In life, one of the rarest mental states is the state of certainty. As Benjamin Franklin once said: "Nothing is certain but death and taxes," this fantastic quote humorously reminds us of how little in life can be objectively predicted with certainty; ergo the sun rising in the east or the various lunar phases. Aside from scientifically well understood events, the state of certainty is just as rare in the world of finance where market participants with a certain view of financial events can capitalize when valuations do not yet reflect a certain outcome.
Knowing this, Infitialis focused on a niche segment of finance where we could project with certainty the ultimate outcome providing significant profit opportunities for our readers while preventing unnecessary losses for retail investors that do not have the expertise to conduct in-depth research. Since August, we have published 9 reports exposing alleged fraud or folly. Every single company we reported on experienced declines of 20% or more with some companies declining by over 99% and one company even being halted by the SEC following our expose.
Today we present a report on a company that provides what we believe is one of those truly rare opportunities in finance: a certain outcome. We decided to write this report after being challenged by one of our readers. Following a rudimentary review of the fundamentals, we explained to the reader that the company was a guaranteed zero alas they remained unconvinced. As a result, we decided to back up our claims with facts and figures that will demonstrate to any reader why Overseas Shipholding (OSGIQ.PK) equity holders receiving zero is as certain of an event as the sun rising tomorrow, death, or taxes.
A Bankrupt Company Bid Up By Naive Penny Stock Traders
Overseas Shipholding Group, Inc. is a New York Based shipping company that recently filed for Chapter 11 Bankruptcy Protection on November 14, 2012. Since then, shares of the company have been delisted from the NYSE to the pink sheets where the ticker has been changed from OSG to OSGIQ.PK. Initially, shares of the company declined by 60% following the bankruptcy announcement, but over the past week retail penny stock traders have bid up shares causing a rise of over 100% with the shares nearly touching their pre-bankruptcy announcement level of $1.00 a share on Friday, November 23.
To most logical investors, this graph may seem a bit crazy: Why would a bankrupt company trade higher immediately after filing a non pre-packaged Chapter 11 confirming the company is unable to pay its debts? Luckily this was not our first rodeo into penny stock land and our previous forays provided some much needed color. After all this was the wild west of finance where in less than four months we witnessed multiple cases of worthless companies with no cash at all and virtual offices be bid up to near billion dollar valuations only to drop like rocks once the herd recovered their senses. But what bothered us most about this recent case of penny stock madness was when we noticed retail investors touting the "wealth surplus" in the equity shares of or the potential for the equity holders to "win big" if/when the company emerged from Chapter 11.
Some of our more astute readers may have already picked up on the fact that the Infitialis collective of analysts specializes in the distressed securities space. As a matter of fact, when we are not exposing frauds and scams, we get paid very handsomely to analyze distressed and esoteric securities. In other words, distressed securities such as this are our bread and butter and so we enjoyed this opportunity to provide our readers with an all-encompassing review of how bankruptcy proceedings work and why there is absolutely no chance for equity holders to be left with anything at all.
A Quick Primer on Bankruptcy and Capital Structure
When analyzing bankruptcy situations, investors should be cognizant of and/or guided by three key tenets:
1) Bankruptcies are negative - No matter what management says, bankruptcies are always bad for both the company and its investors. Simply put, a Chapter 11 filing is an admission on the part of management that the debt load has become too large and unsupportable by the disclosed value of the underlying assets. This is a very important fact that distressed investors have to be cognizant of as a Chapter 11 situation should only be viewed as a cure for what is either a flawed business model, over-indebted capital structure, or a combination of the two.
2) Debts, obligations, and encumbrances are stacked in a hierarchy that leaves the common equity holders at the bottom - In a bankruptcy, all the obligations of the company are stacked. Once a liquidation or reorganization plan is approved by the courts, the net proceeds from an asset liquidation or, if chosen by creditors, the value of the reorganized entity is distributed to the debt holders first with only the remaining piece (should there even be one) distributed to the common equity holders. In other words: Common Equity holders will get paid LAST, only after all debts and obligations are paid.
3) Bonds being senior are the single most important leading indicator for any potential equity recovery - Whenever a bankrupt company has tradeable bonds, investors should look to those prices when trying to assess the potential for any equity recovery. The logic is extremely simple: Bonds trading at or near their par value (the price which reflects 100% principal recovery for bond investors) indicate that market participants are anticipating that there is enough asset value to fully cover the debts and obligations. However, when bonds trade at a significant discount to par value, investors should look to that mathematical discount as the formula from which to project the true value of the assets.
