The Short Case On Frontline

Frontline (FRO) has for a long period of time been a champion when it comes to paying out large and (fairly) predictable dividends, but for how long can it last? I will divide my discussion into three parts: macro economical outlook, industrial development and finally a valuation of Frontline.

When it comes to the macro economical outlook the view seems to be mixed regarding soft landing or a crash. The latest readings from the US have not been very joyful as we looked at GDP growth of 1.6%, decline in housing prices, lower than expected production to higher than expected costs. However, the Euro zone and the Asian economies (especially China) still seem to be growing at fast pace, though we have seen signs of a yet moderate slow down in the Chinese economy lately. Where we are heading is still to see, but as I will suggest later on, the direction of the tanker earnings seems set in a downward directions due to other factors such as the extensive list of new building entering the market.

However, bear in mind that non OECD counties and especially China are the main drivers of the uptrend inGDP growth. China in 2005 accounted for somewhere in between 40 and 45% of the demand growth for tonnage miles in 2005. The Chinese economy is of course still heavily relying of robust demand from the OECD counties and 75% of the Chinese economic growth in 2005 was based on imports and exports, which were mainly imports of raw materials utilized to produce export goods for the world marked. Therefore I strongly suggest that a US slowdown will have a severe impact on Chinese exports (disregarding other demand reducing factors such as a possible appreciation of the Yuan) and that we have seen the best of the Chinese growth in this macro cycle.

According to the latest monthly rapport by R.S. Platou (world class provider of ship brokerage services and economic research,) oil consumption only increased by a modest 0.7 % the first nine months this year. Non- OECD nations accounted for all the growth since we actually saw a decline of 0.9 % in the OECD countries. Despite the less than expected increase in demand and the entry of 13.3 mil dwt in the first 8 months of the year, the rates still kept above the 2005 rates until the start of Q4. This is mainly due to a change in seasonal pattern, since the better part of the refiners secured their crude supplies early based on worries of the crude supplies during the hurricane season.

So, what are we heading for? Currently, the world's total tanker fleet is about 355 mill dwt, while the order book comprise of 115.4 mill dwt, which will give a growth rate of over 10% for the tanker fleets for each of the next three years. With the above discussion about world economic growth and growth in oil consumption, it does not take a genius to the reach the conclusion that utilization rates will decline and that the freight rates will turn further south.

Here it is also worthwhile mentioning that we lately have seen to significant shifts in the trends for transportation of oil products. Before I commence my valuation of Frontline, I will discuss the impact of an OPEC cut and the deletion of the entire single hull fleet taking place in 2010. In my valuations I assume that OPEC not will be able to carry through with their intended cuts, since history shows a total lack of discipline within the cartel. I also lean on R.S Platous' calculations that the existing orderbook is sufficient to replace all the supply lost when the single hulls are deleted.

My base scenario valuation of Frontline relies of average VLCC earnings of 55000 USD/day in 2007 and 50000 USD/day in 2008. The Suez rates are derived from the VLCC rates assuming a demand shift if unhistorical spreads should occur. Finally, I assume OBO rates at 40000 flat.

Under this assumptions and the macroeconomic and industrial forecast of R.S Platou (used for deriving utilization rates, which yield VLCC rates), I end up with the following key financial numbers for Frontline in 2007: EPS: 4.35, P/E 8.7, EV/EBIT 6.9 and EV/EBITDA 6.3.

This gives a prediction of a Net Asset Value (NAV) of 32.5 USD based on correlation between secondhand prices and freight rates (long term time charter rates) 2008; EPS: 3.12, P/E 12.4, EV/EBIT 9.9 and EV/EBITDA 9.3 This gives a NAV of 26.4 USD/Share.

Hence, any reasonable conclusion would be to sell the stock short, due to a demanding valuation at a cyclical peak, bearish outlook and potential downside in possible OPEC cuts and finally a declining dividend. Keep in mind also that Frontline will underperform in a weak market due to a high degree of operational and financial leverage compared with its pairs. Historically it is safe to apply a discount to the NAV in the range of 20-25 %, which leaves me with a sell recommendation and a 6 month price target of 29.5 USD.

Disclosure: Author is short FRO

Comments

[kkin365:]

Reading in context, I presume FRO is in oil shipping. How would a sudden tenseness in international relations affect the market? omooc

2006 Nov 06 10:01 AM

[Rune Rudberg:]

Hi david.

Frontline is one of the worlds largest independent provider of crude oil shipping...

