Description

We believe we have found the AFH US situation from three weeks ago on steroids.

For those unfamiliar with Atlas Financial Holdings, Inc. (“AFH” or “Atlas”) and its thread on VIC, a quick review might be helpful.  On May 13, Atlas announced a $30M capital raise underwritten by Sandler O’Neill (“Sandler”).  AFH had posted strong Q1 2014 results just a few days earlier, and there was heavy upward buy-pressure on the shares following earnings.  AFH stock closed at $15.01 per share the day before the offering commenced.

Pre-raise, AFH was a ~$140M market cap company with modest liquidity (~30k shares per day).  As soon as the raise was announced, the bid in the market disappeared – why purchase shares in the market when you can buy at a discount in the offering? – and the stock began to leak downwards.  The sell pressure was made worse by Sandler, which mismanaged the deal by “talking down” the shares for the duration of the five-day roadshow.  By the time the offering priced on May 21, AFH stock had fallen 2-5% per day for a week straight (for a cumulative decline of nearly 20%) and the deal went off at $12.50 per share.

In the three weeks since, AFH shares have recouped the decline and then some; AFH now trades in the high-$15’s.  The $12.50 mark proved an extreme outlier, just another example of a small-cap company getting screwed by a poorly-executed investment banking deal.  For those able to participate in the raise or in the open market just after, however, AFH has been a home-run investment.

Now imagine the following:

• Instead of a $140M market cap company doing the raise, it’s a company less than half that size (a market cap of $50M when the offering was announced)
• Instead of a five-day roadshow after announcing the deal, the company does a three-week roadshow (allowing 3x the amount of time for the stock to be “talked down”)
• Instead of a stock with an ADV of 30,000 shares, it’s a stock with an ADV of <5,000 shares
• Instead of using a mid-market broker to do the deal (Sandler O’Neill), the company uses a small-cap / micro-cap broker to do the deal (Aegis Capital)

So what do you get?  A stock that has gotten absolutely crushed for non-fundamental reasons.  Shares in the company traded down 5-10% per day almost every day for three weeks straight, tallying a cumulative decline north of 60%.  From a mid-high single digit stock price pre-deal, the offering priced three days ago at $2.00 per share with 50% warrant coverage at a $2.50 strike price.  The shares currently languish at $1.81 per share.  The chart is a straight line down.

The company is Top Ships Inc. (NASDAQ: TOPS, “TOPS”), a product tanker shipping company.  In our view, shares currently trade for less than half of NAV after taking into account the full dilution from the raise.  Comps trade at 1x NAV and historically have traded at 1.1x-1.3x NAV.  Our thesis is that as the dust settles post-deal, flippers from the raise finish exiting, the company takes delivery of its first ships, and management launches a significant investor relations and media effort over the coming weeks and months, that the stock will trade back to NAV or slightly above.  This represents a 2-3x return from the current stock price.

The Business

Top Ships Inc. is a Greek shipping company listed on the NASDAQ.  The company was the first of the Greek shipping companies to list in the US back in 2004, and was a high-flyer for a number of years on the back of the shipping bubble driven by the global commodity boom. 

In early-2008, at the top of the cycle, the company sold 2/3 of its fleet (which was fantastic timing) and locked-in longer-term contracts on the remainder.  It didn’t matter.  The 2008 post-Lehman burst devastated the entire shipping industry with many (most) comps going bankrupt or defaulting/restructuring their debt in the crisis’s aftermath.

TOPS was one of the few that survived – but only barely.   The company managed to sell down its assets over a multi-year period, paying back its lenders in full and coming out the other side as a NASDAQ shell company with a small bit of cash left over.  From its 2004 IPO at $11 per share, the company paid back $9 in dividends, so early investors came out pretty much break-even.  But by all other measures – and especially if an investor came in during 2007 or 2008 – this has been a disaster of a stock.

The recent equity raise is the company’s “re-start” to try to rebuild what it once had.  Its go-forward strategy is to enter the product tanker market (shipping refined oil products).  This is a good business relative to other shipping sectors because (i) there are only a few shipyards that make the boats, as product tankers are much more sophisticated to build than, say, a dry bulk ship, (ii) the structural demand drivers are good as refineries are increasingly being built closer to where oil is produced, so instead of shipping crude from Arabia to Europe now a refined product is being shipped from Arabia to Europe, and (iii) new ships are much more fuel-efficient than older boats, so many older boats are getting scrapped.  Crude oil tankers cannot be converted into product tankers, so go-forward supply growth is effectively “capped” by shipyard capacity.

Putting it in numbers, demand (measured by ton-miles) is growing at 6%+ per year, all the shipyards that make new product tankers are maxed-out in orders through 2017, and even then the total fleet capacity will only grow 3-4% per year due to the number being scrapped.  The ships ordered by TOPS are ECO tankers, which are 25% more fuel-efficient than legacy product tankers and therefore able to charge premium rates.  ECO tankers represent less than 10% of the total product tanker fleet today, and will still only represent approximately 22% of the fleet in 2017.   Industry data is available from the two large independent shipping consultancies, Drewry and Clarkson.

Investment Thesis

TOPS has two key assets.

