Description

Great Lakes Dredge and Dock is the dominant player in the high barriers to entry domestic dredging industry with average annual market share of ~40%. In their key markets (capital and coastal protection), market share is higher. Market share has remained relatively consistent for a long time. Their markets are also an oligopoly in which ~80% of the market is dominated by 4 companies. In dredging, the primary competitive advantage is scale, and Great Lakes is the largest operator and operates some of the largest vessels, which allows it to be a very low cost operator. Roughly 50% of the company's revenue is also recurring (on a consistent basis, there is almost always maintenance work to be done re: port maintenance or coastal dredging), the company sports after tax returns on tangible capital of ~20%, and future capex is likely to generate similar returns on capital.

Despite all of this, at a market cap of ~$880 million and a year end 2021 enterprise value of roughly $1 billion, the company trades at ~10-11x 2019/2020 adjusted unlevered free cash flow, which is roughly representative of normalized cash flow + a conservative allowance for returns from newly built dredges that will come online next year; this is also after tax cash flow at 25% tax rates despite NOLs ($92 million federal and $170 million state) that should reduce taxes for the next few years.

EBITDA - Maintenance Capex has grown from approximately $40-50 million in 2016/2017 to $125 million in 2020 as a result of a new CEO, a restructuring (the company divested from its environmental & infrastructure business) and a re-focus on domestic operations from money losing international operations. From 2018-2020 alone, the company generated ~$400 million of unlevered CFFO-Maintenance Capex, or 40% of the current Enterprise Value. The consistent domestic performance since 2016/2017 is also relatively less clear via consolidated financials because while management has been exiting its international operations, these operations were never strictly classified as discontinued. The company for the first time since 2005 is also beginning to focus more on shareholder returns through stock buybacks.

Cash flow is highly likely to grow over the next few years as a result of the building of new dredges, operating leverage that should benefit from recent legislation (Harbor Maintenance Trust Fund adjustments, Infrastructure Investment and Jobs Act) which will increase the total dredging market size, and continued port deepening projects that take many years to complete. Given the strong market, the company also currently has near record domestic dredging backlogs.

At ~13-14x 2024 year end cash flow (a valuation that strikes me as reasonable given the quality of the company and its dominant market position), I estimate an investment in the company would generate IRRs of high teens to low twenties, but this does not account for operating leverage / market size growth (which should be substantial), as well as a greenfield opportunity in the offshore wind market which management is highly confident in via their contracting for the largest newbuild in the company's recent history at ~$200 million, or 20% of the current Enterprise Value. While I have also not accounted for it, the company has substantial tax loss carryforwards ($92 million federal and $170 million state) that should help protect cash flow in the coming years.

Risk-adjusted, I also think an investment in Great Lakes is quite compelling as downside should be protected given the company likely trades at rough estimates of the replacement value of its assets, the markets it operates in are quite stable, the low valuation on normalized operations, and its dominant market position. 

More in depth discussion is below.

(1) Size is a true competitive advantage in dredging. Most dredging contracts are priced per quantity dredged. The more cubic yard capacity your dredges have, the lower the price you can charge because less trips and therefore less downtime is necessary to move the same amount of sediment as some smaller dredge. Dredges can also be extremely costly (high tens of millions to low hundreds of millions), which means you have to have significant cash and scale to buy one in the first place. Thus, scale begets scale, which helps the dominant companies stay dominant.

(2) The Jones Act prevents low cost foreign competition from entering the market. The Jones Act is sacred to the American maritime industry, and it has been around for a century. Some politicians claim that the Jones Act results in higher costs to the government since government agencies cant take advantage of low cost competition to re-price contracts at a lower cost. While this is probably to some extent true, other domestic legislation also imposes restrictions on maritime businesses (such as ESG standards) that foreign competition might not have, further exacerbating the issue. This is to say that, while a removal of the Jones Act (seems unlikely from what I've read) would certainly pose a risk to the domestic dredging incumbents, the risk is probably mitigated as foreign competition would also have to comply with other costly American legislation if they were to enter the market, increasing their cost structure. Plus, those operators with significant capacity and in depth knowledge of port layouts / structure (e.g. Great Lakes) would be those that could best compete with other low cost foreign operators, while the smaller and more regional players would be the ones to fall by the wayside. 

(3) As a result of a recent legislative change, the domestic dredging market will expand over the next few years. Government dredging contracts are awarded by the Army Corp of Engineers, and the funds used come from a number of accounts, including the Harbor Maintenance Trust Fund (HMTF). The HMTF gets its funds through levies on imported goods that make their way through domestic ports. Historically, ~50% of HMTF funds in a given year were appropriated for dredging / maintenance activities. That has changed over recent years as there has been more congressional pressure to direct the use of all of the revenues received in a given year to infrastructure improvements and maintenance. Now nearly 100% of the annual funds received are appropriated.