Its actually quite hard to determine the effect of a sudden tenseness in international relations, since it would depend both on the effect of tonnagemiles demanded and the risk premium charterers would be willing to pay for securing future shipments of crude.

A bullish scenario might take place if Venezuela directs the countrys export of crude towards China instead of the US, since that would increase the demand for tonnagemiles.

However, I find the direction of the marked given, due to the large surplus of available tonnage the years to come, but watch out for the expected spikes(seasonal among others) and the more unexpected that might occure if for example geopolitical tensions or hurricanes leads to a sudden shift in the demand curve

2006 Nov 06 02:41 PM

[Rune Rudberg:]

If the future rates give a somewhat right prediction of next years market, the recent fall suggest a downward revision of next years estimates.

Since a 1000 USD/Day decline in the rates lowers the EPS with somewhere around 0,2 USD, the recent fall of almost 6000 USD/day suggests a EPS just a little over 3 USD next year and below 2,5 USD for 2008 and 2009.

This makes the picure even clearer in my opinion: Frontline is one of the most obvious short candidate within the whole shipping segment

2006 Nov 27 05:55 PM

[FourBrane:]

At least 15 percent of the float is out short right now, so there's a growing squeeze risk. FRO is almost certain to keep paying at or above its target dividend of $2.50 per year (either in cash or in stock), so that's a steady 7 percent drain built in. FRO's breakeven rates are so low that I cannot see how they could fail to hit that target, plus there is a threat that more SFL shares will be spun off (FRO has declared those holding to be "non-core"). Look at FRO's history of paying generous dividends (dictated by its majority owner who has a serious track record of demanding a sweet dividend return) and remember that your position will be charged for every dividend.

If you shorted on Nov 6th, as per anonymous' recommendation, you're going under water unless you cover before Dec 7th. Next quarter, you'll be dinged another $1.50 per share, and so on.

I don't understand people who short without considering the dividends and the clear history of a company.

2006 Nov 29 05:00 PM

[Rune Rudberg:]

Patrick, if you decide to sit short over a dividend is a zero sum game, since a stock price will decline with the same amount as the dividend when going ex. div.....

Another common misunderstanding is that Frontlines fleets break even rates are among the lowest in the business and that the companies fleet is among the most modern.

Firstly, the companys VLCCs currently have a break even rate at almost 30000 usd/day and further more a profit split agreement, which entitles Ship Finance to 20% of every usd frontline earns above the break even rates...

Frontlines fleet is also getting old, in fact among the older in the industry, which tells us that we should expect that most of the ships would spend more time dry docked as they did i Q3...

Finaly the current rates, in a quarter which was expected to be strong, are getting pretty close to break even rates, at least on the AG- EAST route. The rates are also expected to decline further before they MIGHT strengthen in January. The list of available tonnage tells us that almost 80 VLCCs are expected to reach the AG the next 30 days and everything over 60 VLCCs tells us that the rates should decline further...

2006 Nov 30 10:22 AM

[Rune Rudberg:]

As seen lately FRO have made some gaines from the low of 189 NOK or 30,1 USD. This is a result of the expected thightening of the balance in the marked and expected.

However, the list of available tonnage is expected to grow throughout the spring, as it always does and the rates are gonna decline. Frontline has a breakeven rate of 29.800 USD/VLCC , which is among the highest in the industry and also one of the highest debt/equity ratios so the case is highly geared both operationally and financialy.

Since the fllet growth is 10%/y the next 3 years and the demand growth is stipulated to somewhere around 4% the direction of the rates are given, but one can expect spikes in the winterseason.

This will significantly reduce EPS and thereby the dividend payout capacity and some actors in the business are claiming that Fronline won`t make a profit at all in 2009.

Therefor I suggest that the recent spike in the stock pirce is a great opportuninty to place a new short position and I would say that the range between 210-220 NOK is the place to do so! In mid May I expect Frontlines stovk price to be somewhere inbetween 130- 150 NOK, which gives a return of about 25- 30%, depending on the next dividen (which I expect to be about 1- 1,5 USD/share)

2007 Jan 13 02:01 PM

[herbert68104:]

Looking back at your article from a vantage pt. of 06-24-08 you certainly "missed the boat!"

2008 Jun 24 08:21 PM

[captron:]

I have just been reading these old articles on FRO..., I guess this author/short has lost his pants betting agains FRO. Good article though.

2008 Aug 25 03:05 AM