Description

This is a short idea. Knightsbridge Tankers has benefited from the recent rally in the oil tanker sector, and is trading at a >60% premium to its going-concern value and a 54% premium to liquidation value. The company’s lease arrangement with its only customer (Royal Dutch Shell) will end on February 27. Following this, the company will no longer pay guaranteed dividends. The announcement of the Q2 dividend (sometime in July) will reveal the company’s economics without Shell, and could provide a nasty surprise for shareholders. Alternatively, the company might liquidate or sell itself, which should generate only about $10.50 per share in proceeds.

Company Background:
Knightsbridge is a unique vehicle. It was founded to own and lease five “very large crude carrier” oil tankers (VLCCs). These are modern double-hull vessels built in 1995 and 1996. The company essentially has no employees and minimal direct expenses, and it passes through all of its income to shareholders as dividends.

Knightsbridge raised debt and equity to finance the $440-million purchase of five VLCCs in February 1997. It then leased these ships to Shell on a bareboat basis for seven years. According to the lease, at the end of each quarter, Knightsbridge receives a payment equal to the greater of the average VLCC spot market rate for that quarter or a guaranteed minimum rate. Also according to the lease, Shell is responsible for substantially all of the ships’ operating costs. Knightsbridge’s only ongoing annual expenses are a management fee paid to Frontline ($750k), D&O liability insurance ($125k), bank fees ($50k), and interest on its debt ($9 million). As a result of this structure, Knightsbridge shareholders receive a guaranteed minimum quarterly dividend of $0.45 per share, and often receive additional dividends when the spot market rate exceeds the guaranteed minimum.

The relationship with Frontline could be important in determining the future of Knightsbridge. Frontline is one of the largest ship owners in the world, with 39 VLCCs in its fleet. Frontline runs the day-to-day operations of Knightsbridge in return for a management fee. More importantly, Frontline essentially controls Knightsbridge but has no economic interest in the company.

Knightsbridge has only three “employees” – Ola Lorentzon (chairman), Tor Olav Troim (vice-chairman and CEO), and Kate Blankenship (secretary and CFO). All are actually executives of Frontline, and receive no compensation from Knightsbridge. The Knightsbridge board consists of Lorentzon, Troim, two independent directors, and a fifth director who is a partner at Bermuda law firm that serves both Knightsbridge and Frontline (another partner of this firm is a director of Frontline). The directors collectively earn $82,000 per year from Knightsbridge. None of the officers or directors own any shares of Knightsbridge.

The interests of Frontline and Knightsbridge shareholders are not aligned. It would make a good deal of sense for Frontline to own these ships. In fact, Tor Olav Troim was quoted this week by a Norwegian news service as saying that the Knightsbridge ships would be “prime candidates” to join Frontline’s fleet. In the absence of such a deal, Frontline essentially sets its own management fee. Other than the two independent directors, there is no one looking out for the best interests’ of Knightsbridge shareholders, and this is a good thing for a short seller of Knightsbridge.

Recent Events:
Shell notified Knightsbridge last June that it would not exercise its option to renew the leases, which will expire on February 27. Per Knightsbridge’s by-laws, the company held special shareholder meetings in September and October to determine the company’s fate. The board recommended that the company remain in business (not liquidate), and a majority of shareholders approved this proposal in September. Unfortunately, another proposal to amend the company’s by-laws failed to win the required two-thirds approval at the October meeting.

Without the by-law amendments, Knightsbridge’s activities are limited to actions that were necessary to found the company. These include: chartering its ships, refinancing its debt, raising equity, and disposing of assets at the end of a lease. It will not be able to acquire additional ships, dispose of assets during a lease, replace the existing manager (Frontline), or change the ships’ registry. While these are not critical things, they could, on the margin, sway the company toward a liquidation or sale of the company.

In the past two weeks, Knightsbridge has signed three of the ships to new time charter arrangements. One was signed to a five-year lease at a rate of $31,000 per day. Two others were signed to three-year leases at a rate of $30,000 per day plus 50% of the excess if spot rates exceed $30,000. The other two ships may be signed to long-term time charters, and if not, will trade in the spot market.

Note that the terms of the three new time charter contracts are much less attractive than the Shell agreement, which paid a guaranteed minimum rate of $32,469 per day plus 100% of the excess if spot rates exceeded $32,469. The economics of the company have clearly changed for the worse, yet Knightsbridge shares are trading in the same range that they have for the past couple years.

Valuation:
In the proxy for the special shareholder meeting, the Knightsbridge board estimated the value of the company if it continued in business and if liquidated. As of August, the going-concern value was estimated to be $9.80 per share (based on a DCF), and the liquidation value $7.10 per share.

The board’s going-concern valuation appears reasonable, as it assumes the company leases its ships in the spot market and earns a small discount to the historical average spot rate (a bit more than $30,000 per day), and then sells the ships for their depreciated book value after seven years. If anything, the board’s valuation is overstated because it uses a low 5% discount rate. I estimate that a switch to a 10% discount rate would reduce the board’s going-concern valuation to $8 per share.

