Just after finishing my post on Conrad Industries Nate at Oddball Stocks also published a write-up on the company that prompted me to do some more research and thinking. As already noted in my original write-up I don’t see a compelling reason why Conrad Industries has a real competitive advantage, so it’s surprising to see that the company has a high return on equity for the past five years.
The two best reasons I could think of to explain a high return on equity for a business without a real competitive advantage are:
- More demand than supply in the market.
- A book value that is understated, making returns on equity artificially high.
I think both these factors are at play at Conrad Industries.
Book value is understated (a bit)
Land is carried at cost on the books, but if this land was bought years in the past the value of this land has presumably risen and the true capital base that is employed to achieve the returns is higher than what is reported on the books. This is important because a potential new competitor that sees the high returns and wants to enter the market is going to find out that replicating the business requires more capital than anticipated. I don’t think book value is significantly understated, but it can quickly change a return on equity calculation. Growing value from 43M to 95M from end 2007 to today is a 22% compounded annual growth rate, but if it was understated by 7M the growth was from 50M to 102M, and the growth rate would be 2.5 points lower.
Something along those lines seems to be the case with Conrad Industries, and the best data point is probably the land the company bought adjacent to the Conrad Deepwater facility. They own 52 acres, bought in 2000, with a book value of 1.3 million and bought an additional 50 acres for 5.5 million in 2011. Other facilities are even older, the original Morgan City shipyard was founded in 1948, Conrad Aluminium was bought in 1996 (16 acres, 1 million) and Orange Texas was founded in 1974 (the shipyard was bought by Conrad in 1997, but the land is still carried at the original cost while the goodwill related to this acquisition has been written down to zero). So it’s fair to assume that the replacement value of the business is a bit higher than the current book value.
Besides the land values the other items on the balance sheet are probably reasonably valued. Capex has been on average 4.0 million a year the past 10 years while depreciation and amortization has been running at an average of 2.7 million, so there is no reason to believe that D&A is too conservative (too high).
Demand for barges is high
Most of the boats the company produced the past year were barges, and I found this article at the Pittsburgh Tribune-Review website about a competitor that states that most of their capacity for the next three years is already booked. So I would think that this implies that business prospects for Conrad Industries should also be favorable the next few years, but that maybe some mean reversion should be expected after that. Conrad Industries itself is increasing supply with one of the biggest capex programs in the companies history, and competitors are also not standing still (the subject of the article is also planning to expand in 2012).
The article also has some insight in the economics of the inland shipping business. I can’t quote the whole article, so read it, but some key points:
- Barges are being used for longer travels increasing demand
- River traffic is not back to pre-recession levels
- About 19,000 barges in use in the US
- About 1000 new barges being build every year
- About 3000 barges are about 30 years old
- Qualified welders might be in short supply
Cash is overstated
Something I missed initially is that the company doesn’t have as much cash as I first thought. While the company reported 43M in cash at the end of the year, they also had a big accrued expense related to cancelled contracts, so this was not all excess cash:
At December 31, 2011, Accrued Expenses includes $18.5 million payable to a customer for payments made by the customer on vessel construction contracts that were ultimately cancelled by mutual agreement. The customer was paid in February 2012, net of an outstanding amount owed of $2.3 million on a remaining contract.
So this would mean that the company has at the moment ~$27.4 million in cash, and this also requires me to adjust some of the price targets in my original write-up. The pessimistic valuation moves from $17/share to $14.50/share and the optimistic valuation moves from a $34~41/share price range to $31.50~38.50/share price range. I’m not taking in account the possibly understated book value, because I have valued the business as a going concern based on the earnings and cash flows, not the book value. It does provide a little bit of a margin of safety in a liquidation scenario.
Why is it cheap?
It’s a question that I failed to answer in my original write-up, and it’s a question I’m still unable to answer. I agree with Nate at Oddball Stocks that just being a small company that’s unlisted isn’t a compelling reason for it to be cheap, and I’m also not sure that the ‘trauma’ related to the delisting in 2005 or the temporary reduction in profitability after the financial crisis in 2008 and the BP spill in 2010 are sufficient explanations.
At the same time I also haven’t been able to find a solid reason why this company deserves to be cheap. Sure it is cyclical, but it doesn’t seem a terrible business, and based on the article quotes above the next few years for the barge industry might be good, and a pickup in activity in the Gulf of Mexico is also a possible tailwind.
The case for Conrad Industries is a little bit weaker than I originally thought, but at current prices I think it’s still an attractively priced business. If someone can make a compelling case why the company deserves it’s current valuation I would love to hear it.