Management Summary
In this article I will show that Crude Oil Carriers (CRU) is undervalued and that Nordic American Tankers (NAT) and Teekay Tankers (TNK) are grossly overvalued.
They make for a near perfect pair trade as they pursue very similar strategies, in the same business and have similar financing structure.
Company Description
Very briefly put the companies own crude carriers that transport crude globally. NAT has the largest fleet focused on Suezmax ships, TNK is a close second with a focus on Suezmax and Aframax ships and CRU is about 33% smaller and focuses on Suezmax and the larger VLCC ships. NAT is net debt free and while CRU has little debt and TNK has some debt.
Strategy and Management
All three companies pursue a high dividend policy where they pay out net earnings + plus depreciation and some non-cash charges. My general perception is that they are well managed and aim to optimize shareholder value and provide regular easy to digest information.
CRU and NAT deploy their ships exclusively in the spot market and TNK has a mix of spot and medium term.
It is hard to prove but I am rather convinced that many investors are in these companies for the high dividend. I will therefore spend a larger than normal amount of time analyzing this.
Dividends
As mentioned all three companies pay large dividends. There is a difference in how they reach them. CRU and TNK explain in detail how they calculate the available amount while NAT talks about a somewhat mysterious dividend paying capacity. CRU and TNK's model is quite similar (net income + depreciation and other non cash items - reserves) and if we try to use the same on NAT they compare as follows:
In '000 USD:
| CRU | TNK | NAT | ||||||||
| 3Q10 | 4Q10 | 1Q10 | 2Q10 | 3Q10 | 4Q10 Est | 1Q10 | 2Q10 | 3Q10 | 4Q10 | |
| Net income | -497 | 2351 | 5080 | 2121 | -269 | -500 | 9544 | 7904 | -5119 | -12840 |
| + | ||||||||||
| Depreciation | 4006 | 4068 | 7392 | 9781 | 9722 | 9722 | 15189 | 15799 | 15857 | 15699 |
| Share based comp | 576 | |||||||||
| Non cash items | 321 | 3000 | 100 | 500 | 1900 | |||||
| Unrea. loss from IR swap | 1333 | 5375 | 4188 | 4188 | ||||||
| Amort. debt issue. Cost | -3 | 8 | 118 | 118 | ||||||
| Loss on vessel sale | 0 | 0 | 1901 | |||||||
| - | ||||||||||
| Non-cash accr. on term loan | -240 | |||||||||
| Non-cash rela. to drop down | -574 | |||||||||
| = | ||||||||||
| Cash avai. distri.bef. res. | 3830 | 6995 | 13802 | 16711 | 15420 | 13528 | 27733 | 23803 | 11238 | 4759 |
| - | ||||||||||
| Recommended reserves | -630 | -895 | ||||||||
| Recom. res. f. early redeli. | -1300 | |||||||||
| Reserves for drydocking | -1200 | -1200 | -1200 | -1200 | ||||||
| Res. for loan repayment | -900 | -900 | -900 | -900 | ||||||
| Excess dist. f. bank/loan | 405.8 | 4335.8 | 486.5 | 6965.5 | ||||||
| = | ||||||||||
| Cash distribution | 3200 | 4800 | 11702 | 14611 | 13320 | 11428 | 28138.8 | 28138.8 | 11724.5 | 11724.5 |
| Shares | 16999 | 16999 | 32000 | 43391 | 43391 | 43391 | 46898 | 46898 | 46898 | 46898 |
| Div per share | 0.19 | 0.28 | 0.37 | 0.34 | 0.31 | 0.26 | 0.60 | 0.60 | 0.25 | 0.25 |
| Div ex excess distribution | 0.59 | 0.51 | 0.24 | 0.10 | ||||||
| Share price | 15.08 | 11.31 | 24.75 | |||||||
| 2010 Div yield | 11.3% | 6.9% | ||||||||
| 2010 2H Ann. div. yld | 6.2% | 10.1% | 4.0% | |||||||
| 2010 2H Ann.div. yld ex excess distributions | 6.2% | 10.1% | 2.8% | |||||||
| 2010 2H Ann. div. yld ex long term TC | 6.2% | 3.3% | 2.8% | |||||||
The only way NAT can pay such a high dividend is by using its cash balance/bank loans to pay the dividend. This is what is represented by the "Excess distribution from bank/loan" column (dividend paid - cash available for distribution before reserves). The excess distribution is actually larger when comparing to CRU and TNK as it doesn't include any reserves for NAT.
CRU has only had 2 full operational quarters so to be able to compare the three companies' dividend I have calculated an annualized dividend based on the last two quarters of 2010. TNK hasn't reported yet so I have made favorable estimate for them. TNK (10.1%) has the highest dividend while CRU (6.2%) comes second and NAT (4%) third.
If we exclude the excess distribution the dividend of NAT falls from 4% to 2.8%. NAT can continue this for many years but it comes straight out of equity and it will in the long term be reflected in the share price. It is anyone's guess how quickly this will happen. I see no benefit in sacrificing principal to achieve a temporary higher dividend.
