ADS Crude Carrier – the low risk play in a sea of uncertainty?

At a time where the coronavirus has wreaked havoc around the world and where oil demand has crashed it might seem strange that those who transport oil around the world are seeing record high rates. But that is indeed the case. And the primary beneficiaries are the owners of the bigger vessels, the Very Large Crude Carriers. Those are currently Very Large Cash Cows printing money at a pace that rival that of the central banks…

In this post I will provide an investment idea that I think is uniquely positioned for the current situation, ADS Crude Carrier. The key is this:

Large vessels with short lives and a business model that is all about distributing cash in massive amounts to shareholders in the near term.

(For a quick summary scroll down to the end of this article)

Why are current rates so high?

Before I get to the company specifics here is a bit of background on why the current collapse of oil demand has ended up benefitting tankers immensely here and now.

What we have now in the oil market is the rare situation where short-term contracts are priced much lower than those further out into the future. This situation is known in the commodity markets as contango. The bigger the gap, the steeper the contango: https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html

This has come about because short-term demand for oil has collapsed by unprecedented 30+% due to the coronavirus situation we have all been subjected to. And because production is much higher than the demand the market is way out of balance even when factoring in a huge production cut by OPEC. So this excess oil must go somewhere: Hello tankers!

Oil traders can benefit from this by buying short-term contracts and simultanously sell contracts further out and lock in the difference. Except, they don’t get to keep all the spoils. Actually by the far the majority of it goes to those who can store the oil that is being bought. And since the world is soon running out of storage on land rates for storage on tankers have increased tremendously.

In fact, to rent a VLCC for storage at this moment for six months the contango supports rates above $110,000/day and for one year $70,000/day. Contrast that with a cash break-even for an 18-year old VLCC at around $15,000/day. And tankers tied up for storage decreases the overall supply which pushes up rates for the vessels that get booked for what they were actually built for: sailing, transporting oil. Just yesterday a VLCC was fixed at $187,000/day for an 80 day trip.

There will come a time, however, when rates will plummet from these high levels and that could happen once oil demand start to outstrip production again. This sounds like a great thing for tanker demand but the problem is that initially there will be a drawdown from all the inventories that have been stored. So the whole storage story is double-edged. But the good thing for tankers is that earnings are many multiples above break-even now so it isn’t as easy as to say that a bad month cancels out a good month. Each month that this goes on is tremendously valuable for tanker owners. Those negative on the sector point to the inevitable hangover that will follow. And they are right. But it doesn’t matter all that much to the bull thesis since some tanker owners are likely to earn their entire market cap in 2020 alone.

ADS Crude Carrier – well positioned for this particular market

And this gets to the heart of why I have picked ADS Crude Carrier ahead of other tanker companies for this particular environment.

ADS is listed on the Merkur Exchange in Oslo. The share price currently is 25 NOK and the market cap 585 MNOK ($57 million).

The company owns three 17 ½ year old VLCCs with an average life of 30 months left in them before they are likely headed for recycling.

Of those 30 months 5.5 months have been locked in at rates that cover more than half of the current market cap in operating earnings(!). On a per share basis this is equal to roughly 13 NOK/share – all of which I expect to go towards dividends and debt reduction (less future vessel opex) as per company policy.

Since rates are ”unnaturally” elevated now it isn’t as simple as saying 30/5.5 x 13 NOK to get at the expected return to shareholders over those 30 months but it does go to show that there is a huge margin of safety already built into the numbers, even in the unlikely event that rates crash through the floor in the very near term. I will get to my baseline assumptions for rates for the rest of the period a little further down in this article.

Based on conversations with management I expect capital expenditures and fleet renewal to be zero in 2020 and 2021. And in H2 2022 the base case as I understand it is that the three vessels will likely be recycled and earn their steel value and the remaining debt will be paid off.

The math of it based on current steel prices looks like this:

So approximately 4 NOK/share of additional value when adding back working capital and subtracting the debt. Note that the number supposes current steel prices 2 ½ years down the road which of course is a very big if. For the number to be negative steel values will have to decline by more than 30% from already depressed levels. I don’t deem that a likely scenario but of course not an impossible one either. If steel prices revert to where they were in the fall of 2019 ($16 million per vessel rather than $13 million) the total value would be 8 NOK. In other words, I suspect 4 NOK is on the conservative side.

Optionality kicker

There are other possible scenarios in H2 2022. One is if rates are still expectionally strong the company could decide to take the vessels through a survey that would potentially give them an additional life of 2.5 years. From my understanding this is unlikely to happen.

Another scenario in a strong but not crazy strong market is that the vessels can be sold as storage vehicles. This supposes ADS will be able to get a higher value than they would by recycling the vessels. Also not a likely scenario from my understanding.

So while both of the above two scenarios are unlikely they do provide free optionality for the company. So what is the value of that?

My estimate is 5 NOK and that is the number I will use going forward but it is very hard to assess, admittedly.

The theoretically correct way to find this number would be to multiply the value of all the possible scenarios by the probability of each and then add them all together. Too many unknowns to arrive at an accurate number of course but it certainly is above 0 even though 0 is the outcome in most scenarios. The reason is that some scenarios are worth a lot.

For instance: Supposing ADS were able to sell the vessels for $26 million per vessel in H2 2022 for storage or trading instead of recycling them at $13 million that would equate to 13*3=$39 million of additional value, which is 17.60 NOK per share.

