Description
I recommend buying put options or shorting Knightsbridge Tankers (VLCCF) before the next earnings report towards the end of July/begin August. The main reason for the short is that the VLCCF stock price has largely ignored the collapse in VLCC rates from $200 000 per day in December to $25 000 today. The Q2 earnings report will show revenues 25% below the minimum revenue over the prior 4 quarters. EBITDA will be 31% less than the minimum. But, most importantly I expect the large cut in the dividend to be the key factor in shattering investor confidence.
QUICK FACTS
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Knightsbridge owns 5 Very Large Crude Carriers (VLCC’s). VLCC’s are the largest tankers transporting crude oil mainly between the Middle East and Asia and between West Africa and the US. All 5 tankers were built in 1995/1996 and have a remaining life of 15 years.
Market Cap $687 mil (17.1 mil shares in issue)
Net Debt $113 mil (LTD = 129, Cash = 41, Q1 Div Paid = 25)
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EV $800 mil
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VALUATION
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VLCCF is trading at an absurd valuation. This conclusion is supported by the following valuations:
1)Calculating the arbitrage gap between Private and Public market values, and
2)Using a DCF
Private Market Public Market Arbitrage
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The public market value for each tanker owned by VLCCF is $160mil ($800/5). A second hand 10 year old VLCC’s currently sell for $76mil. As VLCCF’s tankers are larger than the average VLCC I will use $90mil in this analysis. (Note: (i) A new build VLCC’s with a 25 year economic life currently sell for $113mil. (ii) The average price for a 10 year VLCC has increased from $50mil 2 years ago.)
At 90mil per VLCC I can build the identical company using debt of $113mil and equity of $337mil to purchase 5 tankers for R450mil. There is no need to pay a cent for goodwill. This is because tankers are a classic commodity with no differentiating features. Also, VLCCF outsource the management of the fleet for $750k per annum so there is no barrier to replicating the management of the fleet.
(Note: Private market NAV = 337/17.1 = 19.70 per share)
Shorting VLCCF and using the proceeds plus $113mil in borrowings to buy 5 tankers locks in a $350mil arbitrage profit. If anyone has 5 oil tankers to sell please let me know.
DCF
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Building a DCF model for VLCCF’s is very simple as you only need to know a few things.
- The 5 tanker have a remaining life of 15 years
- Tanker #1 has been leased out at $31 000 per day until March 2009.
- Tanker #2 and #3 have been leased out on a $30 000 plus 50% of the profit if spot rates exceed $30 000 per day. The lease ends in March 2007. (Revenue = 30 000 + 50%*max(0 or spot – 30 000))
- Tanker #4 and #5 trade on the spot market.
- Operating costs for the tankers are $7 000 per day each.
- Overhead costs are $600 per day each. (This excludes drydocking expenses)
- Discount rate of 10%.
Once the DCF model is built all that remains is to adjust the spot rate so that the NPV of the cash flow equals the enterprise value of VLCCF (ie $800 mil). You will find the magical rate to be $70 000 per day.
Is $70 000 per day sustainable? There are three ways to look at this.
1) The break-even rate on a new build tanker costing $113mil is $19 600 per day before finance costs. (Depreciation over 25years = 12 000 per day, Vessel operating costs = $7 000 per day and overheads (excluding drydockings) = $600 per day.) If rates are significantly above these levels tanker owners earn abnormal profits. The abnormal profits attract competition and profits revert to the mean. These market forces ensures a strong link between breakeven costs and tanker rates and only the foolish should bet that abnormal profits will persist.
2) The average VLCC rates over the last 15 years have been $34 000 per day. (Source: Clarkson’s Research) Plugging $34 000 into the DCF generates a stock price of $14.50.
3) The other listed tanker companies I follow currently discount much lower equivalent VLCC rates.
CATALYSTS
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The major catalyst for the trade is the Q2 earnings report expected towards the end of July/beginning of August. Other catalysts include the mandatory drydockings for 4 of the 5 tankers and an expected change to the bye-laws at the AGM on the 27 June 2005.
