Orion Marine Group (ORN) is a heavy civil construction firm based in the Gulf Region of the Southeastern United States. It has a market capitalization of $170 million and offers investors exposure to domestic marine infrastructure build and repair, transportation and shipping, and environmental remediation at a bargain price.
Decaying infrastructure in the United States is a time-worn conversation. The theme has attracted and frustrated investors in turns. The crumbling of highways and bridges (such as the 35W collapse in Minneapolis in 2007) provokes safety concerns and drags on future economic competitiveness, and was a centerpiece of President Obama's 2009 and 2011 stimulus plans. The American Society for Civil Engineers estimated in 2009 that infrastructure deficiencies cost the U.S. $129 billion each year, through added vehicle costs and congestion. It rates 26% of the country’s bridges as structurally deficient or unsound. The situation is no better along coastlines and at ports. The ASCE gives our ports and waterways a grade of “D-”, calling for a large program to expand capacity and maintenance. Hurricane damage to the Gulf Coast in particular has worsened in the last decade, damaging critical petroleum refining assets, destroying coasts and harbors through erosion and sedimentation. The word “Katrina” need not even be spoken.
Given the demonstrated need for increased public and private spending, one might think that civilian contractors with proven technology and expertise, such as ORN, would be poised to benefit. Not so. An absence of budget clarity from federal and state governments has left a large portion of our critical infrastructure needs unaddressed. For these reasons, ORN, a company with more than a decade’s experience (public since 2008), a pristine balance sheet, and competitive advantages in technology and know-how, can be had for a song. Because longer-term maintenance of ports, harbors, pipelines, and coasts, particularly in the vulnerable Gulf Region, is not discretionary, ORN has few of the characteristics of a value trap. The company has a large net cash cushion, a management team focused on its core business, and a contract backlog solid enough to weather the storm. Luckily, there are nearer-term catalysts that should allow it to return to profitability, likely as soon as next quarter (Q4 2011).
On November 3, 2011, ORN reported its third-quarter results, a $.23 diluted loss per share, compared to a $.26/share gain a year earlier. Contract revenues fell 45% YoY, impacted by unexpected delays in project lettings by its largest customer, the Army Corps of Engineers, as well as delays on two project starts. Over-reliant on a single customer though this may seem, the details reveal a more optimistic picture. As a contractor whose jobs generally range from 6 to 9 months in duration, ORN has always experienced lumpy revenues. Its customer mix shifts; the private sector accounted for nearly 40% of sales in 2010, but only 18% in 2011. Concentration of account risk with the Corps does not reflect a long-term trend. Shares, already 60% off their 52-week peak, have tumbled a further 6% since the call.
On the other hand, budget uncertainty has led to a downdraft in ORN’s billings. As the Corps operates under a continuing resolution, a fixed 2012 budget (or a highway bill passed as early as this week) could lead to the immediate award of $60m in contracts in which ORN is the low bid. This matters; an incremental $60m to the top-line (on top of a $146m backlog—in line with last year’s comp) would nudge the ledger from the red to firmly in the black.
As of Q3 2011, the company had billed $205m, while at the same time last year revenues stood at $264m. Management has been playing the long game; costs have been trimmed somewhat (SG&A down 6%, capital spending reigned in), and CEO Mike Pearson is loathe to sacrifice the firm’s competitive advantage by laying off idled technical staff.
An estimate of the historical relationship between revenues and operating margin would place the firm's annual breakeven at about half the shortfall between last year's sales and this year's, or roughly $30m in annual revenues. For a firm that employs hundreds of highly skilled engineers, and has a large portfolio of costly fixed assets, this implies a considerable amount of operating leverage in the model. For each dollar of contract billings above the breakeven point, an increasing share should accrue to earnings. It may be noted that, should the depressed environment linger into 2012, there is plenty of room to revisit Pearson’s current balance sheet management strategy.
Despite the headwinds, ORN has maintained excellent operational discipline. There has been a downtick in receivables and costs in excess of billings and estimated earnings, while gross margin is still positive. Contract self-performance is in-line with previous comps. The strategy has been to conserve cash and preserve pricing power. For a contractor, this means not bidding on uneconomic work. Price points slipped in the third quarter for the industry, and ORN was successful on only 11% of its bids. If some budget visibility returns, there should be more attractive projects ahead.
ORN is a leader in several categories, but it is small enough to grow significantly both within its territory and without. Organic expansion has been paired with selective acquisitions in new geographies, with four-year revenue growth standing at 18%. Value investors rarely trust growth-by-acquisition strategies, but ORN has so far done a decent job. Purchases have been small and focused, paid in cash. They have largely accreted to ORN’s specialty businesses, and not diverted the company into fashionable new markets. Despite some small receivable liquidations, they have integrated rather easily.
ORN's acquisition strategy has further improved geographic diversification, adding capabilities along the Atlantic Seaboard, and recently in the Pacific Northwest. Due to the short life of the firm's contracts, CAPEX is largely project-based and doesn't demand tremendous foresight by management. Depreciation of PPE appears more aggressive than the fundamentals of the business require.
