Description

This will be less an investment pitch and more a compendium of facts and questions and answers on why CMRE common equity is or isn’t an attractive investment at current prices.  I will attempt to work backward to understand what the current valuation implies about its future cash flows. I am looking for feedback on issues or mistakes in my analysis.. First some basic facts..

Background:

CMRE is a Greek ship lessor that has been publicly traded in the US for 12 years.  The company operates in the fragmented global shipping space using its equity equity capital, along with bank debt, to purchase new or secondhand ships that are then leased to capital light liner companies under long term lease agreements.  The business is different from a real estate leasing business in that the assets are not only depreciating but have finite lives, thereby requiring lease income to be set aside to renew or grow its assets.  The company offers crews and management of its ships to liner companies similar to a landlord offering maintenance to its tenants.  At its core it's very simple to understand this business.  The business has few barriers to entry and is highly commoditized and extraordinarily cyclical.  

This is clearly not a compounder with a strong moat.  Outstanding returns over cycles can only be achieved by timing the cycle correctly.  Container shipping has just enjoyed its most profitable 24 month period in the history of modern maritime trade.  CMRE Yearly pre tax income from 2010 to 2020 has been as low as $70M in 2018 and as high as $141M in 2015.  The 10 year avg has been $102M.   In 2021 the business earned $435M and $490M is expected this year, in pretty much locked in contractual earnings. 2023 - 2025 earnings are expected to be $500M+ per year.  These earnings are clearly unsustainable.  However, due to unprecedented COVID disruptions the company has been able to lock in $500M in earnings for the next 3 years by signing charter agreements for ~90% of their container ships at similar or mostly higher earnings power to 2022.  

They have used their windfall profits to expand into dry bulk shipping in 2021 at a cyclical low point for dry bulk values.  

The current equity cap is $1.35B. 

At 3/31  Debt was $2.6B. Preferred stock is $315M.  Cash on the balance sheet is $500M.  

EV is ~$3.65B.

Let’s address the possible concerns that could yield a poor investment from current prices and the mitigating steps the company has tried to take to offset them.

Concern 1

1. Due to COVID surge in container shipping rates, orders for newer more efficient and environmentally friendly ships have surged.  This will lead to a surge in capacity hitting the water in 2024-2026,  These new ships are considerably larger in TEU (Twenty foot Equivalent) than the current fleet capacity, with sizes ranging from 7500 TEU to as large as 15000 TEU.  Smaller ships at 2000 TEU or less known as feeders, have not seen a surge in orders.  At the end of May 2022 the new order book with delivery through 2025 stood at 27% of current TEU market size.  The order rate has slowed with 70 ships orders in Q2 vs. 150 in Q1.  This leads to considerable concern for owners of older ships (especially larger ones).  Many that are currently 15 years or older are likely to earn very little post 2025 and may need to be scrapped.  This should likely be the base case assumption and has been factored into my valuation.

Mitigation

1. The age of their fleet is a concern.  The average age of their fleet is 11.9 years.  A significant portion of their assets face obsolescence risk post 2025.  They have 33 ships that are currently 15 years or older out of a total fleet size of 76 container ships.  They are attempting to get out ahead of this issue.  They have sold seven ships older than 15 years in the past year and have 5 ships held for sale that they have agreed to sell.  Of the 5 ~7000 TEU ships sold forward, 4 are 22 years old and 1 is 19 years old.  Their carrying value is $129M and they are being sold for $333M or a $204M gain.  4 of these ships are chartered for 25K a day and the other is $21.5K a day.  At $6500 in op ex per day their total annual profit pre overhead is ~$32M.  The debt on these ships is approximately $60M.  The net cash to equity is $154M after debt payoff  or 12.5% of current equity cap for roughly 6% of their operating profits.

2. New charters signed for older ships - The company has further mitigated this risk by announcing new 3 year charters for 3 of their oldest boats built in 1996 starting in March of 2023 at $41.5K vs. current charter rates of $25k a day.  2 other ships built in 2003 have new 3 year charters at $53K vs. current rate $28K per day starting in Q4 2022.  Lastly two ships built in 2009 and 2010 signed 5 year charters starting in Q2 2023 at $43.25K per day vs. $22.7K currently.  In aggregate these new charters will deliver ~$49M in additional pre overhead PROFIT  and will easily offset the $32M lost from the sale of the other 5 year ships.  The overall 3 year aggregate pre overhead profit from these 7 ships at $7K op ex per day  is $95M per year.  To put that in perspective that is ~18% of their expected profit this year on 7 of their older boats on new charters!  In addition, 16 other ships have charters beginning in the next 12 months with on average 30% higher charter rates.

Concern 2

2) Greek Shipping companies based in the Marshall Islands have terrible corporate governance.  They issue equity at well below NAV and buy ships from management companies owned by insiders who purchased them at lower prices. The markups are egregious.  In addition, they pay insiders high management fees to charter the boats vs. 3rd party broker commissions.

Mitigation

CMRE management owns 57% of the common equity.  They also own the majority of the $315M in preferred stock outstanding.  At current prices the equity stake is worth $770M.  This is at a less than 3x earnings multiple with those earnings locked in for the next 3 years.  The management is not directly paid by CMRE.  The company pays a management company $956 per day per ship.  This amount has NOT been raised since 2015, despite inflation! Their G&A is $12M per year and the management fees this year will be $40M.  Revenues this year will be ~$1.2B.  This amounts to 4.3% of revenues for “total” G&A.  This compares very favorably to many US commodity companies of similar size.  The company has not issued common equity since 2017 and insiders participate in a DRIP program whereby all their dividends purchase additional shares in lieu of receiving cash.  In addition, the CEO purchased $5M worth of stock in 2021 at $16.31 per share in the open market.  He has never sold a share.  If the shares can attain a fairer multiple of 12x normalized earnings of what I estimate to be $2-$3 post 2025, the capital gain from the shares will be $1B -$1.5B.  Clearly those gains are much greater than what he can reap in management fees from the company of which he is majority holder and continues to increase his proportional stake. Lastly, the CEO has a non compete agreement with the company in the container shipping sector.

