Investors have been burned badly in the shipping sector for the last 10 years or so. As has lenders. Now a perfect storm appears to be brewing, especially in the oil tanker segment, where new supply is at an all time low due to longer-term regulation uncertainty which has led to lower levels of new ship ordering as well as an unwillingness from lenders to commit more capital to the industry after all the painful years.
On the demand side the ton/miles ratio is set to increase as the US is loosening up on prior restrictions on export of their shale oil. Since Asia is the big oil consumer this leads to much longer transportation routes than the traditional Middle East to Asia ones.
On top of this there is new regulation called IMO2020 which is likely going to disrupt the broader shipping industry. From January 1st all vessels are required to run on bunker fuel that has lower sulfur content than in the past for environmental reasons. This means a lot of refined oil (clean product) is going to be moved around. This is already starting to cause some chaos which is good for tanker rates. Shipowners can bypass this regulation by installing an exhaust system called scrubbers. Those installations will lead to less supply on the water which is another tailwind for rates for the coming 12 months or so.
Diamond S Shipping
Diamond S Shipping is an oil tanker company that has exposure to both the clean refined products (60%) and the dirty crude (40%) segment. The market cap is currently just below $600 million and the share price hovers around $15. Two private equity shareholders holding 44% of total shares outstanding want to exit and this, perhaps counterintuitive to a lot of people, is why I see a great risk/reward opportunity here. But more on that later.
Diamond S is valued lower than comparable peers by an eye opening margin but before I get to that I want to highlight management’s track record. The company is run by Craig Stevenson who was the CEO of OMI Corporation where he timed a terrific exit within months of the absolute top of the latest true tanker bull market in 2007. In the process they launched a massive share repurchase program when their stock traded below net asset value (NAV) and bought back 36% of the shares outstanding in a three year period. And shortly thereafter sold the company at a 30% premium to net asset value. Shareholder friendly capital allocation of this sort is relatively rare in shipping, to put it mildly.
Craig Stevenson is now back in the public markets for a second run with Diamond S Shipping which he founded in 2007 and where he holds a $6 million stake. About a fifth of that was bought in May earlier this year. Two members of management also hold stock valued slightly below $1 million. Significant insider ownership like this is relatively rare in shipping where empire building for the sake of generating higher management fees is the general rule.
At the age of 65 my guess is Stevenson is more likely to continue focusing on building shareholder value rather than on building a career, ie. he is more likely in my view to focus on the bottomline rather than the topline.
Note however that he has commented on the need for industry consolidation and multi-billion dollar companies to attract institutional investors so mergers involving Diamond S are likely happen. But given all I have written above I think such transactions are more likely to be accretive to shareholders rather than dilutive. But again this is a faith based assumption and I may be proven wrong down the line. If you want more info on his views on consolidation you may want to watch this (Stevenson is the second guy to the left on the panel). I will also link to an informative interview with him and his CFO by shipping analyst J Mintzmyer (whose service I subscribe to) once it becomes public, probably in a few weeks time.
If you look at net asset valuations for Diamond S Shipping (ticker DSSI) and compare to competitors then you begin to scratch your head because it turns out Diamond S trades at a significant discount to peers with a price/NAV in the 0.65 range when factoring in earnings from Q4 thus far. Comparable competitors (Scorpio Tankers, Ardmore Shipping, Torm, International Seaways, Teekay Tankers, DHT) trade in the P/NAV range between 0.90-1.20 with Frontline an outlier at 1.70. The latter probably due to the Frederiksen premium based on his history of large dividends. Investors love such unsustainable dividends but ignore what often happens when the market turns south: here and here (click on max number of years for both of those links to see the full picture).
Asset values have started rising slightly and I think we are approaching mid cycle territory. Historically P/NAV approaches 1.00 around here and in the later stages go beyond that. My base case is 15% vessel appreciation and P/NAV of 1.10 one year from now which would equal $30/share, equal to a double from here.
Since normalized earnings are extremely hard to estimate in such a volatile business such as shipping where companies will often go 20 quarters or more in a row with negative earnings and then have 10 quarters with explosive earnings I find net asset value (NAV) to be the best metric to use in shipping. It is based on a mix of actual vessel sales which uncover the price market participants are willing to pay here and now combined with 1-year charter rates. It is a lagging indicator but it is the best one available. Some find cash flow more useful but this is also hard to predict. Earnings per share is the worst of the three by far as depreciation and book value comes into play. Because asset values fluctuate so much historic book value figures are completely useless. They are rarely adjusted up or down to reflect real value. Since vessels are currently valued lower than their historical costs depreciation will be too high so EPS will be understated in relation to the true value of current earnings. Therefore cash flow is the far superior metric of the two.
So if we look at cash flows and we take current 1-year charter rates of $35,000/day for the suezmax fleet (the crude part of their fleet) and $16,000/day for the MR fleet (the product fleet) then we arrive at cash flow from operations of approximately $5/share, corresponding to a 33% cash flow yield. Capex for 2020 will eat about 10% of that, so no biggie (see page 12 in the latest Q3 presentation). The above mentioned doubling of the share price would not be far-fetched given the above assumptions on rates.
Note that in the rear-view mirror spot rates usually turn out to be higher than 1-year charter rates and since 80% of the DSSI fleet is in the spot market I would expect their 2020 cash flow from operations to be substantially higher than $5/share.