The board’s liquidation value of $7.10 per share is too low. I think the board (read: Frontline) had an incentive to lowball the liquidation value – first to avoid litigation that might occur if they could not achieve the value they published, and second because I think Frontline would like to own the ships, and did not want to set the purchase price bar too high (speculation on my part, but reasonable I think).

My liquidation value estimate is roughly $10.50 per share. My estimate excludes dividends paid since August, assumes a higher dividend for the stub Q1 period (through February 27), and assumes a higher sale price for the ships. These latter two adjustments boost the valuation considerably. As a short seller, I think this is the conservative way to go, and I think that my liquidation estimate represents a maximum realistic number.

With respect to the Q1 dividend, the board assumed only the minimum level ($0.30 per share for the two months). Spot market rates are exceptionally strong right now, and there will certainly be extra dividends for shareholders. I assume a dividend based on an average spot rate of $100,000 per day, consistent with the market rate today. This yields a dividend of $1.50 per share for the two months.

With respect to the sale price for the ships, the board starts with a value of $50.5 million per ship and applies an undisclosed discount. The $50.5 million number is an average of the estimates provided by three independent shipbrokers. The discount they applied appears to be about 10%, yielding a value of about $46 million per ship. There are three somewhat recent precedents for ships directly comparable to Knightsbridge’s (modern, double-hull VLCCs built in the mid-1990s). A 1993-built VLCC sold for $42.5 million in mid-2003, a 1995-built VLCC sold for $49 million in September 2003, and a 1994-built double-hull VLCC sold for $51.5 million in December 2003. My liquidation value estimate of $10.50 per share assumes a sale price of $55 million per ship. Note that the current share price of $16 implies a liquidation value of $75 million per ship.

Valuation conclusion: The board estimated the company’s liquidation value at $7.10 per share in August. While this estimate is likely too low, it is almost inconceivable to me that the liquidation value could exceed my estimate of $10.50 per share. On a going-concern basis, and assuming historical average spot rates, the value to shareholders is roughly $8-10 per share. In the nearly unimaginable case that spot rates for the next seven years average 25% higher than the historical average, and using a 5% discount rate, the going-concern value would equal roughly $17 per share. This implies limited downside for a short position.

Possible Outcomes:
Company continues as a going concern. After the shareholder vote to continue in business, this was the most likely outcome. The three new time charter contracts confirm this. The current valuation is driven by investor speculation that Knightsbridge will lease its ships in the spot market, where rates are near all-time highs ($100,000 per day). The three new time charter contracts clearly demonstrate that this is not the strategy, yet the share price has not adjusted to reflect the terms of the new contracts.

If the remaining two ships are signed to similar leases, and the company refinances its debt such that $12 million of principal repayments are required each year (per company assumptions in proxy), Knightsbridge will be able to pay an annual dividend of about $1.10 per share. With wasting assets (ships that become less valuable with every year that passes) and no growth prospects, this is clearly not enough to sustain a share price in the teens.

Alternatively, if Knightsbridge can refinance its debt such that no principal repayments are required, it will be able to pay an annual dividend of about $1.80 per share. But this charade would last only about eight years until its ships depreciate down to the level of its debt, leaving nothing for equity holders. No matter what discount rate you choose, the present value of eight annual $1.80 dividend payments is worth far less than the current $16 share price.

So what could go wrong? Knightsbridge could lease its final two ships in the spot market and earn exceptional profits for as long as the current strong spot market persists. It would be able to pay a fat but unsustainable dividend (>$2 per share) and the shares might trade up as if it were sustainable (I think most shareholders are unsophisticated and look only at current yield). This is near-term a risk, and I think the biggest risk to this investment. Ultimately, spot rates will revert to something near their long-term average, which should bring Knightsbridge’s share price back to something near $10.

There are catalysts for lower spot rates. Most importantly, the supply-demand balance that determines spot rates will be negatively impacted by a large number of new ships in 2004. Deliveries of new VLCCs in 2004 are expected to result in net fleet growth of 5%, versus 1% average annual growth over the past decade. In addition, the second quarter is traditionally a period of seasonal weakness for spot rates.

2. Liquidation. This board still has the right to liquidate, despite the vote by shareholders to continue in business. I believe that the current by-laws prohibit the sale of a vessel except at the end of a lease. So, with the three new leases just signed, a liquidation of the entire company seems unlikely. The board can sell individual ships as their charters end, so a partial liquidation is possible. It is unlikely that there will ever be a better environment in which to sell, with spot rates and ship values both near all-time highs.

3. Sale or merger of entire company. This is a low probability outcome because I believe it is forbidden by the current by-laws. The proxy does state that Knightsbridge “has received an unsolicited inquiry from a third party concerning a possible business combination,” however the proxy was written when the share price was around $9. It is almost inconceivable that a buyer would pay the current share price, when ships can be bought in the second-hand market for much lower prices.

Catalyst

Knightsbridge’s lease arrangement with Shell will expire on February 27. The company’s inflated valuation should be corrected when shareholders recognize that their high guaranteed dividends are history without Shell. The announcement of the second quarter dividend in July will likely drive home this point, but we may not have to wait that long.