Gulf Island Fabrication: Value with Deepwater Exposure

Gulf Islands Fabrication Inc. (GIFI), at Friday's closing price of 18.06, is a value play in the oil and gas equipment and services industry. The initial attraction is a combination of low P/B (1.0) and low Price/5 Year Average Earnings (11.5). The company has numerous strengths, which over time should allow it to overcome current weakness in revenue and backlog and participate strongly in the growth area of deep water equipment.

I picked up the idea from a screen by Alan Brochstein here on Seeking Alpha. Checking further, the same name appears on a screen he did on 3/28 which also included Carbo Ceramics (CRR) and Lufkin Industries (LUFK), both successful picks I wrote up favorably and bought for my discretionary account. To some extent I work by affinity – I follow Alan and since this idea is a case where our thinking leads in the same direction, I did my own research, developing the following information and opinion.

Overview – Excerpts from the 10-K:

We are a leading fabricator of offshore drilling and production platforms, hull and deck sections of floating production platforms and other specialized structures used in the development and production of offshore oil and gas reserves. The company was founded in 1985 ... and began operations at our fabrication yard on the Houma Navigation Canal in southern Louisiana, approximately 30 miles from the Gulf of Mexico. Our Houma facilities are located on 630 acres, of which 283 are currently developed for fabrication activities with 347 acres available for future expansion. Effective January 31, 2006, we acquired the facilities, machinery and equipment of Gulf Marine Fabricators (“Gulf Marine”) located in San Patricio County, Texas.

Our acquisition of Gulf Marine ... enables us to perform dockside integration, provides us with increased rolled goods capabilities, affords 45 feet of water depth access to our facilities, gives us the ability to construct 1,300 foot conventional jackets and tendons for floating production platforms, offers us much greater lifting capacity dockside (4,000 tons), and makes available an additional labor pool.

We believe that spending by our customers and potential customers for projects for use in the Gulf of Mexico and international deepwater (generally depths over 1,000 feet) will continue to grow as a percentage of their total offshore expenditures. These projects are typically much larger than projects for use in the shallow water. We can now fabricate and assemble all components of deepwater construction projects, which we were previously limited from doing by the physical constraints of our Houma yards. The acquisition of Gulf Marine positions us as a leading U.S. deepwater fabricator. In addition, it has increased our labor pool, provided opportunities for additional work from our cooperation agreement with Technip and given us the largest fabrication capacity on the Gulf Coast.

Our customers are primarily major and independent oil and gas exploration and production companies. We also may perform work as a sub-contractor for one or more of our competitors. Over the past five years, sales of structures and related services used in the Gulf of Mexico by oil and gas exploration and production companies accounted for approximately 76% of our revenue. The balance of our revenue was derived from the fabrication of structures installed outside the Gulf of Mexico, including North Africa, West Africa, Middle East, Latin America, the Caribbean, Offshore Canada and the North Sea.

Strengths - Conservative management has kept the company free from long term debt, steadily growing tangible book value per share at a pace of 12 % per year for 10 years.

Under customary contractual terms, material costs are passed through, while labor costs are subject to a variety of plans ranging from fixed cost to cost-plus, with various intermediate possibilities. The company's labor force, supplemented by a small amount of contract labor, is carefully managed to maintain alignment with production needs. Capex proceeds unevenly year by year but over time has been kept consistent with cash flow, being met from retained earnings.

The track record demonstrates that management has been effective in managing skilled labor, large and complex projects, and capital expansion to enhance shareholder value.

Deepwater vs. shallow water – For many years GIFI prospered by building shallow water platforms for the Gulf of Mexico. Due to the development of directional drilling, fewer shallow water platforms will be needed going forward. Deep-water is becoming much more important, and that is where the larger and more expensive projects are.

In 2006 GIFI acquired the assets of Gulf Marine, which gave them the facilities necessary to compete for these large projects. The timing and positioning were adroit and can be anticipated to bear fruit over time.

Adjacent or compatible businesses – The company has expanded its steel sales operation, which utilizes the material handling capabilities of its primary operations. In 2007 they expanded operations in the marine construction area to reduce the fluctuations in work volume caused by the decrease in awards of projects for shallow water structures, adding experienced management level personnel and acquiring additional work.

