The market’s steady and relatively unabated march higher has made it increasingly difficult for investors to find undervalued stocks. Most of the stocks that still screen as “cheap” resemble the shelves of a Soviet Union grocery store: All that is left is the stuff that nobody wants and for good reason. While this is mostly true for the dwindling “bargain bin” of stocks, I believe I have found a fresh loaf of bread concealed behind the expired boxes of buckwheat kasha and cans of potted meat. Orion Marine Group (ORN) offers equity investors an undervalued stock that is poised to build a bridge to alpha generation.
Orion Marine Group is the fourth largest specialty marine contractor in the U.S. servicing the marine infrastructure market. ORN engages in the construction of bridges, causeways, port facilities, marine pipelines, port expansions, marinas, cruise ship facilities, etc. ORN also provides dredging services, maintenance and repair, salvage, and demolition services on, over and under the water throughout the U.S. ORN owns 100% of its fleet, which is comprised of almost 400 vessels and has over 70 years of operational history. ORN derives roughly 36% of revenue from private customers, 41% from the federal government, 12% from local port authorities and municipalities, and 11% from state governments. Contracts are typically fixed costs and shorter term in nature, taking usually between 3 to 9 months to complete.
ORN has significantly underperformed over the past 12 months as a result of a series of disappointing earnings revisions stemming from timing delays for various projects and pricing pressures from new competitors entering the “near water” market. ORN has exercised pricing discipline during this time and as a result has lost contracts to land-based players that are bidding on marine jobs at or below cost because they are so desperate for work. Longer term this situation is untenable for the industry and I expect more rational pricing will return once these “new” entrants either go bankrupt or prove to be incapable of providing the unique marine work. Longer term fundamentals for marine infrastructure construction in the U.S. are favorable because this area has been underinvested in for years and the explosion in global trade is straining existing facilities in the U.S. ORN has a pristine balance sheet with zero debt and almost $1 per share in net cash so they are well positioned to weather this competitive storm and cherry pick attractive assets as the weaker players fold. I see fair value for the stock at $15.
Stock trading at an attractive valuation on what is likely low-ball guidance
ORN has significantly underperformed the market and peers, such as Great Lakes Dredge (GLDD), over the past year as it reduced guidance three times during 2010. In late December, ORN sold off roughly -20% after it guided down for Q4 and provided FY 2011 guidance that called for flat revenue yr/yr and flat profit margins. This negative revision was due to project delays and competitive issues. The project delays are a transient issue in my opinion, all of the revenue that was removed from Q4 is expected to be recognized in Q1 2011. ORN ran into some harder rock density on one of its large dredging projects, a major subcontractor delay (85%-90% of ORN’s work is self performed), and low water levels at another project.
The more relevant issue for ORN is the change in the competitive dynamic of the industry. Throughout 2010 smaller “land-based” players primarily on the East Coast and in Florida entered the marine construction space and bid on work they had never done previously. These construction firms are desperate for work, which is predictable given the state of the residential and commercial real estate, and as a result bid on jobs at extremely low profit margins and evidently sometimes even below project cost. ORN has held fast to a tough pricing discipline and has walked away from many of these jobs which has resulted in lower than expected revenue throughout 2010 and 2011.
So that is the explanation for the lousy trailing 12 months. The opportunity now is that I believe ORN has finally cleared the deck for guidance and has set expectations to a level that is commensurate with the competitive environment. Buying the stock here gives investors a company with a pristine balance sheet (zero debt, almost $1 per share net cash) trading at 5.3x EV/EBITDA that is a dominant player in an industry that should experience above average growth. I view the most recent guidance as the “bear” case and believe management is being extra conservative after disappointing the Street three times in the past year. Even if ORN is only able to realize the current guidance for FY 2011 I think the stock is attractively valued. However I think there is a high probability that ORN surpasses these results which would provide incremental upside to my $15 target.
There are two potential ways the competitive environment could improve for ORN which would in turn improve financial results. The first would be a recovery in land construction (infrastructure, residential, commercial, etc.), which would shift the attention of the new entrants back to the land business. This outcome implies a widespread economic recovery so this could be unlikely in the near term.
