Description
How would you like to own a bond yielding 18% with almost no chance of default and an upside kicker that could be worth an additional 500 basis points of yield? Well this isn’t actually a bond. Instead, it is Ship Finance International LTD (SFL: NYSE) a very recent spin off from Frontline LTD (FRO: NYSE). I think of it like a bond because there is little or now growth, but the company’s revenues and hence earnings are guaranteed.
I think that we have all seen “sale and lease-back” agreements where a capital asset is sold and then leased back to the parent company. The parent company can then focus on managing that capital asset along with the much higher returns involved. The bank can meanwhile earn a steady and predictable return on invested capital.
Frontline has decided to focus on the chartering of oceangoing vessels and not the ownership of them. This is directly from one of their filings.
"The main strategy is that Frontline over time shall be a world leading chartering company which will adjust the exposure to the market depending on where in the cycle we are. As a part of this strategy Frontline will divest the ownership of Ship Finance.
Frontline will have a good financial position after the spin off. Total recourse bank debt in Frontline after this will be less than $23 million. The main purpose of the split of Frontline was to obtain access to cheaper and different kinds of financing instruments. It is Frontline's intention to use the strong financial position which has been created, combined with an effectively priced equity, to continue the consolidation of the tanker market."
To accomplish this, the company has decided to package 46 vessels and the majority of its debt into a separate entity and spin it off to shareholders. FRO will then lease all of these ships from SFL. Naturally, this is the sort of thing that would make any bank uneasy. To appease the banks, FRO has guaranteed the revenues for these ships for the next few years according to the following lease rates per day.
Year VLCC Suezmax
2003 to 2006 $25,575 $21,100
2007 to 2010 $25,175 $20,700
2011 and beyond $24,175 $19,700
Let me throw another large chunk of legalese at you:
"Ship Finance’s vessel owning subsidiaries that it acquired from us entered into fixed rate management agreements with Frontline Management. Under the management agreements, Frontline Management is responsible for all technical management of the vessels, including crewing, maintenance, repair, certain capital expenditures, drydocking, vessel taxes and other vessel operating expenses. In addition, if a structural change or new equipment is required due to changes in classification society or regulatory requirements, Frontline Management will be responsible for making them, unless the Charterer does so under the charters. Ship Finance expects that Frontline Management will outsource many of these services to third party providers.
Frontline Management is also obligated under the management agreements to maintain insurance for each of Ship Finance’s vessels, including marine hull and machinery insurance, protection and indemnity insurance (including pollution risks and crew insurances) and war risk insurance. Frontline Management will also reimburse Ship Finance for all lost charter revenue caused by Ship Finance’s vessels being off hire for more than five days per year on a fleet-wide basis or failing to achieve the performance standards set forth in the charters. Under the management agreements, Ship Finance will pay Frontline Management a fixed fee of $6,500 per day per vessel for all of the above services, for as long as the relevant charter is in place."
When we do up the numbers, here is what the total guaranteed payout from FRO to SFL looks like. Mgmt & Admin Fees is the combined maintenance cost of $6,500 daily for each ship that SFL owns.
All numbers in $USD Millions.
Year Charter Payments -- Mgmt & Admin Fees == Net Contracted Payment
2004 395.1 113.3 281.9
2005 394.1 112.9 281.2
2006 394.1 112.9 281.2
2007 387.3 112.9 274.3
2008 388.3 113.3 275.1
2009 383.0 112.9 270.1
2010 370.4 112.9 257.5
After 2010, the rules change. I’ll explore that more below.
FRO is also offering SFL a profit sharing agreement. Under the terms of this agreement, SFL gets 20% of the charter revenues realized by Frontline in excess of the average rates of $25,575 for each VLCC and $21,100 for each Suezmax. I will not include this profit sharing figure in the rest of the calculations, but return to it later.
The ‘Net Contracted Payment’ line shows what SFL will get from FRO. It is kind of like EBITDA (except here is the twist). There are no taxes since it is a Bermuda company. Depreciation is a book entry expense, but there is no maintenance cap-ex cost. The $6,500 daily management fee covers all of that, hence this is not a cash cost at all and we can ignore it. Instead, we are mainly looking at free cash flow before interest here.
Let’s look at the interest expense. The company has $1.638b in debt, which is broken down into $580m of 8.5% senior notes, $500m of debt fixed by an interest rate swap at 3.2% and $558m of debt that floats at LIBOR +1.25. Given current rates, the net interest expense will be about $75m a year.
Finally, lets assume a rather robust $5m in corporate overhead expense. Taking $281.9 in net contracted payments and subtracting $80, you get a total cash flow of $201.9. There are 73.8m shares of SFL outstanding. Therefore, cash flow comes in at $2.74 a share.
With the current quote at 15.5, it is trading at 5.6X guaranteed recurring cash flow. It also has a $.25 quarterly dividend, which means that it yields 6.5%. Clearly, this stock is VERY cheap. Now here is where it gets juicy. Lets look at this profit sharing agreement a bit more. Now, I do not know much about the shipping industry other than that it is very cyclical. Peaks are very high and troughs are even lower. I do not want to make any judgment about the direction of lease rates, however I will point out a few facts.
