Description

Summary

Value with a catalyst. DSSI trades on 0.65x P/NAV vs peers on 0.8-1.6x. This is despite IMO 2020 already triggering an upturn that we expect will lead to FCFE of $6/shr in 2020, for a temporary 50% FCFE yield. These stocks typically trade between 0.5-2.0x P/NAV and we think DSSI is worth $24/shr (1x $18/shr NAV + $6/shr FCFE), offering 100% upside if we are right and not much downside if we are wrong. The opportunity exists due to a large PE overhang post spinoff in 2019, 30% sell off YTD from fears over dayrates and the coronavirus, and low liquidity. Upcoming results should act as a near term catalyst, with a sale or merger of the company being management’s target over 2 years.

Situation Overview

DSSI owns 67 vessels. Most of these are either Suezmaxes that transport ‘dirty’ crude or MRs that transport ‘clean’ refined products. Tanker companies are bad businesses and the vessels are commodities. Hkup881’s thread on STNG and “Why Isn't VIC All Over Shipping Stocks?” offer more detailed reading on the industry dynamics.

The economics work like this: 

1. A Suezmax has a cash cost of ~$13k/d and depreciates at $8k/d over its 25 year life. 

2. Dayrates average ~$20k/d over a cycle, meaning tankers earn no economic return.

3. Costs are fixed so there is tremendous operating leverage. We think dayrates will average $45k/d in 2020 so a Suezmax will generate cash of $32/d. This equates to $11.5mm per year or 27% of the NAV of a 10-year old vessel.

4. Most shipping companies also have significant financial leverage. This results in very significant FCFE when dayrates are high. DSSI has a stock price of $12/shr and for Q4 2019-Q3 2020 we estimate it will generate around $6/shr in FCFE including actual capex but before fleet renewal costs.

The best estimate of intrinsic value is usually the replacement NAV of the fleet +/- supernormal cash flow/burn in the near term. Historically, these stocks have traded down to 0.5x P/NAV on a levered basis during the down-cycle and up to 2x during the upcycle.

DSSI today trades on 0.8x EV/NAV on an unlevered basis vs peers at 0.9-1.3x. On a levered basis this is magnified to 0.65x P/NAV vs 0.8-1.6x. We think intrinsic value is $24/shr (1x $18/shr NAV + $6/shr FCFE), offering 100% upside.

The cash generated in the seasonally strong periods of Q4 2019 and Q1 2020 is already mostly in the bank and upcoming earnings will act as a catalyst.  At today’s stock price there is also ‘free’ optionality of a sustained tanker recovery – due to IMO 2020 and/or a normal cyclical recovery after a tough decade bringing supply/demand back into balance. 

If we are wrong, there is 25% downside to 0.5x P/NAV, although the stock is volatile and can certainly trade below this (e.g. down 30% YTD like other tanker stocks). But baring a ‘super bearish’ case where a severe macro turnaround causes both NAV and the multiple to decline further, 25% is the likely loss of capital if an investor can stomach the stock’s volatility and sell at a time of their choosing over the next 18 months.

Ownership & Management

DSSI was spun-off from Capital Product Partners LP (CPLP) in March 2019. CPLP had vessels tied to long-term charters with stable cash flows, while a subsidiary DSS (now DSSI) had vessels on the volatile spot market. The idea was to unlock value by putting these into separate entities.

The board has 7 members: 2 from WL Ross (including the Chairman), 2 from CPLP, the CEO Craig Stevenson, and 2 independents. Our understanding is that WL Ross plan on keeping their seats with an end game of closing the stock’s valuation discount and exiting via a sale of the company or merger within the next 2 years with a company like Frontline, Euronav, or Scorpio Tankers. (FRO, EURN, and STNG in table under “Situation Overview”).

The CEO Craig Stevenson is one of the few shipping CEOs with a track record of delivering this. He previously ran OMI Corp which followed the same approach in the same industry (See appendix). OMI was a 10-bagger from 2002-7 (which we are not predicting here!). Over this period, strong dayrates led to rising NAVs and high financial leverage caused tangible book to double, the company bought back 25% of its shares, and was sold at 2x P/TB. While there must have been an element of luck, Stevenson remains one of the few CEOs who played the cycle well rather than build an empire. He is also one of the few with a decent level of integrity. He owns $6mm in stock having acquired $0.75mm in 2019, been granted $2mm in May 2019, and put the rest in 10 years ago. This is not great considering his cash comp in 2018 was $1.8mm and he held $30mm in stock when OMI was sold. Nevertheless, it is not inconsequential and he is likely to be granted addition shares each year (the comp arrangements are not spelled out in detail).

Why does this opportunity exist?

