Consistent performance has been elusive for Orion Group (NYSE:ORN), even though the company has hard-to-match capabilities in marine construction and a solid concrete construction operation in Texas. To some extent, this is not all Orion's fault, as a lot of the company's business depends upon government budgeting and allocation decisions and the company is vulnerable to very competitive (if not irrational) bidding behavior from its rivals. While the shares have done quite well over the past year compared to other construction and dredging operators like Great Lakes Dredge & Dock (NASDAQ:GLDD) and Granite Construction (NYSE:GVA), the five-year performance record is not especially strong.
Orion looks undervalued, but that undervaluation comes with the underlying cost of a lot of risk and uncertainty. I expect a supportive funding environment for the maintenance of commercial waterways, as well as coastal restoration projects, and I think growth in the cruise sector and terminal demand will support the construction operations, while Texas remains a growth market for the concrete construction business. That said, winning and executing bids should not be taken for granted and this isn't a "widows and orphans" type of opportunity.
A Rare Public Trade In An Interesting Niche
Although Great Lakes Dredge is a much larger player in the dredging market, Orion is unusual as a publicly-traded company in that it operates in the heavy marine construction market. Orion does not compete in the same markets as offshore energy construction companies like Saipem (OTCPK:SAPMF) or TechnipFMC; while Orion has some involvement in marine pipelines, it doesn't build offshore platforms or provide subsea services. Instead, Orion builds marine transport facilities like docks, port facilities, and terminals, bridges and causeways, and environmental structures that help control erosion, create/protect wetlands, and protect shorelines and coasts. Dredging is also a significant part of Orion's construction business, and Orion is one of the four largest players in the U.S. in this market.
Orion has been in the marine construction market for quite a while now and typically performs a very large percentage of its own work (as opposed to farming out to subcontractors). It's tough to estimate Orion's market share given that two of its major construction competitors, Weeks and Manson, are private, but the company's mid-teens to high 20%'s contract win rate is probably a decent proxy for the company's presence in the market/business it wants. The company's share in the dredging space is lower; Great Lakes has long been the leader in the market (and Weeks is a large #2), and I would estimate Orion's share in the high-single digits to low-double digits.
About two years ago, Orion acquired TAS and established an interesting second arm to its business. TAS was the second-largest, Texas-based concrete contractor at the time of the acquisition, and brought the company into light commercial, structural concrete, and labor-only concrete projects that serve a wide range of non-residential markets. Close to a third of the business was in building warehouses, with roughly another quarter in office and retail buildings, and another quarter in multifamily housing, education, and medical facilities. A weakening construction market in Houston is a risk factor, but Orion has been building up this business in the Dallas/Fort Worth area, and the company is also looking to pursue more cross-selling opportunities that tie into the marine construction business (facilities/buildings supporting ports and docks, for instance).
Opportunities To Grow, But Challenges To Consider
A large percentage (historically around 80%) of Orion's contracts is fixed price, which is a higher-risk/higher-reward approach that rewards the company if it can bring projects in on time and under budget, but, of course, the reverse is true. This came home to roost in 2015/2016 when the company saw losses on five construction projects run out of Tampa due to operational issues that the company struggled to resolve after the death of the former COO. I believe management has been working to resolve some of the "key man" risks this exposed, but the fact remains that execution on fixed price contracts is an ongoing challenge and risk for construction companies/contractors.
Another issue to consider is the nature of the budgeting and bidding process. Orion generally gets about half of its revenue from government clients, but that plunged to 30% in FY 2016 on the lowest contributions from federal and state governments the company had seen in many years. Although dredging is an established and recurrent activity, there are still periodic interruptions and delays in budgeting and funding and there are still intermittent delays in project lettings and Orion can and does get underbid at times. What's more, permitting delays (as the company saw in the fourth quarter) can impact revenue in ways that are largely outside of management's control (although this typically delays business and doesn't diminish it).
On a more positive note, the underlying market opportunities for Orion seem to be growing and likely to continue growing in the near-to-mid term. The recent Water Resources Development Act (or WRADA) is meant to support dredging and waterway maintenance/modernization, as well as coastal hurricane protection and environmental restoration/protection projects. That's largely in Orion's sweet spot as is some of the potential bridge and causeway work tied to the FAST Act and coastal rehabilitation work from the RESTORE Act (tied to fines from the BP Deepwater Horizon event).
In the private sector, too, I see growth opportunities. Cruise lines continue to see solid demand, which means more demand for new/expanded dock and port facilities. Ongoing development of petrochemical projects around the Gulf Coast means more demand for terminal facilities, and the expansion of the Panama Canal should likewise stimulate more dock/port and terminal activity around the Gulf.
Concrete construction in Texas is arguably more of a wildcard. The barriers to entry in heavy marine construction are more significant, but Orion's Texas concrete operations have meaningful scale, and non-residential construction activity continues to grow in Texas even with a recent slowdown in Houston. Growth in Dallas is helping Orion offset this, and there is still quite a lot of Texas to expand into in the future, to say nothing of adjacent markets, but the book-to-bill was weak in the fourth quarter and the backlog was down 6% yoy.
Last and not least is a potential benefit from infrastructure stimulus. It remains to be seen what the new administration wants to do in terms of stimulating/supporting infrastructure construction, and what Congress will go along with, but Orion would certainly stand to benefit from money spent on commercial waterways, bridges, and marine causeways - all areas where reinvestment is badly needed.
I wish there is more insider ownership here, but I don't avoid stocks simply on that basis. I'd also note that Orion is on to its third auditor in three years. I haven't seen management comment on this topic, and my own experience in working with smaller companies is that larger auditors don't always provide optimal service to smaller clients. So, it's not necessarily a red flag regarding the company's operations or accounting, but it is something that I think is worth mentioning and monitoring. It also doesn't help matters that construction contract accounting can be messy and complicated in the best of times.
I'm looking for mid-single-digit revenue growth from Orion, based in large part upon those government-approved spending initiatives on waterway/marine projects, as well as the opportunity to leverage commercial growth opportunities (like cruise ports/docks and terminals). M&A is still a possibility; Orion has used M&A to expand its geographical presence and its dredging business, not to mention entering inland concrete construction, and there could be similar deals in the future to expand into other adjacent markets/geographies. On the risk side, I'd note that pricing discipline in this sector tends to go away in tougher times, so Orion may well be faced with hard choices regarding preserving margins or keeping its crews and equipment working.
EBITDA margins can reach the high teens in the good times (high asset utilization and strong pricing), but Orion hasn't seen double-digit margins since 2010 and likely won't again until 2019 (at least). As is normal for the sector, Orion struggles to generate FCF margins much above the mid-single digits in the good years and low-single digits over the long term. I am looking for EBITDA margins to eventually move back into the double-digits, though, and I'm cautiously optimistic that FCF margins in the 2% to 3% are doable, supporting meaningful free cash flow growth and a high-single-digit fair value.
Although I think EBITDA growth over the next three to five years could be in the low teens, a 6x forward multiple on EBITDA still supports a fair value of over $8 on 2017 EBITDA.
The Bottom Line
Orion has given up all of its post-election run, and the company has had its challenges lately meeting sell-side estimates and expectations, including backing away from a long-held target of $70 million in 2017 EBITDA. All of that said, I like the prospects for the marine construction business, and I think the concrete business will do okay even if Houston continues to be slow. I believe relatively restrained expectations can support a fair value in the $8 to $9.50 area, but I would note that execution risk here is real, to say nothing of macro risk, and that undervaluation comes with some above-average concerns.
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