Concern 3

3) Interest rate risk - $1.4B of the $2.4B in debt is floating LIBOR debt.  Debt cost was 2.77% and will move up by 250 bps.

Mitigation 

CMRE aggressively amortizes its debt to the tune of over $150M per year.  The 250bps this year will cost an additional $30M in interest or about 3% of EBITDA.  This is immaterial to a stock trading at 3x earnings.

Concern 4

4)  Never buy a cyclical stock trading at low single digit multiple of peak profits.  

Mitigation

Normally this axiom has been quite useful as a timing tool for cyclical stocks.  However, the peak cyclical profits for CMRE have been locked in due to long term contracts/charters for the next 3 years.  In addition, management has clearly communicated their desire to operate countercyclically.  They have moved to monetize the current peak profits by selling older vessels and have used some of the proceeds to enter dry bulk space at a low point in that cycle.  They have purchased 46 dry bulk vessels with avg age of 10 years and useful life of at least 20 years.  The order book for new dry bulk vessels is basically zero as rates had been mired in bear market since the 2009 crash and shipyard capacity for delivery in before 2026 due to heavy container ship and LNG ship orders.  Since Q1 of 2021 dry bulk rates have spiked to ~25-$30K from an average of $17K over the past 10 years.  The pre overhead operating costs for these ships is $6k a day and all in costs including dry dock are ~$8K.  At the depressed level of $17K averaged in 2010-2020  in revenue per day these vessels generate $9K in daily profit or about $3.2M per year.  Total earnings power from the 46 dry bulk ships at that level would be ~$150M. At current charter levels the dry bulk fleet will throw off $250M in pre overhead profits.  The move to dry bulk, the $500M in cash on the balance sheet plus the $150M additional cash in the next 6 month from the sale of 5 older ships, provides a strong counterbalance to much lower than expected container rates post 2025.

Concern 5

Counterparty Risk - During past shipping busts liner companies have gone bankrupt and charter agreements were thrown out in bankruptcy.  As a result today’s high charter rates that are locked in for multiple years may be a mirage.

Mitigation 

Liner companies over the past two years have experienced an even more impressive burst of profitability then their charterers as rates exploded higher, rising 8x fold from pre COVID while the majority of their charter rates were at pre COVID levels.  The major liners have earned more in the past two years than they did over the past 2 decades.  Their balance sheets have never been stronger.  They have blended charter costs that are still profitable if rates return to pre COVID levels.  As such, counterparty risk is the lowest it's ever been. In addition, during the last bust the major liners consolidated and entered alliances transforming the market structure into more of an oligopoly.

What are we getting at current EV?

1. At year end CMRE will have $940M in cash on its balance sheet without any additional asset purchases.  (Current cash at 3/31  is $500M, $240M will be received from the announced forward sale of 5 container vessels, and $70M in quarterly FCF after dividends and debt amortization at $40M per qtr)

2. 2023-2025 cumulative free cash flow will be $1.5B after dividends, amortization, and interest.  Current yield is 4.2%

3. Post 2025 the fleet will feature a dry bulk segment that can earn $150M a year in unlevered FCF at depressed prices and the container fleet will have 70 ships (assuming no further sales).  The container fleet is 20% higher than pre COVID and on TEU basis is 30% higher as it features 5 new 13000 TEU ships on 10 year charters that generate $60M in pre overhead earnings on their own.  Of the remaining 65 vessels we can conservatively assume 25 will be scrapped.  At current scrap values those ships will yield about $5M in scrap value or a total of $125M.  If the remaining container fleet of 40 ships averages  charter rates of only $15K on avg, with $7K in op ex per day they will generate $115M in pre overhead profits.  At very depressed levels the earnings power of the fleet going forward is $115M + $150M + $60M or $335M.  

4. Post 2025 the $335M in pre overhead profit yields $230M in earnings.  This assumes extraordinarily depressed earnings and no further accretive acquisitions.  

5. The projected cash balance in 2025 will be $900M+ $1.5B or $2.4B assuming no further acquisitions.  2025 Debt at $150M amortization per year will be $1.9B.  Net of cash, the $800M EV will be throwing off $230M in profits at depressed earnings with vessel life of 15 years remaining.  If rates move higher with inflation and trade at normalized levels for containers of $20K a day, adjusted for fleet size, the FCF rises to $305M.   

At current prices none of this is reflected.  What possible messages is the current valuation sending?

1)The market is clearly indicating value will be destroyed through poor capital allocation.  This is at odds with the past 12 years of history.

2) Perhaps the market is saying liners will go bankrupt once again.  This is at odds with liner balance sheets.

3) Market is saying management will skim most of the profits from shareholders.  This is clearly at odds with management being the largest shareholders and continuing to add to share positions.

What is the stock worth?

In my opinion, 10-12x normalized earnings which I calculate as $305M is fair.  $3B EV discounted back at 10% is $2.25B.  124M shares outstanding.  Fair value is closer to $18- $19..  Kicker - This assigns no value for optionality on management making value enhancing capital allocation moves..

Catalyst

Share buybacks/accretive acquisitions