Q2 Earnings Report
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The Q2 results will report operating metrics well below the quarters following the termination of the Shell charters in Q1 2004. The quarterly results since then are shown below:
Revenue/Day EBITDA DPS
Q2 2004: $50 800 $19.6 mil 0.75
Q3 2004: $53 800 $21.5 mil 1.00
Q4 2004: $84 300 $35.0 mil 1.75
Q1 2005: $56 900 $22.0 mil 1.50
For Q2 2005 (to date) the average VLCC rate has been $42 500. At these rates VLCCF will realise rates of $37 700 per day and generate EBITDA of $13.7 mil for the quarter. These results are respectively 25% and 31% below the minimum of the prior 4 quarters. Not very encouraging for investors trying to game earnings momentum.
But, I think the biggest shock to investor confidence will be the cut in the dividend. To calculate cash flow available for dividends one needs to subtract an interest bill of $1mil per quarter and debt repayments of $2.8mil per quarter from EBITDA. This comes to $9.9mil or 0.58c per share using 17.1mil shares in issue)
Investors have become used to strong dividend flows ($5 over last 4 quarters). These yields have been an important driver of the stock price which is up 60% in 12 months. The cut in the dividend will undermine the perception that the strong dividend flows are sustainable which could see the yield hogs desert the stock.
Will future prospects save the day? Current VLCC rates are $25 000 per day. Tankers are booked 1 month in advance and so the impact of these rates will only be reflected in July’s income statement. Not a good start for Q3 for both the yield hog and momentum investors.
Drydockings
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Four of the five tankers are 10 years old this year and are due for a mandatory drydocking. The drydockings are expected to cost $1mil each and require the tanker to be removed from service for 20 days. The total cost of the drydocking is $4mil plus $2.0 mil in lost revenues assuming tanker rates of $25 000 per day.
Therefore, cash available for dividends could be hit by $3.0mil per quarter assuming that the drydockings are spread evenly between the seasonally slow Q2 and Q3 quarters. If this is the case then Q2’s dividend could be as low as 40c (58c – 18c)
Change to the Bye-Laws
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The current bye-laws prevent the sale and purchase of assets. Shareholders are expected to lift these restrictions at the AGM which will allow VLCCF to explore expansion opportunities. While first prize would be to raise capital in a secondary offering there is also the possibility that the dividend payout ratio is reduced to help fund acquisitions.
While members of VIC may be thinking that nobody would be foolish enough to subscribe to a secondary at these prices it can and did happen in March 2005 with Nordic American Tankers. (NAT) I was astounded that investors were prepared to swap $2 for $1. This was a great transaction for NAT as the offering obviously boosts the NAV and detracts from the “over valuation” argument. Despite this it is interesting to note that NAT priced the offer at 49.50 and the stock is now $36. During the same time VLCCF’s stock is up 11%. So even though the offering allowed NAT to grow its fleet and boost its NAV the secondary appears to have had a negative effect on the stock price. I expect VLCCF to suffer the same fate if they issue stock to expand the fleet. VLCCF may also be trapped into expanding it’s fleet at the wrong time. Remember second hand tanker prices are up 50% over the last 2 years.
SHORTING OR PUTS
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I am aware that the stock is difficult to borrow even though there are only 1.2mil shares short out of 17.1mil in issue. For those who have difficulty in borrowing I suggest the September (or later) put options. The bid ask is wide and the volatilities are about 50%. I think this is a good risk reward especially if the options are bought closer to the Q2 report date. It may be wise to wait until after the AGM on the 27 June.
Example
The Sept 35 puts currently trade for $2. If VLCCF falls from $40 to $30 on maturity the option will worth be $5 resulting in a profit of $3 or 150%.
CONCLUSION
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The private market NAV for VLCCF is $19.70 per share and the DCF value based on normalised tanker rates is $14.50 per share. These are well below the current price of $40. My bet is that the stock price will adjust to more reasonable levels in response to Q2’s results.
Catalyst
- Q2 earnings end of July/begin August.
- Heavy drydocking schedule.
- AGM on the 27 June 2005 to change bye-laws.