Deep value is found at the corner of “yucky” and “no way in hell” and over the last twenty years, shipping stocks have exhibited those two characteristics a hundred times over.
Alex did a great job summarizing the macro view of the shipping market in his latest article, which you can read here. To brush up, there are three main drivers of this deep value situation: 1) maximum pessimism in the industry, 2) regulatory requirements from IMO 2020 acting as near-term catalysts and 3) the need for countries to import cleaner fuel (mainly India and China).
With these factors in mind, I’ll offer three companies that are well positioned to capture the uptrend in the industry. Two of the companies mentioned have short-term catalysts that should help bolster share price acceleration while the industry heats up to capital inflows. The final idea is a micro-cap shipbuilder from Philadelphia which could provide handsome returns to those willing to stomach the illiquidity.
Diana Shipping, Inc. (DSX)
Diana Shipping, Inc. (DSX) is a sub $300M shipping logistics company that transports dry bulk cargoes and commodities (such as coal, iron ore, and grain). The company operates 46 dry bulk vessels for a combined carrying capacity of over 5M dwt (dead-weight tons) with an average age per vessel of 9 years.
The thesis for DSX is simple (and like that of almost all shipping companies): increasing charter rates resulting in higher revenue growth, most of which will drop straight to the bottom line. These higher revenues helped drive the rebound back to profitability last year. Along with the turnaround, management believes their shares are undervalued and initiated a Self-Tender offer to purchase 4M shares at $3.66 (current share prices are $2.65) while simplifying their capital structure by purchasing all Class-B shares. Finally, margin of safety can be found in its 40% discount to tangible book value.
Nowhere are the turning industry trends more apparent than in DSX’s income statement. The company reported net losses in 2017 upwards of $500M. Just 365 days removed from that time, the company boasted $16M in EBIT. DSX appears to be making all the right decisions. With this newfound cash, the company is aggressively reducing leverage (net debt trimmed from $560M in 2017 to $404 in 2018), selling off their oldest ships, and repurchasing shares at discounted prices.
Future growth will come from increased charter rates due to IMO 2020 as well as increased demand for the types of items DSX ships. For example, grain imports are projected to grow 4%, thermal & coaking coal to increase by 2 & 3% respectively and total bulk trade expected to grow near 3% (all according to Clarkson’s Research). The company is projecting revenues for 2019 – 2020 to hit between $224M – $255M respectively. If we use historical EBITDA margins of 50%, we arrive at 2020 EBITDA of $127M, which translates to 5x EV/EBITDA. Even at $4+/share the company would be trading less than 7x EBITDA. In other words, it’s cheap.
Risks for DSX mainly involve the commodity products it ships. Although the shipping industry could heat up and charter rates increase, if demand for any of the above-mentioned commodities drops, DSX ships will remain in their docks.
Although not my favorite of the three mentioned, I like what I’m seeing from management and their efforts to reinvest back into the business through the tender offer. Usually, when companies say they’re going to tender, it’s because they truly believe their shares are priced ridiculously low.
If DSX continues to grow top-line charter revenues, pay down its debt and reinvest its capital to shareholders, we could end up seeing that $3.66/share management talked about. Also, the company is paying a robust 12% dividend, which makes waiting for share appreciation easier.
Capital Product Partners, Inc. (CPLP)
Capital Product Partners (CPLP) is another micro-cap shipper that transports cargoes, crude oil, gasoline, diesel, jet fuel and containerized goods. Its 25 vessels include the suezmax crude oil tankers, medium range (MR) product tankers, neo-panamax container carriers and bulk carriers. What’s interesting about CPLP is its decision to spin-off its tanker fleet, which will then be merged with DSS Holdings’ business. This transaction is expected to close by 03/27/2019.
We’ll touch on the spin-off company in a little bit, but for CPLP’s purposes, what does their new business look like? The “new” CPLP will consist of 10 containerships and 1 drybulk vessel (average age of vessels is 6.5 years).
Each vessel is under charter with an average duration of 5.3 years providing high visibility into future revenues — 95% charter coverage for 2019 & 75% charter coverage for 2020 — and will be outfitted with the latest scrubbers (per IMO 2020 regulations). The company operates mostly in the spot rate market, and their longer-term contracts (ones that stretch out to Nov. 2024) are locked in for average day rates of $29,350.
The strategy for the new CPLP is in securing medium to long-term charter rates with their existing assets, while at the same time looking for accretive acquisitions through their dropdown sponsors (Capital Maritime & Trading Corp.) as well as secondhand market opportunities.
CPLP has current right or first offer for 4 ECO Chem/Product tanker vessels (both built-in 2016-17) with three ships having debt facilities in place. Along with the first offer right, the company has visibility to 4 LNG vessels (delivery in 2020 – 21), 4 10,000 TEU container vessels with 3-5-year charters, 4 ECO VLCC vessels with 5-7-year bareboat charters, 2 VLCC vessels on 5-7 charters and 1 Eco Aftramax tanker on a 5-year charter.
The new company will have a stronger balance sheet through reduced leverage and cleaner capital structure from the purchase of all outstanding Class B shares. CPLP’s 3.1x Net Debt/EBITDA compares favorably with the industry peer average of close to 6x.
