Conrad, part deux..

My last post on Conrad ended in a bit of a cliffhanger, I asked a question which I never answered.  It's been five months since that post and I haven't forgotten about Conrad, or the question I had bouncing around in my head, "why are they cheap?"  They'd been in the back of my mind until a friend brought them up recently in an email exchange.  Almost simultaneously I received an email from the author of Credit Bubble Stocks mentioning Conrad.  A quick aside, Credit Bubble Stocks is the absolute best place to go for information outside of Conrad's filings.  The blog has been covered the company for the past year and a half.

If you're too busy to read the previous post here's a cliffnote background on Conrad.  The company is a shipbuilder mainly producing barges for inland waterways in the US.  The company consists of two segments, construction and services.  Construction is fairly stable whereas services revenue can be lumpy depending on client usage patterns.  Facilities are located in Texas and Louisiana, with headquarters at Morgan City, LA.

How the thesis has changed

Conrad has released half a year's worth of earnings since my last post, so it's worth getting a good overview of how they stand now:

-Market cap dropped from $112m to $97m.
-EV/EBIT of 2.34x
-P/B of .94x
-ROE of 17%

Free cash flow over the last twelve months is essentially zero due to a large capex spend in the latest quarter.  But otherwise everything is humming along as it was the last time I posted, the company has continued to execute and has drifted lower.

Why is it cheap?

This was the question that kept me from investing, I couldn't figure out why a company with such great growth and margins was selling at a EV/FCF of 2.8.  My post spawned a few response posts which helped clarify my answer, but the real connection was when Credit Bubble Stocks connected something I wrote with Conrad.

The first reason the company is cheap is that their results might be a bit misleading.  The company has an incredible return on equity, 20% in 2011 and on track to be close to 17% for 2012.  My question was how could a company like this not be attracting competition, and why was it valued so low?  It turns out some of the book value is understated.  A few of the company's properties are held on the books at cost.  Cost for these properties means the price paid to construct in 1948.  In 1948 the annual salary in the US was $3600 a year, the current average US salary is $63,000, a 17 fold increase.   If we had a current appraisal of the company's properties it's reasonable to assume that book value would increase considerably and return on equity would drop as a result.

The more important metric to me is book value growth, this is a better measure of value creation.  Conrad doesn't pay a dividend, and earnings have been growing, so something has to happen with the free cash.  Either the company pays down debt (it has $1.4m worth), pays a dividend/buys shares, or reinvests in the business.  Since the company doesn't pay a dividend the other options should all be book value accretive.  The reason for this is any growth in assets such as tools, equipment, or property is recorded on the books as an asset.  In theory the asset acquisitions should translate to earnings growth.  The company is now able to build more barges, or service more boats.  The only time this doesn't happen is when a company needs to consume cash just to stay afloat.  I try to avoid cash consuming companies, but I've been bitten once or twice then the price is low enough.

Conrad's book value has grown by 9.8% annually over the past 10 years, and 37% annually over the past five years.  These are impressive numbers but keep in mind the context, replacing a machine that cost $100,000 in 1970 with one that costs $450,000 today creates a small jump condition in book value, some of this could be what we're seeing with Conrad.  If Conrad ever needs to move facilities book value would increase considerable and ROE would shrink considerably as well.

The connection that Credit Bubble made that I referenced above was tying the post where I discussed how an average business can be a great investment to Conrad Industries.  In the post I talk about how some companies appear to have moats but in reality they're just niche companies.  Conrad fits this perfectly, the company can earn generous returns on equity (even if it's understated) because they operate in a small barge building niche.  Credit Bubble has done some great work getting information on competitors and the industry is very consolidated, there are only a few competitors and not a lot of companies rushing to join the barge building gold rush.  As long as barriers to entry remain high, which the US Gov is working hard to keep Conrad will probably continue to earn their outsized returns.  The difference between a niche and a moat is scalability. Conrad's growth is constrained by barge retirements and demand for new barges.  Barges aren't exactly a high tech growth industry at this point.

What's the end game?

If you've made it this far in the post you're probably actually interested in Conrad.  I think there are three developments or aspects which could keep Conrad charting a straight course for the next few years.

The first is the company is party to settlement money from the BP spill fund.  There's no indication how large the settlement might be, but the company thought it was important enough to include it in their earnings release.  The company might use the money to buy back further shares, or possibly pay a one time special dividend.

The second item is the long term outlook for the industry.  In my last post I was worried Conrad was a cyclical at the top of the cycle.  I still think the company is cyclical, but after reading more about the barge industry I realized there is a barge supply problem.  The barge industry's production rate is lower than retirement rate.  Barge usage has actually increased straining supply.  As a result there are secular tail-winds for barge builders.  Conrad continues to mention in their disclosures that customers are slow to sign new contracts, but their backlog is telling a different story.  The company's backlog was $57.2m on June 30th 2012.  As of Aug 20th 2012 the company's backlog was $88.7m, a big increase for two months!  The current backlog translates into earnings of roughly $2.80 per share for 2012 giving Conrad a forward P/E of 5.71x.

The last thing worth mentioning is the end-game for this company.  Conrad delisted so they could save the listing fees, the company is family owned, and family run.  They've also been buying back shares consistently over the past few years.  I wonder aloud if the goal is to slowly take the company private by eventually buying out minority shareholders.  The company listed so it could have access to capital to expand, but they've decided their listing didn't facilitate capital access very well.  Without the market serving their main purpose it makes little sense to be listed at all.

Conclusion

When I research some companies I have to strain my eyes to see past the company's warts to develop an investment case.  Conrad is different, the question I've continued to ask myself is why shouldn't I invest?  Sometimes the decision to make an investment is anti-climatic, no red flags, just a cheap boring company with an unclear upside.  This is the way I've felt with Conrad.  The company is clearly cheap on just about any basis.  In the end I think I'm going to take a position in Conrad, I just can't ignore them anymore.

Talk to Nate about Conrad

Disclosure: No position, but will be buying shares at some point soon.