (~$100k) per day.  Management has wisely initiated a 10b5-1 buyback plan in March of last year to increase the amount of stock they can buy back.  In the second and third quarter of 2011 the company repurchased 97,595 shares at an average price of $13 per share.  This represents an annual retirement of 3% of fully-diluted shares outstanding of 6.35 million.  I believe the company bought back shares at a quicker pace in Q4, as overall trading volume rose in the stock (they bought back 809,000 shares in 2008 or more than 11% of the outstanding, so I think they will accelerate purchases if they can).

                There are two key risks here as I see it:  the first is customer concentration, which has become less of a risk over time, and the second is the cyclical nature of the business itself. 

The company breaks out their revenue and profitability two ways: either into “repair” and “new construction” or by customer type (energy, government, and other commercial). 

CUSTOMER CONCENTRATION:

                Revenues have historically been concentrated by customer, but this is the nature of the business as a large portion of revenues for any given year can be a single vessel or order.  In 2010, 6% of revenues were from the US Army for a large crane barge and 14% were from another customer who bought five vessels.  The remainder was split between 186 smaller customers.  In 2009, 12% of revenues came from the US army for construction of a large crane barge and 12% from another customer for whom they constructed 7 vessels.  The remainder was split between 197 other customers.  In 2008 none of their 230 customers accounted for more than 10% of revenues. 

                I don’t think customer concentration is a concern here, despite the occasional high levels of concentration to a few customers.  The larger concern is exposure to government spending, which has accounted for between 6.5%-39.2% of revenue over the last five years.  I only go back to 2005 because that is when they completed their last major expansion (the completion of their deep-water dry dock in March 2005).  The percentage of revenue derived from government looks quite high, but I think the actual dollar amount suggests that this is a fairly reliable revenue stream, which is a higher percentage of the total when overall revenues are down.

                Revenues attributable to the government have been particularly strong in 2011, amounting to $35,646 in the first nine months of the year.  I do not expect this level of activity to continue, but I think that $20 million per year looks like a fair run-rate to expect going forward.  Considering that they are building things like ferry boats, tow-boats, barges and cranes to replace worn out equipment for a wide array of government customers (as opposed to discretionary weapons systems) I do not think a fall-off of government revenues is a big risk going forward. 

CYCLICALITY:   

                The energy industry (as defined as the Gulf of Mexico offshore oil and gas business) has been the largest and most cyclical customer for Conrad.  As a dollar amount, revenues from the energy segment have fluctuated a great deal in the last few years.  This is important not just for cyclicality of the overall business and the affect that has on gross margins for the new construction segment, but also because the energy business contributes disproportionately to the higher margin repair segment.  From the last 10-Q;

“Because a large percentage of our repair work is derived from the Gulf of Mexico oil and gas industry, conditions in that industry affect our repair segment.  We experienced lower gross profits in our repair segment in the first nine months of 2011, as a result of decreased customer activity in the Gulf of Mexico primarily as a result of the Deepwater Horizon incident.”

                This is very good news for Conrad, as it suggests that both revenues and gross margins have a lot of room to run in this cycle.  Note that revenue is split by segment either into repair/new construction or by source (gov’t, energy and other) so that there is overlap (and significant correlation) between the energy segment, the repair segment, and repair segment gross margin.  There is also a clear correlation to oil prices, although I believe the Deepwater Horizon incident in April 2010 has prevented a recovery in this segment.  I expect a rebound in 2012 and beyond, which should yield significant revenues and profitability for Conrad.

                Taking the average of the three years of high oil prices before the Deepwater Horizon disaster (2006, 2007, and 2008) gives average repair segment revenue of $64.1 million at an average gross margin of 25.8%.  The average gross profit for the repair segment during these years was $16.55 million dollars.  Annualizing the first nine months of 2011 suggests repair revenue of $47 million at a margin of 12% for a gross profit of only $5.65 million. 

Assuming a return to the previous level of gross profit and revenue for repairs would add $9.9 million to pre-tax profit and $6.3 million in incremental net income.  Because the level of non-energy revenue in the repairs and conversion segment has grown over time, one could argue that the incremental profitability will be even higher.  In 2005 the gross profit of the repairs segment was only $3.9 million, so we are starting at a higher base of revenue and gross profits today from non-energy sources.  Assuming $6 million in incremental annual net income would add $0.94 per share.  This does not include the effect increased energy spending would have on new construction revenues and margins.

There is a much higher level of non-government, non-energy revenue currently.  The majority of this other commercial revenue is for double-skinned tank barges (for hauling petroleum products) and other barges.  Gross margins in the construction segment are driven by volume. 