Backlog - An area of concern. Large projects may last more than a year and under normal conditions GIFI has a backlog averaging about 85% of TTM Revenues. As of 6/30/09, backlog stood at about half its normal level, due to the indefinite postponement of the MinDOC II project for ATP Oil & Gas (ATPG). I looked at ATPG's operations and did not form a favorable impression. Normal contractual terms allow GIFI to recover the cost of canceled projects and in some cases provide for penalties.

After oil prices tanked earlier this year, capex for many oil and gas companies was reduced. With oil prices around 70 and the world economy in recovery, companies will again be taking a longer term view about the expense of deep-water projects, which are necessary to maintain adequate production.

Most work in the industry is awarded by bid: as production companies increase their capital spending Gulf Island is well positioned to compete for large deepwater projects.

Risk management – This is heavy industry with maritime exposures. The company self-insures their worker's compensation and longshoreman's and harbor workers exposures up to 300,000. 2008 results were impacted by a loss involving four cranes, which were damaged and required expensive rental replacements. Also, there were 3^rd quarter losses due to hurricanes. I don't have details on the crane loss but it does constitute a reservation: it was an operating accident sufficient to affect profits, and presumably was preventable.

The industry is cyclical, a risk that is counteracted by conservative financial management – no long term debt.

Competition - The productive assets are conveniently located and would be difficult for competition to replicate due to environmental and NIMBY issues. Management believes that barriers to entry for smaller projects are not difficult, but for larger projects they are substantial.

Most of the work in the industry is awarded by bid, and is won or lost on price, although past reliability, safety record, financial strength etc. are additional considerations. The 10-K names two domestic competitors. Foreign competition is intense, with some competitors receiving government support or subsidies.

Valuation – For a cyclical industry, 5 year average EPS is useful when looking beyond a trough year. At the end of 2009, my estimate works out to 1.54. Based on historical share prices, an average multiple on that metric would be 20, leading to a target price of 31 within two years. The stock traded as high as 52.59 in 2008, 45.00 in 2007, and 40.24 in 2006. A strong balance sheet and tangible book value provide margin of security.

Strategy - Share prices have fluctuated dramatically for the past 4 years, driven by the price of oil and general market irrationality. The contrast between the relatively steady increase in shareholder's equity or tangible book value and the gyrations of the stock is food for thought, particularly considered in the context of the good visibility afforded by the backlog, which is normally large, and the expected demand for deep water platforms.

I have taken up a starter position and plan to accumulate and monitor the backlog and conference calls as quarterly earnings come out.

Disclosure – long GIFI, no position in ATPG

Comments

[Alan Brochs...:]

Nice work, and thanks for the attribution...

Sep 29 09:22 PM

[Don-n-ABQ:]

Tom,

Well, I typed out a big long reply then hit the wrong button and it was lost.

Anyway, GIFI to me is more of a trading vehicle than a long term hold.

What we need is a chart that shows worldwide offshore rigs under construction. I guess this would be a buy when the price of crude is going up, the offshore rig count is going up, and day-rates are going up? Then it is a buy. When those indicators go down we short.

I like companies like Carbo Ceramics (CRR) a lot better that GIFI because of the cyclical downturns/overbuilds.

Thoughts?

Oct 01 07:21 PM

[Tom Armistead:]

Don, comparing the two strictly on valuation, CRR is now above its midpoint based on historical average earnings, while GIFI is well below the same relative target. Of course the past does not necessarily predict the future, but mean reversion works often enough you have to respect it.

Natural Gas seems to be developing with abundant supply in shale, horizontal drilling, etc., and to judge by how share prices are moving I think CRR has established a place in the new scenario. As such it shoule be more stable in price.

Deepwater drilling particularly in the Gulf of Mexico is uncertain, there is some encouraging work by Arthur Weglein on improving sonic imaging that may make the proportion of dry holes less troublesome. Meanwhile higher oil prices should eventually make deepwater bigger than it is. So GIFI could just sit there for months or years before making a big move when it can demonstrate a meaningful backlog.

If that was one or more big orders they would issue a press release, leading to a quick pop. Otherwise, it might come out with the earnings, again an increase in backlog to acceptable levels would generate a quick pop.

