Conrad Industries released their annual report yesterday, and it’s good news all around. The company reported record gross profit, record net income and record free cash flow together with increasing profit margins. The only thing that’s slightly down is revenue. See the table below for an overview of the historical financial results of Conrad Industries, and how this compares to the 2012 results:

What’s also good to see is that the number of shares outstanding continues to drop, and that the amount of cash is at a record high even though the company returned $12 million to shareholders at the end of 2012 through the $2/share special dividend.

The highlights from the annual report:

• The backlog is high: $120.7 million at the end of 2012 compared to $47.1 million last year. In the first quarter they signed new contracts, bringing the backlog to approximately $122.5 million compared to $70.8 million at March 31, 2012. So it looks like 2013 is on track to be even better than 2012!
• The board approved an increase in the stock repurchase program of $10 million, so they will continue to shrink the share count in the future.
• The $22.6 million claim to the Deepwater Horizon Court-Supervised Settlement Program was approved by the court in December last year, but will be subject to review before it will be awarded. Conrad expects that this will happen in the second or third quarter of 2013.
• The company is going to continue to expand, and the board has approved $22 million in capital expenditures which include an expansion project on the 50 acres of property adjoining the Deepwater location purchased in 2012.

Disclosure

Author is long Conrad Industries

Conrad reported results for the third quarter of 2012 yesterday. Results are pretty good: income is up and the backlog is growing. The amount of cash on the balance sheet is also growing while the share count is shrinking. But what I found really interesting was the following disclosure:

We are preparing to submit claims to the BP Settlement Fund in accordance with the Deepwater Horizon Court–Supervised Settlement Program. We plan to submit these claims to the BP Settlement Fund by November 30, 2012, and estimate a response before the end of the first half of 2013. Certain of our businesses are located within the economic zones included in the class settlement and we believe that the damage calculations have been made in accordance with the guidelines established for the BP Settlement Fund. The cumulative amount of the claims is anticipated to be approximately $22 million to $23 million.

While it’s uncertain if they will in fact receive this money this could be a pretty significant event, even after accounting for taxes. The company has at the moment just a ~115M market cap and it has already 43.7M in cash on the balance sheet. It looks like they are not planning to let it sit idle and waste value:

Management is currently engaged in a detailed business planning process to identify potential uses of the Company’s cash.

There is of course always a risk that money will be wasted on something stupid, but given the fact that management owns more than 50% of the company I think they have a strong incentive to do something smart with it. Maybe it would make sense for them to issue a big special dividend and try to take Conrad private? That’s what I probably would try to do if I would be in their shoes.

Disclosure

Long Conrad

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.

Conrad Industries designs, builds and overhauls tugboats, ferries, liftboats, barges, offshore supply vessels and other steel and aluminum products for both the commercial and government markets. The company provides both repair and new construction services at its four shipyards located in southern Louisiana and Texas. It’s a cyclical business that has shown impressive growth and earnings the past five years, but despite this the company is currently trading at a ~5.3x P/E-ratio including cash and just a 3.2x P/E-ratio excluding cash. Some quick stats based on the numbers that the company reported last Thursday. These are different than reported by for example Yahoo Finance because they haven’t yet updated for the new results and share count:

Last price: 16.80
Shares outstanding: 6,088,287
Market cap: 102.3M
Cash and Equivalents (mrq): 43.7M
Enterprise Value: 58.6M
P/E (ttm): 5.3x
EV/EBITDA (ttm): 1.6x
P/B (mrq): 1.09x

With numbers like this you would expect that Conrad Industries is a business like some of my other holdings: one with a mediocre past and future. I don’t think this is the case at all, the company compounded book value per share at a 13.5% rate the past 10 years and at 21.0% the past 5 years. There is also reason to believe that the company is not operating at peak earnings at the moment since historically a large amount of business was related to oil drilling in the Golf of Mexico, and after the Deepwater Horizon accident this dried up. With the current high oil price drilling activities will probably pick up again, and that should be good news for the company. The best part of course is that at current prices you aren’t really paying anything for this potential.

Historical results

I have created a spreadsheet that includes key statistics for the company for the past 10 years, and made some tweaks compared to the Solitron spreadsheet. The diluted shares outstanding used in the per share calculations are the amount of shares outstanding plus options at the end of the year. All companies report EPS numbers based on average weighted shares outstanding during the period, but I think that’s stupid and not reflecting economic reality. If you own 50% of a business and decide to buy the remaining 50% in the second quarter you would say that you own 100% of the business and profits at the end of the year, not a weighted 75%. I’d guess it would make some sense if earnings would be distributed to shareholders during the year.

