Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.
I recently established a position in FreeSeas, Inc. (FREE) based on the company's undervaluation, competent management, and serendipitous chain of recent events. After evaluating these factors as a singular measurable dynamic, I believe that FreeSeas offers an ideal asymmetrical trade, with massive upside potential and minimal downside risk.
Introduction to FreeSeas
FreeSeas is a global commercial shipping conglomerate that operates in the dry bulk sector through its three wholly owned subsidiaries: Adventure Two S.A., Adventure Three S.A., and Adventure Four S.A. The company was formed in April 2004 and formally became known as FreeSeas in 2005. Primarily, the company transports iron ore, coal, grain, steel products, and other dry bulk cargos. The company is incorporated in the Republic of the Marshall Islands, but is headquartered in Athens, Greece. Currently, FreeSeas has seven ships in its fleet, composed of six Handysize vessels and one Handymax vessel.
Chairman, President, and CEO of FreeSeas Ion G. Varouxakis holds a Candidature Degree in Law from the Catholic University of Saint Louis in Brussels, and a Bachelor of Science degree in Economics from the London School of Economics and Political Science. He is also a member of the Hellenic Committee of the Korean Register of Shipping, a member of the Hellenic and Black Sea Committee of Bureau Veritas, and an Officer of the Reserves for the Hellenic Army.
From 1997 to 2003 Varouxakis was employed in the dry bulk shipping industry in a managerial and/or executive capacity for multiple private shipping entities in Greece. Then, in 2003, he started his own single vessel, self-financed, dry bulk shipping company called Free Bulkers. Due to the immediate success of Free Bulkers, and a growing demand for the company's services in the spot market, Varouxakis began the process of forming FreeSeas in 2004.
Chief Financial Officer of FreeSeas Alexandros Mylonas holds an MBA in Finance and Supply Chain Management from Michigan State University and a Bachelor of Business Administration from University of Macedonia in Thessaloniki. He has served as the CFO of FreeSeas since 2009, and assumed the responsibilities of the company's treasurer as well in December 2010. Prior to joining FreeSeas in 2009, Mylonas had proven himself highly competent in the discipline of shipping finance and management. From 2002 to 2005, he was an investment associate with NBG Venture Capital, a private equity firm investing in Southeast Europe. From 2005 to 2008, Mylonas was an account manager with the Global Shipping Group of Fortis Bank. From 2008 until joining FreeSeas, he served as the banking executive of Cardiff Marine Inc., a ship management company managing a fleet of tankers and dry bulk carriers including the fleet of DryShips Inc., a company listed on the Nasdaq Global Select Market.
A Brief History
Since its inception, FreeSeas has endured a considerably high level of volatility. This inconsistency has not only been reflected in its share price (which peaked on Oct. 19, 2007, with a PPS of 95.80 and bottomed out on Aug. 13, 2013, with a PPS of .17) but also in its daily operations. Since 2004 the company has seen an inordinate amount of executives come and go for an entity of its moderate size, and the natural highs and lows of the global shipping markets have taken its toll on FreeSeas to the same degree that it has affected the industry as a whole. Generally speaking, the industry was quite healthy from 2006-08 before crumbling amidst global recession aftermath in 2009. In fact, during the tumultuous period started in 2009, many dry bulk shippers found themselves out of business entirely.
Although FreeSeas survived this era of financial anarchy, it certainly did not escape unscathed. In fact, to call the company's first seven years tumultuous would be a dramatic understatement. The company has survived being on the cusp of filing for bankruptcy on more than one occasion. It was nearly delisted by the Nasdaq in 2012. In February 2012 one of its vessels, named "Free Goddess," was hijacked by Somali Pirates while en route from Egypt to Singapore with approximately 19,475 metric tons of steel cable and a crew of 21 Filipinos. The Pirates held the ship hostage until November, when a ransom was finally paid and the ship then released. In addition to these signature events, there was also excessive collateralizing of the company's assets, a 1:10 reverse stock split earlier this year, and a significant amount of escalating additional debt.
Nothing has ever been easy for FreeSeas, and the company's survival, until only recently, remained in question.
On July 10, 2013, perhaps for the first time in their brief history, FreeSeas started to find some breathing room. They announced a Debt Purchase and Settlement Agreement with $20 million in loan forgiveness. Then, on Sept. 26, FreeSeas President Varouxakis announced the formalization of their debt settlement agreement with Deutsche Bank, Hanover Holdings, and Crede Limited. This final arrangement immediately removed nearly $30 million from the company's balance sheet and resulted in two of the company's seven ships, that were previously leveraged to an unmanageable level, as now being completely unencumbered.
