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Target Hospitality (TH): A Former SPAC IPO with Multiple Ways to Win

Target Hospitality (TH): Leader in Vertically Integrated Specialty Accommodations


Target Hospitality is the largest vertically integrated specialty rental and hospitality services company in the United States. The company owns an extensive network of geographically relocatable rental accommodation units comprised of ~13,000 beds across 22 sites serving the country’s highest producing oil and gas basins.

Most of the company’s revenues are generated under multi-year “take-or-pay” contracts, providing Target high visibility into future earnings and cash flows. The company went public via SPAC merger with Platinum Eagle Corp and Signor Holdings and is trading for an incredible discount to just a middle-of-the-road valuation.

We believe one can purchase shares of a business generating over 50% EBITDA margins, 90%+ FCF conversion and a 26% 3-year EBITDA CAGR for 60% off — getting all future growth for free.


Is This a Good Business?

The modular accommodations business is a great business with enviable unit economics. There are predictable up-front fixed costs (like the initial build out of the site and beds) with very minimal ongoing maintenance expenditures. This trend translates into high margins with incrementally higher return on invested capital over the course of a project’s lifetime.

Let’s look at Target’s lodging business performance from 2018 to paint a clearer picture.  In 2018, the company generated a little over $186M in accommodation revenues on $93M of operating expense, giving us $93M in gross profit (over 50% margin). Backing out the depreciation of the accommodation assets gives us around $134M in EBITDA.

Most of these margin advantages are exclusive to the modular style of construction. Horizon North (HNL), a Canadian builder of modular homes and accommodations, did a fantastic job of outlining the benefits of switching to a modular construction style in their latest investors’ presentation. According to HNL, there are four main advantages to switching to modular: Time Savings, Cost Certainty, Sustainability and Quality Control. The biggest (and most important) advantage to modular homes is the extreme savings on project development.

How can a company achieve such high savings on time? The typical construction site build schedule goes as follows:

Design & engineering –> permits & approvals –> site developments & foundations –> building construction –> site restoration.

Modular combines of both the Site Development & Foundations and the Building Construction. Modular buildings are built off the job site and usually indoors, enabling the construction to both develop the buildings while making the build site ready to receive the buildings. Further, since the buildings are constructed indoors, build development isn’t stunted from adverse weather conditions. Reducing construction build time by 30 – 50% translates into faster return on investment, which creates a positive feedback loop where that returned capital can be deployed into new modular projects at those same high rates of return.

Another benefit of modular construction is lower waste levels per project (read: less money spent on unnecessary items). A company using modular construction processes knows exactly how much of each component is being built and can scale seamlessly.

For example, a company might need to order 15,000 lbs. of lumber for 400 modular buildings (completely arbitrary figures — I apologize to my former construction workers in advance). If they then go on to receive an 800-building contract, they know exactly how much material they will need to complete the job. WRAP, a UK company specializing in waste efficiency research, reported that an up to 90% reduction in materials can be achieved through modular construction. That 90% reduction in material costs drops straight down to bottom-line earnings.


Signor Holdings: Incremental Cash Flow at Low Cost

The merger of Signor Holdings (the hospitality segment) adds significant incremental earnings and cash flow for very little capital expenditures to an already high margin, high earning lodging business.

Operating independently, Signor’s financials were rock solid.  For the period Jan 2018 – Sept. 2018, Signor generated $61.2M in revenues, $30.5M in gross profit (50% margins) and $32.8M in EBITDA with over 90% FCF conversion. Signor (on its own) generated roughly $0.52/share in operating earnings. The company is a high margin value-add that costs Target (the parent) almost nothing in additional expense.

By combining the two businesses, Target Hospitality owns the entire process from manufacturing / supply of accommodations to catering, amenities and hospitality services within its owned and operated communities. The combination reduces expenses (removing the need to outsource various services) and removes the guesswork for its customers on how they’ll be able to fill all the aspects of rental / accommodation services for their workers.

What happens when you combine a high margin, high cash generative lodging business serving blue-chip customers with another high margin, high cash generative hospitality business providing turnkey catering, security, recreational and other amenities?

You get a robust business providing clients with 100% of their needs while achieving substantially higher margins than competitors.


Impressive Growth & Break-even Reduction

Between 2014 – 2016, Target was a small, albeit growing company with a network of just 5,500 beds. These beds were distributed 56% in Bakken Basin and 44% in the Permian Basin serving (for the most part) upstream oilfield services and midstream companies. Utilization rates were at a decent 65%, and the company’s average daily rate came in at $86. Cost of production wasn’t great by any stretch of the imagination, with break-even rates between $70 – $90 oil prices. This was great, of course, until oil peaked in June of 2014 — falling from $106bbl to the February 2016 low of $30bbl

The company has undergone drastic changes since to drive production costs lower, increase utilization rates while adding more beds in higher growth areas thus lowering their overall break even rates.

