Description

Summary/Thesis:

Orion Marine Group (ORN) operates as a marine civil contractor, offering construction expertise in transportation facilities, bridges, marine pipelines and other marine services.  During the third quarter of 2015, ORN acquired the second largest Texas-based concrete contractor, TAS Commercial Concrete, which provides turnkey services throughout all phases of commercial concrete construction.  Historically, ORN’s results have suffered from extreme customer concentration amongst federal, state, and local customers (most notably, the US Army Corps of Engineers), thereby whipsawing earnings from quarter to quarter. The acquisition of TAS diversifies ORN’s heavy civil marine business towards a steadier and more differentiated private customer base.  Recent and temporary operational stumbles have driven the stock price to unsustainably low levels not seen since the Great Recession. The pro forma combined earnings power of the company and valuation relative to peers provides significant upside potential from here. 

Background:

With public financials dating back to 2004, ORN demonstrated consistent operational success through 2010 and achieved an average 16% EBITDA margin, with earnings topping $0.80/sh over that period.  Unfortunately, the Great Recession caused weak end market demand and operational shortcomings that depressed earnings through 2014. When profitable contracts signed just before the recession began rolling off in late 2010, ORN found itself desperately trying to drive backlog growth amidst sporadic end market demand. Federal, state, and local government agency budgets (roughly 75% of revenue in 2011) were slashed and private sector contracts (roughly 25% of revenue in 2011) were postponed.  ORN experienced the greatest challenges from its largest client, the US Army Corps of Engineers (USACE), who has remained one of the primary funding sources for major US waterway projects industry-wide as well as the largest user of dredging assets. Revenues from the USACE shrank from 28% of ORN revenues in 2010 to less than 10% by 2014.  For ORN, dredging activity can swing company-wide utilization rates greatly, thus effecting gross margin substantially. Further, ORN experienced increased competition from smaller construction operators who entered the marine construction market following a decrease in on-land construction activity.  All of this activity led to irrational pricing and pressured margins across the marine construction industry. In an effort to drive volume (backlog) to cover fixed costs, now-retired CEO Mike Pearson adjusted ORN’s bidding philosophy to undercut competition. ORN locked itself into largely unprofitable contracts as the industry competed downwards towards cash costs. A significant cost containment program aimed at reducing the workforce and overhead failed to make up for the loss in contract profitability.  

The cause of the stock price drop to $4.00:

By the end of 2014, it appeared that management had finally begun to turn the company to the upside. Q414 EBITDA margin hit nearly 17% as ORN generated $0.19 in EPS vs. $0.08 in EPS during Q413.  Demand from private clients was solid, including bid opportunities from downstream and midstream energy benefitting from higher activity within energy, power, and petrochemicals.  Expansion work for local port authorities remained strong, as they executed port improvement plans related to the opening of the widened Panama Canal set for 2016.  Unfortunately, in the first half of 2015, ORN was once again plagued by disappointingly weak Corps of Engineers lettings as well as historical record rainfall activity from April through June. Evidently, these three months were the wettest in over 120 years, causing delays in existing jobs and the startup of new work.  Most damaging, however, was the Q315 preliminary earnings announcement released on October 21, 2015: Due to the recent death of ORN’s Tampa-based COO (a new and experienced COO has since been hired), a vacuum of leadership led to a mismanagement of forecasted costs on 5 projects and forced a loss to be taken driving Q315 EPS to a $0.27 loss per share vs. analysts’ consensus estimate of $0.15 per share. It should be noted that absent the issue that cropped up in Tampa and the associated Florida tax valuation allowance taken, ORN would have successfully met analysts’ estimates for the quarter – and that’s with only two months of TAS operations. Although this was an “isolated” and “correctible” issue, the stock plummeted nearly 20% the over subsequent few days and now sits below $4.00, its lowest level since the depths of the Great Recession. 

Given the one time nature of these recent events and ORN’s conservatively modeled earnings power of $0.70 per share (see below), I believe the stock is oversold at these levels. 

Valuation:

ORN’s acquisition of Texas-based concrete contractor, TAS Commercial Concrete (TAS), is transformative for the company.  

