Description

Investment Overview: Conrad Industries is a classic "Magic Formula" small/micro cap stock (moderately high ROIC and attractive earnings yield), that I believe is selling below intrinsic value with upside of ~25%-30% with a free call option on a legal claim and has a reasonable margin of safety. The Company has: a 16% ROIC, rich cash flow business model, rock solid balance sheet (with cash constituting ~ 22% of the share price), a couple of tailwinds aiding growth prospects and a shareholder friendly management team that has proven to be a good allocator of capital. While the share price has outperformed the recent market rally in the last 12-18 months, the shares are still selling at an attractive valuation on a number of measures: including a EV/EBITDA multiple of 4x, a FCF/EV yield of 17% and a cash adjusted P/E of 6.4x, all on ttm results. While I believe that Conrad will continue to experience healthy growth during the next 18-24 months, at current share prices investors are not paying for this growth. I believe the shares are selling about 20%-25% below intrinsic value of $45-$48 per share, representing potential appreciation of 25%-35%.

Company Profile: Conrad Industries, established in 1948 and headquartered in Morgan City, Louisiana, designs, builds and overhauls tugboats, ferries, liftboats, barges, offshore supply vessels and other steel and aluminum products for the oil & gas, commercial and government markets. The company provides both repair and new construction services at its five shipyards located in southern Louisiana and Texas. The marine vessels the Company builds and repair, are used primarily in the domestic inland waterways or the intracoastal waters of the Gulf of Mexico.

Statistics:

Symbol: CNRD

Date: 12/23/13

Price: $36.25

Avg. Daily Volume: 6,120 shs.

Market Cap: $216M

Net Cash/(per share): $47M ($7.88)

Enterprise Value: $169M

TTM Revenues: $277.2M

TTM EBITDA: $42.2M

TTM FCF: $28.6M

TTM EPS: $4.43

Key Investment Points: The following points underscore my opinion as to why the share price is attractive and selling below intrinsic value:

A Good & Sustainable Business: Conrad has a ~65 year history of operations and has grown from a single shipyard to five locations through a combination of internal growth/expansion and acquisitions. During the last decade the Company has invested heavily and successfully diversified its business to build/repair a broader range of vessels and service a more diversified range of customers. Historically, Conrad primary served customers in the oil & gas industry in the Gulf of Mexico. In the 2003/04 time frame the company embarked on an effort to both expand its capacity and diversify its business to new customers. Unfortunately this diversification effort came at a bad time when industry growth slowed significantly during this time. This resulted in the company recording meaningful losses during this period. However, the end result of these efforts has been to transform Conrad into a more diversified company with a broader and well balanced customer base. The importance here is that these different customers not only provide more growth opportunities, but they remove some of the volatility of the company's financial results during an industry downturn in a particular sector. This was clearly evident during the recent 2008/09 downturn, helping the company remain profitable and able to generate a healthy amount of cash flow. Conrad’s recent diversification efforts in the last few years to target the inland waterways market and commercial customers has been a major catalyst to the Company’s growth.   

While the business is somewhat cyclical and impacted by general economic conditions in the region as well as business conditions in the oil & gas markets. The Company competes with a handful of medium sized shipyards in the region and has "Jones Act" protection from foreign manufacturers. Conrad has a history of healthy growth and conservative management. The Company has an attractive financial model, with ROIC of ~15%-20%, ROE of 20%, and healthy FCF generation.

Industry Tailwinds Driving Growth: While general economic conditions influence demand for the Company's products and services, there are two significant tailwinds that are driving near-term growth. Conrad is a prime beneficiary of the on-going oil & gas boom in the Midwest and the transportation of product inland via barges. An aging US inland barge fleet (some reports indicate the average age is +20 years) is driving a major industry wide cap-x cycle focused on retiring old vessels and upgrading the fleet to new double hulled and larger capacity barges. The research I have done suggests that this factor should continue to be a favorable catalyst to demand over at least the next 12-18 months. Noteworthy in this regard are the comments from senior executives of Kirby Corp (KEX), a leading provider of marine transport services for the inland and coastal markets which appear to support this viewpoint:

Joseph Pyne - Chairman, President and Chief Executive Officer: “The marine business is a cyclical business. I've been in it over 35 years and I am seeing not a number of cycles, but several cycles. What we're seeing today is different and it's different because, for about 30 of those years, we were essentially in a very slow growth business, business that would grow at about GDP and maybe a little less GDP. With the energy renaissance in the U.S. and the need to move crude oil, gas condensate and the significant improved compatibility of the chemical business on a global basis, you have demand that frankly I don't think that we've seen in this business, the 30 plus years. So your typical cyclicality trends are going to be different here because you've got volumes that are actually growing. Now, with respect to which inning you're in, I think that you could make a pretty good argument that you're at the beginning innings in the coastal business. And maybe a little further along on the inland business, the only qualifier I'd put there is that on the coastal side, you're really not building much equipment, on the inland side you are adding capacity, and that capacity is being absorbed, is being absorbed as we speak.”