Seeing the growth prospects in the Permian Basin region (something we’ll touch on in a little bit), Target altered its concentration, putting 81% of its buildings in the area to create the largest and closest accommodation site in the entire Basin. Target’s main customers remain Upstream Producers, Oilfield Services, Midstream Owners and Government entities. Break-even rates are around $44/barrel in the Willston Basin and an impressive $32/barrel in the Permian Basin — representing a 60% cut in production costs over the last two years.


Industry Leading, Enviable Unit Economics

A leading driver of our bullish thesis is the incredible unit economics of Target’s vertically integrated business.

In February of 2018, Target won a contract to build 400 beds in the Carlsbad region in Mexico — located within the Delaware Basin — one of the hottest basins in the Permian landscape. The company’s average project is around 500 beds with $50K/room in CapEx. Average daily revenues are between $86 – 95 per bed, and COGS per bed is $35. Capping it all off, the company spends $3M total in maintenance capital expenditures during a given year. All capital expenditures are underwritten by Target’s contracts, so the risk for speculative building is (for the most part) nullified.

In Target’s latest contract, 400 beds at $50K per room gives us total upfront investment of $20M. Assuming the company’s historical EBITDA margins (and reaffirming that percentage with our median ADR/COGS figures), the $20M investment will generate roughly $7.2M in EBITDA per year. $7.2M EBITDA/year translates into an IRR of 36% annualized.

Due to the extremely low maintenance annual capex spending, over 90% of that EBITDA will drop down to free cash flow to the firm (read: over 12% FCF yield). Target should expect to receive $144M in EBITDA over the course of their latest contract (assuming a typical project lasts 20 years). This means that for every dollar the company spends on investment, they receive over $7 in unlevered cash returns.

To quote Charlie Munger, Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

We believe Target offers the best of both worlds in Munger’s scenario: a business compounding capital at high rates of return while at the same time trading for a huge discount.


Contracted Revenues & Future Growth Prospects

The company’s already raised guidance higher for 2019 revenues and EBITDA, $340-$350M and $175-$180M respectively.

The increased guidance comes off the heels of renewed contracts with four of Target’s largest customers, representing nearly $45M in incrementally higher earnings. According to management’s press release, the contracts will add over $200M in cumulative value with all renewals signed on a multi-year agreement. The contracts extend the existing contracts by a minimum of two years and include the full-scale accommodation services from Signor Holdings (read: incrementally higher revenues per contract extension).

The upward guidance introduces our second largest driver of value: long-term contracted revenues. When looking back on the last few write-ups we discovered we really like long-term, contracted revenues. That long-term revenues provide high visibility into future earnings and cash flow makes these types of businesses some of our favorite to invest in.

Increased visibility offers us a better chance at achieving a more accurate fair value range over the next 3 – 5 years. The latest extended contracts lock up 90% of Target’s revenues for 2019. We’re highly confident these revenue sources will continue to expand as growth in the Permian Basin region picks up, with much of the growth coming from its two largest players: Chevron & Exxon Mobil.


Will Growth in The Permian Hold?

There’s arguably no area in the United States that’s reaped the benefits of a US Energy Exporter in Office than the Permian Basin. According to a Forbes article (dated 02/09/19), the Permian Basin is now the world’s second most productive oil and gas resource. We are confident that growth in the Permian Basin will continue its historic pace. But don’t take our word! Here’s what the US Energy Information Administration (EIA) had to say on the matter:

Growth in the Lower 48 onshore crude oil production occurs mainly in the Permian Basin in the Southwest region. This basin includes many prolific tight oil plays with multiple layers … making it one of the lower-cost areas to develop.

The EIA projects that domestic crude oil production will surpass 15 million barrels per day by 2022 (which would be years before their earlier projected figures) and will remain producing over 14 million barrels per day through 2040. Target’s latest investors presentation paints the TAM for the Permian Basin at $1B and has grown their share from 2% in 2015 to 20% today.

Touching on the two largest players in the Permian; Chevron supported their increased exposure to the Basin due to their past success. Over the last two years there, Chevron added almost 7 billion barrels of oil and doubled its portfolio value. ExxonMobil revised its Permian growth plans to produce more than 1 million barrels per day by as early as 2024 — which reflects an increase of nearly 80%.