Tom

Oct 02 09:28 AM

[HarryW:]

Tom,
You wrote: "I looked at ATPG's operations and did not form a favorable impression." I'm curious to know why you thought it necessary to add that seemingly irrelevant criticism. Is ATP not an important current customer of GIFI, who in all probability will be receiving orders from ATP again in the future. You go on to say that: "Normal contractual terms allow GIFI to recover the cost of canceled projects and in some cases provide for penalties." You seem to be implying that GIFI has a claim against ATP specifically. Do you have any specific knowledge of the contract between the two companies or the likelihood of future litigation?

Oct 05 02:53 AM

[Tom Armistead:]

I don't have any information on the contract or potential litigation. The point in looking at ATP was to see if there was anything to suggest the order might be firmed up to where GIFI could include it in the backlog. Obviously if it is being deferred indefinitely that is the equivalent of a cancelation.

ATP operates with a fair amount of leverage and very generously permitted some of their suppliers to participate in the profits of ventures they had supplied the product for. That seemed like creative financing and if GIFI is to do business with them I can't see why they would want to get involved in some kind of share the profit if we make any, if no profit, oh well type arrangement.

The point is the MinDOC II is not in the backlog and it is unlikely to be resurrected.


On Oct 05 02:53 AM HarryW wrote:

> Tom,
> You wrote: "I looked at ATPG's operations and did not form a favorable
> impression." I'm curious to know why you thought it necessary to
> add that seemingly irrelevant criticism. Is ATP not an important
> current customer of GIFI, who in all probability will be receiving
> orders from ATP again in the future. You go on to say that: "Normal
> contractual terms allow GIFI to recover the cost of canceled projects
> and in some cases provide for penalties." You seem to be implying
> that GIFI has a claim against ATP specifically. Do you have any specific
> knowledge of the contract between the two companies or the likelihood
> of future litigation?

Oct 05 07:41 AM

[HarryW:]

Tom,
Let me say, up front, that I am ATP shareholder and that is where I am coming from. I can certainly understand why you would have formed a negative impression of ATP from a cursory examination of its present balance sheet and revenues. However, the company is getting its house in order: it has recently raised new capital, monetarized its Gomez pipelines and paid down the 2011 tranche of its admittedly substantial debt burden. The future for ATP actually looks pretty good, but that future is crucially dependent on the successful deployment and anticipated performance of Minidoc I. If things pan out as expected, ATP's balance sheet and cash flows are going to be radically transformed in 2010. My point is that, in this particular case, "indefinite postponement" should not be automatically equated with cancellation. The recent discovery of addition pay at ATP's Telemark field also augers well for the future.

I agree entirely that the deferred payment deals are creative financing. Is there something wrong with that? Innovative cash management solutions would seem to be just what is needed in the present environment. Anyway, I do accept that our respective interests would lead us to view this matter through very different prisms. I would just like to point out that some pretty hard-nosed suppliers have signed up for these deals, which suggests to me that they have a fair degree of confidence in ATP's ability to pay their bills going forward. Companies like Diamond Offshore don't keep working unless they believe they’re going to get paid. My understanding is that ATP continues to enjoy a good working relationship with its suppliers, GIFI included.

On a more critical note, I was alarmed by the implication you made concerning GIFI's possible recourse to litigation. I assume that the juxtaposition of the specific reference to ATP and the general comment about normal contractual terms was not accidental. In light of what I have said above and your own admission that you have no knowledge of the contract between the two companies, you might want to correct the highly questionable impression that you have created. I am not the only reader who has interpreted that paragraph in the way I have described (reference available on request). To the best of my knowledge, there is no reason to believe that GIFI is contemplating legal action against ATP, so the question is begging to be asked - why did you imply that such a course of action is potentially in the offing?

Oct 08 12:29 AM

[Tom Armistead:]

Harry, I was not trying to imply that GIFI contemplates litigation against ATPG, or indeed that they have any legal claims against them. My concern was about the quality of GIFI's assets, the point being that if they have any WIP on MinDOCII that is posted as an asset I am not aware of any reason to suspect they may have to take a write-down.

