Description

* Largest and most modern fleet of Very large Crude Carriers.
* Leading consolidator within this critical yet highly fragmented market.
* Valued at 1.3x trailing 12 month earnings and 0.57x book value.
* Through participation in Tankers International pool, controls approximately 40% of modern VLCCs trading on the spot market.
* New regulation requires the scrapping of 30% of the world tanker fleet between 2003 and 2007.
* Modern fleet provides a floor to earnings and cash flows.
* Despite leadership position, FRO trades at a discount to its peers.


Managed by Norwegians and based in Bermuda, Frontline (FRO) owns the largest and most modern fleet of Very Large Crude Carriers (VLCCs). Its fleet consists of 33 VLCCs (+8 newbuilds), 21 Suezmax and 8 Suez O/B/O. VLCCs are the backbone of the long-haul (OPEC) oil transport trade. Frontline is listed both on the Oslo Stock Exchange and, since July, on the New York Stock Exchange.

Very Large Crude Carriers (VLCCs) dominate the long-haul oil trade. Their size enables them to transport significantly more barrels of oil per voyage, resulting in lower transportation costs per barrel. This results in extreme positive leverage during a tight market, when refineries and oil traders need to transport crude oil to the markets. A quick look at VLCC day rates (and Frontline’s financial performance) over the course of 2000 gives a clear picture of the inelasticity of tanker demand: rates began the year at $20,000/day and peaked in December at $100,000/day (in 1973 spot day rates soared to $300,000/day in todays dollars).

Consolidation:
The tanker industry is highly fragmented. The top 10 owners control only 26% of tonnage (this is up from 18% in 1997). Consolidation is occurring in the industry via acquisitions and via the formation of tanker chartering pools. Frontline has been a leader in this process on both fronts. In 2000 FRO took control of the bankrupt Golden Ocean Group, thereby gaining 8 VLCCs. In March 2001 FRO secured 3 additional VLCC newbuilds (November 2001 delivery) by acquiring Mosvold Shipping.

Through its size and via participation in Tankers International, a VLCC chartering pool, FRO is able to generate economies of scale. In particular, these take the form of higher utilization rates that are achievable thanks to scale and chartering efficiencies. These higher utilization rates imply that FRO is able to make more money per ship, at a given level of ‘market rates’, than its smaller competitors. Taken to its logical conclusion, this implies that as consolidation continues, the strong will get stronger (and the weak weaker).

Tankers International controls about 40% of modern VLCCs trading on the spot market. While still ultimately “price-takers”, there are sign that the FRO/TI combination is able to affect prices at the margin.

Ageing world fleet and new tanker regulations:
Today almost a third of the global tanker fleet is over 20 years of age. As the useful life of a tanker is between 25 and 30 years, this segment of the fleet is reaching its scrapping age. More importantly, these tankers are all single-hull. The inherent increased ecological risk of single-hull tankers has resulted in both regulatory as well as market forces pushing for an early retirement of these so-called “older ladies”.

The Erika spill off the coast of France in 1999 was the catalyst which prompted the IMO in April of 2001 to formally legislate the timetable for the scrapping of old single hull vessels. This regulatory mandated scrapping provides an unusual “lid” on tanker capacity over the next several years. In particular, the new IMO rules mandate the scrapping of approximately 30% of the world tanker fleet.

Market forces have actually had a more immediate impact than the IMO regulations. Since the Erika spill, charterers have begun to require modern tonnage. For example in Q1 2000 20% of vessels chartered by BP were over 20 years old. In Q4 2000 the percentage had dropped to 5%. This preference for young tonnage has resulted in a two-tiered market. “Modern” tonnage (vessels built after 1980) receives a $10-15,000/day premium over older vessels. This market segmentation has resulted in a significant strengthening in the competitive position of owners of large fleets of modern vessels. In particular this segmentation provides owners of modern tonnage with a floor in the rates they can charge. In a weak market, the discount old vessels have to accept will result in their owners losing money and scrapping at a time while new vessels are still making money. Frontline has an extremely young fleet, with an average age of only 6 years.

