Description

Investment idea

Philly Shipyard is in the middle of a transition process from building commercial vessels to US Navy ships, which will provide it with business for years to come. Thanks to these new orders, the company’s order book has now come back to 2014 levels at around US$1.2 billion. Near-term guidance is for the shipyard to reach full capacity in early 2022, which implies revenues around US$300 million per year (1 ship per year) and margins in the high single digits. My back-of-the-envelope numbers suggest the P/E multiple should drop to somewhere around 5x and EV/Sales around 0.30x. If the stock were to trade at peer group multiples, it would triple from today’s price of NOK 60. 

The quality of the business

Shipyards are hardly high-quality businesses. But there are three mitigating factors:

1. The US Jones Act market protects incumbent shipyards from competition

2. The US Navy is likely to rely on domestic shipyards to build its vessels

3. Philly Shipyard is a capital-light business since it doesn’t actually own the shipyard

The 1920 Jones Act mandated that ships moving goods between US ports must be American-built, owned and operated. It protects the American shipbuilding industry, justified on the basis of national security.

Philly Shipyard is the largest of all US commercial shipyards constructing vessels for the Jones Act market and only one of two capable of producing oil tankers. It has delivered close to 50% of all ocean-going Jones Act commercial ships since the year 2000. 

The shipyard was revived in the late 1990s by then-Kvaerner (later acquired by Aker ASA) in a public-private partnership with the city of Philadelphia. Government entities invested US$438 million and Philly Shipyard US$135 million to bring the shipyard back to life. There are strings attached: the company needs to maintain at least 200 full-time employees at all times (latest number: 202). The company received a 99-year lease until 2096. Since most of the investment came from the City of Philadelphia, it’s a capital-light business that earns its profits in cash. 

Philly Shipyard’s ships cost four times more than vessels built by foreign competitors. And US owners must also shoulder higher insurance premiums and heftier salaries for US sailors (the ships cannot use foreign crews). And that’s despite using foreign engines and foreign vessel designs. 

But the Jones Act is cemented in US politics and appears unlikely to change anytime soon. President Biden has historically been a strong supporter of it. Transportation Secretary Pete Buttigieg has voiced his strong support for the Jones Act as well.

The business itself is well-run. Incident frequencies are among the best in the industry. Parent group Aker has a strong reputation as far as I can tell. From 2013-2016 - the company paid out almost US$150 million in dividends - almost twice the current market cap. While the business is smaller today due to a sell-down of the company’s shipping assets, high dividend payments suggest that minority shareholders have been treated well in the past. 

A recovery in the order book

Philly Shipyard had 10 strong years from the mid-2000s, producing primarily product tankers to AMSC, OSG, Crowley, SeaRiver Maritime and Kinder Morgan. Following a drop in oil prices from 2014 onwards, new orders ground to a halt. The last commercial vessel on order was completed in early 2019. From 2017 until today, revenues have been close to zero. 

Since 2020, the order book has completely recovered. The company has found a new lease of life through the US Navy, which is modernising its auxiliary fleet that moves supplies to US forces around the world. 

Until the end of 1Q21, Philly Shipyard had received four ship orders in the NSMV program (National Security Multi-Mission Vessels) with a total order value of US$1.2 billion. There’s a potential for a fifth vessel with an additional value of US$300 million. The preliminary request for the US Department of Transportation includes full funding for the fifth NSMV.

In addition, Philly is participating in industry design studies for four government shipbuilding programs, including three for the US Navy and one for the US Coast Guard. These industry studies are the precursors of future design & construction contracts. 

The company may also enjoy repair and maintenance contracts over the next few years, most recently for the USNS Charlton ro-ro ship used in the Navy’s Military Sealift Command.

There are currently no oil tankers or container ships in the order book but further commercial orders remain a possibility. 

The company’s guidance suggests that revenues are likely to shoot up in the near future.

• “To date, Philly Shipyard has received orders for the first four ships in the NSMV program, with a total order intake in excess of USD 1.2 billion… if all five NSMVs are ordered, then the contract value would total approximately USD 1.5 billion with the final delivery in 2025.” 

• “Philly Shipyard expects it will continue to incur operating losses in 2021 due to the shipyard operating at less than full capacity during the ramp-up of production for the NSMV program… it is expected that operations at Philly Shipyard will reach full capacity in early 2022.”

Exactly when revenues will be booked is unclear, but most likely revenues should end up north of US$300 million per year in the four-year period from 2022 to 2025. 

Broader macro backdrop

The US has underinvested in its Navy for many years. 

The most likely adversary today is the PLA Navy, which today controls 360 modern ships. That’s not even counting China’s maritime militia that is in effect an extension of its navy. In April, China commissioned three warships in a single day.

The US is stuck in the water with 300 ageing vessels. In 2021, eight new ships are likely to be built. But with 30-year average lives, ten are likely to be decommissioned each year. So net-net, the fleet is likely to shrink. 

Within 10 years, the US Navy will lag far behind. The disparity between the PLA and US Navy becomes even more pronounced if you consider that the US Navy is spread out geographically whereas the PLA will have an upper hand in the Asia Pacific. 

My point here is that US shipyards are likely to stay busy for years to come - even after 2025. 

If the PLA makes a move on Taiwan (as I have argued on my Substack, is likely), expect a significant hike in US defense spending. 

I’m also positive on the medium-term outlook for oil prices, given record low exploration capex and demand that keeps growing close to 1mmbpd every year thanks to population growth.

Valuation

Philly Shipyard’s main competitors are:

• General Dynamics NASSCO (the only other Jones Act shipyards in the United States capable of producing tankers)

• Huntington Ingalls, who specializes in military ships

• VT Halter Marine (a designer and builder of small to medium-sized ocean-going vessels owned by Singapore’s ST Engineering)

You can tell from the table below that most peers trade at around 1.0x EV/Sales. In the past, Philly Shipyard has earned operating margins in the high-single digits - in line with Hunginton Ingall’s. 

With a market cap of US$82 million and an EV of US$83 million (I deduct customer advance liabilities to properly reflect the nature of cash on the balance sheet), I get to a future EV/Sales of 0.28x, EV/EBIT of 3.4x and P/E 4.3x. That’s assuming high-single digit operating margins and operating profit somewhat north of US$20 million. In this scenario, I believe the stock would have to triple for it to reach peer group valuation multiples. 

Seen from another perspective, assuming mid-single digit net profit margins, accumulated profits from the 4-5 NSMV contracts are likely to add up to close to the current market cap. And within a few years, you’ll still own a shipyard with US$650 million of assets likely to benefit from a build-up in the US Navy as well as potential future commercial vessel contracts. 

Catalyst

• Earnings release on Wednesday 14 July 2021

• Higher oil prices, justifying new product tanker orders

• A “Taiwan contingency” causing an arms race in US defense spending