As I recall in discussing a dry dock they had built specifically for the MinDOCII at a cost of 17 million GIFI said they could put it to other uses. In any event, I expect the management of any company where I own shares to asset any legal rights they may have to protect my interests.

I just read an article by Devon Shire on ATPG, very enthusiastic although not very careful in discussing the balance sheet and creative financing. Also not very specific in defining the types of cash flow discussed or the claims various parties may have on the cash. Devon Shire has not written anything on any other company.

I then went back over the financials and visited the website, noting as you do that Diamond Offshore is a strong player and has participated in the creative financing. I looked at a presentation ATPG gave recently, the main contention was that the NAV of their energy holdings is something like 114 per share, compared to where the share prices are.now.

My experience with other asset rich but over indebted companies suggests that the assets do get monetized, but all too often the shareholders see very little benefit. On the other hand, some of these highly leveraged energy ploys like KWK will do very well at times, they can have some pretty impressive runs, but you have to bail before they crash.

Personally I think there is still a lot of value in energy stocks but I would be very hesitant to take a position in a company with a history of backing themselves into a corner by excessive borrowing, solving the problem by diluting shareholders and engaging in creative financing, and very possibly making bad deals in monetizing assets that should have been retained unencumbered.

Tom


On Oct 08 12:29 AM HarryW wrote:

> Tom,
> Let me say, up front, that I am ATP shareholder and that is where
> I am coming from. I can certainly understand why you would have formed
> a negative impression of ATP from a cursory examination of its present
> balance sheet and revenues. However, the company is getting its house
> in order: it has recently raised new capital, monetarized its Gomez
> pipelines and paid down the 2011 tranche of its admittedly substantial
> debt burden. The future for ATP actually looks pretty good, but that
> future is crucially dependent on the successful deployment and anticipated
> performance of Minidoc I. If things pan out as expected, ATP's balance
> sheet and cash flows are going to be radically transformed in 2010.
> My point is that, in this particular case, "indefinite postponement"
> should not be automatically equated with cancellation. The recent
> discovery of addition pay at ATP's Telemark field also augers well
> for the future.
>
> I agree entirely that the deferred payment deals are creative financing.
> Is there something wrong with that? Innovative cash management solutions
> would seem to be just what is needed in the present environment.
> Anyway, I do accept that our respective interests would lead us to
> view this matter through very different prisms. I would just like
> to point out that some pretty hard-nosed suppliers have signed up
> for these deals, which suggests to me that they have a fair degree
> of confidence in ATP's ability to pay their bills going forward.
> Companies like Diamond Offshore don't keep working unless they believe
> they’re going to get paid. My understanding is that ATP continues
> to enjoy a good working relationship with its suppliers, GIFI included.
>
>
> On a more critical note, I was alarmed by the implication you made
> concerning GIFI's possible recourse to litigation. I assume that
> the juxtaposition of the specific reference to ATP and the general
> comment about normal contractual terms was not accidental. In light
> of what I have said above and your own admission that you have no
> knowledge of the contract between the two companies, you might want
> to correct the highly questionable impression that you have created.
> I am not the only reader who has interpreted that paragraph in the
> way I have described (reference available on request). To the best
> of my knowledge, there is no reason to believe that GIFI is contemplating
> legal action against ATP, so the question is begging to be asked
> - why did you imply that such a course of action is potentially in
> the offing?

Oct 08 07:26 PM

[HarryW:]

Tom,
Thank you for clarifying that point. It certainly is a weight off my mind. What an unfortunate misunderstanding, and it could so easily have been avoided with just a little more care to the paragraphing.

You seem to have rather a jaundiced eye when it comes to ATP, so I think I'll pass on high-speed analysis and stick with Devon Shire's in-depth knowledge of ATP.

Oct 08 09:41 PM

[Devon Shire:]

"just read an article by Devon Shire on ATPG, very enthusiastic although not very careful in discussing the balance sheet and creative financing."

Hi Tom,

I've written a few times on ATP. You should also read the first three articles as I believe I took a very detailed look at ATP's debt.

I don't believe the creative financing is a problem. It is a positive. ATP just raised $300mil in cash. Is raising another $300mil with the sale of half of it's interest in the ATP Titan. And then will be selling the Telemark pipeline for $160mil.

