Description

Investment Thesis

PHLY NO is one of only two large-scale Jones Act shipyards in the United States (the other being General Dynamics owned NASSCO).  At the current price, the stock is being valued at a 30% discount to its cash and present value of its backlog, net of all liabilities.  The shipyard business itself is a decent, albeit cyclical, business.  The business is decent because it has only one major competitor, no threat of technological disruption, minimal capex and thus is highly free cash flow generative, and a very savvy management team which opportunistically adds value beyond the core shipbuilding business.

Applying a 6x EV/EBITDA (or 7.5x unlevered FCF) multiple to run-rate EBITDA of $25mm coupled with the company’s net cash and backlog value, implies a fair value of more than 3x the current stock price.

Company Description and Background

There were VIC write-ups on this company in January 2014 by BJG and in April 2016 by tml2106 so I won’t go into great detail about things they have already covered but the company has nearly completed its exit from the shipping business since those write-ups were written.  I will give a very brief history on the company as it relates to what is currently happening but I would encourage readers to read the earlier write-ups for a more complete background (especially the one from 2014 which is longer).

What is now called Philly Shipyard was created in 1997 as a public-private partnership between Kvaerner (now Aker ASA) and multiple government entities (with the largest help from the city of Philadelphia).  Government authorities committed to funding more than $400 million and Kvaerner committed to $165 million to restore the former Philadelphia Naval Shipyard which was closed in 1995 and to train new employees.  To date, more than $650 million has been invested into the shipyard.

The company has had its ups and downs throughout Jones Act shipping cycles (if you are unfamiliar with the Jones Act see: https://en.wikipedia.org/wiki/Merchant_Marine_Act_of_1920) but has, in general, been a very profitable business for its owners.  There are no growth opportunities as it relates to Jones Act shipbuilding (two shipyards is enough) so the company will dividend cash back to its owners as it builds excess cash.  Shareholders have received $149mm in dividend payments over the past 3 years alone.

Profits are obviously maximized when the shipyard is operating at full capacity so occasionally in the past, management has chosen to partner with shipping companies (or other investors to create a shipping company as further described below) to help with or to create demand for shipbuilding contracts.  It first did this with a profit-share on four product tankers with a Crowley 50/50 JV in 2013 and in 2014 created a shipping company with American Shipping Company (“AMSC NO”) and Apollo (a ~15% shareholder in Philly Shipyard) called Philly Tankers to buy four product tankers from Philly Shipyard.  While one might think these were highly speculative “self-help” decisions to fill shipyard capacity, having discussed the decisions extensively with management and contemplated an equity investment in Philly Tankers when it was being created, these were decisions made with very deep insight into the future of the Jones Act product tanker market.  Again, I refer readers to the prior VIC articles as these authors were bullish on the stock due to the company’s equity investments in these ships.

The shipping investments later proved to be lucrative as the company sold both the Philly Tankers vessels and its interest in the Crowley JV in August and September, respectively, of 2015.  It earned approximately $40mm in pre-tax profits on the Crowley JV and will ultimately earn approximately $26mm on the Philly Tankers investment (which is earned upon delivery of the ships), in both cases earning more than 50% return on the equity investments.

PHLY delivered the final Crowley vessel in 4Q16 and as of the end of 1Q17, the company has delivered two of the four Philly Tankers vessels.  These have been on time and presumably on budget (PHLY has built the ships for ~$110 million relative to the sales price of $125 million).  So, PHLY has made healthy profits on the actual building of the ships, but also healthy profits on its equity investments as the ships are delivered to their ultimate owner.

Technical Selling Pressure

Despite the excellent performance over the past couple years and shareholder friendly dividend payments, the stock price has suffered.  I believe the major reason for this throughout late 2016 and early 2017 was because of forced selling by liquidating hedge funds.

To start, while all operations are in the United States, this is a small capitalization stock that trades on the Oslo stock exchange in Norway.  With no sell-side coverage, the buying and selling done on the margin is by local Norwegian retail investors.

In 2005, the Norwegian holding company, Aker ASA, took control of Kvaerner and listed Aker American Shipping (AKASA) on the Oslo exchange which was comprised of Philly Shipyard (at that time called Aker Philadelphia Shipyard) and American Shipping Company, a Jones Act product tanker shipping company.  AKASA then spun-off Philly Shipyard creating two publicly traded companies.  Aker ASA still owns 60% of Philly Shipyard.

In late 2013 and early 2014, Apollo began building a stake in Philly Shipyard ultimately amassing an approximately 15% ownership of the company.  So between Aker and Apollo, about 75% of the float is held (note: this is speculated based on Apollo’s announcement in 2014 and the consistent amount of shares held by Goldman Sachs shown on the holders list which is where I believe Apollo’s shares sit).