These events led to Varouxakis making the following comment on Oct. 10:
We are pleased to announce the extinguishment of approximately $30 million of debt, representing approximately one third of the Company's total bank debt. This transaction will result in significant gains, which are presently estimated to exceed $12 million. As a result, our balance sheet will be completely transformed, resetting us in position for future growth.
Most recently, FreeSeas has even taken steps to ensure future financing. It announced on Oct. 22 that it had entered into a non-binding terms sheet with an unnamed institutional investor. The forecast for this investment is estimated to represent a full value of $10 million.
FreeSeas operates largely in the spot market. That is to say, their contracts for use of their ships tend to be shorter, seasonal, and thus subject to rate increases in accordance with demand. As a result of this practice, their clients have no commitment or guarantee to renew or extend the charters under current terms, thus allowing FreeSeas the opportunity to re-charter their vessels at favorable rates, with reputable charters, as the market allows. This flexibility allows for maximization of revenues with every new contract, or every contract renewal.
In addition, the recent increases in charter rates, coupled with favorable adjustments to off-hire days, would indicate progressive growth in baseline revenues. These recent market changes, combined with the latest dismissal, forgiveness, or settlement of an estimated $30 million in total debt, and estimated resulting gains of $12 million, should provide FreeSeas with a degree of financial latitude they may have never before experienced. What these factors could offer, for shareholders of a company that once traded at a PPS nearly 2500 times higher than its current price, is yet to be determined. Needless to say, however, the prospects and potential are, at the very least, worthy of consideration.
Furthermore, we have just entered the peak season for FreeSeas. In both good years and bad, the vast majority of dry bulk shippers see their revenues increase dramatically between October and March, the fourth and first fiscal quarters of the calendar year. Entering into this season, with massive debt reduction, increased charter rates, competent management, a history of perseverance, and a growing belief that the Greek economy is returning to a position of strength are all indicators of FreeSeas rebuilding on a strong foundation.
As mentioned above in the "Recent Events" segment of this article, there was a debt settlement agreement that contributed to a sizable portion of the debt relief realized by FreeSeas. Naturally, the returning of these awarded shares into the marketplace at above average volume has resulted in a restriction of the stocks ability to respond as it would organically under less restrictive conditions.
This fact, together with the markets inability to adjust their expectations accordingly and in line with the company's fundamentals as yet, have managed to keep the share price and market capitalization from being corrected as one would expect. Therefore, it is quite reasonable to assume that once the full number of shares is returned to the marketplace by the settlement beneficiary, that the process of growth for FreeSeas will begin to be reflected in its share price. While I am certainly no expert in forecasting a company's true market value, another Seeking Alpha author estimates in his Instablog entry that the potential valuation could reach upward of $5 per share.
As is the case with any and every micro-cap stock, there exists considerable risk. FreeSeas, after all, has been on the verge of bankruptcy multiple times, and in fact only just recently walked back from the ledge. Also, while charter rates are improving considerably, so are the costs associated with dry docking. Thus, if the vessels aren't on contract and generating revenue, they are being held on shore at considerably high costs. Moreover, while $42 million in total debt relief and resulting revenues is considerable, the settlement constitutes only one-third of the company's collateralized debt. Therefore, while their situation is vastly improved, their debt-to-liquidity ratios remains less than ideal. They have posted net losses for three consecutive years. By all accounts, FreeSeas is still a rebuilding project.
In addition, the company's tiny float is a near certain indicator of future volatility, and its history of diluting shareholders in the past leaves many previous shareholders both uneasy regarding future prospects and hesitant to invest again. Lastly, while this is the peak season for dry bulk shipping, there has yet to be any significant industry-wide impact on dry bulk shippers as a whole.
I am a finance professional with a background in behavioral economics, not a professional trader. As a result of my personal and professional history, I tend to weigh the causes of circumstances to a higher degree than the circumstances themselves. From that perspective, I am quite optimistic about the future of FreeSeas.
The company's management is well educated, organized, competent, and has proven to be resilient. Both CEO Varouxakis and CFO Mylonas were born in Greece and raised on the docks of the shipping and finance industry. They are long-time survivors of the business where they now reside. In addition, since the company's commencement, FreeSeas has encountered every possible trace of misfortune. Whether it was global recession, Somali Pirates, or Greece's massive national default, FreeSeas has seen it all in its eight years. Yet, it has persevered and survived.
The company has not failed or struggled due to financial misconduct, mismanagement, or corporate negligence. In fact, one could argue, that it has only survived because of its fine financial conduct, efficient management, and corporate responsibility. Now that it has some financial latitude, some breathing room, and is entering peak season, good things must be on the horizon. FreeSeas has defined what happens when highly competent people suffer indomitable circumstances. I, for one, believe that these same quality people will now emerge profitable and stronger amid far better circumstances.
I see FreeSeas as a low-risk, high-reward long play for all investors with a moderate tolerance for short-term volatility.