Description

Opportunity

'Twas two days before Christmas, when the announcement was made

Not a trader was present, having already been paid.

A savvy Greek shipper enacted a spin

In the dead of winter it smelled like a win

A miniscule ratio, taxable to boot

Might it turn out to be some Christmas loot?

On December 23^rd Diana Shipping issued the following press release (selected text and highlights are mine):

Diana Shipping Inc. (NYSE:DSX) ("Diana Shipping"), a global shipping company specializing in the transportation of dry bulk cargoes, today announced that its Board of Directors has approved the partial spin-off of its interest in the Company's majority-owned subsidiary Diana Containerships Inc., of which Diana Shipping currently owns approximately 55% of the issued and outstanding common stock. Diana Shipping will distribute 2,667,066 shares of common stock of Diana Containerships, or 80% of Diana Shipping's interest in Diana Containerships. The number of shares of common stock of Diana Containerships to be distributed for each share of common stock of Diana Shipping will be determined by dividing 2,667,066 by the aggregate number of issued and outstanding shares of common stock of Diana Shipping on January 3, 2011, the record date for the distribution. As of December 21, 2010, Diana Shipping had outstanding 81,955,813 common shares, which would have resulted in the distribution of 0.0325 shares of common stock of Diana Containerships for every one (1) share of common stock of Diana Shipping. The distribution date is expected to be January 18, 2011. Due to the nature of the distribution the New York Stock Exchange is expected to establish the ex-dividend date as January 19, 2011. Immediately following the distribution, Diana Shipping's shareholders will own directly approximately 44% of Diana Containerships.

The distribution of Diana Containerships common stock or cash in lieu thereof will be characterized as a taxable dividend for United States federal income tax purposes. The amount of the dividend for such tax purposes will be equal to the sum of (x) the fair market value of Diana Containerships common shares received by a U.S. Holder and (y) any cash payment in lieu of fractional shares paid to a U.S. Holder. You should treat the effective date of the partial spin-off as the date of the dividend. Diana Shipping shareholders are urged to consult with their tax advisors with respect to the U.S. federal, state, local and foreign tax consequences of the partial spin-off.

Diana Containerships has applied to list its common stock on the Nasdaq Global Market. Diana Containerships common stock is expected to begin trading on a "when-issued" basis on the NASDAQ Global Market under the symbol "DCIXV" beginning on or around January 3, 2011. Diana Containerships common stock is expected to begin "regular-way" trading on January 19, 2011 under the symbol "DCIX".

Before delving into the underlying business there are four salient points that place the odds of a successful outcome in a value investor's favor: 1. Few people were in the office when the announcement was made 2. The distribution ratio is a minuscule .035:1. 3. Investors had little time to value the business as the when-issued stock began trading on the Monday following a likely boozed -filled- New Year's weekend for many investors. 4. Importantly, the spin will be a taxable event and might be expected to exacerbate the typical post-spin trading dynamics.

Trading at about 85% of book value and 75% of NAV, I believe upside over the medium term is conservatively 25%, and potentially far greater as the company expands its fleet.

Background

A little over a year ago I began doing the work on Greek shippers in thinking about the consequences of a potential rebound in global GDP, retail investors abandoning the group due to dividend cuts, etc. I'm oversimplifying here but there were really two models that I encountered. One group of companies took the conservative route and leased their fleet on a largely long-term charter basis; willing to forego the upside of predictably volatile day rates in order to lock in long term cash flows. The other group took the opposite approach and embraced the spot market in the hopes of making a mint. This is of course slightly unfair since both sets of companies did enact a 'barbell' strategy but the weightings of spot versus long term charter varied greatly between companies. I also found that, on average, the companies that were more concerned with limiting their downside employed far less leverage than did their counterparts. No surprise. But the decision to use short duration, spot market-derived cash flows to service long duration debt struck me as a risky proposition. Furthermore, when factoring in the interest expense for the most levered companies, the breakeven day rate level was often times 4-5x that of their less levered peers. In short, it seemed like a no brainer pair trade: go long the highest quality, most conservatively run shipper and short one that was levered to the gills;  the low quality rally that ensued last year showed that to be a poor idea.

However, the takeaway from my research was that there is a very clear 'best in breed' shipper: Diana Shipping (DSX). In my conversation with management I was struck by the similarity between their approach and many deep value investors: worry about the downside, always keep a lot of dry powder on hand, and be opportunistic and aggressive when an asset comes along at an attractive price. They explained to me the thought process behind their long term charter approach and their conservative balance sheet. It was as straightforward as I had imagined.  They were also appropriately realistic about many of the supply/demand challenges facing their industry. It's no secret that following the commodity boom of '07 ship owners went on an ordering binge and the resulting backlog of ships dwarfed existing capacity. The numbers were in the public domain and yet management teams spoke very differently about the data. I would urge you to go back to 2007 and begin reading the quarterly transcripts. Here is a representative quote that demonstrates management's prudence, and cognizance of macro-economic perils, as far back as February 2008.

