Why Overseas Shipholding (And You) Should Buy DHT Maritime

Includes: DHT, OSGB
by: Dr. Hugh Akston

Sifting through the beaten and the unknown is where investors are most likely to find the greatest pricing inefficiencies and resulting alpha opportunities in the stock market. The pricing inefficiencies that I look for are unique situations where the stock market is essentially selling a $5 dollar bill for four bucks. These opportunities can arise for many different reasons such as investor apathy, liquidity-driven selling, information asymmetries, corporate mismanagement, etc.

These opportunities are uncommon and require a lot of work to properly identify (most cheap stocks are cheap for a good reason) but ultimately should lead to outsized gains over time. One such opportunity that I see in the market right now is DHT Maritime (NYSE:DHT).

This opportunity arises from the fact that DHT has been in stock purgatory since suspending the dividend in early September. DHT owns nine double-hull tankers consisting of 3 very large crude carriers (VLCCs), 2 Suezmax, and 4 Aframax tankers. All nine tankers are chartered out under long-term contracts to Overseas Shipholding Group (NYSE:OSG). Of the nine vessels, seven are chartered until 2012-2013 while the remaining two are chartered until 2015.

The opportunity for OSG (and You) is that the current stock price is attributing virtually no value to the long term charter contracts already in place. The stock is currently trading at $4.16 which is just above the tangible book value (assets being the 9 double hull tankers) of $3.79.

The inefficiency here is that OSG could buy DHT today for essentially the value of the ships and pocket the money that they are scheduled to pay DHT over the next several years, which is equal to about $360m in total revenue. DHT’s current market cap is just over $200m.

Obviously there are expenses to running the DHT business so OSG would not be able to save the entire $360m, however if we estimate zero synergies for an OSG acquisition (which is very unlikely considering OSG is in the exact same business as DHT and they have overlapping processes and capabilities), in other words OSG only changes the name on the door and keeps DHT as is, they would still save the net present value of about $181m.

Essentially OSG could pay up to $6.52 per DHT share and still break-even.

Keep in mind this benefit would increase with any synergies OSG is able to unlock. At the end of 2013, which is when the fleet would no longer be completely chartered out, OSG would have enjoyed an IRR of +12% annually which compares very favorably to the 0-1% they are currently earning on their cash. OSG has $633m in cash on the balance sheet so a DHT acquisition should be easy to execute without accessing the capital markets.

Furthermore, the charter contracts currently in place between DHT and OSG allow for profit sharing should comparable spot rates be above the baseline charter rates. These profit sharing agreements allow for DHT to capture 33-40% of the upside should spot rates be higher than the chartered base rates thus offering DHT a desirable asymmetric payoff, if tanker rates go down DHT is protected through the base rates however DHT also participates in upside from higher rates This aspect would provide OSG with a free “call option” on a rebound in tanker spot rates.

The discounted cash flow analysis cited above that derived the $181m value of the existing charter contracts assumes that DHT earns only the baseline charter rates and does not assume any upside from a rebound in spot rates, such a rebound would provide further upside to the value of the existing contracts and the potential benefit to OSG.

While an OSG acquisition makes sense, DHT does not need to be acquired by OSG in order for the stock to work. On a stand alone basis DHT offers a very attractive valuation and a compelling risk/reward profile. At the current stock price we have the opportunity to buy the stock at just over tangible book value attributing little value to the free cash flow from the existing contracts in place as well as a free call option on a rebound in tanker rates.

Assuming only the base rate charters, DHT is trading at a free cash flow yield of 18% and with the stock trading near tangible book I think the downside is limited. Tanker values should hold up as the new build order book is being squeezed by the credit crisis. According to industry sources roughly 30% of the order book has already been delayed or canceled. Furthermore ~18% of the world’s current tanker fleet are single hull which are to be eliminated by the end of 2010 per International Maritime Organization regulations. DHT has no funding needs with zero vessels on order and zero options and they do not have any debt expirations until Q1 2011.

Somewhere in an OSG corporate office a fellow finance nerd should be firing up his Excel spreadsheet.

Disclosure: Author holds a long position in DHT