Multiple Ways to Win (Organic Growth, Pipeline Catalysts
and M&A)

There are multiple ways for Target to win over the next five years.

We’ve touched on the Permian Basin and the renewed multi-year contracts, but there’s more room to grow. As a near term catalyst, the company’s identified close to 5,000 beds that will come online during 2019 — all through organic growth. Target’s spent $213M in CapEx on these beds and will generate a minimum contracted EBITDA of close to $260M — a 30% return on their investment within 2.8 years.  

The companies also engaged in three major projects (each coming online in 2019): US Government contract, Services Contract and LOI Awarded. The government contract is for multiple, large scale communities supporting a host of US federal agencies. Target estimates contract value for this project to be between $85M – $100M.

The services contract was awarded for work in the Keystone Pipeline, where Target will provide catering and facilities services. Work started on the project in 2018 and is awaiting full release. The company estimates around 5 million meals will be served over the duration of the contract (read: high margin, low capex revenues).

Target was also awarded a Letter of Intent to support the construction of a brand-new oil refinery in the North Dakota Bakken region. Total contract value is estimated between $35M – $45M with minimal capital expenditures (highly accretive free cash flow).

Finally, the company’s targeted (no pun intended) four regional accommodations providers for acquisition. Should Target go out and acquire all four of these local players it would add over 6,000 beds to the company’s network. At Target’s historical rate of $18K in EBITDA per bed in their network, those acquisitions translate to roughly $108M in potential EBITDA expansion.


Valuation

When estimating our conservative fair value for Target, we decided to exclude the multiple avenues of growth (i.e., M&A, organic bed growth and pipeline contracts) in order to give ourselves a clearer base rate range of valuation. The company’s been able to grow EBITDA over 20% annually over the last three years, but will this truly be the company’s growth prospects going forward? In valuing Target Hospitality we’ve projected three different futures: pessimist, neutral and optimist trajectories.


Pessimist Valuation

For our pessimistic view of Target’s future, we’ve assumed the following outcomes:

  • Top-line revenue growth: -10% annually after 2019
  • EBITDA margins: 35% after 2019 (this represents a 15% margin compression from current levels
  • Capital Expenditures: 2% of revenues (slightly above historical figures)
  • Tax rate of 25%
  • Discount rate of 10%
  • Net debt: $340M and EV/EBITDA
  • Multiple: 10.2x (comparable average).

Using the above assumptions, we arrive at 2023 FCF of around $65M, $391M sum of present values, and $972M Enterprise Value. Dividing by the total number of shares puts us at ~$6/share. Shares are trading for around $9.80 (as of 04/05), which represents a 40% downside in this given scenario.


Neutral Valuation

Assuming that Target doesn’t do anything over the next five years. They don’t grow, they don’t shrink, they remain in this static environment of top-line stagnation. For our neutral valuation we’re assuming 0% top-line growth, 40% EBITDA margins (10% lower than historical averages) and an EV/EBITDA multiple in line with industry averages — 10.2x.

Using the above assumptions, we arrive at 2023 FCF of $122M, $525M sum of present values and $1.6B in Enterprise Value. Taking the mean figure between our EBITDA approach and DCF gives us fair value of ~$11/share, or 20% higher than current prices.


Optimistic Valuation

We would argue that this isn’t an optimistic valuation in the sense that we don’t think it will happen — in fact — if each scenario could be put into probability buckets of potential outcomes, we would put this scenario into the bucket of “most likely to happen”.

We’re assuming top-line revenue growth of 15% (given the 3 year 28% EBITDA CAGR, it seems reasonable), EBITDA margins at historical 50% and an EV/EBITDA multiple of 12x. In this example, we’re projecting the market will realize the value of the company not only through share appreciation but multiple expansion.

The above assumptions spit out around $236M in 2023 FCF (8% FCF yield), $673M sum of present value and a near $3B Enterprise Value. At $3B EV, the company would have an exit EBITDA multiple of sub 10x, which we think is too cheap. Attaching a multiple that’s geared towards industry leading gives us a price of over $20/share, in line with our DCF estimation. At around $20/share you have a chance to 2x your initial investment.


Risks

Anytime you have a company that is tied to a commodity (i.e., oil) there is the chance of commodity price risk. Target’s been able to reduce this risk dramatically as the company’s been able to cut their breakeven prices from $76 in 2014 to $32 today.

