In my previous posts (post #1, post #2), we became familiar with Nordic American Tanker's (NYSE:NAT) model and its problems. We saw that NAT does not issue debt to finance its new vessels but taps on the equity market. It distributes its entire operating cash-flow as dividend, including depreciation, showing an almost constant payout ratio of above 100%. We saw problems caused by this model, in its current implementation, problems related to vessels age and timing of issuing new shares.
Now let's see some remedies to the problems I've demonstrated:
Problem #1. One of the problems was that the company is paying too dearly for the vessels, above the current shares/vessel ratio. This is because when shipping prices are down, vessels are sold cheaply, but so are the company's stock. NAT ends up issuing more stock to cover cheap vessels, thus eliminating the cheap vessel price advantage. It is fairly visible, since 2004 shares/vessel count did not drop and even rose. Another problem, as we saw, is time that passes by between the equity offering and the actual physical delivery of the purchased vessel causes dilution of the current shareholders, as described at length in post #2.
Disconnect the time of vessel purchase and equity offering. Make sure the offering is done AFTER vessel purchase and physical delivery.
When shipping prices are low, and so are vessel prices, use DEBT to purchase a vessel at a low price as management sees to be right. This leaves a lot of room for management experience, I prefer not to complicate things with mathematical formulas, but they exist. The interest and principal for this debt will be paid from operating cash-flow, imitating the toll of new shares issued to cover the dividend of the new batch of shares and the time difference between equity offering and physical vessel delivery, as we saw in the previous model, with one giant difference - interest expense does not permanently increase the number of shares, thus will not perpetually hurt the dividend generation power.
When shipping prices are back up, share price will rise to reflect the new higher dividend yield. Wait till the share price reflects:
Cost of vessel Vessel Count
------------------------- < ----------------------
Current share price Share count
current dividend power < dividend power of new ship
And then issue shares to cover the debt. This way, dividend power will increase, or at least it won't decrease.
This means, in English: Management should use debt to buy new vessels. Then, management should wait for a time when the share price is high enough in a way that issuing new shares in that price to cover the debt for the ship will actually reduce the number of shares / vessel, or yield more dividend power than the company currently has.
Another upside of this strategy is that by the time this anticipated share price arrives, some of the principal of the debt was paid, so we will end up issuing less shares (or waiting for a lower share price). We are actually ensured that with every month that goes by we will need to issue less shares to cover cost of the vessel. If the share price won't rise for some reason, the debt will be smaller, and the number of shares needed to be issued to cover this debt will be smaller as well.
NAT has 1 vessel and 1000 shares. 1 ship "feeds" 1000 stocks with a dividend. Ratio is now 1000 shares per ship. Now NAT buys 1 more vessel using 10,000$ debt, since NAT's management thinks 10,000$ is a low price to pay for a ship. Now we have 2 ships, one feeds the same 1000 stocks and the other is used to pay interest and principal on its own loan.
When shipping prices take off again, wait till shares rise above 10$ per share - let's say 15$ per share. Now to cover the 10,000$, you need only to issue 667 shares, and the new ratio will be 1667 shares / 2 vessels = 843 shares / vessel.
The tipping point is the moment in which the current ratio of shares/vessel times share market price equals the debt.
Now let's imagine that we have waited for a year, and now debt levels are only 9,000$. Now the tipping point will be 9$ per share rather than 10$ per share.
If NAT's management will use this strategy, it will eliminate almost ALL of the problems related to the equity offering timing and will BOOST significantly the dividend generating capacity of the company. It will also significantly slow down the share count over time. This model was tested by my partners and I using many scenarios, including the financial crisis of 2008, and it was found to be 100% more efficient, in ALL scenarios, than current management practices.
Using this strategy, NAT won't be able to brag of having "zero debt" 100% of the time, but only part of the time. In the other part, it will carry a relatively small debt, around 10% of its equity, still far less from its debt ridden peers.
Another hint for NAT's management is that it is common knowledge, even in academic circles, that equity is more expensive than debt, especially in today's zero interest rate environment. Using debt will be much more efficient.
If NAT's management will start using this method, with no other modifications, it will make the stock appropriate for long term dividend investors, but not perpetually since the vessels' age still progresses. Still, the suggested model will slow down considerably the rate of share count increase and also increase dividend power - two birds in one stone.
In the next post we will discuss the vessels' age problem (problem #2), and suggested solutions for it.
Disclosure: The writer does not hold any stocks of NAT, long or short.