OSGIQ: A Vanilla Bankruptcy With an Obvious Surplus of Debt to Equity
Using the short primer we provided we will now walk readers through the capital structure of OSGIQ. Contrary to what some penny stock promoters may try to sell, this is not a GGP situation (where the assets being prestigious tangible shopping malls actually appreciated in value while in bankruptcy) nor is it even a Dynegy situation (where after much fanfare and several outspoken equity investors claiming sufficient asset coverage equity holders still got shafted).
OSGIQ is a simple bankruptcy situation to decipher because it is a business that has no discernable moat or durable competitive advantage, no brand at all, no strategic irreplaceable trophy assets, and no intellectual property. This company is in the seaborne transportation market with its assets consisting of some cash and 63 rapidly depreciating vessels encumbered by nearly $3 billion in debt. There is no reason for any business to use the services of as opposed to the plethora of other seaborne shippers as the industry has become highly commoditized with rates being valued weekly via a market based system transparently driven by supply and demand. Moreover, the industry is plagued by pronounced cycles of booms and busts with one of the worst busts being experienced currently leading not only to significant declines in shipping rates but sharp declines in the asset values of vessels.
These reasons are part of what led to the bankruptcy for with the business becoming worthless over the past few quarters as the double whammy of rate and demand declines led to significant losses with the company burning over $275 million in cash in the 6 quarters from March 30, 2011 to June 30, 2012, equating to a quarterly burn of $46 million. Adding insult to injury, the company has not filed financials since June 30th 2012, with the Audit Committee officially declaring the financials as unreliable on October 19, 2012 , providing the first sign of the company's insolvency to the market and leading to over 60% declines in both the debt and common stock.
For a company like OSGIQ, a Chapter 11 proceeding will be relatively straightforward and expeditious with only two likely outcomes that would provide an exit from Chapter 11:
1) A liquidation and/or a distribution of ownership of the assets (cash and vessels) to the creditors.
2) If solvency can be achieved (a tall order in this case) and the desire exists (unlikely), a combination of (1) plus a pro-forma better capitalized entity could emerge with the creditors converting a portion of their debt to equity.
As bonds trade at between $0.30-0.40 on the dollar (indicating that only 30-40% of the debt will be repaid) the odds of scenario (2) are of very low probability. More relevant to this report is that equity holders only stand a chance to receive anything under scenario (2). Unfortunately for equity holders, as we will detail in the next sections, the true debt load when weighed against the true asset base confirms the bond pricing as fair and the common stock as wildly overvalued.
An Accurate Review of Both Assets and Liabilities Confirms Equity Is Worthless
In this section, we will objectively tally up both assets and liabilities of OSGIQ. As we noted, the assets per OSGIQ's own audit committee should not be relied upon nevertheless we have constructed a model that provides a range we are comfortable with and which reconciles with the bond valuations that project a 30-40% recovery on the debt.
In the table below, we have tallied up the debts using both the Bankruptcy Filing as well as the most recent 8-k filed with the SEC. We have also provided pricing on the bonds that were exchange traded. It is important to stress that there may very well be additional debts/obligations and/or encumbrances that emerge as part of the Chapter 11 process.
As readers can see, the total tally comes in at $2.73 billion, a whopping figure that must be fully paid with interest owed prior to any equity holders being in any position of recovery.
Against this table of liabilities (which could ultimately be larger due to undisclosed obligations in the worst case) weigh the assets from which the bond and equity investors hope to recover their capital.
There are several issues with the asset side of the balance sheet for :
1) The company has not filed financials since June 30th, making it more difficult (but not impossible) to estimate its financial health, specifically its cash balance.
2) Even if one wanted to believe the asset side of the balance sheet, the Audit Committee itself stated that the financials should not be relied upon, making it clear that there are to be major impairments made on the asset side of the ledger.
3) Even if relying on the outdated June 30th, financials over 80% of the assets on the balance sheet consist of vessels which are supposed to be carried at cost minus impairment but for which OSGIQ had not made any meaningful impairments in nearly 4 years, a time which saw vessel prices decline by as much as 50%.
With this understanding, we will now review the asset side of the balance sheet from June 30th and make adjustments that we believe provide a more accurate picture of the company's financial health.
