Description

Business description:

Great Lakes Dredge & Dock is the largest Jones Act dredging business in the United States.  The company completes capital (e.g. port deepening), beach, and maintenance projects throughout the coastal regions of the United States, and maintains a dominant #1 market share in the industry.  The company also competes for business in international markets.

Investment Thesis:

GLDD maintains a dominant #1 market share in the Jones Act dredging business in the United States. The domestic business has been under-earning for the past few years, because the Army Corps of Engineers dredging budget was cut in half at the start of the Iraq war.  These dredging projects must eventually be completed, and when they are, the pent up demand will lead to dramatically increased pricing and utilization.  Further, the company’s International business and LNG business continue to expand rapidly.  Assuming only partial utilization increases and reasonable international/LNG assumptions, the company could generate ~$35MM of FCF in 2008, a 13% FCF yield on its current market capitalization. 

Investment Merits:

• Pent up demand from federal spending cuts during 2004-2006 has created a backlog of capital projects that will need to be completed over the next five years
• As a result of the Iraq war, Federal funding for dredging projects was cut in half after being stable and growing for the prior fifty years
• Congress demonstrated its renewed interest in the dredging by passing the first WRDA bill since 2000 in August, 2006
• Bill authorizes $5Bn of capital spending (timeframe unclear) projects to be completed, vs. a capital market that has averaged $300MM the past 5 years
• Pricing has started to rebound over the past few quarters, indicating that the glut of unused dredges may be subsiding as GLDD has removed approximately 5% of supply from the domestic market and some delayed projects are starting to be released
• A return to historical federal spending levels would lead to a 15-20% utilization increase at 30% margins, and the increased demand would drive prices up substantially
• A 15% increase in utilization and a 5% increase in price would lead to an increase of $29MM of EBITDA (assuming 3% cost increases) on a base of ~$51MM in 2006. 
• Jones Act industry prevents foreign competition from entering the U.S. market 
• The lack of a large competitor in the U.S. affords GLDD a dominant, protected market position on U.S. dredging projects (~35-40% of the market, twice the size of the #2 player)
• To qualify for Jones Act status, dredges must be built, owned, and crewed by U.S. citizens.
• New domestic supply is unlikely to enter the U.S. market as it is uneconomical to build new dredges in the United States.
• LNG and International markets provide growth opportunities for the business above and beyond its traditional U.S. government business
• GLDD has won three out of four U.S. LNG Terminal dredging projects thus far and is clearly the preferred vendor on these projects.
• Each terminal requires ~$50MM of dredging (vs. $426MM of LTM revenue for GLDD) out of $3Bn capital costs for the entire LNG project…dredging isn’t awarded on price, but on brand name and quality where GLDD is a clear #1
• Likely to be 1-2 terminals built/year the next 4 years (17 are permitted currently)
• International dredging demand is experiencing a massive cyclical upturn, and GLDD is riding the wave
• International backlog has grown from $30MM in 2003 to $162MM currently
• GLDD won a $300MM contract in Bahrain that is keeping 4 of its dredges working for the next five years
• Secular trends in capital business combined with recurring beach and maintenance revenues provide long-term growth prospects
• As global trade expands, there is a need for increasingly large vessels to make shipping economic.  Worldwide ports are currently too shallow to accommodate the newest classes of ships, and this problem is exacerbated in the United States where most port deepening projects have been on hold for 3-4 years.
• Beach and maintenance projects are recurring revenue streams that can only be put off for limited amounts of time before permanently damaging the coast line
• This fact has led to state and local municipalities starting to fund critical beach/maintenance projects where federal funds are still not available.
• Non-core real estate provides hidden value
• Company is in the process of selling its non-core real estate in Amboy, NJ.  The sale will likely be completed in Q2 2007.  I estimate the sale will bring GLDD approximately $20-$25MM in cash
• Opportunity to make a levered bet
• GLDD has 18.4MM fairly liquid warrants outstanding ($5.00 strike price), that offer an investor with conviction the chance to leverage this investment.
• Warrants trade at $1.80, a 5.8% premium to intrinsic value

Investment Risks:

·         Bid market for new projects is unpredictable and lumpy.  If the company fails to win key contracts put out for bid the company could suffer materially due to high operating leverage in the business

o        GLDD’s three different markets (domestic, Int’l, and LNG) reduce its dependence on any one project or supplier, relative to its primary competitors

·         Continued turmoil in the Middle-East could lead to substantial outlays of defense spending leading to continuing levels of reduced infrastructure budgets.  Any new terrorist activity would likely harm business substantially.

o        It is not practical to reduce the dredging budget from the bare bones level it is at today without doing irreparable damage to the United States coastlines

o        Historically, Democratic Congresses have spent more money on Civil Works and dredging than Republican congresses

o        Many people believe Katrina would not have destroyed New Orleans had the Army Corps budget not been cut, and as a result there is considerable political backlash associated with further funding cuts in this arena

·         LNG terminal construction is dependent on the natural gas prices remaining at economic levels, and it is possible that most of the approved terminals will never be built.

·         Madison Dearborn owns 67% of the common stock, and may depress the stock with share sales over time 

Valuation:

• I don't think we need to push it too much to make an investment case, we value this stock at 12.5x $35MM of 2008 FCF for a market value of $438MM.  Factoring in the dilution of 18.4MM warrants struck at $5.00 the pro forma shares outstanding would be 48.2MM, implying a price target of $9.07, a 35% premium to the current market of $6.70.  In addtion to a number of accretive tuck in acquisitions they could make, one could easily use a higher valuation multiple or a more aggressive pricing assumption and come up with a higher valuation.
• The company has $191MM of net debt outstanding as of 12/31/06, which I estimate will be reduced to ~$130MM by 6/30/08 from cash flow and the real-estate sale.
• The $438MM market value + $130MM of net debt = $568MM enterprise value, 7.1x 2008 EBITDA of $80MM
• An investment in a GLDD warrant, would return (forced conversion at $8.50 stock) 112% on a $9.07 stock price.

Catalysts:

·         Large contract wins

·         Congressional decision to return Army Corps Funding to historical levels

Catalyst