1. Private equity overhang.

2. YTD sell-off from dayrate decline/seasonality/coronavirus. 

3. Small cap with $480mm market cap and $5mm in daily trading volume.

4. Spinoff in late March 2019.

Private Equity Overhang - Many investors acknowledge that DSSI is cheap but avoid it for this reason. (See table under “Ownership & Management”). At the spinoff, 70% of the shares were owned by legacy holders and this is around 50% today. The two big holders (WL Ross and First Reserve) sold shares in December post a lock-up expiry. The next and final lock-up expires in late March. 

Our understanding is that First Reserve will look to sell out. They launched DSS with the CEO Craig Stevenson 10 years ago and want to recycle their cash into a new fund and start earning carry again. WL Ross will likely only sell a token amount as they target an exit via a sale or merger over 2 years.

The smaller legacy holders are not subject to a lock-up and have/will act as a drag on the stock. However, we think the company will do a buyback at some point with some of the $130mm in FCFE generate(d) in Q4 2019/Q1 2020. $50mm would buy back 10% of the stock. Again, the CEO bought back 25% of the stock at OMI over 2 years. We therefore don’t see the overhang as negative for a patient investor and at 0.65x P/NAV would be happy to buy more if the stocks falls for non-fundamental reasons.

YTD sell-off - Most tanker stocks are down 30% YTD. This was initially due to dayrates coming down then exacerbated by fear that the coronavirus would lead to some sort of China slowdown. Part of dayrates coming down is due to seasonality from winter & Chinese New Year, but the decline has been more vicious than usual: from their peak spot rates are down 50% for VLCCs and 75% (yes) for LR2s. The two main vessels DSSI operates (Suezmaxes and MRs) have only seen spot rates fall 25% and 5% respectively yet the market has sold down all the tanker stocks similarly. All vessel classes are correlated over the long term however and our estimates for this year take the above into consideration.

It’s also worth pointing out no one seems to have noticed that DSSI refinanced most of their debt on Dec 27th which removed a $550mm repayment due in 2021.

Catalyst

Like many commodity industries, the supply/demand balance is crucial yet difficult to predict. For what it’s worth, after a decade-long downturn orderbooks are at all time lows, while oil demand and ton miles continue to grow. But that was true 2 years ago and who knows what supply may unexpectedly come out of China or what the macro will do.

Our thesis instead is that IMO 2020 is a forecastable event that is triggering some level of supply/demand balance. This has already led to a spike in dayrates and cash flows this winter comparable to the boom years of the 2000s (see chart above). The reasons for this are well documented: increased demand due to transportation of low-sulfur fuels; supply constrained as vessels leave the water to fit scrubbers, refueling bottlenecks due to insufficient barges, higher fuel costs leading to slow steaming and scrapping of older vessels. 

We are NOT predicting a return to the 2000s and at 0.65x P/NAV we don’t need to. IMO 2020 triggering 12 months of strong earnings or a longer period of average earnings should be sufficient to see a re-rating to 1x P/NAV – which is where DSSI’s peers are already at – while we collect the cashflows in the meantime. At today’s prices, a return to some type of boom is optionality that is ‘free’ but valuable.

The immediate catalyst should be Q4 reporting and Q1 guidance. We think DSSI will generate around $1.5/shr in FCFE in Q4 and guide to something similar/higher in Q1. Peers are also likely to report strong results with Euronav going first on Jan 30th. The discussion on how these companies will use their cash should ‘wake the market up’. We think over the next 6 months DSSI will pay down debt and do a buyback.

Management’s end goal within 2 years is to sell or merge the company. There is some risk here that they consolidate at a dumb price so that WL Ross can get out, but we would be surprised if the price was below NAV.

**Finally - this is shipping, the macro is unpredictable, and this is a bad industry. An investor needs to have their eyes wide open to these factors. But we think the risk/reward is very much in our favor with the stock at 0.65x P/NAV and peers at 0.8-1.6x, IMO 2020 already triggering strong cash flows, a management team with a track record, and being able to buy post a 30% sell-off right before (strong) earnings. 

Keys Risks

As discussed above, the macro is important yet difficult to predict. Risks include: (1) General global slowdown, (2) Prolonged China slowdown due to trade war/coronavirus, (3) Prolonged oil price decline, (4) COSCO ships returning to market, (5) Dumb M&A.

Appendix: OMI Corp (DSSI CEO's previous venture in the tanker market)

Tangible book per share went up 3.5x due to NAVs being revised upwards as the market strengthened & newbuilds, financial leverage, buybacks:

Stock went from 0.5x TB to 2x:

Leading to multi-bagger returns. (They sold the company at peak of cycle):

Catalyst

Earnings and use of cash. Over 2 years a sale or merger of the company. (All discussed in writeup).