One is the cash raised from the recent equity offering less outstanding liabilities on the company’s balance sheet.  As of March 31, TOPS had $3M of cash and no long-term debt but a working capital deficit of approximately $5M.  The equity raise brought in $20M from common shares (10M shares at $2.00 per share) plus $12.5M from warrants (5M warrants exercisable at $2.50 per share) less estimated banking fees of $2M, for a total of roughly $30M.  Adding these funds to the balance sheet, we reach a net asset value of approximately $25M.

The other is the value of the order contracts in hand for six vessels to be delivered over the next three years, with the first delivery expected within the next week.  These contracts were vended into the company within the last six months by the company’s CEO in exchange for shares (struck at $7 per share) and $2.5M in cash.  The contracts are tradeable in a relatively liquid resale market, so it is possible to mark them to a fairly accurate value.  The ships were ordered in 2012 and 2013 when the value of new-build product tankers were at their nadir of $34M.  Today a new-build product tanker, based on recent industry data, goes for $38-39M.

Immediately before the offering, TOPS commissioned a third-party (Arrow Shipbroking Group) to value its order book.  Arrow’s valuation was $222M, as compared to $158M in remaining commitments on the vessels, for a total net asset value of $64M.  This matches up well (and actually may be a little low) with recent comps that would indicate TOPS’s four 50,000 dwt vessels would trade for $37-39M apiece and TOPS’s two 39,000 dwt vessels would trade for $36-37M apiece.  Total paid-in capital for these vessels is $33M.  The delta between the $64M figure and the $33M figure is the increase in value of the ships over the intervening 1-2 years.

Post the raise, TOPS has 18M shares outstanding and 23M shares outstanding including the warrants.  We believe the hard-asset liquidation value of the company is approximately $90M ($25M net cash plus $64M+ net asset value of its order book).  The true net asset liquidation value of the company is therefore approximately $4.00 per share ($90M+ divided by 23M shares), or approximately 120% higher than the current share price of $1.81 per share.  Should TOPS trade at 1.1x or 1.2x NAV (the best comp is probably STNG US) the upside would be closer to 170%.  Our thesis is that management will soon aggressively move to close this valuation gap by getting in front of investors, doing media appearances, and releasing a slew of announcements including the shortly-expected delivery of the company’s first ship.  We view this as a short-term (3-6 month) trade as management focuses on getting the shares to reflect the company’s demonstrable intrinsic value.

Odds and Ends

Why did management go through with this equity raise at such a deep discount to valuation?

We believe management felt it had no choice but to execute the raise at almost any price.  Management viewed the raise as a necessary step to “re-start” the business – creating liquidity in the shares, building an investor base, and attaining the funds needed to bring the company back into a positive working capital position and to conclude delivery of the first ship.  With the first delivery imminent, management had a deadline to act against.  Longer-term, management thinks it can recreate the successes of 2004-2008.  Whether that is possible is still to be seen, but we think shares should trade at least at liquidation value.

Did management participate in the deal?

Yes.  Management accounted for $5M of the $20M raised in the offering.  We have also heard that other smart investors participated including Hayman Capital (Kyle Bass’s shop).

Will further equity raises be necessary?

Management has emphatically said no additional equity raises are required.  The company’s model is asset-light, outsourcing operations to a third-party and all ongoing operating costs (including fuel costs) to the charterer.  The business will be cash flow positive as soon as the first ship is delivered.  Incremental ship purchases are expected to be completed with debt; the company’s business plan calls for each vessel to be financed with 60% debt and 40% equity, but management believes lenders are currently willing to lend as much as 75% of the value of the vessels, freeing up capital for additional fleet expansion.

What is the counterparty risk of the contracts in the order book?

The six vessels currently in the order book are contracted out with multi-year charters that begin upon delivery to highly reputable counterparties including BP, EShips (owned by the Abu Dhabi government), and Norden A/S.  The shipyard building the ships is Hyundai Mipo Dockyard Co. in South Korea, a top-5 global shipbuilder.

The Risks

One – it’s a Greek shipping company.

Two – there are a bunch of related-party transactions.  The CEO vended the six vessel contracts into the company in return for stock.  The CEO also controls the external management company that oversees the operations of the ships (TOPS just owns the boats), much like an externally-managed REIT or a hedge fund might operate.  On the plus side, between the related-party transactions and the recent raise, the CEO does have a lot of skin in the game with nearly 50% ownership of TOPS and more than $30M personally invested into TOPS over the last 24 months.

Three – TOPS has not yet taken possession of any of its ordered ships.

Four – management previously destroyed a ton of shareholder value (unless you sold shares at the top).

Conclusion

We have made this a modest-sized but real position in our book.  We believe the margin-of-safety is large given the stock is trading at less than half of NAV.  We believe management is focused on correcting the mispricing, especially as the CEO has so much skin in the game.  We believe news flow is about to get a lot better as the first ship is received, cash flows start coming in, flippers from the raise finish exiting, and management gets in front of investors and the media.  This might be viewed more as a “trade” than as an “investment”, but we think the risk/reward is attractive and the upside is large with a relatively short timeline to get paid.  AFH dropped 20% on its raise and almost immediately bounced back 20%+ (on its way, we think, to a $30 valuation).  This one dropped 60%+ and we think can bounce back 100%+ to trade more closely in-line with its NAV.

Disclaimer

The author of this posting and related persons or entities (“Author”) currently holds a long position in this security.  Author may buy additional shares, or sell some or all of Author’s shares, at any time.  Author has no obligation to inform anyone of any changes to Author’s view of TOPS US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in TOPS US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

Catalyst