It’s been almost a decade since we had a proper bull run in the shipping industry. A reduced appetite for newbuilding orders, sharp recovery of Brazil’s iron ore exports, upcoming IMO regulations and the retrofitting of scrubbers on larger dry bulk carriers could lead to an improvement in supply-demand fundamentals.
We have also seen the Baltic Dry Index increase with 41% gains YTD. It looks like the excesses that were previously built up finally dried up, but let’s not jump to too many conclusions based on the charts.
In light of all these factors, I feel that dry bulkers will be facing an upside in rates. The positive outlook is already reflected in some degree in the market but I expect it to go higher in the coming months.
Scorpio Bulkers (NYSE:SALT) is the best among its breed of dry bulkers and I feel that the company is well-placed to benefit from any rise in rates.
Scorpio Bulkers is a marine transportation company that involves dry bulks of coal, iron ore and grain. It owns 54 mid-sized dry bulk fuel efficient ‘Eco’ vessels with an average age of 3.2 years.
Youngest Eco Fleet
Compared to their competitors, they have the youngest fleet in the industry and is among the leaders in the mid-sized segment. A younger fleet would mean that it is more fuel-efficient and have lower operating expense as compared to its competitors.
Stake in Scorpio Tankers (STNG)
On October 2018, SALT invested US$100M in Scorpio Tankers (NYSE:STNG) for approximately 54M shares, which translates to about 10.9% issued and common outstanding shares at US$1.85 per share. After a one in ten reverse stock split, SALT now owns 5.4mil shares of STNG. Their stake is now worth US$185.7mil.
STNG has the largest fleet of modern product tankers in the world. Riding on the upcoming IMO2020 regulations, STNG is currently enjoying a rise in product tanker rates and is expected to report an improvement in EBITA for the next few quarters ahead. For more information, you may also refer to my investment thesis on STNG here.
Strategy for IMO2020
In 2020, the International Maritime Organization will require shipowners to reduce sulfur emissions. To comply, shipowners will have to either;
- Install scrubbers to enable vessels to burn High Sulfur Fuel Oil (HSFO)
- Use compliant fuels with low sulfur content (<0.5%) such as Marine Gas Oil(MGO) or Very Low Sulfur Fuel Oil (VLSFO)
- Switch to Liquified Natural Gas (LNG) propulsion systems
SALT has commenced installation of scrubbers on all 54 vessels. They are scheduled to be completed by Q4-2020. In order to reduce off hire time, management has coordinated the installation of scrubbers with the vessels’ scheduled drydocks.
The Scrubber Solution
The benefits of installing scrubbers would be the fuel savings that SALT would enjoy as they have access to cheaper fuel options compared to those using MGO or VLSFO. [Editor’s notes: Multiplied across ships, travel distance, and operating leverage, this translates to a hell of a lot of savings. Some would say the ships are not even playing the same ball game.]
Currently, HSFO is about $220 cheaper per metric tonne as to VLSFO. Figure 3 below shows the savings generated per type of ship. If we assume that scrubber installation costs about US$3-5mil per ship, the scrubber will be fully amortized in 4-5 years.
Currently, there is a long lead times of 6-9 months that are required for the installation of scrubbers. Even though the installation can be completed in 2-4 months, the limited number of available drydocks that are suitable for installation means that only a small number of ships will be scrubber-equipped before the IMO2020 deadline.
Only a handful of ships will make it in time for scrubbers to be installed. Those without will have to use Low Sulfur Fuel Oil/Marine Gas Oil/Liquified Natural Gas. Demand for the IMO2020 compliant fuel will rocket – which is good too for STNG.
Another point to note is that as ships are drydocked for installation of scrubbers, there will be a decrease of ships available for charter and combine this with a slow 2.6% growth of dry bulk carrier fleet growth in 2018, it is highly possible that rates will continue to elevate.
In 2Q19, SALT reported a revenue of US$49.1mil compared to US50.4mil for the same period in 2018. Adjusted EBITA increased more than 2 times but this is largely due to fair value gains of US$52.6M for their stake in STNG. After removing all one-off income/expense, SALT would have a EBITA of US$16.8mil and a net loss of US$13.4mil.
According to management, the decrease in revenue is due to weaker rates and loss of Brazil’s iron exports and reduction in European and Chinese coal imports.
Shipping companies operate with very high leverage, hence high debt is very common for shipping companies.
As of July 2019, SALT has a debt of US$895mil and cash holdings of US$160mil. In recent months, SALT has taken measures to raise cash such as divesting their assets. We also take a look at their debt payment schedule and it seems that with their balance sheet, they are able to make the payments through to 2020.