The reason I ran into this issue was because Conrad Industries is buying back shares, and it bought this year a lot back in the last quarter. So the share count is down nicely, but the weighted average share count is not.

A last tweak I made is to base the average earnings and cash flow per share numbers on the reported shares outstanding in the most recent quarter. What matters is how big of a piece of the business you are buying right now, not how big it was in the past. If I would also make this adjustment for Solitron those numbers would be looking a bit worse since it has a slow but steadily rising share count. Anyway, enough about the accounting, the financial overview (click to enlarge):

The historical results show some positive and negative things. The company was facing troubles in the years leading up to 2005, and that was also the year when the company decided to delist from the Nasdaq to save costs, and since then Conrad Industries has been trading on the pink sheets. The company has not gone dark, and is still publishing quarterly and annual reports that provide an excellent amount of information. Besides audited financial statements the company breaks down revenues by segment and provides information about the order backlog, among other things. Small positive note: the CFO managed to reply within an hour when I emailed a question about the latest annual report.

If we would know nothing about Conrad industries a conservative valuation would probably be to assume that the average earnings for the past 10 years is a safe estimate for the normalized earning power of the company. Throw a conservative multiple on that, add back the cash and you can be fairly sure that you are not paying too much. Average EPS for the past 10 years has been 1.17, combine that with a 8.5 no-growth multiple and add back the $7.07/share in cash and you would end up with a $17/share price target: basically today’s price.

I would say that the 17$/share price target is ridiculously negative since the company has shown a good growth rate and healthy margins even when we include some of the worst years in it’s history, and the company managed to achieve this growth in book value while carrying a large non productive cash position. The company has also become more diversified. Historically most of it’s revenue was Golf of Mexico related, and that this has been successful is shown by the fact that the Deepwater Horizon accident is barely visible in the results. If you would take a more normal multiple for the business (let’s say 10~12.5x) and take the average of the past five years as a guess of normalized earnings power you would get a price target between $34 and 41$/share.

And I don’t think that’s overly optimistic since we are talking about a period that includes a recession and the Deepwater Horizon accident. It should be noted that the backlog is down this year, it was $47.1 million at December 31, 2011 compared to $89.5 million at December 31, 2010. The estimated backlog at March 31, 2012 is $68.7 million.

Another important thing to note is that the company has changed between now and 2002. The company expanded into the aluminum marine fabrication and repair business in 2003 and in 2005 the development of a new construction area was competed that enables Conrad to efficiently construct larger vessels than before. In the past years they also seem to have replaced a lot of rented equipment with company owned equipment, so the capex in the past years wasn’t just maintenance capex. This supports the notion that the financial results after 2005 should be weighted more heavily.

Capital Allocation

The company has shown some good capital allocation decisions in the past: it bought back ~11% of outstanding stock in 2008, and reducing the share count by another 6% since. The trading volume in the stock is limited, so this is a decent result, and the board of directors have approved a new share repurchase program for 2012. Can’t say the repurchase program was executed genially: they stopped it at the end of 2008 only to resume end 2010 because of concerns about the economy, and obviously that would have been the best time to buy with the lowest prices. But hindsight is of course 20/20.

A bigger development is a new capital expenditure program for 2012 for $20.8 million, a very significant increase compared to previous years (Conrad spend approximately $40 million on capex the past 10 years). It’s of course always a bit uncertain how this is going to work out, but in this case it could be a positive development. The company has been compounding book value at a nice rate the past years, and it’s only better if the company can reinvest a big part of the cash balance in the business:

Our Board of Directors has approved a $20.8 million capital expenditure program for 2012 which includes a contract we entered into July 2011 to purchase 50 acres of property adjoining our Conrad Deepwater facility for approximately $5.5 million which is subject to customary closing conditions.

And another quote from the latest annual report (emphasis mine):

Other significant approved capital expenditures include bulkheading, upgrade to launch system and purchase of various cranes. The remaining capital expenditures are for the repair and upgrade of existing facilities and purchase of machinery and equipment that will allow us to improve production efficiencies. The board has indicated to management their desire to be prudent and if conditions are not favorable to postpone the less important expenditures.