Tangible Assets as of June 30 2012
Total Tangible Assets
Operating under the assumption that the financials should be relied upon (even though the audit committee asked us not to do so), we must first adjust the cash balance to reflect the business period from June 30, 2012 to November 14, 2012 (the date of the bankruptcy filing). Over the past 6 quarters, the company has produced negative cash flow of $46 million per quarter ($15.3 million per month). Since June 30th, business conditions have only deteriorated for seaborne shippers with shipping rates and demand declining making it not only plausible but highly probable that the company continued to burn cash at the same rate. Therefore, we predict that from June 30 to November 14, it has burnt an additional $69,000,000 in cash ($15.3 million multiplied by 4.5 months). Following this exercise which we believe to be very conservative, we project that the company currently has a cash balance of $157 million.
For simplification purposes, we are going to assume that all receivables and inventories will end up fetching their entry values. The reality is that those assets will most likely fetch 30-70% of their entry values but because the overwhelming majority of the assets consist of vessels, we need only to quantify the true value of the vessels in order to prove that the asset side of the ledger falls short of the $2.7 billion in debts and obligations.
Everything Hinges on the Value of the Vessels
The OSG business has not produced free cash flow since 2006. Not only is the business wildly unprofitable, it is truly a liability to any purchaser in its current form. There is neither a discernible brand nor moat nor any intangible asset that would garner any premium above what may be reflected on the balance sheet. We stress this again because as we reach this stage of the analysis, it becomes crystal clear that any prospects for recovery at all for creditors will come from a liquidation of the vessels to the highest bidder.
The company values its fleet of vessels at $3.18 billion as of June 30. This valuation bears no relation to reality. For one, the company has impaired its entire fleet of vessels by only $300 million since 2004 instead choosing an approach which allowed the company to leverage its fleet by utilizing its holding company's top line revenues via credit facilities and bonds as opposed to individual collateralized deals on a per vessel basis. This is very analogous to how banks financed themselves during the housing bubble by utilizing holding companies and marking their loans according to internal models. Let us review in detail how OSGIQ values its fleet from the most recent 10-K filed with the SEC:
The notion that OSGIQ vessels are worth $3.2 billion today is one that is completely unrealistic. As bond investors have indicated by rerating the bonds to the $0.30-$0.40 on the dollar levels, a more realistic valuation for the vessels would be in the $1.5-$2.0 billion range conservatively. This is partly why on Friday bond investors decided to sue Citigroup (C) and Morgan Stanley (MS) for signing off on the OSG financials and underwriting the bonds. It is imperative to remember that we are not talking about a portfolio of appreciating tangible property such as power plants or real estate. Shipping tankers are rapidly depreciating assets much like automobiles and airplanes. Coupled with a terrible macro-environment, a fire sale of vessels may in our view fetch only $1.0-$1.3 billion in the present environment.
More Realistic Valuation of Vessels:
VLCCS (Includes ULCCS)
Total Other International Flag
Total US Flat Vessels
We conducted three separate valuations of the fleet. Of all three, this was the most optimistic amounting to roughly $2 .0 billion in value for the fleet which was why we decided to use this valuation when constructing our valuation model for OSGIQ.
Using a more appropriate valuation for the fleet, we can now construct a more realistic snapshot of the actual assets available for recovery:
Infitialis Pro-Forma Potential Recovery Table
After subtracting the $69 million in cash that was most likely lost in the period between June 30 and November 14 and incorporating a more realistic valuation for the vessels, we are left with the following assets. It is important to keep in mind that in this table we assume all receivables and inventories are worth their June 30 entries even though that is also highly improbable.
Even when trying to give OSGIQ every chance by valuing the vessels at our most optimistic valuation and including nearly $270 million in inventories and receivables, we are still left with a deficiency of $237 million when weighed against the debts and obligations of $2.73 billion. Moreover in our exercise, we have made the assumption that OSGIQ will pay no taxes on any of the proceeds from a sale of the vessels when in reality there is nearly $300 million in deferred tax due to tax related depreciation taken on the vessels over the years. The assets do not provide enough of a cushion to even warrant a punt for equity holders. Again, had the portfolio of assets consisted of real estate or even securities, there may have been an investment case made as to potential future appreciation, but given the assets are rapidly depreciating vessels, there is no investment case at all.
Experience Teaches Only The Teachable... Aldous Huxley
Had the balance sheet truly been as rich as management of OSGIQ marked it, the company could have easily supported the $2.7 billion debt load. In reality, the vessels require significant impairment in the order of 40-60% while the business itself is worthless producing losses of $50-200 million per annum. While we have done a lot of work here, we have merely confirmed what the bond prices already told us: equity is a guaranteed zero. No macro environment will change this fact as the committee of creditors will likely decide to liquidate the vessels and distribute the proceeds expeditiously. Conversely, if the creditors see value in a reorganized entity, they will be the ones to own that entity in its entirety.
Disclosure: I am short OSGIQ.PK.