Capital Partners currently trades for a roughly 70% discount to tangible book value, less than 6x unlevered free cash flow and just 7x EBITDA. Here’s where it gets interesting, since CPLP shareholders retain 33% of the spin-off company, it presents the investor with the opportunity of owning an extremely cheap medium/long-term tanker while at the same time owning a stake in (what will be) the third largest publicly traded shipping company (by NAV) in the world.
Diamond S Shipping — Vessels Galore
There’s an argument to be made that the CPLP spin-off is more attractive than the parent.
After spinning off its product and crude tankers, the new company will then merge with DSS Holdings, Inc. One of the largest owner/operators of modern crude and tanker fleets, to form Diamond S Shipping (ticker DSSI).
The newly merged company will have a large modern fleet of 68 tanker vessels with a combined NAV of close to $700M. The 68 vessels will be split between 52 product tankers and 16 crude tankers with an average vessel age of 7.8 years.
This spin-off seems well-timed by CPLP management — picking the bottom of the industry cycle. There’re significant short-term catalysts in place for DSSI when it comes to their crude fleet. Since DSSI deals primarily in the spot-focused crude market — in fact, 100% of their crude vessels are on spot contracts — upward momentum in spot market prices directly drop to the bottom-line for pure incremental profit. Those crude spot market prices are on a meteoric tear over the last year, going from $16,171 to $40,497 — that’s an increase of 250%.
On the product tankers side, DSSI expects to benefit from the following three catalysts:
- Strong near-term growth in oil consumption
- The order book is less than 9% of the total fleet while the scrap rate has picked up
- IMO 2020 regulations could drive up product tanker demand by ~10%.
Within the product tanker business, medium-range (MR) ships are ideally positioned to sustain this supply/demand balance due to enough 20-25+ year ships expected to be scrapped with regularity over the next 3-5 years, thus offsetting order book deliveries. This idea is backed by Clarksons Research Services (the go-to source for all things shipping), who wrote in September 2018, that:
Fundamentally, we believe the market remains primed for a rebound through 2019 – 2020, with the orderbook remaining limited in the product tanker space, particularly for the MR fleet, while IMO 2020 regulations could support utilization trends.
Operating Leverage & Low Breakevens
DSSI is unlike some spin-offs in that it will end up having greater operational leverage and less debt. In the spin-off world, you routinely see the parent company throwing gobs of debt onto the newly public entity — but not in this case.
The company sports 60% net debt/fleet value, making it the fourth lowest of its peers. For comparison, Scorpio Tankers (STNG) sports a 67% net debt/fleet value. Diamond S will have a little over $90M in liquidity available — $50M in cash and $35M in a revolving line of credit. The debt they’re obligated to pay (close to $900M) is spread out over the next 5 years with $548M due in 2021, $63M in 2023 and $300M due in 2024.
On top of the favorable liquidity and net leverage aspects of the balance sheet, both of DSSI’s segments (crude & product) have low breakeven rates, making it easier to generate profits even in times of spot rate compression.
DSSI estimates their breakeven rates (based on daily operating expenses, G&A spend, and debt service) for 2019 to fall around $17,900 for their crude business and $12,800 for their product business. As a comparison, Frontline, Ltd. (FRO) breakevens are north of $20,000, Scorpio Tankers (STNG) are just under $19,000 and Tsakos Energy Navigation (TNP) fall between $19,000 – $20,000. All of this means that each incremental increase in spot rates drops straight down to bottom-line cash flows.
Management & Top Holders of DSSI
The newly spun-off company will be run by Craig Stevenson, Jr. Craig has over 40 years of experience in the shipping industry and previously served as CEO and chairman of OMI from 1998 – 2007 before selling the company to Teekay Shipping, Co and Denmark’s D/S Torm A/S for $2.2B. During his time at OMI, Stevenson grew the company into one of the largest project carriers in the world.
When it comes to major shareholders, you can’t do an analysis of DSSI without bringing up the fact that Wilbur Ross — yes that Wilbur Ross — will own roughly 25% of the company. First Reserve will own 20%, CarVal Investors will hold 6.5% and Chengdong Investment Corp (controlled by state-owned China Investments Corp) will hold 6%.
Valuation
Luckily for us, CPLP gives us financial projections for its spun-off entity as well as the Diamond S business that will merge with CPLP’s tankers. You can see the financial projections below:
We know that there will be roughly 1 share of DSSI for every 10.20 shares of CPLP, which equates to close to 38.5M in shares outstanding. Taking the sum of the present values after discounting the unlevered FCF we arrive at $739M.
CPLP’s SEC filing makes it easy for us to find the average EV/EBITDA multiple for comparable, which ends up being 8.3x for 2019 and 5.3x for 2020. Assuming an average EV/EBITDA multiple of 7x we arrive at a terminal value of $1.26B, which then gets us a PV of $782. Combining both figures puts Enterprise Value at roughly $1.5B. Dividing by our 38.5M shares outstanding we arrive at a fair value range around $16/share.