Gregory Binion - President, Marine Transportation Group: “In terms of announced construction….. even, if we were to start tomorrow, you're talking almost two years, before you get delivery of a unit. So we've got some legs yet to go on this.”

The second tailwind that the Company is benefiting from has been the recent resurgence in business from oil & gas customers (primary for higher margin repair work). This appears to be correlated with to the easing of drilling permit restriction in the Gulf of Mexico following the BP Deepwater Horizon oil spill in April 2010. Following the accident, permitting for new deep water exploration was curtailed until October 2010, when new safeguards & restrictions were adopted. Data from the US Bureau of Safety Environmental Enforcement (which was formally established on October 2011 as part of a major reorganization of the Department of the Interior's offshore regulatory structure), show the number of revised new deepwater (>500 feet) exploration permits in The Gulf of Mexico were 3, 127, 283 & 319 in the years 2010, 2011, 2012 & 2013 (ytd). The report can be accessed thru the following link:

http://www.bsee.gov/Exploration-and-Production/Permits/Status-of-Gulf-of-Mexico-Well-Permits/

In addition, data from the Baker Hughes Offshore Rig Count Report shows the increase in exploration activity in the Gulf of Mexico. For the full year to date, the average number of offshore rigs is up about 18% on a year over year basis. The following is a link to the report/chart:

http://gis.bakerhughesdirect.com/Reports/YearToYearCompChart.aspx?chrtName=rigOffshoreChrt

The impact of this increase in oil & gas exploration in the Gulf of Mexico has had a favorable impact on Conrad’s revenues from this segment of customers, which until recently had been the Company’s major source of sales. Revenues from oil & gas customers, which had dropped to ~5% of revenues in 2011/12, now constitute ~25%-30% of revenues during 2013. These customers tend to have a disproportional impact on the Company’s repair business, which tends to have higher margins than it’s new construction business.

As a result of these favorable tailwinds to demand, Conrad has seen a significant increase in its order backlog, which as of the latest report, is up ~50% y/y and now stands at record levels. In addition to continued improvement in the domestic economy, another potential driver of future demand would be rule changes to allow barge transportation of fracking waste, which the U.S. Coast Guard is currently proposing.

New Additions To Capacity Coming On-line: Over the last 24 months the Company has invested a significant amount of its FCF back into the business in the form of growth cap-ex to both expand its capacity, broaden its manufacturing & repair capabilities and increase its efficiency. In the 10 years prior to 2012, cap-ex averaged about $4.5M per year (combination of maintenance & growth related). However, in 2012 the company re-invested over $15M in cap-ex and this year the amount should be ~$20M. Highlighting the investments the Company has been making during the last 24 months, cap-ex has been running in excess of 4x D&A over this period. In addition to equipment purchases, refurbishments and enlarging its dry-docks, as well as building an indoor construction facility, the company purchased a new parcel of land adjacent to one of its facilities and constructed its fifth shipyard. While this new facility will add to Conrad’s revenue generating capabilities, it will enable the Company to construct and repair bigger vessels and expand its business to new markets/customers. This capacity has just begun to come on-line in 2H of this year, which should help Conrad turn its growing backlog more rapidly into revenues. While management has not discussed its cap-ex plans for 2014, I suspect they will return to more normalized levels, favorably impacting FCF generation.

Cash Rich Balance Sheet: Given the combination of a conservative management team coupled with the Company's healthy FCF generation, Conrad has a rock solid balance sheet rich in cash with minimal debt. Despite the re-investments made in growth cap-ex over the past two years, along with the payment of a special dividend and some share repurchases, the Company's net cash position has about doubled in the last 24 months. At the end of the September quarter net cash had grown to $9.88 per share; representing ~28% of the current share price. Following the payment of a $2.00 per share special dividend on December 17^th, the net cash position has declined slightly to $7.88 (excluding potential FCF generation during Q4), or ~22% of the share price.