                So far in 2011, new construction revenue has been $148 million dollars, albeit with an outsized amount of government revenue at $35 million.  The gross margin for the new construction segment has only been 13% this year despite the higher volumes.  With the end of the Gulf drilling moratorium, I expect a significant amount of higher-margin new construction related to the energy segment (service, support and supply vessels).  Annualizing the last nine months of gross profit in this segment suggests $25.7 million in gross profit for 2011.  I expect a level of $25 million can be maintained due to the current backlog ($87.7 million at the end of Q3) and the expected gross margin expansion for the construction segment (only 13% so far in 2011). 

OTHER CONSIDERATIONS:

                In Q4 a customer defaulted on four large tank barges that were under construction.  As a result of provisions that allow them to recover the difference between the contract price and the actual selling price (they say market conditions are favorable to sell the vessels) they do not expect any material adverse financial effect from the default.  They have received progress payments along the way, so this should be no problem, but along with other timing differences has led to a buildup of unbilled costs and accounts receivable net of accounts payable.  This number stood at $31.1 million at the end of 2010 and had grown to $54.4 million at the end of Q3.  While some of this is likely attributable to the growth in the business over this timeframe, I expect a significant reversal in Q4 and the coming quarters.  I believe the Conrad will earn another $3.5 million in Q4 (the same as Q3) and that half of this amount tied up in working capital will revert to cash on the balance sheet (an additional $11.6 million).  This would put year-end cash, not including any Q4 buybacks, at roughly $41 million dollars.  (I think there will be a decent amount of stock bought back, but this is accretive at these levels).

                Assuming they end the year with $40 million in cash, the current enterprise value at $15.00 per share is only $60 million net of cash and debt.  Adding the aforementioned additional $6 million per year in incremental net income from the repair segment attributable to the energy business would take earnings for the foreseeable future (barring massive government spending cuts, a decline in bulk transport, or a permanent drop-off in Gulf of Mexico oil exploration) to $22.5 million per year ($6 million more than the annualized amount for the first nine months of 2011).  This suggests the business in trading for less than three times peak earnings.  This level of earnings might only last a few years, but after three years they will have more than paid for the business . . .

                I believe the shale boom should be a tailwind as there are a lot of natural gas liquids that need to be transported (The price of Ethane on the Gulf Coast is nearly double the price in the Eastern Pennsylvania Marcellus due to the lack of dedicated pipelines and demand in the northeast).  I couldn’t find exact figures, but railcar construction is also up, suggesting continued demand for barges for coal, fracking sand, aggregates etc.

                An anecdotal note on the operational abilities of management:

“During the second quarter of 2011 we were affected by rising water levels along the Mississippi and Atchafalaya Rivers. The primary adverse impact was the temporary suspension of operations at our Morgan City shipyard which is located on the Atchafalaya River outside the protection of the levee system. In order to minimize the impact of the imminent flooding and decrease the amount of down time, we constructed our own levee system to protect our Morgan City shipyard. This resulted in no property and equipment damage and also allowed us to return to full operation with minimal clean-up, months sooner than otherwise. We relocated all of our production and support personnel and many of our projects to our other shipyards and continued operations at a minimally reduced level for approximately forty-five days. We resumed limited operations at our Morgan City shipyard during middle of June and were fully operational at this yard by July. All of our other yards remained fully operational. Due to the efforts of our people to plan for protection and move projects to other facilities, there
was only a minimal impact on our profitability and no material adverse effect on our Company. Additionally, we were able to keep our people working and we were able to meet the delivery deadlines committed to customers.”

                Conrad trades on the pink sheets and is technically a non-filing company, but they put out 10-Qs and 10-Ks with a very good degree of disclosure, although they are not exactly standardized.  These can be found on their website.  Other obvious risks are that management does something stupid with the money; however they are huge shareholders and have shown good capital discipline thus far.   

From the Q3 10-Q;

“In July 2011, we entered into a contract to purchase 50 acres of property adjoining our Conrad Deepwater facility for approximately $5.5 million which is subject to customary closing conditions. The board has indicated to management their desire to be prudent and if conditions are not favorable to postpone the less important expenditures.”

“Management is currently engaged in a detailed business planning process to identify potential uses of the Company’s cash.”

The business is of course cyclical and they lost money in 2003 and 2004.  Gulf of Mexico activity might take another year or two to ramp up, and there is no guarantee that oil prices will stay high over that time, but there will be a continued need for new service and supply vessels regardless.  Some oversees operators prefer to buy Jones Act (US) vessels so that they can use them here if they choose to.  I think the current valuation and presence of a share buyback more than compensate for this uncertainty.

Catalyst:  Q4 earnings at the end of March will show profitability for the year of $16-18 million dollars, and may show a much larger cash balance as well as a faster pace of share buybacks. 

Risks: Management could make a large acquisition or expansion, although these have worked out well in the past and we are early in the cycle for the energy segment.

Catalyst