Gulf Island Might Be Getting Ahead of Itself

Includes: ATPAQ, GIFI
by: Tom Armistead

Gulf Island Fabrication (NASDAQ:GIFI) popped on its earnings, closing Friday at 25.49. I wrote the stock up favorably in late September last year, when it stood at 18.06, setting a 31 target with a two year time frame. At the time, I noted the company's diminished backlog and planned to take up a starter position and monitor quarterly for progress.

Building on the material in my original post, this update focuses on recent news and attempts to form a clearer impression of the company's future prospects and possible price trajectory. After making a relatively quick 40% move, the stock is a little bit ahead of itself, although long-term its prospects are brighter than they were six months ago.

Backlog – When this item becomes an issue, I add a sheet to my workbook, and keep a running tally of backlog quarter by quarter: (Click to enlarge)

It is mildly encouraging that backlog has increased in recent quarters, both in dollar amount and as a percentage of TTM Revenue. Implied orders are also increasing. The nature of the business is such that a few big orders, scheduled over a year or more, can have a dramatic effect on backlog.

Management and sales personnel stay in touch with potential customers and the company bids on projects as they become available. Deep water platforms, which are big ticket items, are awarded at sporadic intervals. With oil at 80 a barrel it seems likely that these projects will start moving again. If and when GIFI is awarded a few orders, or shares parts of several orders as a subcontractor for the competition, backlog will look much better. The company issues press releases on large orders as they are received, which could generate a gap upward.

Earnings – Operating with reduced backlog and diminishing TTM revenue, GIFI has demonstrated an ability to maintain margins and continue to operate at a profit. A large part of this can be attributed to strong results from their marine construction business. The company increased their presence in 2007, adding experienced management and getting additional work. On the conference call, CEO Kerry Chauvin was enthusiastic about how this business is developing and plans to expand it at a controlled pace. From the 10-Q:

Included in the 2010 capital expenditure budget of $18.9 million is $4.5 million for the completion of the graving dock gate located in our Gulf Marine facilities. The gate will allow us to open and close the entrance of the graving dock within a few days opposed to a few weeks. We believe the new gate will improve our efficiency and enhance services to our customers through a shorter dock turn-around. Also included is $7.0 million for a fabrication shop and warehouse in the west yard of our Gulf Island facilities to further expand our marine construction and repair activities. We believe these facilities will allow Gulf Island Marine to become fully operational and improve its operations by becoming more centralized and efficient.

Believing the company is starting to move up off its bottom, I developed the estimates highlighted with light blue for the rest of the year. Management has not provided quantitative guidance and expects that the 2nd quarter will be more difficult than the first. The second half of the year they expect to do better. The 1.54 estimate for 2010 is probably pushing it a bit but if industry conditions improve with the price and demand for oil it will be in the ballpark.

Marine Construction – As discussed under earnings, this area of the business is doing well and when oil and gas comes back it will be the frosting on the cake. The company does not report any segments so there is no breakdown of the business between marine and oil and gas.

My impression is that the company with its increased marine construction and repair business is now stronger to operate profitably through cycles in the oil and gas equipment sector. As the earnings above show, they have so far been able to ride out the crash in early 2009, and consequent slowdown in oil industry capex, without posting any losing quarters.

Receivables – In the wake of the creative financing by ATP Oil and Gas (ATPG), GIFI is dependent on a limited royalty agreement for the final 48 million of the contract on the MinDoc I – ATP's Titan. The accounting is, they have discounted the receivable at rates between 11 and 18% to reflect the risk involved, and will be booking the discount back as interest received over the period that payments are expected to be made. From the 10-Q:

Bluewater agreed to pay the remaining $48 million owed to us pursuant to the assignment of all of its right, title and interest in the Conveyance of Overriding Royalty Interest between Bluewater and ATP. The interest we received from Bluewater is a limited overriding royalty interest because the amount to be received by us is set not to exceed $48 million. Upon cumulative receipt of the $48 million, the limited overriding royalty will revert back to Bluewater. Originally, we projected that we would start receiving royalty payments from this limited overriding royalty interest in February 2010, and we anticipated the entire $48 million to be paid over a thirteen-month period based on our review of petroleum engineering reserve reports applying strip prices in effect in mid-June 2009. Included in our estimate of contract revenues for this contract as of December 31, 2009, we projected that we would start receiving royalty payments in late May or early June of 2010 that would continue over an anticipated payout period of approximately fourteen-months. Based on information through April 22, 2010, we continue to anticipate this payout timeline. Strip prices for oil and gas as of April 22, 2010 are in line (the increase in oil prices exceed the effect caused by the decrease in gas prices) with the mid-June 2009 prices used to previously estimate the repayment period.

While we believe the available oil and gas reserves for the properties subject to our limited overriding royalty interest significantly exceed $48 million, we have no guarantees from Bluewater or ATP if the limited overriding royalty interest does not fund the $48 million balance. To the extent the limited overriding royalty interest does not fund all or a part of the $48 million, we will be required to recognize a charge against earnings, which may be significant depending on the shortfall.

Valuation – Using projected 5 year average EPS of 1.74 and a multiple of 18, my revised midpoint target is 32, by the 4th quarter 2011. That would return 17% annualized from Friday's price. The company is operating profitably during an industry slowdown, not so much a survival shuffle as a measured pace under difficult circumstances. One or several good size deep water projects could have a dramatic effect, with the potential to create a situation where 40 per share would be in reach.

Strategy and Tactics – Putting the above through the blender, some of the news needed to drive shares up to target has yet to be received and may not necessarily occur. The market as a whole has done well so far this year, and may be due for a correction. Patient investors may be able to get a better entry point by waiting on this situation. Beta checks in at 2.2 so the chance of catching a good size dip is out there.

Items to keep track of: earnings, backlog, receivables from Bluewater, growth of the marine construction business.

Digression – the value investor's lament. As a value investor, I have the tendency to sell early. Sometimes I think I should be subject to adult supervision on my selling activities. On GIFI, I happily sold covered strangles, the July 17 2010 20/22.5 back a few weeks ago. Then last week I sold some extra shares I had at 25, going on to sell puts at 22.5, under the theory I would be happy to buy the shares back at the lower price.

So when the shares got over 27 today I was not altogether pleased, since my recent trades will get me out of the position at effective prices between 25 and 26.50. I get that mouse going, click click click, and look what happened now, I gave away my shares.

From a logical point of view, my rate of return for a six month hold was about 80% annualized, quite a bit better than the 17% I expect going forward. I have done well during the past year by taking profits on a regular basis. So I will have to deal with seller's remorse for a while, it goes with the value investment style.

Disclosure: Long GIFI, no position ATPG