You never see the bus that hits you. Experienced market participants know that it can be dangerous to take a long or short position based on information already widely known. With this in mind, is the market correct for dragging shares of Frontline (NYSE:FRO) back down to near $2?
Frontline's convertible bond due in April 2015 has been the focus of investors for several quarters now. Bears are convinced that with VLCC rates back near record lows, Frontline will lack the liquidity to meet this debt obligation when it comes due, and the company will be handed over to creditors, leaving shareholders with nothing. Market sentiment on Frontline has been decidedly bearish since the short-lived spike in VLCC rates earlier this year.
The bear case is laid out nicely in this article, but what those investors who are collectively short 8,450,000 shares of Frontline (as of May 15) fail to realize is the grossly asymmetric risk/reward that Frontline's equity represents, especially considering that the company's market cap makes up only 16.4% of the company's enterprise value, meaning that changes to the company's enterprise value are magnified 6:1 in the share price. This double edged sword is why the share price has been cut in half since January 2014.
The obvious bull case for Frontline is an unexpected rise in VLCC rates. Judging from how quickly VLCC rates fell from December 2013 to the present, nobody can credibly claim the ability to predict rates with reasonable accuracy. This means rates could rise again next quarter or even next month.
But what about the more subtle bullish arguments? For example, has the market missed the possibility that nudging Frontline's highly leveraged balance sheet in the right direction could have a major effect on the stock? Evidence for this is found in a comparison between Nordic American Tankers (NYSE:NAT) and Frontline. Nordic American Tankers has an EV/EBITDA ratio of 78.12. Frontline's figure for these same valuation metric is only 13.24. One could argue that Frontline's EBITDA is not meaningful because it ignores the company's massive debt load and corresponding interest. However, what if John Fredriksen decides - or has already decided - that he will personally inject sufficient capital to cover any shortfall that would otherwise occur with respect to the April 2015 convertible bond? Even with no increase in VLCC rates, news that Frontline no longer has the April 2015 obligation hanging over its head will undoubtedly send the stock higher, setting in motion a virtuous circle that will allow Frontline to issue more shares at a higher price, thereby without diluting those shareholders, including Mr. Fredriksen himself, who will have acquired at least some shares at lower prices.
Is Mr. Fredriksen's incentive large enough to come to Frontline's rescue? Fredriksen's holding company, Hemen, owns 28% of the company's shares as of March 10, 2014. With a share price of $2.40 as of this writing, Hemen's stake is worth approximately $65 million. For simplicity, consider the worst possible case, wherein VLCC rates remain at levels where Frontline is operationally cash flow neutral or even negative, and additionally the company is unable to sell any assets (such as vessels or its stake in Frontline 2012) at acceptable prices. In this worst case scenario, if Fredriksen were still willing to step in with the entire $190 million due April 2015, thereby buying considerable time, Frontline's market cap would at least return to levels seen in 2011, which was the last time that such low VLCC rates accompanied a large and potentially unmanageable debt obligation that was still several years off in the future. Again for simplicity of the analysis, even if the share count were to fully double because Mr. Fredriksen is somehow able to accumulate shares under the market's radar at today's price, by my work the share price would necessarily move to around $12 on the news. Of course this is an oversimplification, and in reality the share price would begin to rise much sooner as the balance sheet improvement would become apparent, thereby resulting in less than doubling of the share count, which is even better yet for this bull case. Who is to say that this process has not already begun, or that Fredriksen is not standing by waiting to see how the ATM offering goes, ready to make up any shortfall?
If Frontline's demise was ever going to be caused by the April 2015 convertible bond, the market would not have telegraphed it so clearly, and so far in advance. Frontline's shareholders will survive the current nightmare. Mr. Fredriksen knows that his $65 million stake is not a liquidation value, which is probably zero. If Mr. Fredriksen can turn $190 million (or less) into $1.275 billion, I'm betting that the company's founder and largest shareholder will do exactly that.
Disclosure: The author is long FRO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.