In addition to a rock solid net cash position, I believe that Conrad’s book value could be somewhat understated by the value on the books of the Company’s land holdings. Reviewing the escalated cost of land expansion purchases (in 2003, 52 acres were purchased for $1.3M, while in 2012, 50 acres were purchased for $5.6M) and Conrad’s accounting for land dating back a couple of decades on the Company's books at cost, suggests that Conrad's book value may be conservative. This would make the Company’s assets more valuable to any outside interested party.

Free Call Option On Potential Legal Claim: In December 2012 and February 2013, the Company submitted claims totaling $22.6 million to the BP Settlement Fund in accordance with the Deepwater Horizon Court Supervised Settlement Program. Certain of the Company's businesses are located within the economic zones included in the class settlement. The outcome and timing of when these claims will be decided is uncertain and has already been delayed. Originally management had expected a resolution by the end of 2013. Recent indications from press reports suggest that BP has objected to the formula used by the court administrator and is seeking more documentation from each company filing a claim. Thus, while full or partial payment is uncertain, the potential award ($3.79 pre-tax) could provide a meaningful increase to cash balances. I suspect that if the full amount of the claim is realized, management would consider another special dividend to shareholders.

Conservative & Shareholder Friendly Management: The Conrad family owns 47% of the stock and three generations of the family are in the management ranks, with the Company founder J. Parker Conrad (age 97) Co-Chairman, John P. Conrad (age 70) CEO & Co-Chairman. Thus, given that management is not overpaid and does not have a lot of stock options, they are very much aligned with shareholders in increasing wealth through share appreciation. From my perspective, management is somewhat conservative and backed by past history, not likely to do anything stupid with the cash (i.e. a big acquisition or move away from their core business). They also have a good track record of capital allocation and being shareholder friendly. In the past the Company has reinvested its cash back into the business or made timely acquisitions of a few shipyards in the region, which have provided healthy financial returns. Also, management has used excess cash to repurchase shares and pay two special dividends (in 2012 and 2013). The only criticisms that can be made of management are the decisions to remain a non-SEC filer (for cost reasons) and to not hold quarterly conference calls or give investor presentations (to focus on running the business). However, the Company's financial reports contain more disclosures than many, and I have found management open to discussions of the business fundamentals.

A noteworthy point regarding management is the age of both J. Parker Conrad and John P. Conrad. While there is a third generation Conrad working at the Company, it is unclear of whether he is part of the Company’s management succession plan and if/how soon he would be ready to run the business. This raises the possibility of a potential sale of the Company (something management has not given any indication it is considering) sometime in the future. Sources I have spoken with indicate that given the Company’s excellent reputation and presence in the industry/region, there would likely be interested buyers.   

Financial History & Projections: Conrad's historic annual P&L results along with my forecasts are illustrated in the following table. The numbers show the cyclical nature of the business. In addition, further volatility in the financial results were caused by a number of additional factors. From the 1999 period when Conrad operated just two facilities and was focused primarily on the Gulf of Mexico oil & gas industry, the company's growth over the next few years was driven by: an expansion in the number of facilities, moving its dry docks to larger facilities, broadening the product mix (including a move into the aluminum vessel business) and diversifying its customer base. These expansion efforts coincided to some degree with the post-9/11 downturn in the economy and weakness in the oil & gas industry during the late 2001 thru 2004 period. Beginning in late 2005 and lasting through 2008, the combination of improved economic conditions, higher oil & gas prices and the impact of hurricanes Katrina, Rita, Gustav and Ike combined to create an unusually strong lift to both demand and pricing. The business turned down with the economy, financial/credit crisis in late 2008 and continued soft following the Deepwater Horizon accident and subsequent weakness in the oil & gas industry in 2010. The combination of an improving economy, Conrad’s diversification into the inland market and the addition of new capacity has helped fuel a significant recovery in the Company’s business beginning in 2011.

Looking out to the future, given the combination of the tailwinds fueling the Company’s demand coupled with its record backlog and new capacity coming on-line, it is reasonable to expect that Conrad’s revenues will likely grow from current Q3 (September) quarter levels in future quarters. However, in an effort to maintain a conservative posture (and a margin of safety), I have chosen to use a no revenue growth model for future forecasting purposes. As a value investor, I like growth, but don’t want to pay for it if possible. Given that the Company’s backlog is at record levels on both an absolute basis and as a percent of revenues, I would not be surprised if the total backlog were to decline from current levels over the next few quarters. From the standpoint of profitability, both 2013/14 should result in record EPS on both a GAAP and operating cash flow basis. FCF, should rebound in 2014 to ~$25 million (or ~$4.20 per share) as cap-ex spending will likely decline to a level slightly above maintenance cap-ex levels. The following tables illustrate my GAAP and FCF estimated for 2013/14 profitability under this zero revenue growth scenario.