The more likely path toward industry rationality would be the failure of these smaller players. A lot of these companies became overly bloated in anticipation for stimulus spending projects and now have cost structures/personnel/equipment levels that are not appropriate for the level of work that is available. As these players take on more jobs below project cost it will likely make their situations even more dire, much like a marooned sailor drinking salt water to avoid dehydration. ORN is a dominant player in the industry (fourth largest) and with no debt, $75m available credit facility, and access to capital markets, it can ride this out much longer than these marginal players.
There is also a very real possibility that a good portion of these land-based players will prove incapable of providing the expertise needed for marine work. These players are new to the space, so it remains to be seen how well they will be able to execute on these project wins. It appears some of these land-based players are getting in over their head and taking on projects they don’t fully understand (which would explain the seemingly irrational bidding). The likely outcome would be delays and poor project results which would drive maritime contracts back to the players that have the marine expertise. ORN has shown strong pricing discipline (much to the dismay of the top-line) so I think it will be able to protect margins fairly well. I do not think we need to see a widespread construction recovery in order for ORN to work, but rather just patience. ORN owns its fleet and has a book value of $9 which I think limits the downside.
Maritime infrastructure fundamentals are favorable; industry has been underinvested in for years
ORN is a niche player that specializes solely in maritime related infrastructure. Marine construction is a high value-added service because of the unique capabilities required and the hostile environment relative to land construction. Marine infrastructure in the U.S. has seen under-investment for years and the increase in global trade is putting a strain on the existing facilities. Recent undertakings such as the widening and deepening of the Panama Canal will require updated ports, piers and causeways to handle larger ships. ORN estimates there are $4.7 B of future bidding opportunities for 20 of the ports it works on.
There is a bill in Congress that could provide a large long-term funding catalyst for maritime maintenance funding. The bill relates to the Harbor Maintenance Trust Fund, which was established in 1986. The fund is paid for by an ad valorem tax levied on cargo moved through federally maintained channels and harbors and is intended to be used for waterway operations and maintenance dredging. However, in a typical year only about 50% of the tax revenue is spent on dredging projects and as a result the trust fund now has a $5 B surplus. The problem, from the perspective of the maritime industry, is that currently any money not spent on harbor maintenance is available for use as general revenue (deficit reduction, etc.). The HMTF bill seeks to ensure that all revenue collected for harbor and port maintenance will be used solely for the intended purpose which would effectively double the amount of maritime maintenance funding. The bill has bi-partisan support and was sponsored by Charles Boustany (R-LA) who is now the chairman of the Ways and Means Committee. ORN would likely react very favorably to passage of this bill.
Balance sheet gives ORN flexibility to cherry pick assets from struggling competitors, share buybacks
Given the trouble within the industry, ORN can use its balance sheet as a competitive advantage to cherry pick assets from weakened competitors. Last January ORN acquired TW LaQuay for $60m, which according to ORN was less than the market value of the equipment alone. As a dominant player with an excellent balance sheet, ORN should be able to make opportunistic acquisitions.
ORN generates a healthy amount of cash flow and with the stock near its 52-week low I think there is a decent probability that ORN could announce a share buyback. The cash sitting on the balance sheet alone ($23m) is enough to repurchase 8% of the shares outstanding.
* Government spending at all levels truly gets curtailed across the board, putting pressure on maritime infrastructure spending. Government customers (federal, state and local) make up roughly 64% of revenue so this would be a headwind for ORN. However, maritime spending is not a large piece of government spending and has been under-invested for years, so I see other areas (healthcare, entitlements, etc.) presenting much greater opportunities for spending cuts.
* Land-based contractors continue to bid on maritime work at irrational levels out of desperation. I think this phenomenon is unsustainable over the longer term.
* HMTF bill fails to pass. Bill passage would be incremental upside given that failure to pass the bill would just be perpetuation of the current status quo.
* Dislocation or panic in the muni bond market, this would make it harder for governments to raise funds for marine infrastructure projects. Hard to handicap the likelihood of this happening but many respected investors such as Bill Gross think the U.S. government would step in to support the muni market if things get rough.
Disclosure: I am long ORN.