How to Evaluate Cyclical Companies: Conrad Industries ($CNRD)

I have written about Conrad Industries (OTC: CNRD) several times, but I thought it would be worth looking at again, in light of the cyclical nature of its industry and the company's improving fundamentals. For those who may not be familiar, CNRD builds, converts and repairs marine vessels at its four shipyards located around the Gulf of Mexico. The following chart shows the historical returns of CNRD since it went public in 1997 (note: the company ultimately delisted to avoid the expenses associated with being listed on the NASDAQ and complying with Sarbanes-Oxley, but as a company listed in the pink sheets, it has a superb track record of timely and transparent filings).

Conrad Industries, 1997 to 1Q 2011

From this graph, we can see the cyclical nature of the company's returns. This is somewhat expected, as a large portion of the company's customers operate in a cyclical industry: oil and natural gas drilling in the Gulf of Mexico. CNRD benefited from two things beginning around 2005. First, the energy business in the Gulf started to pick up. From the company's 2006 10-K:

During 2003, we expanded into the aluminum marine fabrication and repair business after transforming one of our existing repair yards in Amelia, Louisiana into a facility specifically designed to handle aluminum marine fabrication and repair (“Conrad Aluminum”).  In addition, in February 2003, we significantly expanded our repair capabilities when we opened our second facility in Amelia (“Conrad Deepwater”).  We now have the five largest of our six drydocks at that facility. In January 2005, we commenced the development of a new construction area at our Deepwater facility. This development was completed in March 2005 and enables us to efficiently construct larger  vessels  than  we  were  able  to  work  on  at  our  existing facilities.

Second, the company expanded its capacity at an opportune time. From the same 10-K:

Although in previous years there had been a decline in new construction opportunities in the Gulf of Mexico oil and gas industry, we were successful in securing work from government sources.  We have seen in 2006 a major increase in projects for other commercial customers as well as an increase in energy projects. …

There has been an increase in revenue and gross profit in the repair and conversion segment starting in the fourth quarter of 2005 and continuing for all of 2006 related to increased oil and gas activities in the Gulf of Mexico and the impacts of Hurricanes Katrina and Rita.

We can see these effects combine the following chart depicting CNRD's revenues and margins:

Conrad Industries Margins, 1997 - 1Q 2011

As demand picked up, the company was willing and able to ramp up production, which led to a dramatic improvement in revenues and margins.

There is a common value trap in which a company looks cheap compared to recent performance, but recent performance is unusually strong and proves to be only temporary. The investor, believing recent performance will continue indefinitely, purchases. As the performance reverses to the mean, the investor gets burned. This is a particularly important consideration when analyzing a company in a cyclical industry. As the industry fundamentals peak, the company may look cheap, but then prove to be expensive relative to the poorer future performance.

How can we gain confidence that investing in CNRD today is not a value trap? We start by looking at the company's capital structure, because when assessing cyclical companies, it is extremely important to evaluate whether the company would be able to service its debt when the cycle turns down. (Remember, it is important to make sure the downside is covered first!)

Conrad Industries Capital Structure, 1997 - 1Q 2011

What this chart shows us is that the company has been aggressively deleveraging since 2005, both repaying debt and accumulating a massive cash hoard. Given that the company's cash balance is significantly higher than its debt level, we see that there is little chance this company would be unable to service its debt when the industry cycle turns down. With this confidence, we can turn to valuing the business.

Net cash (cash & equivalents less total debt) is currently $31.4M, which amounts to approximately 1/3 of the company's $93.8M market capitalization (as of 6/28). So, a purchaser at today's prices would be assigning a value of just ~$62M to the business operations. In order to avoid being blinded by the company's recent stellar performance, when valuing the company's operations (to test whether they are worth more than ~$62M) I include in my various scenarios revenues that are below the present levels (despite the company's backlog having recently hit an all-time high) and use long-term average margins. By using long-term averages that encompass a full business cycle, we include both the ups and downs which should avoid the value trap discussed above.

While we can never be certain about the future, as investors we must assess the expected return given various probable outcomes. In making this assessment, I create different scenarios of potential paths this company can take. My results suggest that CNRD is trading at a substantial discount to its intrinsic value in all but the most pessimistic scenarios, and even in these highly bearish scenarios, the company is only trading marginally higher than fair value. Furthermore, given the company's ability to pick up significant levels of government work over the past year while the Gulf drilling moratorium was in effect, I believe the pessimistic projections are unlikely to occur in the near term. As Gulf drilling resumes, I think we are more likely to see a repeat of 2007 – 2009 before we see a repeat of 2002 – 2005. Only time will tell, but I like the odds. While I wait, the company is likely to eliminate what little debt it has remaining (It has been paying down ~$500k per quarter, so it should be debt free early next year) and given the cash build-up, I wouldn't be surprised by a share repurchase or a special dividend.

Author Disclosure: Long CNRD

Talk to Frank about Conrad Industries

Related posts:

1. Conrad Industries Update: Impressive first quarter results! ($CNRD)
2. From the Mailbag: Conrad Industries Responses (CNRD)
3. Conrad Industries Update: Positive signs in backlog growth and resumption of Gulf of Mexico drilling (CNRD)