From the point of view of world economy, it is with great apprehension that we quote a section from our presentation during the February 22nd, 2007 conference call when we said "The effective control of systemic risk in global financial markets requires further consolidation of the existing institutional framework of international financial regulation.  It is obvious that even a short lived interruption of international capital flows not to mention a breakdown of the world financial system will seriously disrupt international trade with devastating effects for the shipping markets". We need not remind this call's participants of how uncomfortably close recent developments in the credit markets have brought us to realization of this risk scenario.  We are hopeful that these events will not only prompt governments and central banks to take short-term measures to avoid a most  serious problem from developing, but will expedite the creation of a simple  but effective system of financial regulation which will prevent more serious manifestations of this pricing of risk from appearing in the future.  The  point made earlier on by our Chief Executive Officer about our balance sheet policy and prudent chartering strategy to serve this company well going forward in what appears to be a positive but also volatile shipping market.

Because of my positive feelings about the company, and the aforementioned circumstances surrounding the spin-off press release I was more than intrigued.

The Partial Spin of Diana Containerships

Ratio:  .035:1

Record date: January 3^rd

Distribution date: January 18^th

Ex-date: January 19^th

Total Shares Outstanding:  6,106,161

DCIX Float: 2,667,066

DSX Continued Ownership: 11%

 In February 2010, Diana Shipping announced that they had injected 50mm of equity into Diana Containership for a 55% stake with private unnamed investors constituting the remaining 45% :

ATHENS, Greece, Feb. 16, 2010 (GLOBE NEWSWIRE) -- Diana Shipping Inc. (NYSE:DSX) ("Diana Shipping"), a global shipping company specializing in the transportation of dry bulk cargoes, today announced that it has agreed to invest US$50 million in the previously announced new project involving a company formed for the purpose of investing in containerships. The investment by Diana Shipping is equivalent to an interest of approximately 38% of the common shares of the new company. The balance of the new company's common shares is being purchased by institutional and accredited investors in a private transaction. 

The proceeds raised in the private transaction from Diana Shipping and the other investors are expected to be used primarily to invest in containerships over the next 12-18 months.

At the closing of the investment, scheduled for February 19, 2010, Diana Shipping's wholly-owned management company will also enter into administrative and vessel management agreements with the new company, and certain Diana Shipping executives will also hold positions as executives of the new company. In addition, Diana Shipping has agreed with the new company so long as the administrative agreement or any of the vessel management agreements remain in effect not to invest in containerships, while the new company has agreed not to invest in dry bulk carriers. The closing of the transaction is subject to customary closing conditions.

And further, in June of 2010 they put out the following release:

ATHENS, Greece, June 21, 2010 (GLOBE NEWSWIRE) -- Diana Shipping Inc. (NYSE:DSX), a global shipping company specializing in the transportation of dry bulk cargoes, today announced that Diana Containerships Inc., its majority-owned subsidiary formed for the purpose of investing in containerships, has entered into agreements to acquire two 3,400 TEU newbuilding containerships built at TKMS Blohm + Voss Nordseewerke GmbH, Emden, Germany from a third-party seller for a purchase price of Euro 37,300,000 each (approximately US$45.5 million based on the Euro/Dollar exchange rate as of June 8, 2010).

The first vessel is scheduled to be delivered to Diana Containerships Inc. by June 25, 2010, and the second is scheduled to be delivered between July 5 and July 15, 2010. Upon delivery, the first vessel is scheduled to be employed on charter with A.P. Møller-Maersk A/S for a period of minimum nine (9) to maximum twelve (12) months at a gross daily rate of US$16,000.

In order to get a sense of the potential of DCIX to fully utilize its balance sheet it's helpful to look at how DSX, parent company, has funded its historical growth:

Business Development and Capital Expenditures and Divestitures

                        Date                                                             Purchase Price                                                              % Equity Funded                                 Source of Capital

• Feb 2007 98mm 6% Revolver
• Mar 07 110mm 21% Revolver
• .Apr 07 110mm 100% Equity issuance
• Oct 07 140mm 20% Revolver
• Oct 07 135mm 20% Equity Issuance
• During 2008, we drew down an aggregate amount of $237.2 million under our revolving $300 million credit facility with the Royal Bank of Scotland and repaid an aggregate amount of $97.5 million. On December 31, 2008 an amount of $214.7 million was outstanding under the revolving credit facility, which was used to fund part of the purchase cost of the Salt Lake City and the Norfolk .
• In 2009, we drew down an aggregate amount of $ 30,100 under the loan facility with Fortis Bank to finance part of the first and the second instalment of the construction cost of the Houston , and the second and third instalment of the construction cost of the New York . After delivery of the Houston, in October 2009, the Company repaid $30.1 million of the outstanding loan and drew down $40.0 million under our loan facility with Bremer Landesbank.
• In May 2009, we completed a secondary public offering in the United States under the Securities Act, of 6,000,000 shares of common stock at a price of $16.85 per share from which we received $98.4 million of net proceeds.
• In December 2009, we, through our wholly owned subsidiary Taka Shipping Company Inc. ("Taka"), entered into a Memorandum of Agreement with an unrelated third party to acquire the 76,436 dwt Panamax dry bulk carrier "Melite" (built 2004) for a total consideration of $35.1 million of which a 10% advance or $3.5 million was paid in December 2009 and the balance of $31.6 million was paid in January 2010 when the vessel was delivered. The acquisition cost of the vessel was funded with funds drawn under our revolving credit facility with the Royal Bank of Scotland.
• In March 2010, we took delivery of the New York and repaid $30.1 million under our loan agreement with Fortis Bank and therefore, our loan with Fortis Bank was terminated. We financed $40.0 million of the acquisition cost of the New York with funds drawn under our facility with Deutsche Bank AG.