That is $760mil in cash against $290mil of creative financing and doesn't consider the fact that cash flow from operations will approach $800mil per year once Telemark is fully on production.

Let me know what you think.


On Oct 08 07:26 PM Tom Armistead wrote:

> Harry, I was not trying to imply that GIFI contemplates litigation
> against ATPG, or indeed that they have any legal claims against them.
> My concern was about the quality of GIFI's assets, the point being
> that if they have any WIP on MinDOCII that is posted as an asset
> I am not aware of any reason to suspect they may have to take a write-down.
>
>
> As I recall in discussing a dry dock they had built specifically
> for the MinDOCII at a cost of 17 million GIFI said they could put
> it to other uses. In any event, I expect the management of any company
> where I own shares to asset any legal rights they may have to protect
> my interests.
>
> I just read an article by Devon Shire on ATPG, very enthusiastic
> although not very careful in discussing the balance sheet and creative
> financing. Also not very specific in defining the types of cash flow
> discussed or the claims various parties may have on the cash. Devon
> Shire has not written anything on any other company.
>
> I then went back over the financials and visited the website, noting
> as you do that Diamond Offshore is a strong player and has participated
> in the creative financing. I looked at a presentation ATPG gave recently,
> the main contention was that the NAV of their energy holdings is
> something like 114 per share, compared to where the share prices
> are.now.
>
> My experience with other asset rich but over indebted companies suggests
> that the assets do get monetized, but all too often the shareholders
> see very little benefit. On the other hand, some of these highly
> leveraged energy ploys like KWK will do very well at times, they
> can have some pretty impressive runs, but you have to bail before
> they crash.
>
> Personally I think there is still a lot of value in energy stocks
> but I would be very hesitant to take a position in a company with
> a history of backing themselves into a corner by excessive borrowing,
> solving the problem by diluting shareholders and engaging in creative
> financing, and very possibly making bad deals in monetizing assets
> that should have been retained unencumbered.
>
> Tom

Oct 09 04:17 PM

[Tom Armistead:]

Devon Shire and Harry W,

I went back to the original article and as you have said the debt issue is covered in detail. Congratulations on a good call, a multi-bagger from where you wrote it up.

As a value investor I have had mixed results on high debt cases, two for five and lost more than I made, so with the amount of tech cases that were trading at discounts and had plenty of cash and no debt, I have been staying away from debt cases and perhaps have become excessively negative on the issue.

Going over the presentations at ATPG's website, most of the recent ones make a point of the PV-10 compared to the share value. Early presentations are careful to distinguish proven from probable and state the pricing used, typically a three year strip. The most recent presentation does not make these distinctions. This leaves me concerned in attempting to reconcile management's recent claims on value back to the material included on the 10-K. Of course oil prices have increased from the 12/30 level and natural gas is a wild card.

David Einhorn was long the stock at the end of the 2nd quarter, he is well known as a value investor and has enjoyed some success. I also saw where Cam Hui who I follow mentioned it as a Phoenix stock, I went with the strategy but used other selections.

If the 75 number you suggested in the April article can be realized then this still has a way to go. Backing away from my original negative impression I would say this stock is interesting from the point of view of having a large but indefinite upward potential.

For energy plays right now I am long COP and XOM, using options for leverage. That way I have the possibility of large returns from energy without doing heavy analytical work on debt where I have had poor results. It's about what works for me.

Tom

Oct 10 07:59 AM

[babajay:]

Devon, Tom and Harry thank you for a civil and well carried out discussion on ATPG. I was also quite alarmed at Tom's paragraph on ATPG and felt that some clarification was needed. Having followed the thread, my concerns have been set aside. Tom is obviously approaching this from the viewpoint of a GIFI shareholder. While ATPG shareholders may take a littule umbrage at the paragraph, it is important to note that Tom's view is probably what makes ATPG a good investment. management that uses creative financing that they understand is obviously preferable to management that takes on a lot of debt that they dont understand. ATPG managements strength lies in the acquisition and development of reserves. Financing is key to their activities. Their strategy so far has proven to be a win-win for shareholders and suppliers alike. Will it continue.? I beleive it will; Others may not, but then thats what makes a market.

Oct 18 08:23 AM