Earnings power:

Fully incorporating the TAS acquisition, ORN had a 2014 pro-forma revenue base of $622m and $58m of EBITDA (9.3% EBITDA margin). Prior to the announcement of the Tampa contract issues, ORN expected 2015 pro-forma revenue to grow 3-5% with a similar EBITDA margin to 2014.  For both ORN legacy and TAS, business activity is picking up. On the legacy heavy civil marine side, there remains unprecedented pent-up demand for civil marine construction given the age and condition of existing infrastructure in the U.S. (see catalysts for more detail).  In addition to the already strong bidding activity seen in the legacy civil marine construction business, management stated the following with regard to TAS: “…The TAS acquisition brings diversified exposure to the tremendous growth in the Houston and DFW non-residential construction market. Since 2011, the combined nonresidential construction market in Houston and DFW has grown 68% to $11.9b at the end of 2014. During the same time frame, TAS grew revenue by 104%, while maintaining a solid EBITDA margin.  We expect this segment’s demand to continue to grow with the population of Texas expected to double by 2050.”  Thus, with both businesses (marine civil and concrete) on the cusp of rebound, I expect the underlying earnings power of ORN to be at a critical inflection point. 

Since the unprofitable Tampa projects will be completed by the end of the first quarter 2016 if not sooner, according to management, gauging a correct valuation for ORN must take a longer term perspective on ORN’s normalized earnings power.  The following are my earnings model assumptions: 

Top line: Although ORN was expecting 3-5% growth in 2015 with higher levels in 2016, assume a more modest 2% growth rate per year over the next three years on top of the 2014 pro forma revenue base of $622m. This results in 2017 pro forma revenue of $660m.  

Margins and operating earnings: ORN’s long term goal is to return the company to historical (pre-2011) EBITDA margins of 14-16%, with an intermediate goal of 10-12%.  I’m assuming that over the next three years, they only achieve 9.5% EBITDA margin in 2017 (basically flat with PF 2014 performance, AKA no improvement), implying 2017 EBITDA of $63m.  Subtracting combined company 2014 D&A of $25m, leaves $37m of EBIT or a 5.6% EBIT margin (well below 2004-2010 average EBIT margin of 9%).  

Balance sheet and interest expense: As part of the TAS acquisition, ORN entered into a new syndicated credit facility, providing a 5-year $185m senior secured credit facility that includes $135m term loan and a $50m revolver. Total debt outstanding post the transaction is $149m, with $36m available under the revolver.  The rate on the new debt is LIBOR +250bps plus 50bps on unused portion of the facility. Assume implied interest expense of $5m. 

Tax and share count: Assuming a full return to long term profitability, I’m modeling a full effective tax rate of 38% for a net income figure of $20m or a 3.0% net margin (half of the 2004-2010 average of 6.0%, albeit ORN has more leverage now).  In October 2014, ORN’s Board approved a $40m stock repurchase plan. ORN repurchased 350,000 shares unfortunately at $8.83 during the second quarter, leaving roughly $37m of repurchases left on the existing plan. For conservatism, I give them no credit for the remaining buyback capacity, so I assume the shares outstanding count stays at 27.4m shares. 

EPS and earnings yield: $20m in net income divided by 27.4m shares implies that ORN should conservatively earn $0.70 in EPS in 2017 and on a normalized basis. This implies a normalized earnings yield on the $3.70 stock price of 18%+ (my earnings yield hurdle is 15%). 

Stated more plainly, even though ORN has just completed an acquisition that will boost revenue by 60% and EBITDA by 70%, I expect earnings to still fall short of pre-recession levels when ORN was a stand- alone marine construction business. This provides a substantial margin of safety. 

P/E multiple: Although the marine construction business is highly fragmented with many private competitors, few operators have the ability to integrate large and complex projects given maritime law constraints, specialized equipment needed, and adequate financial resources necessary to provide a turn key solution to clients in the way that ORN can.  Thus, there are high barriers to entry. Public comparables are limited, but Granite Construction (GVA), Primoris Services (PRIM), Aegion (AEGN), Layne Christensen (LAYN), Sterling Construction (STRL), and Great Lakes Dredge & Dock (GLDD) valuations can be studied, with GLDD being the closest comparable. With calendar year 2015 almost behind us, the median 2016E P/E ratio for the group is 16.0x (GLDD is 22x).  For ORN, given previous operational issues, acquisition integration risk, and increase leverage, I’m applying a conservative 10x multiple to ORN’s $0.70 EPS power, for a target price of $7.00 in three years.  This equates to a 89% upside potential over a three year time frame, given today’s purchase price of $3.70. 

