More on Conrad Industries

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:

  1. More demand than supply in the market.
  2. 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.

Revisited conclusion

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.

8 thoughts on “More on Conrad Industries

  1. Adib

    Also, the cash will be lower by another $1m as they bought back shares worth $1m already in Q1. But share count will be lower as that’s great. 6.1M roughly outstanding.

  2. Tim Eriksen

    If paying off an obligation changes your valuation I would humbly suggest that you revisit your valuation approach. For example, if they increased cash by $10 million by slowing payables by $10 million you wouldn’t (or at least shouldn’t) increase the value of the company. Conversely paying off a payable shouldn’t decrease the valuation.

    I would note that in the Balance Sheet there has been a short term spike in Costs in Excess of Billings. This will be billed and move to Accounts Receivable and eventually cash in a few months if it has not already. The spike from the prior quarter is $25 million. It more than offsets the whole adjustment regarding the payable. It would in fact increase cash per share by $1 from the year end amount.

    Regarding the conservative valuation. I would argue that you should exclude the charges for impairment of goodwill and the failed acquisition in 2002 – 2004. This amounts to $8.5 million. I would reduce it by a 20% tax rate. One could also argue that you should use average net income divided by current share count as well. Since the share count has been reduced by 20% this also increases the conservative valuation. This results in a conservative $1.37 per year in earnings for the past ten years.

    1. Alpha Vulture

      Tim, thanks for your comments. The idea behind excluding cash from the calculations is to assume that it is excess cash that isn’t needed to maintain operations at the current level, and that it can be freely spend by management on expansion, dividends or share buybacks. Since a large part of this cash had to be used to pay back a customer this wasn’t the case. And since I’m valuing the businesses as “business value” + excess cash something like this does impact my calculations, although I agree with you that it’s not perfect. Using some cash to pay liabilities is obviously keeping book value constant.

      The fact that the high earnings from the previous period haven’t been fully converted to cash is a good point, but if you already start to count it as cash I think you would be double counting a bit since the valuation is also already based on the earnings that will produce this cash and if the company manages to continue to operate at the current level it would require the same amount of working capital as today, and in that case it’s not excess cash. But if you have some good suggestion on how to incorporate this in the valuation I’m listening, otherwise being a bit too conservative can’t hurt.

      Totally agree that excluding the goodwill impairments would have been better to estimate normalized earnings, so guess I need to readjust it up a bit again. I’m by the way already basing the average numbers on the latest share count (ok, almost: the 31 dec numbers)

  3. Marcelo Zinn

    Though I generally concur with your thesis and conclusion, I disagree with the stance that you have taken in regards to why they company remains undervalued. I also have a point to make regarding small cap companies in general.

    Firstly, small companies that aren’t tracked by analysts and have low volume, do generally trade at a discount, as discovery is not easy for normal investors. No large institutions are going to be buyers due to the size, hence its the little guy that must become interested. What is needed is a catalyst for individual investors to come out of the woodwork.

    Its not just being cheap, but an improving dynamic (i.e. growing profits, prospects) that people, especially individuals, are looking for. One of my investments, ROFO, announced three months ago they were doing a major stock buy-back. Then two months ago they announced that sales and profits were climbing and that they would report earnings which would equate to a P/E of <6. Stock moved a bit after the buy-back announcement, but only really moved after they reported AND said Q1 2012 was going to be better YoY. Then stock moved 25%.

    When dealing with small caps, catalysts are thee major factor. Cheapness (i.e. being undervalued) is not enough in general (I own 2 tiny stocks with P/E's of less than 3 and are growing). Sometimes you can create a catalyst to help with exposure, like making a presentation and posting it guerrilla marketing style, but without obvious improving earnings and prospects, its difficult for it to make a large move towards IV.

    Specifically relating to Conrad, there is a concern (mine) that oil prices in the near to medium term are going to decline due to the real and perceived substitutabililty of Natural Gas in various industries, combined with the fact that the world economy is slowing a bit (Do a chart comparison of CNRD with some oil companies [max timeline], they move largely in unison) This would hurt Conrads demand. Now, if they announced that their backlog was up huge and they expected a major Q and year, you would see immediate stock appreciation. the buy-back helped, but so too did the oil price move.

    Additionally, its usually when an industry engages in growth projects that a top is forming in an industry. I believe Conrad may have reached that place. Therefore, it will take a fundamental shift in perception for CNRD to charge ahead and reach IV.

    On a totally different note, check out QEPC when you get a chance. Cheap, growing, excellent prospects, and its riding the coattails of two industry giants, HD and Lowes.

    Keep up the nice work. I enjoy reading your write-ups.


    1. Alpha Vulture

      Marcelo, thanks for your comment. You just took the #1 spot in the length leaderboard 😉

      I’m not sure if I agree with everything though: being small and unlisted can be a contributing factor for a low valuation, but I think this is usually just going to explain a small part of the cheapness. Usually there is a much better explanation for it to be cheap (for example something ugly in the history, and I’d guess this is also a bit the case for Conrad). And sure, size might prevent big institutions to research it, but you also need a lot less buyers to move a price. And there are plenty small funds, money managers or activist investors that might look at <100M companies.

      And yes, the easiest way to realize value is to have the business generate better numbers, but you don’t (always) need a catalyst to realize value. Let’s say you have a company that’s growing book value at 20% per year, but is not trading at a premium to book value. After one year book value and share price are both up 20%, but you still have a company that is just as undervalued as the previous year. As longs as you are not buying assets that are doing nothing I don’t think you need to worry about a catalyst too much.

      About Conrad: they used to have a lot of oil related business, but not anymore after the BP spill, so it would not be logical if the stock continues to be highly correlated with oil companies (although a dropping oil price would still be negative since it would imply that they are possibly also not getting that business back the next years).

      I might check-out QEPC, but so many companies I want to research and so little time…


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