Description

(As I was working on this, Navigator and EPD announced plans to develop an ethylene export terminal on the Houston Ship Channel.  I updated this for the details in the announcements)

Navigator Holdings Ltd. (“Navigator”) (NYSE: NVGS) is the owner and operator of the world’s largest fleet of handysize gas carrier vessels. The Company’s vessels transport three cargo types – liquefied petroleum gas (“LPG”), petrochemicals, and ammonia – that are used for residential (heating and cooking), industrial and farming applications. The Company operates a highly versatile modern fleet with an average age of 6.7 years and serves customers across the energy, industrial and commodity industries. In total, Navigator operates 33 handysize vessels, 3 medium gas carriers and has 2 new-builds on order.  14 of Navigator’s vessels are capable of transporting ethylene.  

Due to the downturn in the broader shipping industry over the past several years and a decline in oil prices, Navigator stock sold off along with other shipping firms. Most of the shipping industry, consisting of drybulk and crude oil ship owners, is purely commoditized – vessels are mostly interchangeable, companies over-build when demand is good, and in weaker demand environments, companies compete aggressively on price and burn cash flow to stay in business and wait for an up cycle.

However, Navigator operates with the dominant market position in a niche shipping industry with barriers to entry and lack of substitutes, and has generated material free cash flow during trough cycle conditions. Navigator stock is cheap on free cash flow yield and net asset value metrics, entering an up-cycle in end market demand (market setup to strengthen in 2018 and potentially squeeze in 2019) and is likely to win long-term contracts from key customers in the next several months which should change the narrative to a long-term contracted cash flow story. The company also offers a free option on significant tailwinds from U.S. export policy, and I believe is likely to be ultimately sold to a strategic acquirer for a much higher share price as the cash flow stream becomes more contracted.

Unlike traditional shipping, Navigator operates in a complicated and sophisticated part of the global transportation market, with complex on-board handling requirements and heavy dependence on trade triangulation and regional price and supply/demand differentials. In order to service its various customer types, Navigator operates a very versatile fleet of primarily semi-refrigerated vessels, which gives Navigator’s fleet the flexibility to carry petrochemical gases (ethylene, propylene and butadiene) and ammonia, in addition to traditional LPGs (propane, butane and ethane). Semi-refrigerated vessels use pressure and cooling to liquefy gas cargos on the ship itself (without port liquefaction facilities) which allows Navigator to load gases that had not previously been liquefied. Navigator’s vessels can also re-pressurize cargos on ship to deliver cargos to facilities without regasification capabilities. As a result, Navigator’s semi-refrigerated vessels have much greater trading opportunities that allow them to capitalize on a much greater pool of regional trade imbalances than larger vessels (specifically, very Large Gas Carriers or VLGCs) operated by shipping companies such as Dorian LPG, BW LPG and Avance Gas.

I believe Navigator is an attractive value investment in an increasingly expensive equity market as the equity currently trades significantly below book value (trades at ~0.6x) and my estimate of mid-cycle net asset value. The Company has generated superior returns compared to shipping peers throughout the cycle, including producing significant free cash flow at trough day rates, and has pending catalysts that will uniquely position it to earn industry leading ROEs. Nonetheless, because of the niche market in which Navigator operates (the Company has no public peers) and a significant contraction in general shipping rates over the past several years (led by dry bulk and container ships), I believe Navigator’s business and outlook is misunderstood by the investment community.

Unlike traditional shipping peers that operate in fragmented markets, Navigator has a dominant market share, controlling ~31% of the handysize gas carrier market. Navigator’s significant scale in the handysize segment (the next largest player has a fleet ¼ of the size of Navigator) allows Navigator to negotiate favorable terms for its charters and secure contracts of affreightment (COAs) allowing the Company to maintain high utilization and profitability for its fleet, even in weaker shipping markets where smaller peers could struggle to find cargos for their fleet. This also allows Navigator to capture a greater share of the time-charter market in what is historically a shorter-term spot market. As of February, Navigator disclosed they have committed revenue of ~$327mm and an EBITDA backlog of more than ~$224mm through 2019 (and another ~$200mm of EBITDA backlog post 2019), which compares attractively to the Company’s $580mm market cap.  (Note this backlog is before any contracts associated with the ethylene export announcement)

Further (and as mentioned earlier), the versatility of the Company’s fleet allows Navigator to optimize its earnings in the spot market by shifting the cargo types it is transporting. Demonstrating this flexibility, Navigator shifted their cargo volumes toward higher earning petrochemical cargos in 2016 as heightened deliveries of LPG vessels has suppressed near term charters rates. As such, Navigator has utilized their semi-refrigerated vessels to ship ethylene and butadiene out of Houston, Brazil, and the Middle East (where large price differentials between eastern and western ethylene are allowing the Company to earn spot rates double what an LPG only vessel is earning). Of their open “spot days” during the first 9 months of 2016, Navigator’s petrochemical earning days increased to 74% from 40% over the same period in 2015. This shift has allowed Navigator to maintain significant cash generation as the company laps the brunt of the supply delivery of LPG vessels in 2016. Despite depressed LPG spot rates, Navigator generated ~$85 million of free cash flow in 2016 representing a ~15% free cash flow yield – a stark contrast to most of shipping that is burning cash at similar discounts to book value with a longer period of time till market inflection.

