Description

Overseas Shipholding Group (“OSG”)

Introduction

How would you like to buy a crappy and illiquid small-cap company with virtually no research coverage? There’s more. It’s levered – both financially and operationally and it previously filed for bankruptcy. What if I told you that the equity trades at <3x pro forma free cash flow? Ok, it’s not that bad a company and it’s a potential takeout candidate and double from current trading levels.

Overseas Shipholding Group (“OSG”) operates in the protected Jones Act space where I believe a recovery is underway. New supply is expensive and the market is poised to go from oversupply to equilibrium, or even under-supply as additional vessels are scrapped. Unfortunately, as I was writing this up OSG announced an extension of its charters with American Shipping (“AMSC”)* and the stock appreciated ~25%. That said, this move was off of a very depressed level.

*OSG has evergreen options to extend charters from AMSC upon expiration in 2022, 2023 and 2025, respectively.

Cash generation in 2020 will be masked by high drydocking expenses, ballast water installations and new build capital expenditures. The “real” cash generating ability of the company will become apparent in 2021 when new build capital spending declines, new vessels contribute for an entire year and day rates reset higher upon strengthening fundamentals. This underpins strong FCF growth which should exceed $0.85/sh in 2021.

Description

OSG emerged from bankruptcy in August 2014 and is the stub entity after the spin-off of International Seaways (international tankers - VLCCs, LRs, MRs) in December 2016. The remainco transports domestic crude, petroleum products and chemicals. The fleet of 21 vessels is comprised of Jones Act and a few non-Jones Act vessels. Under the Jones Act, vessels shipping crude oil and products between US ports must use a ship constructed in the US and must be 75%+ owned by US citizens.

OSG’s Jones Act fleet of 17 vessels consists of handysize product carriers (10 chartered – 24% market share), shuttle tankers* (1 chartered / 2 owned – 100% market share), conventional refined product ATBs (2 owned – old/retiring in 2020) and lightering** ATBs (2 owned – 100% market share). A key part of the fleet is the 10 chartered vessels from AMSC. As a non-US entity, AMSC is unable to operate the vessels themselves. OSG pays a fixed charter rate plus profit sharing depending on day rates. End-use charterers include Shell, BP, Chevron, Phillips 66, Marathon Oil, Murphy Oil, government entities and others.

*Similar to a floating pipeline for transportation of oil from offshore fields to onshore storage facilities or refineries.

**Transferring cargo between vessels of different sizes as ocean-going vessels are too large for some ports.

The non-Jones Act fleet is comprised of MSP tankers (2 owned) and Marshall Island flagged tankers (2 owned). The MSP vessels participate in the US Maritime Security Program which provides a subsidy for making these vessels available to the US DoD. This subsidy amounts to $5 million per vessel in 2019-2020 and $5.2 million starting in 2021. These vessels receive a preference for the transportation of any government cargo. Currently, the company has a contract with the Government of Israel to deliver fuel through the end of 2020.

As its older ATBs retire, the company has been renewing its fleet. Average age of the fleet is below 10yrs as new vessels help to lower the average and older vessels leave the fleet. Two new 50,000 DWT Hyundai chemical tankers came online in 2019 and two 204,000 bbl Gunderson Marine barges are under construction and expected to be completed in 2Q and 4Q 2020.

The company also has a 37.5% investment in Alaska Tanker (“ATC”), a JV with BP West Coast and Keystone Shipping to support BP’s (now Hilcorp) crude transportation requirements in Alaska. Equity income has been very consistent over the years - ranging from $3.5 to $3.8 million. Recently, OSG agreed to purchase the remaining 62.5% equity in ATC from BP Oil Shipping and Keystone Alaska. Since BP sold its Alaskan assets to Hilcorp, ATC became a stranded asset which likely allowed OSG to purchase the 62.5% for a good price.

Industry

The entire Jones Act trade encompasses six main tanker routes (per AMSC presentations).

https://live.amsc.eyego.no/wp-content/uploads/sites/2/2019/11/Q3-2019-AMSC-presentation-final.pdf  

1. Gulf Coast refineries to Florida and the East Coast (Clean trade - tankers act in place of pipelines)

2. Alaska and Intra-West Coast movements for both clean and dirty products

3. Cross-Gulf movements (Corpus Christi shipments to Gulf Coast refineries and US Gulf crude to LOOP)

4. Delaware Bay Lightering - dirty trade

5. Shuttle tankers from deepwater US Gulf to refineries in Gulf Coast

6. Gulf Coast crude to Northeast refineries (tied to WTI Houston to Bonny Light)

The Jones Act trade is split between clean US Gulf trade (48%), crude oil shipments (22%), chemicals (8%), West Coast trade (17%) and other. Due to the repeal of the US crude oil export ban, the dirty trade declined from as high as 36% in 2015. More recently, the Philadelphia Energy Solutions ("PES") explosion and bankruptcy reduced ~60% of the Delaware Lightering trade that OSG controlled. I have not followed the bankruptcy closely and I assume the PES refinery will remain shuttered. However, a news report indicated that 15 parties expressed interest in acquiring the refinery. A full or partial restart would represent upside for the lightering trade. An auction will take place in January. Should PES not restart, we could see incremental diesel shipments into NY Harbor (especially with higher international MR and LR rates) as PES produced 80,000 bbls/d.

