GIFI - Gulf Island Fabrication: Overlooked Unloved And Undervalued

Summary

• Gulf Island Fabrication's turnaround is complete but the market remains skeptical.
• A negative legal ruling and the ghosts of a failed shipyard division are spooking investors.
• Gulf Island Fabrication has completed the revamp of its Services and Fabrication divisions.
• I project that Gulf Island Fabrication will generate significant net income in 2023 and attain an earnings multiple of at least 10.
• My price target for the company is between $8-$9/share by the time they announce FY 2023 earnings in Spring of 2024.

Gulf Island Fabrication ( GIFI ) is set up to have a great 2023, but the market is overly focused on the outcome of a recent legal dispute. Despite hurting GIFI's book value, the negative ruling does not hurt the company's long-term prospects. The recent dip in GIFI's share price provides an opportunity for investors with a 12 month investment horizon. I expect to see 2023 net income between $12-$13mm and for that to translate into a share price around $8-$9/share.

GIFI's Turnaround is Complete

Prior to 2016, GIFI's primary business was fabricating offshore drilling and production platforms. At the end of 2015, the offshore oil and gas industry was in rough shape. Oil prices dropped more than 60% from June 2014 to Jan 2016, aided in part by the growth in US domestic onshore oil production. GIFI had experience repairing marine vessels for customers operating in the Gulf of Mexico, so in early 2016 management decided to acquire the assets of LEEVAC Shipyards to diversify their business away from the offshore oil and gas market. This move was a disaster; in the following years GIFI struggled to maintain their shipyard workforce, made costly engineering errors, and built up a substantial backlog of work billed below cost. The company lost tens of millions of dollars in asset write-downs and impairment charges before CEO Richard Heo arrived in 2019 and began to shut down the division. Shipyards were closed, projects were sold off, and focus was put back on GIFI's Services and Fabrication divisions. GIFI bought staffing company Dynamic Industries in 2022 and landed a $100mm fabrication contract to be completed throughout 2023. The last remnants of the Shipyard division will be wound down in Q1 of 2023. In three short years, Heo has divested a hugely unprofitable division, made an excellent acquisition, and landed a lucrative fabrication contract.

GIFI's Negative Court Ruling is a non-Fatal Wound

GIFI announced on Feb 1st that:

As previously reported, Gulf Island Shipyards, LLC (“GIS”), a subsidiary of Gulf Island Fabrication, Inc., is engaged in a lawsuit with a customer relating to the construction of two multi-purpose supply vessels. On January 31, 2023, the district court granted the customer’s motions for partial summary judgment dismissing the claims by GIS that the customer had wrongfully terminated the vessel construction contracts.

GIS disagrees with the court’s decision and intends to seek immediate review of the ruling by the appellate courts. Absent a stay of the ruling, the trial scheduled for March 6, 2023, will proceed to resolve the remaining issues in the case, including claims for damages that each party has made against the other.

GIFI shares fell 10% on the news and continue to trend downward. GIFI has invested significant capital into legal fees and stands to lose the remaining contract balance from the customer involved in the lawsuit. The ruling implies that the $12.5mm of "non-current assets" on GIFI's balance sheet will be written down to zero. GIFI management has stated that they are unsure exactly how costly a negative ruling will be. The trial in March will hash out the details, but there could be additional cash "damages" assessed to GIFI. GIFI has appealed the summary judgement ruling and has counter-sued the customer for damages of their own, but at this point I wouldn't bet on things working out in GIFI's favor.

Despite the short-term hit, I'm not worried about the lawsuit's long-term impact on the company. With GIFI's turnaround complete, the investment thesis has shifted from an asset-based play to an earnings-based play. The company's physical assets and cash will continue to provide a (reduced) margin of safety to investors, but once it is clear that GIFI can generate meaningful earnings and cash flow again I think the market's valuation of the company is going to focus more on those metrics.

I Project GIFI Will Earn $12-$13mm in 2023

I see a clear path to at least $12mm in net income for 2023. GIFI's Services division is humming along nicely with a steady backlog and a growing suite of products. The division recently rolled out a new product, Spark Safety, which provides welding enclosures that create a safe environment for welding, cutting and burning in live production locations. In Q3 the Services division generated $2.5mm in operating income ($10mm annualized); I think this is a reasonable "average" quarter going forward. There is some seasonality to Service division work (less work is done in Q4 during the holidays), but new offerings allow room for modest growth to counteract lower Q4 output.