Other valuation metrics:

ORN trades at a Price to Sales ratio (pro forma for the acquisition) of 0.16x, vs. a peer group median of 0.38x. Applying the peer group median P / Fwd Sales ratio implies a target price for ORN of $9.00. 

ORN trades at Enterprise Value to Sales ratio (pro forma for the acquisition) of 0.38x, vs. a peer group median of 0.56x. Applying the peer group median EV/Sales implies a target price of $8.00. 

Using the same methodology, implied valuations for ORN based on peer median EV/ Fwd. EBITDA and P/TBV multiples is $9.70 and $6.00+. 

All told, ORN is highly undervalued. 

Risks:

·         TAS integration risk

o    Management is unproven at integrating an acquisition as large and transformative as TAS. Although cross selling opportunities exist, the magnitude of potential cost synergies (if any) is unclear. 

·         TAS exposure to oil-linked Texas economy

o    As a Texas based operator, TAS’s long term success depends on continued local economic strength, and consequently, continued growth in non-residential construction.  Prolonged energy market weakness could have broader implications for the entire state, impacting the market for concrete projects.  

·         Marine construction customer concentration risk:

o    Although revenue concentration for USACE has shrunk from 28% in 2010 to less than 10% in 2014, inconsistent lettings by the USACE have continued to hamper earnings stability. Earnings are inherently lumpy in the marine construction business given overlapping customers with similar funding drivers and market demands across the entire business. Backlog and booked revenue can vary greatly by customer from quarter to quarter.

·         Operational issue in Tampa could just be one roach in the kitchen. 

o    Although management has stated that the issues there are short-term and isolated, it begs the question as to how the death of one person could cause such a disaster for the company. 

·         Credit covenants

o    ORN’s financial covenants on the new credit facility include a maximum leverage ratio of 3.25x through 12/31/15 and 3.0x from 3/31/16 through 6/30/16.  Although management does not believe there will be any near terms issues, further deterioration in near term earnings could force ORN to seek a waiver.

·         Dependence on federal, state, and local government funding

o    Absent sustainably budgeted marine constructions from USACE and Congress at large, construction work could continue to be lumpy

Catalyst

Catalysts: More consistent earnings and the achievement of longer term earnings power with the help of: 

·         Strong industry tail winds for heavy civil marine

o    The age and condition of existing marine infrastructure coupled with large government funding sources aimed at the replacement and repair of aging U.S. marine infrastructure highlights a pent up need for large-scale infrastructure spending. According to the USACE, “civil works infrastructure is on an unsustainable glide-path of benign neglect.” 

o    Still a key customer to ORN (roughly 6% of pro forma revs.), the USACE is the primary funding source for waterway projects.

o    Rising consumer confidence and economic activity is driving an up-cycle in non-residential construction in Texas. Increased civil and building demand should grow TAS’s backlog of concrete projects.

·         Consistent contribution from TAS construction

o    The addition of TAS diversifies revenues away from choppy government funding of the marine construction business and towards a more private and recurring customer base. TAS customers are primarily in the private sector, with an average relationship tenure of 12 years.  TAS’s largest customer will account for only 5.6% of revenue on a pro forma basis. Further, there is no customer overlap between TAS and Orion.

o    Cross selling opportunities with legacy dock work and on-land concrete services

o    Expanded reach into fast growing Texas market

·         2016 Panama Canal expansion

o    Need to overhaul existing US coastal waterways in response to the 2016 Panama Canal expansion that will usher in increased traffic and ship sizes

·         Expansion of petrochemical industry and mid-stream refinery water-borne logistics

o    Relative to the upstream sector, midstream and downstream sectors have not been as negatively impacted by the recent decline in oil prices

o    With low energy prices, strong consumer demand for refined energy products and petrochemicals, and increased coastal refinery expansion will increase the need for ORN’s marine construction.

·         Recreational marine activity

o    Increase in the number and size of cruise ships operating in the Coastal US region has generated demand for port development.