Two hedge funds which held an estimated 10-15% of the company began a liquidation process in late 2016 putting tremendous pressure on the stock.  We presume the smaller holder (estimated 2-3% of the company) has fully exited, but the larger holder with an estimated 10% stake ultimately distributed this position in-kind at the end of the year to its limited partners.  I believe this has created a long and slow overhang as many hedge fund allocators do not even have proper brokerage accounts to sell a Norwegian listed stock.  I believe the market is continuing to digest this selling pressure from unnatural holders of the stock.

Recent Negative News Further Exacerbating the Selling Pressure

While I believe nearly all of the selling pressure prior to the 1Q17 earnings release on May 4^th was technical rather than fundamental, there have been two recent negative events for PHLY shareholders exacerbating the decline.  The stock is over 20% since its earnings release.  While a decrease in value is justified (the justifiable quantity of decrease can be debated), it was doing so from a dramatically undervalued starting point.

The first recent negative catalyst was the company announced that it is fully cutting its dividend (it was previously paying USD 25c per quarter for a ~13% dividend yield at the pre-earnings price).  While a dividend obviously doesn’t change the value of a company, it’s comforting as a value investor, especially when you believe there is significant excess cash value that isn’t being appreciated by the market, to lower your cost basis via dividends.  Also, Norwegian investors particularly like dividend stocks so I think removing the dividend added material technical selling pressure from the local dividend-oriented investors.

The most recent negative catalyst occurred on May 11^th when Pasha (the only competitor to Matson in the Jones Act Hawaii trade-lane) announced it had selected Keppel O&M to build two new containerships rather than PHLY.  This was a big surprise to me and I believe it was to Philly Shipyard as well. 

While PHLY is contracted through 1Q19, these vessels require a lot of lead time so a new contract needs to be signed shortly to avoid any possible downtime at the yard.  I don’t have a particularly strong insight into where the next contract may come from but I wouldn’t be surprised if PHLY went back to its bread and butter of producing product or oil tankers.  OPEC announced in November 2016 that it would cut oil production by 1.2 million barrels per day which it has achieved, however U.S. oil production from the lower 48 states has increased by more than 800 thousand barrels per day with no signs of stopping.  A report from Seaport on May 16^th predicted an increase in lower 48 U.S. production to 1.4 million barrels per day by November 2017. 

Valuation

To value Philly Shipyard, I start with the value within its current balance sheet and then add this to what I consider going-concern or enterprise value of the shipbuilding business itself.  I think this type of valuation is particularly relevant for this company today because a significant portion of its “balance sheet” value today is due to Philly Tankers which is not a core part of the business (because PHLY owns a majority stake in Philly Tankers, IFRS required it to account for the contract as being built for its own account which means it builds costs on its balance sheet and accrues revenues as deferred revenues until the ship is fully built and delivered before recognizing revenues and expenses to flow into the equity account).  The Philly Tankers construction contract and the equity investment will be converted into cash by the end of 2017 which is the bulk of the company’s balance sheet value.

Philly Tankers Contract Value:

Balance Sheet Value:

As mentioned in the comments, the balance sheet value doesn’t include the PP&E which is what creates the going-concern value.  However, the above is what would be generated in cash if the company were liquidated after completing the containerships for Matson.  I also believe there is significant value in the shipyard itself (if bought as a going concern) but PP&E is listed on the balance sheet at $51.1 million.  This is simply all the equipment on the yard that the company has installed itself – feel free to take whatever discount to this value you choose but even assuming $24.5 million (52% haircut for round numbers), the liquidation value of this company is still $130 million, 78% greater than the current market cap.

Going-concern Shipyard Value:

Note: The Adjusted EBITDA are provided by the company.  The EBITDA is so high in 2015 and 2016 because the company adjustments assume the revenues and expenses for the Crowley and Philly Tankers vessels were recognized as if the contracts were for third parties (and it recognizes the profits on the equity investments when realized).  The revenues are not adjusted in this way therefore the EBITDA looks abnormally high relative to the revenues (this is partially from profit from equity investments but mostly from the non-apple-to-apples comparison to the EBITDA).

10 Yr Avg EBITDA = $29 million

5 Yr Avg EBITDA = $45 million

2011 was the only year of negative EBITDA and unlevered FCF going all the way back to 2006 (as far back as I could find financials).

For valuation purposes, I assume a run-rate EBITDA of $25 million.  This is slightly less than 2 product tankers per year (yard capacity is approximately 3 per year) or about 1 containership per year (yard capacity is approximately 2 per year).  Given the current Jones Act fleet size and assuming NASSCO produces the same number of ships per year, this implies about a 40 year useful life for each ship which I think is appropriate.  I would point out, however, that it doesn’t include any additional value outside of shipbuilding which the company has been able to create in the past.  It’s also less than both the five and ten year averages of EBITDA for the company (I think more recent results are more relevant because the company has improved its efficiency boosting margins).