Cash Flow Statement
Looking at the operating cash flow graph in Figure 4, SALT started to generate positive operating cashflow as the dry bulk rates started to recover from the 2016 low and it fell again after the DBI rates dropped in 1Q19.
Recently, we have seen further improvement in the charter rates and this should lead to higher operating cashflow in the coming quarters.
For assessing the valuation of shipping companies, I will be using an asset based valuation where I will be using the net book value to determine the target price for SALT
At current price of US$6.77, SALT trades at 0.5 Price to net book value of US$12.95. A comparison with its peers revealed that its P/B ratio is trading below average. As rates continues to rise, I expect a re-rating for the stock price and thus, my target price for SALT is pegged at 0.75x P/B ratio, or US$9.68 per share.
The valuation is also supported by the historical P/B ratio where it trades the highest at 0.75xP/B during the recovery of DBI in 2017. If we compare the historical P/B ratio with the ROE, it shows some correlation and we should expect P/B to continue to trade at a multiple near its 2017 range.
Stake in STNG
The difference that SALT has over its competitors is that they have a stake in STNG, a product tanker play. Currently, SALT’s stake of STNG is worth US$185.7mil, or about US$2.70 per share.
In view of the long-awaited switch to VLSFO in 2020, I anticipate major disruptions in the supply and demand for product tankers, which will drive the rates up. If that happens, the share price may continue to appreciate and contribute to SALT’s book value. Every US$1 increase in STNG’s share price would increase SALT’s book value by US$0.78.
SALT could also unlock the valuations of STNG by cashing out its investment. This would give the management a huge inflow of cash which they can return value to shareholders by either distributing as dividends or conducting share buybacks.
Investing in the shipping is fraught with risks as there are too many factors that the company cannot control. Each of these risk factors could affect the performance of the share price.
Dry Bulk Rates
The investment thesis is largely based on the fact that dry bulk rates would continue to rise towards the end of the year as we approach IMO2020.
However, if dry bulk rates continues to stay depressed or drop to abysmal levels, SALT might need to increase their debt through borrowing or secondary offerings.
The comforting point is that SALT is cash flow positive at current rate levels and their balance sheet has enough cash to match its debt maturities until end 2020.
Fuel Cost Spreads
I have mentioned that the installation of scrubber will provide cost savings coming from the HSFO/ VLSFO spreads. The current forecast for VLSFO and HSFO is US$531/mT and US$309/mt respectively, giving a cost spread of US$222.
I foresee that given the small number of scrubber-equipped ships (about 5000 by 1H2020), the fuel demand will shift towards VSLFO and MGO when IMO2020 kicks in, increasing the cost spreads further in the short term. However, as refinery efficiency improves in optimizing the blending of VSLFO, it will cause the narrowing of the cost spreads which will reduce the economic benefit of the scrubber solution.
So there is an uncertainty as to when this will happen as the shipping industry is still struggling to ensure global availability of IMO2020 compliant fuels (See https://www.bunkerspot.com/global/49100-global-intercargo-2020-still-dominates-dry-bulk-shipping-s-challenges) However, fuel cost spreads will determine whether SALT (as well as STNG) investment in scrubbers will pay off.
Global Economic Uncertainty
Due to the tense geopolitical situation that we are currently in, any deterioration in the trade war conflict would also affect the supply and demand of cargo around the world.
Referring to Figure 9 below, these are some of the challenges that SALT faces which is out of their control. Any disruption in the demand for dry bulk would affect the charter rates.
Scorpio Bulker, or SALT, is a very promising opportunity in a traditionally volatile and risky industry. Nevertheless, the current situation has made SALT an attractive investment due to the few factors;
- Strong balance sheet that is able to make debt maturity payments to end 2020.
- IMO2020 a catalyst due to company’s strategy to install scrubbers.
- Dry bulk rates have started to rise above breakeven levels.
- Investment stake in STNG to provide boost to its book value with potential unlocking for gains.
Investors must understand the risk factors that will alter the investment thesis. The risk factors could either SALT’s fortunes to soar for the next few quarters or it might turn out to be another disappointing year for the dry bulk shipping industry.
Disclosure: The Moss Piglet is long SALT and STNG. I wrote this article myself and it expresses my own opinions
Editor’s Note: long time readers of our blog will be aware that I ususally add disclaimers here. But I would also like to add some of my own analysis.
Disclaimer: I am long shipping via STNG and TNK. DYODD. Caveat Emptor.