That is obviosuly a blue sky scenario but to put things into perspective: Earlier this week a 2001-built Suezmax vessel (which is half the size of a VLCC) was sold for $21 million which is a figure that is more than double its scrapping value even though it only had one more year left of trading. But of course the main reason for this price is the current contango making it an earning machine in the short term. I wanted to mention it because even though the contango likely will be long gone by 2022 other factors could come into play that would make the vessels sell above scrap value.

Valuation

So what we know for sure is 13 NOK is in the bank for 5.5 months out of 30. This number is the most important of all because of the certainty of it and it is the basis of the whole safety thesis.

4 NOK for scrap value+working capital-debt. And 5 NOK for optionality. Those are both my fair value estimates and neither are close to being bankable.

In total: 22 NOK.

What then is the value of the remaining 24.5 months of vessel days? Again, remember this is a period with a lot of uncertainty in a space that is already known for high volatility so whatever estimates one arrives at will be extremely uncertain. At some point the current steep contango will no longer be in play and rates will go lower. Judging from analyst reports and adding a layer of conservatism I arrive at the following estimates for TCE rates going forward.

$60,000/day average for the remaining 6.5 months of 2020. OCF 12.60 NOK/share.

$40,000/day average for the 12 months of 2021. OCF 13.20 NOK/share.

$30,000/day average for the 6 months of 2022. (They reach their 20th birthday on different months: March 2022, August 2022 and October 2022 so 6 months is an average.) OCF 4.20 NOK/share.

Adding all of it together I arrive at 52 NOK per share. (Fair value is slightly lower because of the time value of money but I expect most of this value to be earned and distributed in 2020 already so not a huge effect.)

To give an idea of how quickly estimates might change let’s say in an upside scenario that the company manages to fix their two vessels ADS Serenade and ADS Stratus that will both be open for new fixtures in a couple of weeks time at the current rates of $110,000/day for 6 months then that would add another 8 NOK of value to the 2020 scenario. And in that case operating cash flow will exceed 30 NOK/share for the year with still approximately 150 of a total of 1095 vessel days left in the year. And again remember there is no capex for 2020 and 2021 so all earnings are headed for shareholder pockets.

In a downside scenario where rates fall to below break-even levels on a cash basis there is some protection in the possibility that the vessels can be recycled ahead of time.

Quarterly dividends

One reason I like the thesis is that most of the cash that is currently being generated will be returned to investors in the very near term due to the company’s philosophy of returning excess cash on a quarterly basis.

An agreement with debtholders stipulate that once debt has been reduced from currently $36.6 million to $27 million all excess earnings (minus liquidity needs) can be distributed to shareholders:

Since earnings are so massive right now this debt reduction can be accomplished using cash flow from Q1 alone. According to my estimates ADS will earn approximately $15 million in operating cash flow in Q1. After debt reduction $6 million of that can be distributed to shareholders, equal to 2.70 NOK/share.

For Q2 I estimate operating cash flow to be $17 million and that all of it will be distributed to shareholders, equal to 7.70 NOK/share. So by August/September of 2020 my base case is roughly 10 NOK/share will have been distributed to shareholders.

So what can go wrong?

There are a few yellow/red flags that needs to be monitored by investors, such as party-related transactions. Because the two major shareholders John Fredriksen owned SFL (17% owner) and ADS Shipping (10% owner) provide both loans and technical management services to ADS Crude Carrier there is a question of whether interests with other shareholders are 100% aligned.

And there is also the question of whether they are incentivised to close up shop in H2 2022 or whether they will prefer to buy vessels when that time comes in order to continue earning management fees. This is not clear currently.

So besides declining rates this is my primary concern. On the flip side I expect investors to have received dividends covering more than the entire market cap by the time these decisions will be made.

Summary of the thesis – fair value: 52 NOK/share

I believe ADS Crude Carrier provides excellent downside protection and very decent upside potential despite an uncertain environment because of the following:

• They own three 2002 built VLCC vessels that are likely headed for recycling by H2 of 2022. This leaves 30 months of trading from January 1st 2020 till then.
• 5 1/2 months already booked at an average rate of 72,000/day in 2020 providing 13 NOK per share of free cash flow to shareholders. The stock currently trades at 25 NOK.
• The most likely scenario in my view is that the company will earn its entire market cap in 2020 alone.
• Company policy is to return excess cash as quarterly dividends to shareholders.
• The contango is exceptionally steep currently and this supports storage rates of $110,000/day for 6 months. Two of their vessels are up for booking within the next two weeks.
• Current scrap value plus working capital minus debt: 4 NOK.
• Additional optionality value in H2 2022: approximately 5 NOK.
• Tanker companies that own younger fleets always have to worry about others spoiling the party by ordering large numbers of new vessels thereby putting pressure on the value of their fleet. Not a problem when your vessels are soon heading for recycling. It takes two years for a VLCC order to be built.
• Red flags: Unclear whether there are conflicts of interest between the top two shareholders and the rest of shareholders longer term. Empire building has not been ruled out.

 

Disclaimer: I own shares in ADS Crude Carrier at the time of this blog post’s publication. Nothing herein should be considered investment advice. The post is to be considered a starting point for further investigation. Please perform your own due diligence before making any investment decision.

Diamond S Shipping – Taking Advantage of Shareholder Overhang in this New Oil Tanker Play

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.

Valuation

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.

Downside protection

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.