Most analysts expect the period from now until at least the end of 2021 to be a bull market due the conditions I described in the beginning. There is relatively good visibility on the ordering of new vessels in the big segment (no new VLCCs and Suezmaxes that are ordered now can be built within the next two years) and somewhat lower in the MR segment where ships can be built in 15 months. But for all segments the age profile looks favorable as many are close to the end of their useful lives and owners don’t know what to build until there is more certainty around regulation and so the bull market could very well drag on into the mid 2020s. After all, it would suck to build something that is built for a 20 year life and then new regulation comes in to chop off a ton of the value before the vessel even hits the water.
The advantage of age?
Diamond S Shipping’s fleet is around 10 years old which is older than the industry average. I view this has an advantage because the bull is here now and if it lasts for 2-3 years then that is a more significant part of the life of a vessel that only has 5-10 years of life left in it than a newer vessel that has say 15-20 years left to breathe. The latter is likely to see a greater proportion of bear years I would think. And if that is so older vessels would have more price appreciation potential than newer ones. This is illustrated by management in this slide on page 8.
The flip side to that argument is that newer vessels, especially those with scrubbers, may get a premium on their voyages depending on how things turn out with the new focus on ESG (Environmental, Social and Governance). But again what about new regulation? You would hate to have a two year old vessel be on the wrong side of that. Better to have one that is 15 that is closer to scrap value as you risk less.
On the cost side Diamond S has among the lowest break even Time Charter Equivalent numbers in the industry (the day rates at which their vessels break even), primarily due to cheap ship financing. The financial leverage ratio is at 48% which is reasonably safe if the bull thesis doesn’t play out. Most other names have higher leverage, for better or worse. Of course some of the ultra leveraged plays will take off faster than Diamond S but when combining the upside and downside scenarios I see only extreme bull runs as an area where Diamond S is likely to underperform some peers, and even then I think only a few of them will (Scorpio Tankers, Teekay Tankers, Frontline and some of the Greek names come to mind). The more certain you are of an extreme bull market the more you should be inclined to add to those names. But the flipside in those names is that they are much more vulnerable on the downside.
On the other side of the equation a few good downside protection names besides Diamond S in my opinon would be International Seaways and Euronav. Obviously those will rip in a bull market as well but likely not as hard. In my estimate the overall risk/reward ratio favors Diamond S over other names at current valuation.
Why is it cheap?
So why is a company of relatively high quality trading way below peers? That is the key question.
Those below $1 billion market cap will always trade a bit lower than the three names that are in the $2 billion market cap range (Euronav, Scorpio Tankers and Frontline) but the majority of tanker names have a market cap below $1 billion so that cannot be the explanation. (Btw. I think a price differential for those three and the rest will likely average P/NAV of between 0.10-0.20 going forward because those three are easier to enter and exit for institutional money.)
One reason could be that Diamond S is the newest kid on the block so perhaps part of the market hasn’t noticed they are around yet. Many analysts don’t cover them yet so they have gotten less expsoure. DSSI became public in March of this year. Capital Product Partners spun out the tanker part of its fleet to merge it with Diamond S and with it came investors that were used to big quarterly dividends from the more stable container business. So that means no IPO, no road shows and a ton of investors with shares from an income play now stuck in a volatile tanker play.
I think a more significant reason, and this I think is the reason for the attractive price, is that the two largest shareholders, WL Ross & Co (shareholder since 2010) and First Reserve (founding shareholder since 2007), both want to exit. This wish has been communicated by management since becoming public but it is only now that the offering saw the light of day. So 44% of shares are looking for a new home and the market often hates situations like that although it doesn’t interfere in any way with the company’s operations. The reason is of course that the supply of shares is now much greater than the demand for them. But the thing is:
THIS IS TEMPORARY
My time horizon is longer than next weekend so I say thank you for the cheapness this situation provides. Some participants may be able to game the market by waiting for the overhang to clear out and I wish them luck but I suspect it will be hard to enter at today’s prices once the two major shareholders are out. I also suspect that this is another one of those many instances where you get paid for the impatience of other investors. Waiting when others are unwilling is in my opinion the easiest edge attainable in the markets today, one that requires very little brain power and the one we have to fight the least for (except against our own impulses, which can be hard enough).
There comes a lock up period with the two major shareholders’ shares. The first half of that expired in September and it didn’t lead to any selling. The other half comes in March of 2020. So there may be buyer hesitation till then. We will see.
An added benefit of being a shareholder in DSSI that I see is that if shares still trade at a heavy discount 6-12 months from now the company will probably have generated enough cash flow to repurchase significant amounts of shares from the market cheaply. And history has shown they are likely to do so.
I’m betting on a repeat of history on this one.
(NOTE: A few hours after this blog post was publised an offering from the two major shareholders was announced for 4.7 million shares at a selling price of $13.75/share. The share price dipped when the market opened the following day but gained half of the loss at the close of the day. More than 1/4 of the stock overhang is now gone and that liquidity is now added to the market. There is a loc-up period until March 21st before the two shareholders are able to sell the remaining shares should they choose to do so.)
Disclaimer: I own shares in DSSI at the time of this blog post’s publication. None of this is to be considered advice to buy or sell any of the stocks mentioned herein. Instead this post is to be considered a starting point for further investigation. Please perform your own due diligence before making any investment decision.