On the supply side, the gas carrier has been impacted by an oversupply of vessels, particularly in the very large gas carrier, or VLGC market, as high charter rates attracted new orders. As a result, charter rates in the gas carrier market reached trough levels in 2016 (but have since bounced since October). Navigator has also been impacted by the increased supply of vessels. Over the past 3 years, supply of handysize vessels has grown 24% which has put downward pressure on charter rates in 2016 as the brunt of the order book delivered. However, the outlook improves from here with only 7% of the handysize on fleet on order. Further, there are no scheduled deliveries after 1H’18. On the VLGC side, which has impacted Navigator’s handysize LPG earnings, supply growth falls significantly after Q3’17. In 2018, VLGC supply growth will slow to ~2%.  The supply side sets up favorably for a rate recovery starting at the end of 2017.

On the demand side, demand for LPGs has remained strong, outpacing growth of nearly all other segments of shipping. A noteworthy aspect of the LPG global market is that LPG has historically been a supply-driven industry, as LPG is a by-product of natural gas (and to a lesser extent crude) extraction and LPGs represent a small part of the value chain to energy producers. There is a higher price elasticity to selling propane/butane at any price in the U.S. since the majority of the value lies in the natural gas itself (although producers do have the ability to put into storage in the Gulf but they will reduce when Mariner East two pipeline opens later this year). The supply driven nature of LPGs and petrochemical gases is important because the supply of these cargos will continue to see expansion as a result of expanding US shale gas production. The exponential growth of shale gas has made the US the low cost supplier of LPGs and petrochemical gas in the world, and there is an increasing bid in Asia to source these cargos from the U.S. at a cheaper all-in cost than what had traditionally been crude-linked pricing from the Middle East.

In addition to a strong fundamental supply /demand outlook, Navigator is uniquely positioned for a demand boom that can squeeze the gas carrier market, causing a significant increase in charter rates. This “home run potential” is the increasingly likely possibility of large increases in ethylene exports out of the U.S. (of which an initial announcement to construct an ethylene export facility was made by EPD and Navigator as a 50/50 JV on 7/12/17).  Because of the U.S. shale revolution, the U.S. is flush with the world’s lowest cost ethane. As a result, companies are significantly increasing their olefin manufacturing capacity, principally ethylene, with nearly a dozen companies building new plants. In total, U.S ethylene capacity will increase by ~50% over the next several years. While the majority of this capacity will stay within the U.S., a material portion will be earmarked for the export market. In order to export this ethylene, new specialized ethylene terminal facilities will need to be built, and I believe up to two new terminal export facilities could be announced in 2017 (including the NVGS/EPD announcement).  To put this in context, one 50,000 barrel / day ethylene export facility (the reported size of the EPD/NVGS export facility per analyst notes) would require between 10-14 vessels annually for the trade. Currently, including the orderbook, Navigator has 14 ethylene capable vessels, representing ~50% of the handysize ethylene capable fleet. I expect that as these ethylene export facilities are announced, Navigator will likely enter into long-term contracts to transport ethylene at ROEs in the 30% range.  Further, per the EPD announcement, Navigator will also own 50% of the export terminal, which we expect can be completed in 2019.  While details in the initial press release were scarce, I think the terminal and an order for new ethylene vessels that will be required to service to terminal (I assume 5 newbuild orders) will add at least $0.50 to run-rate EPS.  Given the EPD announcement, I think announced contracts for offtake and the vessel charters are likely close and should be announced in 2017.  I also find this announcement to reduce the downside in Navigator.  By 2019, Navigator should be in position to contract, at a minimum, its ethylene capable fleet at long-term rates that should guarantee around at least $1.00 but likely close to $1.50 in annual EPS.  This excludes Navigator’s remaining 24 vessels, some of which are also likely to be on longer term contracts, as well as Navigator’s share of earnings from the ethylene export terminal JV.

I find the current valuation of Navigator quite compelling. Unlike other areas of shipping that attract more investor interest such as dry bulk, Navigator is trading at a discount to its NAV (dry bulk, for instance, is trading at NAV / slight premium despite operating at breakeven rates). I estimate mid-cycle NAV is $17/share, a 60% premium to the current stock price (book value per share is also $17.28).  Further, Navigator has historically traded to a ~2x premium to NAV given its ability to generate positive returns throughout the cycle.  Navigator’s current order book is fully financed, the Company trades at north of a 20% free cash flow yield on my 2018 numbers, and I think it is likely that spot rates are at their bottom and are likely to increase materially starting in 2018.

Lastly, Navigator’s largest shareholder is WL Ross & Co with a 39.4% stake, whose owner is Wilbur Ross – the current Secretary of Commerce. Navigator was one of a handful of Mr. Ross’ investments (out of over 100 investments) for which he requested a waiver to maintain ownership as he accepted his new role. Ross has been a proponent of exporting low-cost U.S. energy to fuel U.S. economic growth. I think Ross and management (CEO David Butters is the second largest shareholder after WL & Ross) see similar upside as I do a Navigator with a fundamental tightening of the market due to lack of supply growth and upside in the ethylene trade. There is a tremendous amount of operating leverage in shipping, but I see a strong possibility of EPS reaching $3.00 in 2019 with upside should the ethylene demand squeeze rates for midsize LPG carriers.  At a 10x PE multiple, I think shares could reach $30.00 over the next two years, with a decent probability of a sale of the entire company given the current ownership structure.

Catalyst

• Announcement of long-term charters
• Announcement of newbuild order for ethylene vessels
• Spot rate improvement