Insiders

Insiders own 51.2% of all outstanding shares so while they should have the incentive to operate the business in a prudent manner, other shareholders have a weaker position as minority shareholders. I’m not worried about this since management seems to have a solid track record, is not excessively paid, and there are no ugly related party transactions. The CEO, John P. Conrad, Jr., gets a base salary of $330,000 and a bonus that varied between $330,725 and $549,300 the past three years. The company stopped using an option based compensation plan after delisting from the Nasdaq (this is by the way driving the decreasing diluted share count from 2002 till 2007, basic outstanding shares has remained constant in that period).

The founder of the company J. Parker Conrad is 96 years old and owns 18.7% of the outstanding stock while his son, the current CEO, is 69 years old and owns 17.8%. His daughter owns 12.1%. John P. Conrad, Jr. assumed the role of CEO in 2004 and has been in charge turning the company around in 2005/6. Conrad was written up earlier this year on VIC and the author included a nice quote about the operational abilities of the management:

During the second quarter of 2011 we were affected by rising water levels along the Mississippi and Atchafalaya Rivers. The primary adverse impact was the temporary suspension of operations at our Morgan City shipyard which is located on the Atchafalaya River outside the protection of the levee system. In order to minimize the impact of the imminent flooding and decrease the amount of down time, we constructed our own levee system to protect our Morgan City shipyard. This resulted in no property and equipment damage and also allowed us to return to full operation with minimal clean-up, months sooner than otherwise. We relocated all of our production and support personnel and many of our projects to our other shipyards and continued operations at a minimally reduced level for approximately forty-five days. We resumed limited operations at our Morgan City shipyard during middle of June and were fully operational at this yard by July. All of our other yards remained fully operational. Due to the efforts of our people to plan for protection and move projects to other facilities, there was only a minimal impact on our profitability and no material adverse effect on our Company. Additionally, we were able to keep our people working and we were able to meet the delivery deadlines committed to customers.

Competitive advantage

When buying a company because you think it’s potentially a good business you have to ask yourself what kind of advantage the company has that is protecting profits and margins, and I’d say that this is a bit of a weak point in the thesis. The company is protected from international competition by the Jones Act:

Section 27 of the Merchant Marine Act of 1920 (the “Jones Act”) requires that all vessels transporting products between U.S. ports must be constructed in U.S. shipyards, owned and crewed by U.S. citizens and registered under U.S. law, thereby eliminating competition from foreign shipbuilders with respect to vessels to be constructed for the U.S. coastwise trade. Many customers elect to have vessels constructed at U.S. shipyards, even if such vessels are intended for international use, in order to maintain flexibility to use such vessels in the U.S. coastwise trade in the future.

While the Jones Act has been in existence for a long time I see it more as a risk than a competitive advantage, since protectionism is being reduced worldwide. The geographical location of the company, near the Golf of Mexico, is a bit of an advantage because it’s making the company attractive for the oil and gas industry in that part of the world, but I don’t think there is a real big competitive advantage at Conrad Industries compared too other shipyards. They are simply well managed and able to serve a diversified customer base thanks to the different facilities they operate.

Conclusion

The case for Conrad Industries is quite simple. If you are very pessimistic about the growth and future earnings of the company you are not paying too much at today’s prices. If the company manages to maintain the average performance of the past 5 years it’s already significantly undervalued, and if it can continue to grow at current rates the sky is the limit. I wouldn’t bet on a lot of growth though since I can’t find a compelling reason why the company has a big competitive advantage.

I have been on a buying spree the past month and Conrad Industries is the latest addition to my portfolio. It’s a bit of a different idea than most of my other idea’s that are asset based. I’am not saying that Conrad Industries doesn’t have a strong balance sheet (it does), but the great thing is that it’s a healthy business that should be growing intrinsic value yearly. With an asset based play you are more betting on someone unlocking the value contained in those assets, and the longer that’s taking, the lower your returns will be. With Conrad I’m actually hoping that time is going to be my friend.

On a scale from 1 to 10 I give the stock a 9: It’s a nicely growing company with a strong balance sheet that seems to be well managed, and most importantly: you’re not paying anything for the upside potential.

Disclosure

Author is long CNRD.PK

More reading

The company has been written up three times on VIC (one, two & three) and while finishing this write-up I noticed that the author of Portfolio14 also published some thoughts about the growth potential of Conrad Industries.