Currently, the fleet size is relatively small at 88 vessels - split between product carriers and large ATBs. This compares to 93 vessels a year ago and over 100 at the peak. Since 2016, four tankers and 11 ATBs have been retired. An estimated 80 vessels are required for clean product movements with dirty shipments absorbing the remaining supply. As such, one swing factor is domestic crude movements from the Gulf to the Northeast.

The order book is limited to only two small barges (from OSG). Only two US yards remain, NASSCO and Philly Shipyard and the latter is busy with Navy work. No new tankers are expected for 3-4 years. Incremental retirements should continue as 10 tankers and ATBs will approach 35 years or older in 2020, which is when age requirements start to kick in. As a result, we should see negative fleet growth in 2020 and 2021. For example, OSG will retire 2 ATBs in 2020, Seacor may retire a vessel in 2021 upon contract expiration and US shipping has two chemical tankers that are candidates for demolition. Tanker new build costs are $150 to $165 million and require two years to complete. Day rates of $70,000/d are needed to justify new builds.

The main players in the space are OSG, Kinder Morgan, Crowley, Seacor (Seabulk), Bouchard, US Shipping, Kirby, Genesis, Moran, Keystone and Reinauer. Most are private or smaller entities within larger companies.

The company characterizes Jones Act shipping as more industrial than commodity-based due to a higher co-dependency between owners and end-users who are focused on stable “distribution” networks. Historically, this meant time charters averaging three years in length as opposed to the shorter durations seen more recently. Due to an expectation of a market recovery, OSG kept charter duration short and several charters signed during periods of weakness will reset soon.

One common concern is a repeal of the Jones Act. Occasionally, there is noise around this but my understanding is this is one of the strongest lobby groups in Washington. McCain tried for years to get it repealed and it never gained any real traction. Per management, there is a broad consensus in Washington that a critical shortage of tanker personnel exists today (to provide support for military sealift activities) and Jones Act vessels provide the necessary training.

Recent Commentary

On the 3Q conference call, management indicated that recent time charters, further rate resets of time charters and new vessels should drive improved results in 2020. Since 2Q 2019, OSG has secured time charters for 10 vessels at higher rates, an indication of a more supply-constrained market. Forward revenue cover for 2020 is at 75% of available vessel days. Recent spot rates in the $60,000s/day compare to a low of mid-$30,000s at the trough in 3Q 2017. Anecdotally, I’ve heard that more customers are inquiring about longer-term time charters as the supply-demand balance continues to tighten. Similarly, the CFO told me there were no spot vessels currently available. This improvement should continue into 2021.

As such, I expect OSG’s FCF generation to grow significantly from 2020 to 2021. This is despite the aforementioned PES bankruptcy and the retirement of the company’s remaining older ATBs. New vessels, including the Overseas Gulf Coast and Sun Coast ships are expected to add $7 million of EBITDA and the new barges completed in 2020 are projected to contribute $4 million of EBITDA for the partial year of operations and an incremental $11 million in 2021. Additionally, drydocking and ballast spending will decline and NOLs will limit tax payments.

The operating contribution of the new vessels has been well telegraphed. The hidden value here is the conventional Jones Act tankers chartered from AMSC. There is massive operating leverage within this bucket as a function of their fixed charters (with profit-sharing above certain levels) and LTM operating contribution of only $3 million. This optionality should manifest itself as rates improve over the next several years.

Capital Structure

The capital structure is debt heavy. I calculate pro forma debt (including new builds and finance leases) of $470 million split up between several term loans at L+400-500 bps with maturities in 2023 to 2026. Debt amortization is $56 and $54 million per my estimates in 2020 and 2021. Netting off cash and adding in the market capitalization results in an EV of ~$620* million. As earnings improve and debt is reduced due to the amortization schedules of the loans, I would expect the company to refinance the entire structure into one loan at a lower rate or a blended loan/bond. This should both reduce interest payments and increase FCF.

*This does not capture the Alaska JV 62.5% stake purchase.

Projections

Due to an extensive capital program in 2020 plus a few ATB vessel removals and only partial year of earnings for the new vessels, 2021 will be a cleaner picture for the pro forma fleet. I triangulate an estimate for 2021 EBITDA and cash flow using a few methods. All figures strip out stock compensation, despite management adding it back in the presentations.

The first is to annualize 4Q 2019 guidance ($30 million), excluding one-time or seasonal benefits based on color provided during the Q&A of the 3Q call and then adding the incremental benefits from the new vessels while subtracting the retiring ATBs. The one-time benefits I exclude include higher MSP earnings due to voyage timings and the full year distribution from the Alaskan Tanker JV (captured entirely in the 4Q). The lightering hit from the PES shutdown is already accounted for in this calculation. However, the potential upside from higher day rates on the chartered AMSC fleet is not fully captured in this figure.  