Firstly, we are most likely near the peak of the cycle. There is a lot of ship building underway. When this comes online, it will certainly depress prices. I will argue, however, that the coming trough will not be anywhere near as deep as previous ones. The first issue is the imminent scrapping of all single hulled vessels in the industry, which is mandated to occur in 2010. As lease rates begin to trail off, I think that we will see accelerated scrapping of older ships in advance of this date; especially since scrap metal rates are so strong now. The scrapping of single hulled vessels after 2010 will take a lot of capacity out of the market.
Secondly, the US is loading an increasingly large percentage of its crude in the Middle East and the Black Sea area. This differs from even very recently when we drew much more crude from closer locales like Argentina, the Gulf of Mexico, Nigeria and the North Sea. This means that more shipping hours will be needed for each barrel we consume since a return trip is necessary from the US all the way back to the Persian Gulf. Thirdly, recent pipeline destruction in Iraq has created numerous bottlenecks all along the supply chain. Day rates spike when ships are sitting motionless awaiting loading. Finally, world oil usage is continuing to increase at a healthy clip. Someone has to transport it.
The SFL first quarter outlook says that if rates achieved thus far this year into the 2nd quarter remain constant, the company should receive $74m from their profit sharing agreement. This would amount to just over a dollar a share in additional cash flow. That would bring total cash flow to $3.74 and give you a price to cash flow of 4.1. I will not argue that these profit sharing rates are sustainable for more than a few quarters, but after that, I would guesstimate that SFL should receive about half of this rate going forward.
Of course, a stock this cheap is an anomaly. Why is it cheap? Firstly, 18 of its ships are single hulled. This means that after 2010, they will no longer be allowed to operate in most ports and will not be eligible to participate in this charter agreement. When these 4,017,000 dwt are scrapped, assuming current rates of $270 a ton prevail, the company should receive $1.085b. If scrap rates drop to $200, they will receive $803.4m. In either case, these ships are held on the books at much less than fair value. The company should receive enough money to pay back about half of the outstanding debt or dividend between $10.89 and $14.70 of the scrap income to shareholders. This alone nearly covers the cost of the shares. If crude costs remain high, it is possible that governments extend the moratorium on these vessels by a few years, to drive transport costs lower. In this case, they will continue to bring in cash flow.
Secondly, I want to discuss is the current share overhang. FRO only spun off a quarter of the shares outstanding or 18.4m shares. They still own ¾ of the shares outstanding. I do not know what their intention is. I am guessing that they did a spin off so that they could establish a market price and then either do a secondary offering of the rest, or spin those shares off to existing FRO owners. FRO has stated that they intend to dispose of these shares by the end of 2004. In either case, this will keep a strong lid on the shares for the foreseeable future and is probably responsible for the abnormally cheap trading price. I personally am willing to wait a year to see what happens while I earn a nice dividend.
The last question is how safe is the chartering agreement. I do not want to say that it is guaranteed, but FRO has put up $250m as an assurance that even at the trough in the cycle, they can pay the full costs of the charter. This looks pretty much assured as long as the world continues to need crude.
For me, the big question is, what will happen to all this cash flow? That is a big question indeed. $93.7m is slated each year to the banks so that they can pay down some of the debt before the single hulled vessels come off line. Another $73.8m is slated for shareholders in dividends. This leaves $34.4m plus any cash flow from the profit sharing agreement. I do not know what will be done with this. My guess is that the company will both increase the dividend and also continue to purchase ships and lease them back to Frontline on similar terms as these. They may also try to pay down more debt, or more specifically try to refinance the 8.5% bonds at a much lower interest rate. At current rates, it would save the company another 25 cents per share. No matter what happens, I think that it will only benefit current shareholders in the coming years. SFL has the same management as Frontline and Frontline has normally taken care of shareholders, especially since the chairman owns about a quarter of it.
Finally, I would like to touch briefly on today’s news. SFL has sold 1.6m shares at 15.75 for a net purchase of $25.2m. The company is considering a number of options. One such option is the purchase two newbuildings. The company currently owns one option already. While I am disappointed at the low share price received, sometimes companies have to take advantage of options as they appear. I assume that this will be accretive to current shareholders. In the same press release, the company says that the “board is optimistic that the company’s long term minimum dividend can be increased from the existing $1.00 per share. The board is expected to comment further on this issue in connection with the release of the company’s second quarter results.” I think that tells you what you need to know. This company intends to grow and also continue returning excess capital to shareholders. At the current quote, I think that the downside is very negligible, while the upside could be a double or more. I normally do not pick stocks that could not be at least 5-baggers, but given how limited the downside appears, I think that it is worthwhile to sit back and wait for the risk free double, along with a few healthy dividends.
Disclosure: Long
Possible negatives:
1. FRO dumps ships on SFL with lease rates that are unattractive.
2. Tanker rates drop precipitously and SFL does not get any profit sharing.
3. The company does something stupid with all the cash flow and buys many more ships at the top of the cycle.
4. Scrap rates drop and the company can not get much for their single hulled vessels.
Catalyst
FRO decision on what to do with overhang.
Management raising dividend.
Investor recognition of how cheap it is.