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Attractive Valuation: While the stock price of Conrad has outperformed the market during the current rally, the shares are still attractively priced on a number of measures. I believe that the tailwinds that have helped the Company's expansion in the past few years, will continue to drive growth over the next 18-24 months and that the capacity additions coming on-line in 2H of 2014 will translate into further increases in profitability and FCF during this period. However, given the cyclical nature of the business and the desire to be conservative, I can make a case that the shares are attractive based on both ttm data and down cycle profitability. Based on ttm data, the shares are valued at a EV/EBITDA multiple of 4x, a FCF/EV yield of 17% and a cash adjusted P/E of 6.4x. For cyclical companies, it is always helpful to look at how they are valued relative to their down cycle profitability. In 2009, like many companies, Conrad was faced with a weak economy and a major financial crisis. In addition, the Company's business (especially vessel repair) was impacted by the BP Deepwater Horizon spill, which had a significant impact on the exploration activities in the Gulf of Mexico and Conrad's oil & gas business. At current prices, the shares are selling at an EV/EBITDA multiple of ~7x and a cash adjusted P/E of ~13x on its cyclical though 2009 earnings. I believe these attractive multiples on down cycle profitability provide investors a healthy margin of safety.

The Share Are Selling Significantly Below Intrinsic Value: I believe the shares are selling at about 20%-25% below intrinsic value of $45-$48 per share. In calculating intrinsic value, I believe I am using a conservative set of assumptions. First, while I believe the combination of a record backlog and additional capacity additions should bode well for some growth over the next few quarters, I am using a no revenue growth (from Q3-2013 levels) scenario in forecasting profitability and FCF for my intrinsic value calculation. In addition, a fair amount of my analysis is based using trailing twelve month (ttm) numbers. Thus, as illustrated in the analysis below, looking out approximately 12 months and estimating the Company can conservatively generate FCF in 2014 of ~$25 million with cash reserves increasing commensurately, and assuming the share can command a reasonable EV/FCF multiple of 8x (still implying an attractive 12.5% yield) would equate to a share price of ~$46.50 per share. Note assuming a multiple of 10x (or a 10% yield) would equate to a share price of ~$55 per share.

Relative to a private market valuation, there are not a lot of comparisons to look at. The closest comparison is the December 2011 acquisition of Seattle based Todd Shipyards by Portland ship-builder Vigor Industrial LLC. for about $130 million in cash. This equated to a valuation of about 5.3x EBITDA and 9.4x EPS. However, Todd was primarily in the repair business, with limited manufacturing capability, and derived ~95% of its revenue from government contracts. Additionally, Todd appeared to have about half the number of dry-docks and construction bays and does not appear to have made the investments that Conrad has to modernize its facilities and equipment. From a financial standpoint, while the revenue base of Todd at the time of acquisition is about similar in size, Conrad has a higher return, richer FCF business model that Todd. For example, at the time of its acquisition Todd’s EBITDA margin of ~9.5% trails the mid-teens margin of Conrad and Todd’s three year average FCF is about 1/3^rd that of the Company. Applying the same EBITDA and EPS multiples to Conrad translates to prices of about $45 and $40 respectively. Noteworthy, these valuation measures were accorded in a depressed market environment, with a subsequent 45% rise in the S&P 500 index since the date of the acquisition. Thus given the combination Conrad’s higher return business model, more modern facilities, more diversified customer base, the improved economy and a higher public market, I believe it is reasonable to accord some premium to these numbers.

Thus, when triangulating this data, it leads me to an intrinsic value for Conrad of $45-$48 per share, which represents upside potential of 25%-35%.

Why Are The Shares Mis-Priced?: I believe the shares are mis-priced due to the following: non-SEC filer (due to cost issues, but they release all financials), no conference calls (but management has been very accessible), no sell-side analyst coverage (i.e. they don't need investment banking) and that the Company does not screen well due to temporary growth cap-x cycle in 2012/13 (likely ending in 2013).

Risks: Another economic downturn, a significant/prolonged drop in WTI oil prices, a sharp rise in steel prices, competitive pricing pressures, loss of a major customer (the top 10 customers comprise ~2/3rds of revenue) and a weather event (i.e. hurricane).

Catalyst

• Continued growth in earnings and cash flow.
• A reduction in growth cap-ex, which will aid free cash flow and help the stock screen better.
• A favorable resolution from the Company's legal claim regarding the BP Deepwater Horizon oil spill.
• Possible sell-side analyst coverage.