GIFI's fabrication backlog ballooned to $140mm after closing their aforementioned contract. Management guided that the Fabrication division should be able to produce 10% operating margins at full utilization. The Fabrication division operating margin in Q3 was only 5%, but this was in an "underutilized" environment. In this context underutilized means that GIFI is paying fixed and semi-variable costs on their fabrication facility while not operating at production capacity. This means that a larger percentage of additional fabrication revenue is going to drop through to operating earnings, giving me confidence that management's 10% target is reasonable (and perhaps understated). I'm penciling in about $14-$15mm in operating income for the Fabrication division in 2023.

GIFI's Shipyard division should be fully closed in early 2023, but I am assuming that there will be a full quarter of operating loss from the division. Based on Q3 numbers, I expect an operating loss of $1.5mm from the Shipyard division. The Corporate division overhead came in at $2.5mm in Q3, but included a $500,000 charge due to lease restructuring. I'm willing to annualize the $2.5mm number, however, as I expect growth in corporate SG&A in 2023. I estimate net operating drag of $10mm in corporate expenses in 2023.

Putting these estimates together, I project ~$12-$13mm in net income, given minimal interest expense and minimal tax burden due to operating loss carryforwards.

GIFI Will Prove That it Deserves a PE of at Least 10

If I am correct that GIFI returns to meaningful profitability in 2023, I think the company will receive an earnings multiple of at least 10. I think GIFI is facing a market hangover from their years of shipyard failures. Prior to 2016 GIFI had a stellar reputation as a metal fabricator. CEO Heo even cited his positive experience as a GIFI customer as a major reason he wanted to join the company( source ). With a much diminished fabrication backlog and setback after setback in the shipyard space, I believe GIFI's reputation was damaged and the company became associated with failure and embarrassment. The market hasn't rewarded the company's turnaround as much as I would have expected, and I expect GIFI will get a sentiment bump when it proves that it is still a top-notch fabricator.

I also believe the share price will get a boost when GIFI moves from unprofitability to profitability. GIFI is a small and overlooked microcap company that is unlikely to be on investors' radar, especially given that it screens poorly and looks terrible on a trailing basis. Regaining profitability on strong revenue growth and improving margins is likely to attract more positive attention from investors that are unfamiliar with the company today.

Finally, I think a successful 2023 will demonstrate the strength of GIFI's leadership team and make a case of a higher earnings multiple. I've been impressed by Heo's performance thus far; he inherited a company with a lot of problems and has been able to deftly turn things around. It took guts and acumen to divest the shipyard assets. The Dynamic acquisition looks like a steal now that the company has been fully integrated into GIFI. GIFI paid $7.5mm for Dynamic in 2022 and is reaping roughly $5mm in annualized operating income. I also give Heo credit for being patient when vetting and bidding on large-scale fabrication contracts, which has resulted in a healthy $140mm backlog with higher-margin projects. Strong company leadership warrants a higher earnings multiple.

Risks

In addition to the usual risks associated with micro-cap companies (low share liquidity and high daily volatility), the two biggest risks to the investment thesis are the risks that the market is acutely aware of. First is the uncertain impact of the legal dispute. I am reasonably confident there isn't an outcome where GIFI has to pay damages higher than its $40mm cash balance, but I also can't say with confidence what amount they will be on the hook for. As stated above, I think the company's valuation is going to be based on its earning potential, but there is no doubt that asset loss hurts the company. Second, I agree with the market that GIFI is in "prove it" mode when it comes to generating meaningful profit from their fabrication work. I think GIFI will indeed prove that they can translate their backlog into earnings, but management's estimates of a 10% operating margin are just estimates until they prove they can reliably meet that target.

I do not have concerns about GIFI's liquidity, even with the uncertainty surrounding their legal dispute. The company has no long-term debt, roughly $40mm of cash, and a credit facility that can be tapped for up to $20mm in a pinch. Cash burn has slowed dramatically, with management stating on the Q3 conference call that they expected positive cash flow in Q4 due to improvements in working capital.

Conclusion

GIFI has capable management and is about to generate meaningful net income for the first time in nearly a decade. The market is skeptical about the company due to years of shipyard failures and a negative legal outcome. I think the market will take more notice of GIFI once the Shipyard division has been fully wound down, the lawsuit has been settled, and the company posts double-digit net income for full year 2023. I project a share price in the neighborhood of $8 on net income of $12-$13mm by the time GIFI reports full year 2023 earnings, providing 100% upside in the next 13 months.

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