The other method starts with guidance for 2019. This is $86 million (after stripping out stock compensation). The adjustments here include the loss of lightering premium as PES didn’t shutdown until after 1H 2019, the retirement of ATB vessels, improved Jones Act day rates* and utilization and earnings from the new vessels. Other upside exists from incremental shuttle tanker volumes** and the Tanker Security Program in the pending National Defense Authorization Act.

*Previously, management mentioned every $1,000 improvement in day rates adds $3.5 million in EBITDA. This is only up to a point as profit-sharing with AMSC kicks in at certain levels ($67,500, $63,400, $59,000 in 2020-2022).

**Management believes there is demand to expand from the current two vessels to three.

The two methods result in $115 million+ of EBITDA in 2021. At current prices, I calculate 2021 EV/EBITDA of ~5.5x before capturing the benefit of NOLs* and the immediate accelerated depreciation treatment of the barges and 2020 debt repayment which takes the multiple <5x. Due to the leverage and NOLs, the real torque here is FCF. For 2021, I calculate FCF of $0.85/sh. (pre debt amortization and before a charge for the “economic” depreciation of the fleet since these are finite-lived** assets). Part of the increase in FCF is from new vessels, a portion from higher rates / increased utilization*** and a decline in capital spending for drydocks and ballast water installations ($39 to $6.5 million). With debt paydown and some help from the AMSC vessels, this figure could hit $1.00. Most of this will go towards debt amortization so the play is either to refinance to reduce amortization or to grow equity market capitalization through debt paydown.

*Along with the immediate depreciation shield from new barges, OSG’s federal and state NOLs of $250 (expiring in 2034) and $246 million will offset future tax payments.

**Since the fleet is relatively young post the retirement of the ATBs, new build capex should be limited over the medium term. Jones Act vessels also last a long time.

***Per 3Q 2019 CC (re: impact of utilization): I'll remind you that in the Jones Act, if you have a vessel in the spot market, the voyages are pretty short. So even if you do very well, if you're doing a 5- or 6-day voyage and you take a day or 2 in between voyages before your next cargo can load, that reduces your effective utilization rate down into the sort of 70% to 80%. And to achieve time charter equivalent returns in the low 60s on a 70% or 80% utilization rate means you're going to be up in the 80s or 90s on a spot market rate. And we're not yet there. We could get there but we're not yet there.

Valuation

For comparison purposes, I would look at Seacor, Kirby and American Shipping. Seacor recently purchased a 49% stake in its Jones Act fleet from its JV partner for <6x EBITDA, or even less since they expense drydocking whereas OSG capitalizes those costs. I don’t believe this transaction is representative because Seacor is a notorious bargain hunter and the PE seller owned a non-controlling stake in a fund that was nearing the end of its life. Plus, the Seacor assets are older on average than OSG’s fleet. Kirby trades at 10x EBITDA, although it’s bigger, more diversified and as a consolidator merits a premium. Several years ago, Kirby purchased Penn Maritime, an operator of tank barges and tugboats participating in the US coastal transportation of black oil for ~8x EBITDA. Lastly, AMSC trades at 8.5x, although this doesn’t capture upside from the aforementioned profit-sharing in the outer years.

With the business inflecting, I believe we could see a re-rating here as the focus shifts from excessive debt and retiring vessels to cash generation. At 7x EBITDA, the shares are worth over $4 (or higher if we bake in debt retirement in 2020 and the NOL). On a FCF basis, if we assume a multiple of 6x, the stock is worth over $5. As an aside, book value is $3.70/sh and this doesn’t capture the value of the AMSC charters due to lease accounting.

Besides earnings growth and debt repayment, a catalyst could be a takeout. Both Kirby and Seacor are potential buyers. Due to its small size, I think OSG would be an interesting acquisition candidate for Seacor. This appears to be a low probability scenario since my guess is that Seacor is angling for the American Commercial Lines bankruptcy and they recently bought out their Jones Act fleet JV partner. Still, I believe OSG would be a great fit for Seacor as they could buy it non-recourse (similar to their offer for Gulfmark), take out a bunch of costs and enter new businesses within the Jones Act space (i.e. MSP, Alaska, lightering). This would move the needle quite a bit for them with little risk. Similarly, for Kirby, a deal is very accretive given their elevated multiple and low cost of debt.

Risks

-Repeal of Jones Act; unlikely but stock is a zero if this happens

-Narrowing of Bonny-WTI Houston spreads reducing Gulf Coast to East Coast oil movement

-Recession reducing product demand

-New build announcements

I do not hold a position with the issuer such as employment, directorship, or consultancy.

Catalyst

-FCF generation and discussion of use of that capital in 2H 2020; dividends

-4Q rate commentary (signed time charters for 4 vessels available in spot market in 1Q 2020); fleet retirements; PES restart

-Takeout?