If we took a NAV approach, we can assume a P/NAV range of 0.91x to 1.01x (average of the industry competitors that we used for our DCF) and arrive at a valuation range of $600M – $66M for the net assets alone.
So, here’s a business that’s growing net asset value, being spun-off to take advantage of the spot rates in crude and product tankers / medium range contracts that we’ll likely be able to pick up for pennies on the dollars…
Risks
The risks — with all spin-offs — is the initial forced selling. The company will be leveraged, although not to the extent of its competitors, but debt always worries me in these commodity plays. Drastic reduction in spot rate prices below breakevens would result in significant operating losses — so if spot rates stay above breakeven, we won’t have to worry about that risk. Finally, failure to comply with IMO 2020 would keep ships at the docks unable to transport goods.
Philly Shipyard ASA (AKRRF)
I originally found this company after going through the OTC List of 10,000+ companies (it was easy because I started with the A’s) but never gave it the time of day due to its high operating losses in 2018.
However, Dave Waters from Alluvial Capital did an intro write-up to the company on his blog OTCAdventures.com. After reading Dave’s pitch, I decided a deeper look was warranted. The thesis is as simple as it is hard to stomach: AKRRF has no more ships to build, they’re laying off workers by the hundreds and hoping their strong balance sheet rides them through the trough of the shipbuilding cycle.
The company is taking steps to fill their short-term orderbook through government contracts while waiting for (hopefully) more ship contracts to satisfy the longer-term backlog. If the company can withstand this season of sit-and-wait, shareholders should be handsomely rewarded for their patience.
Philly Shipyard is a shipbuilder in, you guessed it, Philadelphia. The company builds ships for the US Jones Act market, which requires all commercial vessels transporting goods between ports in the United States to be built in the US, owned and operated by US citizens and registered in the United States (I can hear the patriotic fifer drums in the background playing as I write this).
This act covers all waterborne transportation between US ports — including mainland US, areas of Alaska, Hawaii and Puerto Rico as well as tankers in the Gulf of Mexico. The company owns the Jones Act shipbuilding space having built close to 50% of all ocean-going vessels for the Act since 2000.
What to Do When the Gold Dries Up
But that was then, and this is now — and times are tough. After the company delivers its 030 Hull vessel by Q1 2019 they’ll be left with no more ships to build. Delivering the largest container vessel ever built on US soil is a great way to end 2018, but what will Philly do now?
Management’s already begun the process of laying off workers — going from 1,200 at the beginning of the year down to >400 — and is cutting costs where they see fit. From here, there’s really two things they can do: 1) Rely on their balance sheet and melt the ice cube as slowly as possible until a new order comes in, or 2) go out and try to get shorter-term contracts. Luckily, they can do both.
The company has a strong balance sheet, low net debt and around $3.30/share in net-current-assets with $10/share in tangible book value. Cash burn isn’t great, however, as Philly burned through more than half of their 2017 cash in 2018, going from $110M to $49M. Once again — how fast will the ice cube melt before the next contract comes in?
In his letter to shareholders, CEO Steinar Nerbovik acknowledges that “… the market opportunities in the next 5-10 years will be cyclical and will not produce a steady and predictable stream of income.” Since its inception as a public company, AKRRF dealt exclusively with commercial contracts. Seeing that those have dried up, the company is now pushing efforts towards securing shorter-term government contracts.
Kickstarting this initiative, the company participated in a government-funded industry study and submitted a bid to be a major subcontractor for the US Coast Guard’s Heavy Polar Icebreaker. Although they failed to win the bid, it’s reinforced the necessity to keep bidding and bidding and bidding.
Along with the increased bidding for projects, Philly Shipyard is in the midst of having their facilities inspected for U.S. Government certification — which would qualify them to accept U.S. Navy vessels for repair work and dry-docking services.
Realistic Outcomes for Philly Shipyard
Shares are down over 50% from a year ago — which makes sense given the lack of contracts, laying off workers at the lowest trough in the shipbuilding cycle — but will it stay that way for long? If things do turn around, shareholders of AKRRF should be taking profits in truck-loads. As an example, Dave points out in his article that between 2014 – 2017, Philly Shipyard paid out nearly 3x their market cap in special dividends.
How are they able to do this? When times are good, they’re incredibly good. In 2017 the company generated close to $100M in free cash flow with a market cap of $100M — that means an FCF yield of 100%. Not bad! Even in 2016, the company generated an okay free cash flow yield of near 50% with $40M in FCF generated on $86.7M in market cap.
All the above scenarios assume that the company will once again win contracts and build new ships. That’s not a guarantee — so position sizing must be important if one wants to take a stab at the Philly shipbuilder.
How to Invest in These Shipping Companies
We know what the future could look like for AKRRF, but at this point, we have no idea which road they’ll end up taking. Because of this, the best way to invest with AKRRF would be to take a very small percentage of your overall capital (no more than 1% – 2.5%), buy your allotment and then don’t even look at it. Please note that I’m not saying you should explicitly buy these securities but give you a framework for how you should go about allocating capital to the shipping industry.
I’ll be releasing a more detailed, deep-dive piece into this world of “basket” picking stocks — so keep an eye out on your inbox.
-Mr. Bean