Because there were so many years where 100% of the funds received were not appropriated, the HMTF has a significant unspent balance of $9.3 billion (roughly 5x the historical annual spending from the HMTF). Legislation passed in 2020 specifically allowed appropriations to begin occurring from this HMTF unspent balance, and certain discretionary caps on HMTF spending were also lifted. The apparent plan is to allow the unspent balance to be spent down at a pace of $500 million in year one and an additional $100 million in annual spending until a $1 billion amount is reached (by 2025 or so). This, combined with an increase in levies / receipts (which have grown at a 6% or so CAGR since 1987), should provide for continued dredging market growth.

For reference, in 2020, HMTF projects received roughly $1.7 billion in funding. This year, funding will be $2.05 billion and will likely reach ~$3 billion by 2025 as a result of these changes. At 20% gross margins (assuming no operating leverage from increased fleet utilization) and assuming no change in market share, this growth could add ~$17-18 million in gross profit by 2025, which would fall directly to the bottom line given SG&A stays fairly constant from year to year. That would be ~17% cash flow growth from 2020 levels.

Further, as a result of historical underinvestment in port deepening / growth, and now effectively forced expansion of ports via the 2016 Panama Canal expansion project completion and the Infrastructure Investment and Jobs Act, growth in port deepening projects has started (in 2016/2017 or so) and should continue given for a long time given (1) a significant influx of cash from the Infrastructure Act (as well as some disaster relief funds) and (2) the fact that these projects can take many years to complete. The current supply chain crisis has also highlighted the need for more efficient and re-constructed ports to fit ever larger and more efficient vessels, which should create a long term growth runway for port deepening projects. Prior to the aforementioned infrastructure act, proposed budgets for the Army Corps of Engineers for 2022 stood at $3 billion for the construction line item, or an 11% increase over 2021 appropriations. Operations & Maintenance proposals (partly derived from HMTF funds) were a ~22% increase over 2021 appropriations.

Importantly, as more ports are expanded and deepened, this increases future market size on the recurring revenue side of the business; generally, the more capital/deepening/construction work that is done, the more future maintenance work needs to be done to maintain previously completed capital work. Expanded ports also mean more goods can flow through ports, which means more levies, which means more funds go to the HMTF for more maintenance work, which means growing future funding. As such, the company operates in a market where this virtuous cycle exists: future steady state market size grows alongside the amount of work completed today. 

Note that all of this market growth and its potential operating leverage / pricing power have not been accounted for in my valuation; I have simply used the 2020 cash flow + a low teens IRR on announced newbuilds (below mgmt expectations), put a ~13-14x multiple on cash flow, and added the cash that will be generated at that cash flow over the next 3 years to get to a 2024 year end valuation. The company also has standing bids (close to $100 million) for LNG related work that should be awarded sometime this year or next; these awards would be purely incremental to current market growth (nearly 100% of 2019 and ~95% of 2020 revenues were from federal and state governments) but are seemingly increasingly likely to proceed with the high commodity prices.

(4) In response to a strong market, dredgers have been investing in fleet expansion and renovation. Great Lakes management expects to earn mid teens IRRs on their new investments, which are expected to be a cumulative ~$100 million by 2023 (they also have options to purchase more dredges should the market prove stronger). For reference, Great Lakes built the Ellis Island (their largest hopper dredge) in 2016/2017 for ~$100 million and they attribute roughly $20-30 million of today's EBITDA to that dredge specifically. Overall company returns on tangible capital have expanded to the 20% range as well.

IRRs are typically higher visibility for Great Lakes given the stability of the market size, very long building times for dredges (which helps get a view on supply growth), and their ~40% market share. Should the market become saturated, Great Lakes (or its competitors) could also easily take their older dredges (which have gotten expensive to maintain) offline and improve margins on lower amounts of revenue if pricing becomes an issue, helping to keep cash flow stable in such an environment.

As a corollary, this is one of the major differences between the domestic dredging market (where 80% of the market is controlled by 4 companies and ~40% of the market is controlled by 1 company) and for example the highly cyclical oil shipping industry and its many sometimes irrational players with their newbuild binges that inevitably crush everyone. Because of the relative concentration, domestic dredging appears to have much more rational players and much higher visibility as to returns on investment and overall fleet / market utilization.

Probably the main risk with the investment is that some of Great Lakes' competitors are building new dredges that are of similar size to the Ellis Island (previously, the Ellis Island was the only dredge of its size in the market), and these should be delivered in 2023 or so. Should the dredging market size decline, the new capacity would probably pressure pricing and margins. That said, a fair amount of dredges (industry wide) are also quite old, and as such might be taken offline in the event of a market decline once newbuilds come online given the better margins. Further, future newbuilds (after the ones current being built) would take a number of years to complete after their announcement. So, if the market continues to grow past current newbuild plans there would be intermittent mismatches between market growth and supply growth, creating more favorable pricing dynamics. Nonetheless, market growth should continue to be watched closely in concert with new supply growth. 