I too am long on STNG in addition to TNK (Scorpio Tankers, Teekay Tankers). STNG was picked up on a bloomberg terminal back in May or June on a routine exploratory sweep for stocks trading under liquidation values/NAV. If memory serves me right, the share price was $16-17 per share. Net Asset Value (total assets minus total liabilities) placed share values at about $35 roughly.
Coupled with IMO2020, I believed STNG would climb but was sadly unable to capitalise due to a lack of cash, which basically had me selling lots of my other…non-traditional investments.
By the time I did unwind and get $8-$10k extra to invest, STNG had climbed to $29.10 per share, which is where I got in – punished for lack of cash I guess. I’m sitting on 20% gains now but I could have been sitting on 100+% gains. Ah well. Live and learn. But that’s ok. I think we’re still only on the 1st 100 meters of a 24km marathon for shipping and here’s why.
My thesis then and now was still simple. IMO2020 will (1) take ships off water because the cost of running is too high and some ships are too old to economically install scrubbers on (2) produce arbitrage opportunities since STNG transports fuels (3) shipyards are docked through 2021 for repairs and installations, meaning ships will hit waters late when demand is higher but supply is lower (4) ships are being produced at a slower rate than future scrapping rates.
This is in addition to: refineries needing more oil to produce compliant fuels, COSCO sanctions affecting shipping charter rates. and more ships simply intending to burn LSFO which will see rates for LSFO go up and rates for HSFO go down, increasing the spread and savings for ships with scrubbers. I haven’t even gotten into how the outperformance will mean a premium being attached by investors late to the party as well as how much more of a time advantage/cost advantage STNG will have versus all of the other ships on the market with its charter rates.
Talking of shipping charter raters, my thesis for investing in Teekay Tankers is pretty simple too. Rough calculations for NAV place its value at about $4. It was trading at $1.80-$1.90 before spiking up to above $2. But that’s not all. Low values alone won’t entice me to invest. The turn-around needs to be present or I need to be rewarded somewhere else – or I wouldn’t sink my money in. Fortunately, the turnaround is rather obvious – in charter rates.
Teekay tankers generates around $1.50 per share in annual FCF in the lower-$30k/day TCE range. (Reference slide 11).
As of the latest market rates, Suezmax rates are $136.7k/day and Aframax rates are $56.5k/day. Go figure out for yourself what kind of free cash flow that generates.
Can these rates be sustained? Probably not in the long run.
But even a short run of 1-2 months is enough to make a hell of a difference to the earnings. Shipping companies are always leveraged to hell and back. So when things go south, they go south fast (as the shiping industry has experienced for close to a decade), and when things go well, they can be more explosive than…well, Bitcoin. And I imagine most of you would remember how bitcoin looked. If not, go look it up.
Let’s talk abit of macro. Imagine you’re an oil producer and you need to ship oil. You’re almost always short on shipping. What happens when rates drop? You lock in as much charter as you can because if you don’t, your boss might fire your ass for causing the company millions of dollars for your lack of prudence and foresight. So what happens then to charter rates after they fall? Increased lock in rates at premiums is what I’m thinking. Think about that for a minute.
To sum up, Teekay Tankers should generate enough Free Cash Flow to be worth much more in addition to its being undervalued. Both companies are the sort of investments where once you take into account the risks and rough valuations, kind of becomes a no-brainer. I’ll say that Teekay Tanker does have a red flag in that it intends to burn LSFO, so once share price appreciates to NAV, I’m probably out (unless LSFO vs HSFO fuel spreads thins, which could happen but is unlikely).
Are they both likely to be multi-baggers? IE; retuning multiple times what I put in? Probably. If sanctions don’t lift, and if everything shakes out where I want, 5-10x what I invested isn’t out of the question. This is the kind of investments you want to hunt. Something so stupidly undervalued, so unfocused, so uncovered, so hated (as mentioned, shipping has been a bad industry for a decade, go figure), that you get to slip in and take it for almost free. And then, when you’re right, you’re massively rewarded, whereas when you’re wrong, you’re just slightly rewarded/punished.
Having said that, caveat emptor. You are responsible for what you buy. Don’t just jump into the waters because we did.
Do your homework.
If you’re willing to work 8hours a day for less than $3-$10k a month, you should be willing to work 8 hours a day to make much more in capital gains for your stock investments. Don’t cheapen it. Don’t slack. Don’t make excuses. You’re better than that.
I would be remiss if I did not mention that the original teacher of how to think about investments for myself was learned under the auspices of the Intelligent Investor Immersive Program. If you want to hunt how we hunt, you can do a lot worse than signing up for a seat and finding out how we do it.