Saturday, August 25, 2012

Decomposing Conrad's Return on Equity ($CNRD)

The question about Conrad Industries is always: where does their competitive advantage come from, and is it sustainable? We take it as a given that there is some sort of competitive advantage, because the company has a record of attractive returns on equity.

One way to think about return on equity is the DuPont identity, which breaks ROE into three parts. ROE = (Net Profit/Equity) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity). The three parts are profit margin, operating efficiency (asset turnover), and financial leverage.

Conrad is almost debt free. The impressive returns aren't coming from leverage. And net income margins are less than ten percent, so it's not that either. That suggests to me that the ROE is coming from operating efficiency/asset turnover.

In a shipyard, that means using its big, discrete tools more effectively: the dry‐dock, berths, and lifting equipment. That means job scheduling and bidding jobs so that the equipment is kept busy.

It turns out that asset turnover is a big deal for shipbuilders. I found a paper about this, Benchmarking Shipbuilders' Turnover of Main Assets [pdf]. It points out that,

The concept of turnover [consolidates] several of the companies’ management capabilities into a single measure. Thus, for instance, a shipyard that does not use adequate planning, scheduling and control systems will possibly have lower turnover; a company that has a strong pipeline of orders will possibly have a higher turnover; a shipyard that has made wrong investments in the past, or wrong demand estimates, acquiring inadequate equipment or capacity, may possibly show a lower turnover; and the shipyard that does not use the plenitude of its assets will show a lower turnover. [...] Since dry‐dock, berths and lifting equipments are some of the dearest assets in a shipyard, the rates of their use is certainly related to their financial performance. [...] Improvements in turnover may be related to more and less efficient processes. Usually when resulting from pressure arising from a substantial backlog, it is not related to improvements in efficiency of those processes driven by cost reduction. Efficiency improvements usually last. If the high turnover of a recent period is mainly driven by demand pressure, the authors would expect a decline even in the outstanding shipyards as soon as demand slows down.
This sounds like asset turnover in a shipyard is driven by effective job scheduling and bidding. These would need to be tightly coupled so that you would end up with a mix of jobs that used the labor and equipment most profitably. This probably requires intelligence and a lot of experience. Conrad mentions on their website,
"All of our new vessel construction is done indoors in well-lighted space specifically designed to accommodate construction of marine vessels up to 350 feet in length. As a result, marine vessel construction is not hampered by weather conditions, and we are able to more effectively utilize our workforce and equipment.

We employ modular construction techniques and zone outfitting, which involve the installation of pipe, electrical wiring and other systems at the modular stage, thereby reducing construction time while at the same time simplifying systems integration and improving quality."
That makes sense. Indoor facilities increase the asset turnover. So does modular construction, which is a proven technique for making construction happen faster. (You'll notice in that picture that they are in front of the seawall. So during the flooding last summer, they constructed their own levee system to protect the Morgan City shipyard.)

These techniques are probably much easier for a family that's been in the business for 60 years. But, there's another thought that occured to me after reading this excellent post on Oddball Stocks,
"There are plenty of ordinary businesses that earn abnormal returns as well. Why aren't there competitors reducing the abnormal return down to an economic return? [T]he difference between a niche and an economic moat is the ability to scale. [Some companies] operate in a niche and earn excellent returns yet they don't have additional reinvestment opportunities and will most likely remain the same size forever."
That too sounds like Conrad. No one is going to go opening Conrad shipyards like See's Candy stores. So it's more of a niche than a moat.


Taylor Conant said...

Two questions that remain are:

1.) Are their competitors not using these processes (and why)?
2.) Why aren't their competitors entering the market and utilizing these well-known processes if it earns such great returns?

Are CNRD's returns normal for the industry? If they're not, then the average returns of competitors need to be explained as well-- CNRD says right on their website how they do it and I'm sure this stuff is taught at every good engineering and industrial design school. Why can't competitors adopt the same philosophy and increase asset turnover themselves?

And then if this technology is public, and it does offer such great returns, why aren't more shipbuilders entering the market? It's pretty small scale and not the most capital-intensive.

I don't really want to answer my own questions but I'll offer two pieces of evidence that are interesting:

1.) The CNRD CFO has said in the past that the Conrad family is key to their customer relationships-- there's some goodwill here that isn't visible on the balance sheet that seems to influence the number of jobs they get which may not be available to competitor firms, especially because net margins are so low as it is that there isn't much room to cut prices and thereby win business
2.) Something Geoff Gannon has pointed out is that industries with more moat-like characteristics tend to have clusters of "foundings", meaning, all the dominant firms started around the same time, decades earlier, and the industry has not been characterized by constant entry and escape of new and old firms over time (as you'd expect in a rapidly changing or commodity-type industry). I don't know when Jeffboat and other competitors were founded but I'd imagine that's characteristic of this industry.

CP said...

Why can't everybody else swim as fast as Phelps? They just need to move their arms more.

Why can't everybody make movies as good as Dreamworks or Pixar? Isn't it taught at good film schools?

The point of Nate's post is that this is a niche, not a moat.

Another factor is that book value is understated, making returns on equity artificially high.

