“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” –Adam Smith
Among other notable takeaways from The Wealth of Nations, Adam Smith highlighted the importance of identifying incentives. Recognizing the true motivations of a person or entity is beneficial in many aspects of life, but is especially critical when investing capital. When discussing our investment process with other investment professionals, they often suggest that active investment management might be particularly effective for microcap companies given either the inefficiency of microcap stock prices or the irrationality displayed by other microcap investors. While I generally do not publicly disagree with these suggestions, our firm operates under a belief that all markets behave efficiently and that all actions have a rational explanation behind them. Humans (and all other living things) select the course of action they believe is best for them in an effort to improve their situation in life. Although incentives can vary substantially depending on the individual and the specific situation, ultimately all individuals are trying to maximize their own utility. While it might seem easy to cite examples when others acted either inefficiently or irrationally, a closer examination of their incentives at the time likely shows there was a method to the perceived madness.
Given our view of both market efficiency and rational human behavior, it might seem futile to attempt to generate attractive investment returns through active portfolio management. On the contrary, market efficiency and human rationality actually help ensure that successful active management of microcap companies is possible. In addition to our thoughts on market efficiency, we also believe the market for obtaining information is efficient. Gathering information can be both time-consuming and expensive, and information will only be collected if the perceived benefits of having the information outweigh the costs of obtaining it. Within the microcap space, we attempt to gain an informational edge over most other investors by conducting in-depth research, management interviews, and site visits that other investors might not believe is worth the effort. Our investment process focuses on making long-term investments in deep-value companies that provide investors with a significant margin of safety. This approach has proven to be successful over the long-term and encourages us to take a contrarian mindset and build significant conviction before allocating capital. Our stable, long-term base of capital also allows us to avoid hasty decisions necessitated by unexpected capital outflows. Finally, with the majority of my net worth invested in the Fund and an incentive fee structure that rewards the generation of attractive, absolute returns, our interests will remain aligned with our investors.
With that overview, I wanted to provide the short thesis behind our recent investment in Gulf Island Fabrication, Inc. (“Gulf Island”, “GIFI” or the “Company”). Gulf Island builds specialized structures and vessels for customers in the offshore oil and gas and marine segments. The Company operates the largest group of fabrication assets in the Gulf of Mexico and can fabricate structures for the largest offshore drilling platforms in the Gulf (capabilities that can matched by only one other North American competitor). Gulf Island has a market capitalization of $100 million and with a $40 million net cash position has an enterprise value of only $60 million. The Company’s stock price has performed poorly over the last three years as falling energy prices and project mishaps have hurt operating results. In addition, a sharp reduction in the Company’s dividend payment and a suspension of the share repurchase program following a disappointing Q4 2015 earnings report further disappointed an already unhappy shareholder base. These negative events resulted in the Company trading at a sharp discount to liquidation value and at approximately 2.0x forward EBITDA.
Despite the unfavorable operating environment, Gulf Island is expected to generate nearly $30 million of EBITDA in 2016, resulting in an EV/EBITDA ratio of 2.0x on what is likely near a trough level of profitability. While the downturn in energy prices has significantly reduced exploration activity, the Gulf of Mexico still accounts for over 20% of U.S. oil production and will likely attract additional investment as energy companies seek to replenish their reserves. Even without a sustained recovery in exploration spending in the Gulf of Mexico, there are several sizeable long-term opportunities that could be very value-accretive for Gulf Island. First, the Company’s recent purchase of LEEVAC Shipyards in January 2016 looks to be quite attractive. Gulf Island acquired three shipyards, significant design capabilities, and a $120 million backlog for a rock-bottom price of $20 million. In addition, Gulf Island received a $24 million cash payment at closing from LEEVAC’s owner and surety bond provider for taking on several prepaid contracts, essentially resulting in Gulf Island receiving cash for acquiring LEEVAC. The acquisition also puts Gulf Island in a prime position for a potential contract to construct six river cruise ships should Viking River Cruises move forward with plans to offer river cruises on the Mississippi River. The river cruise ships are estimated to cost $90-100 million and the inaugural launch could proceed as early as 2018. Additionally, Gulf Island recently constructed the jackets required to support five offshore wind turbines for the Block Island project off the coast of Rhode Island. The pipeline for U.S. offshore wind projects is robust and the Company’s prior success at Block Island should make Gulf Island the frontrunner for future offshore wind projects. Finally, LNG-related activity in the Gulf of Mexico is currently moving forward at a rapid pace and the Company should benefit both from additional fabrication work, shipbuilding activity, and repair and maintenance work.
Even with the positive business prospects highlighted above, most of our due diligence efforts on Gulf Island were focused on the margin of safety associated with an investment in the Company. I have visited each of the Company’s five facilities and also attended the Company’s recent annual meeting. Of note, I was the only outside shareholder in attendance at the meeting and to my knowledge am the only outside shareholder to visit each facility. These visits helped build my conviction in the value and margin of safety provided by the Company’s owned asset base (including over 1,000 acres of land, 25,000 feet of water frontage, 1.5 million square feet of buildings, 7 dry docks, 4 barges, and over 60 cranes). As a brief indication of value, in Q1 2016 Gulf Island sold 2 cranes for $5.4 million – the enterprise value of the entire company is currently under $60 million.
In closing, there are numerous reasons why investors might look to sell shares of Gulf Island Fabrication, and the Company’s current share price is not the result of either irrationality or market inefficiency. However, I do believe our due diligence process has given us an informational edge over other investors – especially in regards to the margin of safety provided by the Company’s asset base. These efforts have helped me build the conviction needed to make Gulf Island Fabrication one of our larger holdings.
Michael Melby presented his in-depth investment thesis at Wide-Moat Investing Summit 2016.