Declining oil prices lead to capital and labor leaving the industry. This cycle ends up costing Target Hospitality the chance at filling their beds and generating revenues / cash flow. Target can mitigate this risk due to their long-term take-or-pay contracts. TH solidifies their contracts with their customers at certain oil prices — which are fixed in the contract. This means that for the life of the contract, it doesn’t really matter what oil prices do because Target locked in its contract at that fixed oil price during the time of signing.


Growing Pains in Basin

While all this growth is extremely bullish for Target, the major problem the Basin faces is in Takeaway Capacity. The basin saw early signs of this towards the end of 2018 with Midland – Cushing spreads hitting as low as $20bbl as every pipeline was full. If production continues its expansion as planned, there will once again be a need for increased takeaway capacity — or suffer backups.


SPAC Stigma & Liquidity

Another risk to share price appreciation is the fact that Target went public via SPAC IPO. SPACs have a sketchy history (at best) of post-IPO performance, which can dissuade many investors from becoming part owners. In other words, yes, over time the market is a weighing machine. However, if there isn’t a market of willing and able buyers, share prices might never truly reflect the underlying value of Target’s business.

Liquidity is also a risk when dealing with newly IPO’d SPACs, and TH is no exception. The company averages 30k – 70k shares in daily volume. At current shares prices its between $300K – $700K of daily volume. Again, not bad for the smaller investor — but for an institution or larger fund, it will take some time to build into a full position.


Buying Value, Get Growth for Free

To conclude, here’s a business that’s trading around 8x 2019 EBITDA with a current enterprise value that implies the company won’t be able to achieve any top-line growth in EBITDA over the next 5 years. Mr. Market is giving the investor an opportunity to own a high margin, high FCF conversion business with long-term take-or-pay contracts business for less than 8x next year’s EBITDA.

Target has many levers to pull to expand earnings, cash flows and multiples over the next five years. Over time, we believe the market will value this business closer towards (and even potentially higher than) its intrinsic business value. The company is an industry leader in vertically integrated specialty accommodations serving some of the hottest end markets in the United States — and current prices on both the warrants (which are 3-for-1) and the common stock offer a chance to buy the business while getting all its future growth for free.

If you want to know my process for finding these hidden market gems click here to receive my value investors checklist!

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Anchors Away: My Three Favorite Shipping Ideas

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:

  1. Strong near-term growth in oil consumption
  2. The order book is less than 9% of the total fleet while the scrap rate has picked up
  3. 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

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Value Ventures: A Prologue

Hello Macro Ops World! Like the first program to run on the original Macintosh, my introduction into this growing community of people striving to be the best they can be inside and out of the markets isn’t fancy. My name is Mr. Bean. No, it’s not the name I wanted — I would’ve rather preferred something sexy, like ROGUE. However, Chris D made it very clear that you don’t pick your nickname, your nickname picks you. That being said, I’m thrilled to join the MO team and look forward to becoming both a better investor and human.

So what is Value Ventures?

Value Ventures will be Macro Ops’ one-stop-shop for all things value investing. Think of it like Bruce Greenwald and Michael Burry having a love-child in which pillow talk revolved around balance sheets, not bed sheets — you get the picture. Value investing has many definitions and everyone is quick to give you their views on the subject. Out of all the movers and shakers in the industry offering their definition, spin-off OG Joel Greenblatt’s makes the most sense: Trying to figure out what a business is worth, and then paying a lot less for it.

I could stop there — that’s it. Value Ventures is all about trying to figure out what a business is worth, and then seeing if we can pay a lot less to own it. Shares aren’t blips on a Bloomberg screen or tickers on a chart; they’re physical pieces of ownership in real businesses. This sense of ownership is vitally important to us as value investors. Without this “ownership” level of conviction in the businesses we buy, we won’t be able to stomach the downturns that inevitably come over time. As value investors our time horizon is far off in the distance — perhaps 10, 20, or even 30 years. This time frame gives us a tremendous edge against the fast-paced market shakers that are prodded out on CNBC every day.

What Content Can I Expect to Receive?

You might be thinking, “that sounds all good and dandy, Mr. Bean … but what kind of content should we expect from you?” Excellent question! You should expect deep work on individual businesses, topical musings on psychology, physical health, mental models, business moats, and the like. Finally, you’ll get a heavy dose of smaller write-ups on off-the-beaten-path companies such as spin-offs, SPAC’s, reverse mergers, and micro – caps. Wherever there’s value, we’re willing to venture.

I look forward to learning and improving each and every day with the MO community. You can reach me on Twitter @marketplunger1 or email mrbean@macro-ops.com.

Stay Venturing!

P.S. If you want to take a look at my pre-trade value checklist click here for a free download!