Source: 2009 10K

The strategy, in a nutshell, involves acquiring assets via bank debt that is treated like bridge financing. Shortly after identifying and acquiring a vessel, the company taps the equity market when its stock trades at a premium to NAV and uses the proceeds to pay down debt. The result is that book value per share and, importantly for investors, the dividend is accretive to existing shareholders. Management made it clear on their roadshow that they employ leverage very prudently and are only comfortable levering depressed assets. In their words, this approach is akin to performing acrobatics from one foot off the ground: if something goes wrong, they escape with a twisted ankle.

While the eventual purchase of new ships on a much larger scale will need to involved equity issuance on an undilutive basis to NAV, in the immediate future it seems that DCIX will be able to lever its existing balance sheet in two ways.

• Use the cash balance plus available room on the revolver
• Line up additional bank financing

Management said they are targeting ships that sell for 20-25mm.

Cash: 12.2mm

Available revolver balance: 20mm

New bank debt: 25-30mm

Total liquidity available: 57-62mm

While the ultimate goal is to procure a modern fleet that can recognize maximum pricing power at the peak of the cycle, for now the company is targeting older builds (early to mid 1990's) of 3500-3700 TEU capacity. Market prices are approximately 14-18mm per ship.  Current charter rates are approximately 14-16k/day and operating expenses are 7-8k/day.

Thus, it appears that the company can reasonably be expected to acquire another four ships in relatively short order bringing the total fleet to six vessels.

Financials

Balance Sheet

Valuation

So there's little to go by here as the company is still in its infancy. As such, it makes the most sense to use the balance sheet to determine value for the equity.  Given management's conservative nature and the recency of the new build asset purchases, there's little reason to think that book value isn't accurately stated and a legitimate estimate of the company's liquidation value.

The company should also be expected to initiate a dividend, especially if the stock trades at a discount to NAV. They will do this to help unlock equity value, attract shareholders and get the stock to a point where they can issue equity.

As previously stated, because of the sub-scale operations of the company, P/B or P/NAV are the most appropriate metrics to use when comparing companies in this industry.  Relevant comps are:

                                                                P/B                          Dividend %

Danaos (DAC)                                     1.3                          NA

Seaspan Corp (SSW)                         1.3                          3.1%

Global Ship Lease                              1.2                          NA

Costamare                                            2.6                          6.0%

Diana Shipping Container                   .85                        6.6% (Estimated)

Management seems to have picked an opportunistic time to begin their venture as all indications are that day rates and asset values have troughed.

Here's a look at what the company might be expected to look like if they manage six vessels.

Revenue: 35,000,000 (16.6k avg daily rate)

Opex: 14,700,000 (7.1k avg daily rate)

G&A: 4,600,000 (annualized 3Q runrate plus 1.5mm in extra public costs)

Interest: 3,000,000 (5% floor on 60mm debt)

EBITDA: 15,300,000

Dividend capacity: 12,300,000

Maintenance capex runs through the balance sheet in the opex line so EBITDA-Interest is a decent proxy for distributable cash flow to equity. Given management's tendency to husband cash for vessel acquisitions I think 40% is all that can be expected this early in the company's lifecycle. So 4.9mm or .80/share on an annual basis. That would equate to a 6.4% dividend yield at today's price.

Industry Dynamics

While the new order backlog is still daunting for dry bulk shippers, container shippers are in a much better position.  Specifically, for the ships that DCIX will be targeting, 2500-7000 TEU in the Intermediate, Panamax, and Post Panamax categories, the orderbook only represents 15% of the existing fleet. Interested parties can reference a recent 6K filing with the roadshow slides. There are several pages documenting container correlation with global GDP growth, the impact of slow steaming, and some of the reasons that the order book might actually be overstating ultimate capacity that's brought on.

Risks

• Dayrates could unexpectedly drop, which would lower the value of the fleet and hence the collateral supporting their debt.
• Lower rates would expose the company to diminished earning capacity when time charters elapse.
• The stock price might remain depressed for longer than expected, making equity raises unfeasible or heavily dilutive.

Catalyst

• Growth of the fleet over time which increases its earning power.
• The company institutes a dividend.