If we further exclude the temporary benefit TNK has from its long term charters its dividend falls from 10.1% to 3.3%. At this point in time CRU has a 2.9% higher dividend.
Valuation Model
As I have argued many times before on SA the ship-owning business is one of low barriers of entry and close to perfect competition. See here. The only real obstacle is to raise enough funds but apart from that most tasks are easily outsourced as evident by the low head count numbers in many of these owners. I therefore focus on book value by taking net liquid assets + market value of the vessels from third party brokers + market value of long term charter party agreements being the difference between the agreed rate - the current market rate * duration discounted with 10% to get the Net Present Value.
This is in many ways a Net Asset Value (NAV) calculation.
Valuation Result
Below is the outcome when using above model:
| NAT | CRU | TNK | |
| Net liquid assets | 160 | 4 | 79 |
| Debt | (50) | (130) | (410) |
| Prepayments | - | - | 15 |
| - VLCC | 221 | ||
| - Suezmax | 674 | 185 | 299 |
| - Aframax | 346 | ||
| Total ship value | 674 | 406 | 645 |
| Value of charters | - | - | 23 |
| Fair value | 784 | 280 | 337 |
| Market cap | 1,146 | 241 | 588 |
| Overvaluation | (362) | 38 | (251) |
| In % | -32% | 16% | -43% |
| In % of ship value | -54% | 9% | -39% |
NAT is over valued relative to its NAV by 32% while TNK is overvalued by 43%. The ships on NAT books are overvalued by 54% and for TNK 39%. The reason why the overvaluation percentages are opposite for NAT and TNK are due to leverage in TNK. CRU is undervalued by 16% and its ships by 9%.
Trade Construction
The logic conclusion is to short NAT or TNK and go long CRU. We, however, have to be careful not to be caught out by differences in leverage.
If we do a pure short NAT and long CRU, then if the tanker market falls sufficiently much then the leverage difference will result in CRU loosing value faster than NAT. If we go short TNK and long CRU then we risk that the tanker market goes up too much and the leverage in TNK leads to a more rapidly rising share price than in CRU.
I have therefore looked at a combined short NAT and TNK and long CRU. The calculation below is based on long 10000 USD CRU and I have then tried to optimize how much NAT and TNK to sell to have zero net leverage.
The outcome is as follows:
| NAT | CRU | TNK | Net Result | |
| Investment/USD | (2,500) | 10,000 | (11,250) | 3,750 |
| Net liquid assets | (358) | 168 | (1,519) | (1,709) |
| Debt | 112 | (5,460) | 7,875 | 2,527 |
| Paid installments | - | - | (288) | (288) |
| VLCC | - | 9,280 | - | 9,280 |
| Suezmax | (1,506) | 7,752 | (5,748) | 497 |
| Aframax | - | - | (6,647) | (6,647) |
| Net ship value | (1,506) | 17,031 | (12,395) | 3,130 |
| Value of charters | - | - | (448) | (448) |
| Net non ship value
| 81 | |||
| Fair value | (1,752) | 11,739 | (6,487) | 3,500 |
| Short term div yld | 4% | 6.20% | 10.10% | |
| Short term div | (100) | 620 | (1,136) | (616) |
| Long term div yld | 2.80% | 6.20% | 3.30% | |
| Long term div | (70) | 620 | (371) | 179 |
If you sell short for $2,500 USD NAT and $11,250 USD TNK while buying for $10,000 USD CRU you will get net proceeds of $3,750 USD on your brokerage account. You will end up owning net ship values of $3,130 USD while having net non ship assets (cash - debt + paid installments + value of long term charters) of $81 USD.
In the short term you will be paying an annual dividend of $616 USD but as the long term charters of TNK mature during 2011 and 2012 and NAT stops paying excessive dividends you will start receiving $179 USD.
Potential Capital Appreciation
Over time it is fair to expect that this relative over and undervaluation will even out as the industry is one of perfect competition and if and when it does happen the capital appreciation of above suggest trade is as follows:
| NAT | CRU | TNK | Net Result | |
| Share price | 24.17 | 14.89 | 11.25 | |
| Target share price | 16.53 | 17.26 | 6.74 | |
| Capital gains | 790 | 1,590 | 4,511 | 6,891 |
Conclusion
By entering into this market neutral transaction you achieve significant gains from the following sources:
Net cash positive: $3,750 USD.
Dividend positive long term: $179 USD.
You get "free" ship assets in the process: $3,130 USD.
A potential capital appreciation of $,6891 USD.
Risks
All transactions have risks but I think they are manageable.
The key ones are:
- VLCC and Aframax markets may develop differently though a high degree of substitution is possible.
- It takes so long for the trade to bear fruit that the brokerage financing costs even out the profit.
- CRU management does something stupid/fraudulent.
When the market opens today I will put on above position.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CRU and short TNK and NAT over the next 72 hours.