Taylor Conant said...

I guess what you're trying to say is you have a gut feeling. Cute.

The Lonely Value Investor said...

CP is on to something here... ROE is pretty useless at Conrad. The real point is the return on market cap (that's the real price of "equity" hear). And when you look at the balance sheet, no debt, etc. Conrad is attractive.

We have a lot of semantics here. I mean you don't have to take Competitive Strategy or whatever in B-school to know that a niche can be a moat. And I guess a moat can really create a niche.

The question is: do you buy Conrad at this price? Answer: I think so. Seems the Conrad family likes the stock at these levels too.

CP said...

I think you need to make an educated guess about the reason for the capex spending this year, after reading what all the other public barge makers and shipping lines have said in their recent filings.

Those are serious tells.

The Lonely Value Investor said...

So what is the reasoning behind the increased capex and the land purchase?

CP said...


They must be making a bet on this. Notice how much $ in new orders were booked after the end of Q2.

The Lonely Value Investor said...

I read those... so are you bullish on CNRD or not? I must be misunderstanding your point above.

CP said...

I'm very bullish. My first post was in 2011 at $10.

You can see the other posts:

CP said...

My point is that there is going to be a barge building boom, and even conservative little Conrad is doing a bit of expansion. Given how conservative they are, they must be pretty fired up.

The Lonely Value Investor said...

Obviously. When you said I needed to make an educated guess, I thought you were saying something negative after I said Conrad looked like a buy.

Clearly they see something in the future + they have made moves in the past (like going from leased to owned equipment, etc). They are very long term focused so I'm not sure I'd read too much into the short-term.

They are smart operators. Not sure that the short-run demand is that big of a secret.

The bigger issue is the claim against BP. That is the wildcard.

Only a couple of people have mentioned it. A good indication of who is actually reading CNRD's material.

CP said...

Interesting. Maybe the capex ($15mm) is going to get paid for by BP?

CP said...

The Lonely Value Investor said...

Not sure that gets us any closer to knowing how much (if anything) CNRD is going to collect. I'm pretty sure they have no idea either, but have their collective fingers crossed.

I just hope it is (in the words of management) "significant".

Been a lot written about Conrad recently all over the web. Some more valuable than others.

In the end, it is a question of invest or not, and at what price.

Just to reiterate, I agree with what you seemed to suggest before, that ROE was raised due to a low book value... and it would be even higher if the cash was paid out.

End result: ROE is useless here.

CP said...

I don't think ROE is that meaningful in any case.

The real story is how quickly they can take themselves private if it remains at this valuation.

The Lonely Value Investor said...


CP said...

This was a great thread... keep on reading the new cnrd posts. I'm digging up new stuff.

CP said...

CP said...

CP said...

This analysis worked out well.

One thing I wanted to add regarding the Conrad repair business, which has been very cyclical; not only revenue cycles but margin cyclicality as well.

Any marine vessel needs constant repair over its lifetime. Saltwater and steel have a very uneasy peace. Actually, saltwater inevitably wins given enough time.

That means boats need regular maintenance. A key concept is the "survey" - ships are periodically examined, problems and corrosion are found, repairs are needed.

A shipyard is a "toll booth" on marine activity. Every second in saltwater and every turn of the screws accumulates damage to the vessel that the shipyard industry will need to fix if the beneficial uses of vessels are to continue.

There will be revenue, but will there be profit? And how much, and by whom will it be earned?

Now imagine you own a working vessel in the Gulf of Mexico. Maybe an offshore supply vessel. When you need repair, you look at the list of Gulf coast shipyards, of which there are a finite number. Only some of them will specialize in your type of vessel and work, only some of them will be available at the time you need service, etc.

The shipyards are also spread across the Gulf coast, some closer to where your vessel is (and will need to be) than others. You will also undoubtedly perceive a quality tradeoff: how long will it take a given yard to complete the work, and with what likelihood that it will fail or need to be repeated?

Thus, shipyard repair work is not a commodity like bushels of corn. There are tradeoffs between distance (which means time, which means money) and cost of work, and quality (which means time, which means money) and cost of work.

When the vessel market is tight and your ship rents for $50,000 per day, you're going to be less price sensitive regarding repair work. That's good for Conrad margins. Lots of work and lots of price-insensitive customers. No wonder that when their repair segment is good, it's really good.

We also know that when repair work is weak, Conrad's repair segment is really weak. Think of a soft vessel market. (Like right now in 2015, unfortunately, because of oil prices.) You forgo less revenue by moving your ship around for cheaper repairs. Also, with ships sitting idle you have some options to postpone maintenance. You have alternatives (which help your repair negotiating position), and you need to tighten your belt because of the soft market.

Think of all the whipsaws in the energy business since 2007. There have been three busts actually! In 2009, in 2010 (post-spill) and now! It actually speaks highly of them that they have been continuously profitable and have continuously built shareholder value over that time period.

However, it is hard to get a clear picture of Conrad's sustainable earning power. What if the tank barges never come back and GoM oil exploration is underwhelming since it's higher cost than the onshore shale basins? Seems like revenue and profit could fall quite a bit.