Using $25 million of EBITDA and a 6x multiple, I think the fair value of the shipyard is $150 million.  Combine this with the balance sheet value of $105.5 million and I get to a fair value of $255.5 million, or $21.10 USD per share or $178.32 NOK per share (248% higher than the current price) at the current exchange rate.

Critics may argue that it’s not appropriate to separate all the balance sheet value (other than PP&E) from the going-concern business because working capital is necessary to create the going-concern value.  My counter to this is that if you look at the current working capital numbers from the balance sheet in the balance sheet valuation section (which exclude Philly Tankers related items), net working capital is only $30.5 million (unrestricted cash + A/R – A/P).  But I have also deducted all the debt on the business, including the $60 million L+250 (government supported) Welcome Fund loan.  In practice, the company would not pay this back so it can comfortably debt finance an excess of its working capital needs.  And lastly, some may ask, “If the company has $105 million of what you consider ‘excess’ balance sheet value, why did they cut the dividend?”  To start, I think this management is very conservative so it prefers to be considerably over-capitalized which is probably the right move given the cyclicality of the industry.  I think the bigger reason, however, is that this is a very opportunistic management team.  So while $105 million is a lot of excess cash relative to a $73 million market cap, containerships cost more than $200 million to buy and product tankers cost $125 million so substantial cash is needed if the company is considering partnering with a shipping company to make an equity investment in some of its ships.

I have one final point, aside from what I mentioned in the beginning, as it relates to this being a better business than many people realize.  Unlike global shipyards and shipbuilding contracts which require minimal payments by the buyer until a final lump sum payment at delivery, typical U.S. shipbuilding contracts have frequent milestone payments.  Looking at the company’s balance over the past 10 years, there are many circumstances where shipbuilding customers have paid upfront more than PHLY has invested in construction dollars so the capital intensity of this business, contrary to what many people would expect, is very low.  Couple this with government supported debt funding, this is a business that can earn extremely high returns on equity capital.

Lastly, some investors may be wondering how $650 million has been invested into this shipyard but PP&E is only $50 million?  The reason for this is because PHLY doesn’t actually own the yard, it is controlled by the city of Philadelphia and leased to PHLY under a 99-year lease with annual lease payments of $1.  The only stipulation to this lease is that PHLY must employ at least 200 people (current employees of nearly 1,300).  So, while this doesn’t benefit PHLY shareholders from a liquidation perspective, it’s an incredible deal from a return on capital perspective.  While the yard is operating, PHLY gets all the cash flow associated with the shipyard (PHLY “owns” the yard from a going-concern perspective but not from a liquidation perspective).  I think it helps bring some perspective to my $150 million equity value and why there is no risk of any competition (the market certainly couldn’t handle another large-scale Jones Act shipyard but if an enterprising person with a lot of capital wanted to build a shipyard to displace either PHLY or NASSCO, it would cost ~$650 million to create something that I think is only worth $150 million based on its future cash flows).

RISKS

• ·         Repeal of the Jones Act: I didn’t spend any time on the Jones Act as it very easy to learn about (this was long enough…).  Personally, I think the risk of the Jones Act going away is very small.  It is nearing its 100-year anniversary with the only notable pushback by John McCain in 2010 with very little traction.  People can debate how risky this is, but I think everyone would agree that there is little chance this law is changed during a Trump administration.  It is the “jump to zero” risk for why I use a 6x multiple to value the business which I think is conservative given the durability and high free cash flow generative characteristics of this business.
• ·         Continued time lapsing between now and a new shipbuilding contract.  I think this risk is substantially mitigated by the current cheapness of the stock but there will be cash burn associated with an idle shipyard.  The company has substantial cash cushion to cover many years without a contract and management has stated in the past that it would be willing to liquidate the yard if long term prospects were fundamentally challenged.  The Jones Act provides downside protection here (while it is also a risk) because having U.S. shipyards with the ability to build and operate ships is the entire purpose of the law (which has been in place with limited objections for nearly 100 years).  I think if Philly Shipyard decided it would be better to liquidate than to continue operating, government agencies would step in with support (as they have done in the past).

Catalyst

• Delivery of Philly Tankers vessels and conversion of the Philly Tankers equity investment to cash – I think this will clean up the balance sheet making the significant balance sheet value more apparent than it currently is (last vessel will be delivered in 4Q17

• ·         New contract signed growing backlog and providing further cash flow certainty beyond 2019

• ·         M&A.  It has long been rumored that Aker ASA would consider taking this company private again at the right price.  It is capital inefficient for Aker to have this as a public company because a substantial cash cushion is needed during times of uncertainty (as is the case currently) but if it were a wholly owned subsidiary of Aker, it could move cash between companies with ease optimizing the productivity of the capital.