Black Holes in Nordic American Tanker's Model

Oct.11.10 | About: Nordic American (NAT)

In a previous post, I described the problem with Nordic American Tanker's (NYSE:NAT) strategy, a problem that management actively ignores. In this post I shall go deeper into the reports, history and even more problems with this strategy, and reveal some possible hidden interests that may easily remain unseen to the inexperienced eye.

In my previous post, we saw how NAT's equity offering model falls short of its stated target, as the share count vs. vessel count ratio has not been decreasing since 2004, even though management claims otherwise. We also saw how share count vs. ship count represents the dividend generation power of the company. I also stated that a non-decreasing ratio is good for this company, as it can still deliver good returns with the current ratio. Hopefully management will be wise enough not to cause the ratio to rise by overpaying new vessels or by over-issuing stock. The bottom line is that the ratio will HAVE to rise in the near future, a rise that will eliminate the return and will cause a permanent capital loss. This unavoidable rise in share/vessel ratio will be caused by the ships' advancing age - and eventually by the ships' demise.

Now I shall elaborate a little bit on my calculation methods and add some more previously unmentioned issues that will strengthen the final conclusion.

First, let's examine how one might calculate the current share count per ship ratio. This task may seem fairly simple; just divide the current share count - which is obtainable from the latest company report - by the current fleet size. In reality, one must take some more issues into account.

Let's review the common case in which the company issues about 10% more shares in order to buy a few more vessels. It will often take the company several months to close deals and actually have the ships working in the fleet. Sometimes, aside from the time that it takes the company to close a deal, there is a major delay between a ship's contractual purchase time to the ship's physical delivery time. A good example is the newbuilds, which take three years between equity offering to delivery. Thus, dividing the current share count in the current fleet vessel count will yield (unfairly) unfavorable results for the company. To be more accurate, one must consider planned number of ships, rather than current number of ships. After each equity offering, the company states how many vessels it intends to buy with the money it gets from the market. The table in my previous post was generated using planned number of ships, and this is also the reason why some of you got different numbers. To generate this list I sifted through all of the equity offerings and the shareholders letters that followed them.

Now we are aware of another aspect of NAT's equity offering model - the time difference aspect. The time difference aspect represents the time that passes between the equity offering and the actual vessel delivery time. This aspect has a major negative effect on the current shareholders of the company, although they are unaware of it. Let's see how the time difference aspect hurts the investors over the long term.

1. Money from the market (and the inevitable capital loss generated after it) is injected in the company now, but vessels arrive only long after. Sometimes the company loses more than 10% after an equity offering. In this time, the money earns interest for the company, but not for shareholders. This is a minor problem, I would dismiss it in a second if it were the only problem.

2. Many, many times, the company declares a dividend to be paid in the coming months, and in between, it declares an equity offering. This creates a very serious problem. I'll explain using an example. Imagine a situation where the company has 40M shares outstanding, and it declares a $1 dividend per share, or a total of $40M. As we saw in my previous post, this amount should be equal to the previous quarter's operating cash-flow.

Now, in order to purchase a new vessel, the company wants proceedings that are equal to issuing 3.5M shares to the public. It issues the shares before it distributes the dividend. When the distribution day will come, the company will have to distribute more than $40M - $43.5M, not as planned, since newly issued shares must also get a dividend. Where will the extra $3.5M be taken from?

The answer, which is also officially stated by the company, is that the money is taken from the equity offering funds, by issuing a few more shares, say 4M shares, instead of the calculated number of 3.5M shares that are actually required to purchase the vessel. Now, let's see what happened: The company issues new shares, some of them are going to finance the dividend of this new batch, instead of going to fund a vessel purchase. The investor loses twice in this transaction, once since he is paying money of which some will NOT go to vessels purchase, and second, more importantly, is that the investor is losing pieces of future dividends because those shares that are issued in order to cover the newly issued shares dividend are, as we seen previously, eternal, so they will take a bite into the company's future dividends, forever, lowering the dividend generating capacity.

I call this by the unflattering name - "The Ponzi effect", since new shareholders are buying in when the company issue new shares, and some of their funds are used to pay other shareholders. In the way of paying those other shareholders, new shares are created that are used for nothing but thin air, yet nevertheless still take their cut in future dividends.

The severity of the Ponzi effect can be eliminated if management acts correctly, by calculating when it is right to issue new shares in relation to the close dividend distribution, and issuing small debt instead of shares for the new shares dividend. Management can also close vessel purchase deals first and only then issue equity offerings, saving "dead" time for investors, time that will perpetually affect the company performance.

Unfortunately, management's past behavior teaches us that it does not take this into account whatsoever. Sometimes it takes well over 6 months to physically get the ship working to cover the dividend of the stocks issued for its purchase, 6 months in which at least 2-3 dividend cycles are distributed. NAT can do better when it comes to timing and capital management. Equity offering is a powerful instrument and one must use extra caution when using it; when used slightly erroneously it can cause more harm then benefit.

3. Since NAT is almost always in the process of growing, there will always be shares outstanding that are "waiting" for a vessel's purchase or delivery to cover those shares issuance and get the dividend capacity back to what it was. It is a never ending cycle. For example, NAT issues 10M shares to buy 3 vessels, they close the deal and the vessels are to be delivered in 6 months. In those 6 months, the 10M "new shares" eat away some of the dividend capacity of the investors that held the "old shares". After 6 months, they receive the vessels and issue more shares, some more shares that will again have to wait for new vessels. This again lowers the previous holders' dividend in favor of ships they did not yet receive, and this continues endlessly.

These three problems, and some more that I omitted, demonstrate the problems in NAT's model. Some of the impact of these problems can be lowered if management acts correctly, and in a timely manner. Such action, if taken by management, can dramatically improve future dividends for any given shipping rates that are currently available.

Another overlooked issue about NAT is its management's alignment of interests with shareholders. NAT's CEO, Herbjorn Hansson, reserves a perpetual 2% of the company. This means that the CEO retains 2% of any company equity issuance in a way that his 2% stake in the company is always maintained. The problem is that the CEO gets those shares FOR FREE. This puts him in a different playing field than other shareholders.

Taking this a step forward - it is in his interest that the company will grow as much as possible, because for the CEO, a 2% stake in a company with 50 vessels is much better than a 2% stake in a company with 10 vessels. For the investors, on the other hand, it's not growth that matters, it's the WAY growth is done that matters. Investors in NAT see that their portion in NAT is always shrinking as the company issues more shares. They must make sure that the offerings are done in a way that will reduce the shares/vessel ratio, as we demonstrated before, in order to preserve or increase the value behind their shares. Numbers show that the company is eager to grow, but the ratio is NOT decreasing. This ratio is the most important factor when investing in NAT, more important than the share price.

As discussed in my previous post, NAT's management need to act in the coming 2-3 years to reduce the fleet's age as about 8 ships (~50% of the fleet made in 1997-1998) will retire in the near future, but the shares those ships are feeding have no plans on retiring whatsoever.

In the current strategy, with time, the "last shareholders" of the company will pay the price that the "first shareholders" should have paid. This is because the later one invests in the company, the older its ships become, and the closer they come to retiring. Upon vessel retiring, share count will remain constant but the vessel number will decrease. Each share will represent a smaller vessel portion - share value is likely to drop as well as the dividend.

In the next post I will outline how management can fix their strategy, not without a cost, and turn NAT into a perpetual money-making machine.

Disclosure: The writer does not hold any shares of Nordic American Tanker (NAT), long or short.