ORN reports only a single segment, but is engaged in marine construction, dredging, and specialty services such as diving, underwater inspection, salvage and excavation. Much of the same equipment and expertise is used across all three business lines. The construction business consists of public ports for container, cruise, and Navy ships, docks and marinas, bridges and causeways, and underwater pipeline installation. These projects typically involve heavy barges, light barges and tugs, cranes, concrete mixers, and diving equipment, all of which ORN owns. Most are short-term in nature, but frequently provide recurring revenues from maintenance. Operating in subsurface environments, often driving concrete pilons 90 feet into the sea floor, may insulate the company from competition. It is a niche market, outside of the expertise of many larger diversified contractors, but too capital intensive for small operators to easily enter.
The other main business is dredging, which consists of removing silt and sedimentation via backhoes and heavy suction equipment. Dredging deepens and improves the navigability of waterways. This is important as heavy use, hurricanes, and flooding cause harbors and channels inexorably to fill in. Dredging is integral the construction of breakwaters, jetties, and levies which protect shoreline from flooding and erosion. It is fundamentally a maintenance business; active ports and channels require work every few years due to natural sedimentation. Along the Gulf Coast, where few deepwater harbors exist, or where ship sizes exceed the capacity of rivers and canals, it can be essential.
There are a number of secular reasons to like ORN’s business besides decaying infrastructure and a worsening environment. Container, dry-bulk, and liquid cargo ships are trending larger due to fuel efficiencies. This will sustain the demand for deepened channels and expanded dock space. As the Panama Canal expansion projects near completion, more East Coast-bound cargo may find its way to the Gulf, bypassing the Port of Long Beach. Capacity will need to be increased. Environmental standards and quality of life concerns among growing coastal populations may drive demand for beach nourishment, wetlands protection, and land reclamation. Lastly, if energy prices remain elevated, midstream and downstream energy companies will invest more in maintaining or upgrading pipeline assets. ORN's exposure is to near-shore drillers; concerns over deepwater should have a muted impact.
As indicated above, I believe ORN should return to profit in this quarter or the next. Beyond the near-term, conservative assumptions based on below trend levels of growth and profitability can support a valuation well in excess of the current $6.23 a share.
This thesis is predicated on a discounted cash flows model that assumes sharply declining growth rates, penalizes companies for uneconomic asset growth, and predicts few cost savings as the company grows. Using a discount rate of 10% and a perpetual growth rate of 2%, net of cash and debt, ORN’s stock is worth about $6. Adjust any of these back toward their historical mean, and the valuation rises into double digits. My effort is not to hang a target price on ORN shares, but rather to identify the expectations the market has embedded in the stock at $6 and change. Clearly, these assumptions are highly pessimistic, given on historical precedent.
First, revenue has grown in every year (bar 2011) since 2005 (the first year in my sample). Despite rising input costs, cost of revenues has grown at roughly the same pace. Operating expenses have grown more slowly. Thus margins have remained fairly steady in a range from 8.6% to 13.1%. The company has managed its balance sheet decently. Even in periods of economic stress, such as 2008, receivables and inventories have not surged. Signing short-lived contracts, predominantly with the government, should insulate the company from broader financial malaise. Low levels of long-term debt were retired prior to this year.
There are a number of cash-flow adjustments that might be justified (subtracting deferred revenues from cash, adding back minimal stock-based compensation, converting operating leases to capital), the most material assumption concerns CAPEX. Cash Flow Statements are inconsistent in how they account for this quantity, and I have found that the simplest strategy is often the best: CAPEX = long-term asset growth + depreciation (maintenance spending). Expenditures that don’t show up in operating accounts generally appear on the balance sheet at some point. Over many periods, an average is discernible. If CAPEX runs at 36% of revenue, as it did in 2010-2011 (due to the purchase of a Texas-based dredging outfit), there is no cash flow available to equity. This, I believe, is understandable in an immature business. If it runs closer to the historical average, free cash flow is marginally positive.
Management does control a lever, however, that could return massive amounts of cash from earnings--bringing down CAPEX to a few hundred basis points above D&A. This would necessarily imply a sharp reduction in revenue growth, and such an assumption is reasonable. Over ten years, a reduction in growth from 18% to 15% to 12% to 2% generates a stock price with a 6 handle. This includes a continuing of this year's difficult environment through 2012. I believe lower-than-average growth and declining capital spend assumptions are conservative, and suggest a margin of safety in the stock. If contract, selling, and admin costs remain elevated as a share of revenue, the stock should go nowhere. If, on the other hand, expenses return to normal or better, as the firm rationalizes its operations and gains clout with suppliers, margins will improve markedly, boosting the bottom line. In my opinion, this is conservatively run company that can grow without strategically altering its business in any way. Given its current price, a “return to normalcy” in the economic environment could quite reasonably imply 30-50% appreciation over the next 6-12 months.
As previously noted, budget clarity from Washington should lead to the award of $60m in contracts from the Army Corps of Engineers. Even a passage of the 2011 highway bill should ameliorate beaten-down investor sentiment in the infrastructure space. If this happens, ORN is very likely to report much better sequential numbers in Q4. As many 2010 projects have rolled off, but talent and equipment is in place, new awards flow instantly to the bottom line. More qualitatively, it appears that the turbulence of the last few quarters has chased most of the hot money out of the name. It is 94% institutionally held, and is a “boring” business, with a long-term shareholder base whose insiders have been buying swathes of shares. Since August, officers and directors purchased, net, some 420,000 shares. Barring a catastrophic government paralysis (and ensuing Mad Max scenario) there should be relatively little downside in the name.
Disclosure: I am long ORN.