(5) If you go back to the 2013 10-k, the company published an appraised value for the replacement cost of its then fleet, which was $1.5 billion. Since then, the company has reduced the number of dredges owned by 12 (approximately 37%), but they have also added very high value newbuilds such as the Ellis Island (which cost $100 million, or 6.6% of the 2013 appraised fleet value) and a few others. Also since 2013, the cost of building new dredges has risen as a result of raw material price increases (most recently due to high inflation).

If we conservatively assume a 25% decline in fleet replacement value from the 2013 level (in line with the reduction of fleet size, partly offset by new additions), that gets us to a replacement value of ~$1.125 billion (in 2019, the fleet was apparently valued at "over $1 billion"). Taking today's balance sheet, adding in current assets, and subtracting out all liabilities gets us to an equity replacement value of roughly $865 million. Compared to today's market cap of $880 million, there is essentially no downside. This is also certainly not a dying market plus dredges can be freely traded (like VLCCs or similar ships), so replacement value should work well as another estimate of value.

(6) The company is pursuing a greenfield opportunity in the offshore wind market as a result of government plans to significantly expand offshore wind capacity. New offshore wind turbines require subsea rock dredging to create the foundation for the windmills. Currently, Great Lakes is producing one of its largest ever dredges (a $200 million investment) for this opportunity, and at present is the only domestic dredging company that is producing dredges specifically for the gear up of offshore wind (not expected to come online until 2024/2025 or so). Notably, the offshore wind opportunity has a much better outlook now than at the time the company committed to the investment (the government has committed to a 200% increase in offshore wind capacity relative to when Great Lakes first contracted to create their dredge, and contracting has apparently started).

It's hard to say what the returns will be on the new dredge, but if they are anything like domestic dredging, this opportunity could result in $30-40 million of incremental cash flow for the company, which if capitalized would represent (net of the $200 million investment) 20-35% of the current Enterprise Value. I have not accounted for this in my valuation, so any benefits here (above the $200 million cost) are purely incremental to my valuation.

Importantly, there was originally some uncertainty around whether the offshore wind market would be protected by the Jones Act. In early 2021, the administration began to make it clear that the Jones Act would apply to this market, and section 9503 of the National Defense Authorization Act affirmed that the Jones Act would apply to offshore wind development. This has been another incremental positive development since Great Lakes contracted for the dredge.

(7) We are being provided this opportunity because of two reasons: first is the obvious sell off that is now infecting pretty much everything in the markets, and the second is because company cash flow for 2021 is depressed relative to the more normalized 2019/2020 levels. The depressed cash flow margins are due to Covid related delays; covid policy has been that dredges had to be taken off the market if covid cases occurred / staff needed to be vaccinated, which results in impaired dredge utilization.

The company estimated 'direct' covid related costs (e.g. vaccinating, testing, ship disinfection etc.) of ~$9.4 million YTD, but this does not include utilization impacts as they are harder to measure (e.g. the delay in project completion as a result of protocols, which then delays other projects and impacts utilization / efficiency as projects take longer to complete). The latter are also likely the majority of covid related impacts because of the high fixed cost nature of the business and as a result its high operating leverage (e.g. when projects are delayed and scheduling interrupted, revenue takes longer to earn which means lower margins given significant fixed costs). For reference, Q1 and Q3 gross margins (adjusted for some one time costs mentioned in the calls) were roughly low to mid 20%, while Q2 gross margins were significantly below that at low teens %. To me, this seems like a clear aberration. Note that management also expected at the end of 2020 that earnings / cash flow for 2021 would be higher than 2020 levels. 

Nonetheless, if I'm wrong and this year's new level of cash flow represents the true new normal of operations, then we're still probably only paying ~12x cash flow (less when you account for the operating loss carryforwards), which still strikes me as cheap for this dominant franchise, especially given the market growth on the horizon. Downside should continue to be limited in this case. 

DISCLAIMER: The Author currently holds a long investment in the securities of Great Lakes Dredge and Dock (Ticker: GLDD) and stands to benefit should the price of the security rise. The Author may buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note and disclaims any obligation to update such information. The views expressed in this note are the sole opinion of the Author, which may change at any time. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note. This written note should not be construed as a recommendation to buy or sell any security or as investment advice.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Catalysts:

Continued market growth

IIJA funds roll out in late 2022/2023

New port deepening projects

Delivery of new dredge in 2023

Delivery of offshore wind vessel and ramp of offshore wind market in 2024

Announcement of new LNG projects