Given that $15,000 represents breakeven for older vessels, when modern vessels earn $30,000 older vessels breakeven and thus are scrapped. This correlation is confirmed by the fact that in May and June of this year, as rates slipped below $20,000 for older vessels, scrappage picked up significantly. Frontline’s VLCCs break even on a net income basis with rates at around $22,000/day. What this tells us is that it is highly unlikely that Frontline will experience financial distress, despite its $1.7bln net debt level.

Valuation

Frontline has an awesome cash generation power. In Q2 2001 Frontline had fixed quarterly expenses (operating and interest expenses) of $50 million. FRO’s Q2 average VLCC rates of $51,000/day generated $195 million of net revenues and thus cash flow from operations of $145 million ($1.90 per share) and EPS of $1.40. Over the last twelve months FRO generated EBITDA of $631 million ($8 per share) and EPS of $7.00. Despite these impressive numbers, FRO has a market cap of only $677million!

The business model is simple. With mainly fixed costs, FRO’s earnings rise and fall with day rates. The question therefore becomes “what are day rates going to be, how high can they rise, how low can they fall”. Given the modern vs. old rate differentials, and given the fact that the IMO regulations will eliminate 30% of the world tanker fleet by 2007 it is likely that FRO’s rates will stay strong, on average, over the next several years.

The IMO regulations and the two-tiered market make it unlikely that FRO’s VLCC rates would fall below $30,000 and remain at or below that level for long. Assuming no further debt reductions I estimate that if rates fell to $30,000/day and remained there for a year, FRO would earn $0.80 per share and generate cash flow from operations (after paying interest expenses) of $2.00 per share. Short of global economic meltdown and a halting of Middle Eastern oil exports, this represents the worst case scenario.

I don’t know what the best case scenario could be. In Q4 2000 the $100,000/day level was reached on a VLCC time charter. The last 4 quarters indicate that FRO can easily generate earnings of $7.00 per share and cash flows (after interest expense and assuming no debt reductions) of $8.50 per share.

At $8.87 per share, FRO is trading at 4.4x and 11.0x trough cash flows and earnings respectively (which I am not expecting), and at 1.3x and 1.1x trailing twelve month earnings and EBITDA respectively. FRO is valued at 0.57x book and at 0.6x NAV. Remarkably, despite being the clear leader in the VLCC sector, FRO trades at significant discounts to its smaller and weaker peers (VLCCF, OSG, NAT).

Frontline is also very actively distributing value to shareholders. FRO is aggresively repurchasing shares and has paid out $1.40 per share in dividends so far this year. FRO announced a 7.5million share repurchase program in May this year, and has already repurchased 4.6million shares to date (600,000 since September 24th!).

Frontline’s valuation more than fully reflects the risks posed by the current weak state of the global economy. More importantly, the market is not assigning any value to the very positive fundamental, regulatory and competitive developments that FRO should be able to take advantage of over the next several years. Similarly, given the ‘floor’ in rates on the one hand and the fact that rates can and do spike very violently and unpredictably on the other, I would argue that a high “option value” should be embedded in FRO’s valuation. At $8.87 this option value is not reflected in FRO’s stock price.

Catalyst

1) If the global economy remains weak, increased scrapping of older vessels will set the stage for a rebound in rates.
2) In 2003 IMO mandated scrapping begins.
3) Draw-down in US crude reserves through the winter (especially if it’s a cold winter) could lead to tanker rate spikes in late winter/early spring as refineries need crude to build gasoline reserves for the 2002 driving season.
4) Escalation in the war in the middle east could lead to an increase in rates as oil trade patterns are disrupted (thereby reducing tanker capacity) and as tankers are used as storage facilities (by producing and consuming nations, and by oil by traders).
5) US (and other nations’) policy of increasing reserves in the wake of the recent disaster could lead to an increase in tanker demand (particularly if the Strategic Petroleum Reserve is increased to 1 trillion barrels as congress is proposing).