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While volatility is still expected, the market in general looks as though it has found its bottom for the current cycle at least. Of course, with the US government now reporting a shrinking GDP and even formal measures indicating a full blown recession, further downside is certainly possible. But even with that risk, there are a number of companies trading at a considerable discount. Like every market correction or significant drop, prices will recover over the course of the next couple of years at the latest. That’s not to say that some companies won’t declare bankruptcy or disappear, they will. So although the entire market is on sale, it’s still important to pick companies with strong fundamentals.

As you know if you been watching the news, anything with the word “bank” or “finance” in its name has been effectively badly battered as investors have sought, and rightly so, to distance themselves from the possibility of damage due to the mortgage credit default swap debacle. However, there are some companies that are in specialized niche financing operations that might have been hit a little too hard. Let’s take an in depth look at one of those companies.

Ship Finance Limited (NYSE: SFL) owns ocean going vessels. They own dry bulk freighters, oil tankers, and deep sea drilling rigs, all of a number of different types and sizes. They are closely affiliated with other ocean shipping companies such as Frontline (NYSE: FRO) and Golden Ocean (Oslo Bourse: GOGL.OL). By closely affiliated, I mean they share the same major owner, Norway’s John Frederickson. Ship Finance Limited buys ships and then leases them out to companies like Frontline who operate them. Most of Ship Finance’s vessels are leased out on very long-term leases, meaning that Ship Finance can predict its minimum monthly income for those vessels very accurately.

I say 'minimum income' because many of those contracts also contain a profit-sharing provision. In other words, if Ship Finance leases a tanker to Frontline for a flat daily rate, Ship Finance gets that rate whether the vessel is working or sitting idly. However, the profit sharing provision ensures that if Frontline is able to secure a contract for the vessel in excess of an agreed base daily rate from an Oil company, then as much as 50% of the amount Frontline receives over and above an agreed upon plateau level is payable to Ship Finance. In good times, Ship Finance has great upside potential. In bad times, they are guaranteed a profit by the base lease rate of each vessel.

Ship Finance does borrow money to finance its own acquisition of new ships; however, the debt is backed not only by the asset value of the ships themselves, but also by the value of the long-term lease contracts. The one major risk that Ship Finance faces is the possibility that one or more of its major leasing clients will declare bankruptcy and void its leases. In this event, the leased vessels are returned to Ship Finance, and Ship Finance can lease them out to other shipping companies. With the reduced international trade that goes on during a global recession, however, it might be that Ship Finance cannot find a new lease for any returned vessel, at least not at a highly profitable rate.

In this case, Ship Finance would have to continue paying the debt on the vessel without significant income being produced by that particular vessel. This scenario is plausible if not likely, so Ship Finance does hold some risk as long as the economy stays weak. Oil demand is slowing, US imports are certainly slowing, although this is helped by the strong dollar. However, when the recession ends, expect Ship Finance to do well. Let me tell you why.

It has been feared for a couple of years now that around 2009 we would see a glut of new ships entering the market. This, analysts said would drive down the daily rates that shippers could charge for the hire of their ships, perhaps to the point of a net loss. This is because of the visible order book of new vessels. It takes a long time to build a big oil tanker or dry bulk freighter and there are relatively few shipyards capable of producing them. That means everyone can count the number of new ships being built and ordered. The completion dates are visible to the world as well.

What isn’t as visible is the health and capabilities of some of the shipbuilding companies. Some of these shipbuilders are quite new and have delivered few if any actual vessels to date. Furthermore, when they took the orders, they locked in the prices for the completed vessels. If the price of steel goes up, the shipbuilder generally eats this loss and their margins are eroded. On the other hand, the shipping company must generally pay the shipbuilder several installments during the course of the building. Since new vessels can run from tens of millions of dollars to well over one hundred million dollars apiece, these payments can be quite substantial. The shipping company almost always seeks financing to make these payments. In the current credit climate, many of the smaller players are unable to secure that financing. This has resulted in the cancellation of a number of shipbuilding contracts in the past year. This, to some extent has helped reduce the fear of a glut of new ships in 2009. The outlook, for shipper’s and for Ship Finance’s profit sharing upside, might be a little healthier in the medium term than previously thought.

In the last twelve months, Ship Finance has traded in the range of $32.43 and $23.54. That is up until the market went haywire in September. Since then is has been hit very hard, hitting a low of $10.92 on October 27th. Since then it has been steadily rising to over $14. That’s about a fifty percent discount to its usual price. There’s one more little fact to throw in to the mix. On September 16th, Ship Finance announced that it would raise its quarterly, dividend to $0.60 per share. Yes, I said quarterly, so that amounts to $2.40 per year if they continue to hold to that level. That would be a 16% dividend yield at $15 per share. To date, the company has been very steady in its dividend payments, though it hasn’t faced a global economy like the one we face today.

So although there is some risk if Ship Finance’s clients cannot remain afloat and continue to make their guaranteed lease payments, Ship Finance has been heavily discounted. If you’re looking for bargain prices, look for other specialized finance companies and evaluate their business environments as thoroughly as you can. Some of these companies have been dramatically oversold, some are priced correctly, and some should carry big warning labels. I leave it up to you to decide into which category Ship Finance Limited falls.

Disclosure: none

Source: Ship Finance Limited: Hit Too Hard?