Sunday, April 1, 2012

A followup post on Conrad Industries

Two days ago I wrote about Conrad Industries (CNRD). Nate at Oddball Stocks later jotted down his thoughts on Conrad in his recent post. Nate raised two important questions:
  1. Why is Conrad cheap?
  2. Is Conrad a cyclical business currently at the peak of its cycles?
These are important questions. These are excellent questions. I will try to address them here.

(I have to be carefully here not to do this for the sake of merely defending own investment decision. Otherwise, all sorts of nasty psychological biases will surface and cloud my judgments. But everyone has blindspots. "I am the easiest person to fool." It's always good to have a second opinion, particulary when the view is an opposite one. While investing by a committee is a dumb idea, having a sounding board forces one to examine and re-examine one's assumptions. "Always invert." Always in the outlook of contrarian views. That's why Warren Buffett and Charlie Munger make such a lethal team. A dialogue is beneficial to the participants.)

Knowing the History is Crucial

I believe to come up with an educated judgment of CNRD's value, it is instrumental to understand CNRD's history.

CNRD has been in the industry for very long time. It was founded in 1948 by Conrad Snr. It was listed in 1998 on NASDAQ and subsequently delisted in 2005. But the most important period for our discussion is from around the time it was delisted to now. I see 3 phases in this period:
  • 2002-2004: Tough business environment. Lost money every year. Loan covenants were breached and renegotiated many times. Solvency was at risk. The management decided to delist the company in order to save $800k annual expense.
  • 2005-2008: Management was replaced. Conrad Jr. took over as the CEO. Profitability improved every year. The client base was broadened.
  • 2009-now: General economy was hit by GFC. Exploration activities were suspended in the Gulf because of the oil spill. Profitability took a hit. The management made efforts to reduce its dependency on the exploration activities in the Gulf. 
Keep this in mind. This will set the backdrop of the ongoing discussion.

Is CNRD is a cyclical business? 

We shouldn't have any delusion that CNRD is a defensive business like Coca-Cola or even ADVC which can maintain very consistent profits even in recessions. Instead, I would ask how cyclical CNRD is. CNRD's revenue used to be very dependent on oil/gas exploration activities. That was very cyclical. That was a key factor why CNRD got into trouble in 2002-2004. But the current management has successfully moved away from this. Offshore oil/gas industry used to account for 47% of CNRD's revenue in 2006. It has been falling in a linear fashion to 7% in 2011.

My take is, CNRD has become less cyclical over the years.

Were the turnarounds flukes?

Apparently, I've placed significant weight on the prudence of current management. In actual fact, my current investment thesis rests on the quality of the management. Ultimately, CNRD has no structural competitive advantage. (e.g. It doesn't have the kind of network effort Facebook enjoys. And it doesn't have the kind of brand loyalty Apple or Coca-Cola has.)

So, the improvements and turnarounds could just be luck but not skills, couldn't it?

One evidence that tells us the current management has indeed been a positive factor in CNRD's performance is the trend of its selling , general and administrative (SGA) expenses over the years. SGA was $4.8m in 2002. SGA was still $4.8m in 2010. It isn't that it hasn't moved. It did go up to $6.2m in 2009 and it was $5.4m in 2011. But this gives me the confidence that the management has been taking a very active role in lookinag after the business in tough times and successfully adjusting its cost structure.

What if I am wrong?

I agree with Nate 100% it's important to answer oneself why a company is cheap. Another question that I ask myself all the time is "What can go wrong?"

What if I am wrong? What if CNRD is still a cyclical business? What if the current high volume of non-exploration related revenues was a pure coincident, coinciding with the recovery of the US economy?

How bad is our downside?

The current management turned around the business in 2005. It was a breakeven in that year. Since then, it has been profitable every year in the last 6 years. In these 6 years, the lowest ROE was 13% in 2010. So, even if CNRD is indeed a cylical business, at the lowest point of it cycles it still managed a 13% ROE. And it was acheived with "negative leverage" (i.e. not only without debt, but with non-operational cash on the book). With that, I will think it deserves more than 1x BV, even for a cylical business.

Besides, as I already mentioned in my original post, I still expect exploration activities in the Gulf will recover. This gives us another wildcard of another up cycle.

(In actual fact, when talking about "what can go wrong", I am more worried about the possibility that the Jones Act will be abolished. Hence, I'm mindful of the size of my position. I'm managing this risk by position sizing.)

Why is CNRD cheap?

I can't be sure. What I have is a guess.

I think CNRD is cheap because investors were burnt twice in a row. The adverse period in 2002-2004 and the subsequent delisting must have left a sour taste in the investors mouth. Then, while seeing the business was picking up again in 2006-2008, it was hit hard again by both GFC and the oil spill. Investors must have concluded CNRD is so cyclical and dependent on gas/oil exploration activites in the Gulf that it shouldn't be worth more than its book value. Investors must also be skeptic of CNRD's pursuing of non-exploration related revenues.

One last thing. I do think the current high volume of non-exploration related revenues was a coincident, coinciding with the recovery of the US economy. Given the trend of its backlogs, I also expect revenue in 2012 will be lower. But I take a longer term view. When the management with a good tracking record thinks it's now good time to expand, I give them my trust.

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