Opportunity In Conrad Industries' Cyclical Weakness?

| About: Conrad Industries, (CNRD)

Summary

Q3 results reported in mid-November were weak other than the huge backlog add in the month after quarter end. Investors are concerned this backlog has low margins attached to it.

Make no mistake: Conrad is a cyclical business. It lost money from 2002-04 and could well dip into losses again driven by over capacity and operating deleverage.

What risk are we concerned about? Conrad performing poorly for a few years, or Conrad's fundamentals through the cycle permanently deteriorating?

The answer is the latter, but the former is reason to wait for a better buying opportunity before loading up.

Conrad Industries This will be a fairly short writeup as Conrad Industries (OTCPK:CNRD) has been well-covered on SA and elsewhere. I'd encourage readers to read the articles on Seeking Alpha, Value Investors Club, and the discussion thread on Corner of Berkshire and Fairfax. I've held a small starter position in Conrad since the summer, but the recent results and much lower price have made the story more interesting, and so I'm considering adding to my position. There are some intellectual hurdles to overcome here, but I think it's worth owning and following.

Q3 Results

A few months ago on November 16, Conrad reported their Q3 2015 results. The results were not very good. Revenue declined 14% y/y in the quarter and is down 16% YTD. Gross margin was cut in the quarter from 11.5% to 4.8%. YTD is 6.4% vs. 13.6%. YTD backlog add was $93.4mm vs. $175.5mm last year. Management communications in the reports seem to suggest the tough times could continue through 2016.

The one bright spot in the quarter was that subsequent to quarter end in the period from September 30 to November 13, the company secured an additional $147.5mm in orders - more than they'd secured all year through Q3. The orders related mostly to several contracts to construct vessels for one customer. These awards bode very well for revenue, but some investors are concerned that the awards may be lower margin than what the company typically earns on newbuilds.

There are a few reasons for this concern. One is that the company has been engaging in stock building recently where it will start constructing a ship before there is a firm order from a customer to buy the ship. This is done to leverage fixed costs at the shipyards, but it introduces inventory risk if they can't sell it right away or at a good price. It's also a sign that the company is operating below capacity and may be more aggressive on bids. The company has also mentioned recently that they are expanding to construct bigger vessels. These ships take longer to build and are more expensive, so more capital will be tied up for longer periods. Perhaps these new orders are the bigger ships management has been talking about. Finally, if 6 months worth of backlog came almost entirely from one customer, that introduces customer concentration risk and could mean that the customer had considerable bargaining power to get a low price on the contracts. The next few quarters of results will show if this concern is unfounded or not.

It Could Get Worse Before It Gets Better

Although Conrad has performed extremely well over the past 10+ years, it's important to remember that a little bit earlier, from 2002-04, they lost money. This is a cyclical business. In the 2004 annual report they say this explicitly:

"Our Company has experienced many of these peaks and valleys in the offshore oil and gas industry throughout our 56 year history and has always survived."

There is dependence on commodity prices, demand from commodity-producing customers, and a good amount of operating leverage that can create swings to losses without too much difficulty. In the 2004 annual report, management cited a weak economy, depressed activity in the Gulf of Mexico oil & gas industry, and a dramatic increase in steel prices. Right now, we're only really experiencing one of those issues - Gulf of Mexico oil & gas weakness. The economy is fairly strong and steel prices have been declining somewhat quickly, which benefits margins.

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But the US economy is probably closer to its next hiccup than it is from the 07-09 crisis and it's naive to think steel prices won't ever rebound, particularly when you look at the long-term chart:

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Oil prices can also get worse, and in fact they have since the company reported Q3 results:

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This all could pressure sales/margins and operating deleverage would be magnified by the company's recently expanded capacity from investment in its Deepwater South facility. The company could well dip into losses at it did from 2002-04.

Defining Risk

If Conrad's results continue to get worse, and especially if they lose money, it's very likely that the company's stock price will go lower from here. But is that risk? Are we concerned about mark-to-market losses here, or permanent impairment in the value of the business? I think the answer has to be the latter, but it's good to be aware of the former because that has important implications for position sizing - better to size small if you think there's a very good chance of getting a better price. As for real, permanent risk of loss, I think the most important thing to think about is (as it frequently is for cyclical businesses) determining the "new normal" for margins. Conrad has had its ups and downs over the last 15 years (which includes the losses in 2002-04, and it is a cyclical business, but they've managed to average operating margins of almost 11% per year. There's been a range from -12% (excludes goodwill impairment) and 19%, but that's been the "normal."

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Johnny Conrad Jr. and Cecil Hernandez came in operationally in mid-2004 and have guided the company's performance since. It seems like the company has made improvements since then, so the existing "norm" could be even better than 11%. Because most of Conrad's contracts are structured as time and materials, their long-term exposure to things like steel are not all that bad - it's the sharp fluctuations that occur mid-contract that hurt them. And long-term, the company should be able utilize its increased capacity because of it's strong, double-digit growth record, which transcends the fluctuations that have been experienced over the last 15 years. So the long-term norm on margins is positive, but what is it? Simplistically, a conservative assumption would be that it is half what it has been or 5.5% and a more reasonable "base case" assumption would be that this is just cyclical weakness and the norm of 11% is unchanged.

In that case, this begins to look a lot less risky, but don't forget about the mark-to-market possibilities.

Qualitative/Structural

One of the things that keeps pulling me back in with Conrad is how excellent the disclosures and management integrity are for an OTC small cap. When I was reading the 2004 report, I was astonished to see that the company cut the salaries of the then-Co-CEOs, Conrad Jr. and his father. This is remarkable. You don't normally see the family running a family-controlled company (one of which had founded it 50 years ago) agreeing to reduced salaries. That same year, they also did the de-registration which saved $800k annually and has not really resulted in any falloff in the quality of disclosures. I wish more small companies would do this. Management is paid very reasonably. One of the company's suppliers is Conrad Jr.'s business, Johnny's Propeller Shop, but there's no evidence this is value extraction.

Current management has, in my eyes, clearly demonstrated competence in all 3 facets of good management: operations, capital allocation, and integrity. I already touched on integrity. On operations, they've managed to grow the business >10% annually over more than a decade and seem to have improved margins through the cycle. On capital allocation, they've not been reticent to pay dividends or repurchase shares, but they haven't done dollar cost average repurchases - they've actually had okay timing. That's all resulted in total returns of about 22% per year since they came in April 2004. Further, I think they have the business well positioned in terms of capital structure. Too often I see micro caps with 80% of the market cap in net cash and that has a severe deleveraging impact on forward returns. Conrad is a cyclical business that may see further cyclical weakness, so it's appropriate to have a net cash safety net right now, but it's not too large.

Conclusion

I think Conrad is worth substantially more than where it trades today if the long-term fundamentals are unchanged and probably worth around where it trades now even assuming fairly severe permanent fundamental deterioration. However, it seems likely that the business will experience further near-term cyclical weakness. That is likely to create a better buying opportunity in shares and there is uncertainty about the severity of the weakness, so I'm content with a small position for now. Conrad is high on my watchlist though. I'm hoping shares will get to $18 in the next year or two.

Disclosure: I am/we are long CNRD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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