Our most recent article on Stealth Gas Inc. (NASDAQ:GASS) illustrated how the company was undervalued on a net asset value basis. Throughout the economic crisis, the fundamentals of not only Stealth Gas but also the Liquefied Petroleum Gas (LPG) Handysize shipping sector (3,000-8,000 cubic meters (cbm) vessels) remained favorable and should continue to strengthen. With a 13.5 percent market share and an average vessel age of 10.9 years for its LPG carriers (the youngest age in the Handysize segment for a fleet this size), we believe Stealth Gas will profit considerably from anticipated rising charter rates.
Stealth Gas is a Marshall Islands-incorporated, vessel-owning company primarily serving the LPG sector of the international shipping industry. The company has 35 Handysize LPG carriers with a total capacity of 168,097 cbm, three Medium Range product tankers, and one Aframax oil tanker. The average size of its LPG vessel is 4,619 cbm. The company is focused on transporting small quantities of LPG into niche markets.
Handysize LPG carriers typically avoid trade routes dominated by very large gas carriers, as from the Middle East to Japan or North America. Instead, these smaller vessels concentrate on moving products on shorter routes, as from Singapore to Malaysia, Indonesia, the Philippines, Vietnam, or China. Stealth Gas vessels also transport LPG along coastal areas, such as Brazil or Australia, and where it is uneconomical or simply impossible to accommodate larger gas carriers, as in shallow ports or river ways.
LPG vessels and ports require special crews and equipment to transport LPG in either its gas or liquid form. Additionally, the quality of these vessels varies from one manufacturer to another, with many of the leading LPG shipbuilders located in Japan. These characteristics limit the ability of large shipping companies with access to capital markets, or financial investors investing directly in LPG vessels, to acquire quality vessels and find skilled crews. Over the past 10 years, the industry did not witness a speculative boom in its orderbook of new builds, as was the case in the dry bulk, tanker and carrier markets (see graph 1). The fairly flat number of vessels operating in the LPG market, and in the Handysize LPG market in particular, has caused charter rates to remain relatively stable throughout the economic downturn and is leading to even stronger rates today (see graph 2). The newbuild orderbook for the Handysize LPG segment is flat in 2011. The lower right corner of graph three demonstrates that the change in the supply of Handysize LPG carriers becomes negative over the next two years. (Graphs were provided courtesy of Stealth Gas, Inc.)
LPG is a byproduct recovered from refining natural gas and crude oil. It consists primarily of propane and butane. Both products are gaseous at room temperatures and liquid when cooled. LPG is used throughout the world in many different applications, providing clean, affordable energy for domestic, commercial, agricultural, and automotive consumers. According to Ken Otto of Purvin & Gertz, an independent energy consultancy firm, worldwide LPG consumption has increased by an average of 2.4 percent annually since 2000 to over 250 million tonnes in 2010 and is expected to reach 270 million tonnes in 2012. Additionally, the World LP Gas Association estimates that LPG emits about 15 percent fewer greenhouse gasses than heating oil and 50 percent less than traditional electricity sources. We would expect to see further growth in LPG supply as natural gas production expands worldwide.
Stealth Gas creates value by chartering-out vessels to either large integrated oil companies such as Shell (NYSE:RDS.A), or major energy trading companies such as Petredrec and Vitol. Stealth Gas charters out its vessels either in the spot market or on time or bareboat charters. Bareboat charters offer the least risk, as Stealth Gas is not responsible for any expenses or liabilities, such as maintenance, associated with operating the vessel; with a time charter, Stealth Gas pays for vessel operating expenses, which include crewing, maintenance, insurance, stores, etc. Finally, in the spot market, Stealth Gas is responsible for all voyage costs, including bunker fuel and port expenses.
The company has strategically staggered, both by time and charter type, the employment of its LPG vessels. It has all of its product and crude tankers on longer-term bareboat charters. This staggered approach to fleet management means that vessels will be coming off charters at different times and ensures relatively predictable cash flows for roughly two-thirds of the vessels over the next 12-24 months. Fortunately for Stealth Gas, vessels in the spot market as well as those coming off of time charters in the near term will be able to take advantage of today’s rising time charter equivalent (TCE) rates.
At present, a 3,200 cbm semi-refrigerated LPG vessel can be time chartered-out for nearly $10,700/day. Stealth Gas announced in May that it chartered a 1996-built 5,014 cbm vessel, a 2003-built 5,000 cbm vessel, and a 1996-built 3,517 cbm vessel for an average TCE rate of approximately $10,000/day.
The value of each vessel in Stealth Gas’ fleet is a function of TCE rates (which translates into bareboat rates), operating and management costs, depreciation, utilization rate, capitalization rate, interest rate, and leverage. As previously noted, a bareboat charter is the amount a vessel owner earns when chartering out vessels without responsibility for operating charges. The only expenses that affect an owner who puts the vessel on a bareboat charter are depreciation, interest, and management fees (usually paid to a third party manager to find charterers). Once a buyer establishes his required return on investment, borrowing rate, and leverage ratio, he can work backwards to determine the value of his vessel.
After valuing each ship, Stealth Gas becomes a sum-of-the-parts equation. Stealth Gas currently has approximately 11 LPG vessels around 5,000 cbm; six LPG vessels greater than 6,000 cbm; 10 LPG vessels around 3,500 cbm; four 4,000 cbm LPG vessels; one tiny 1,320 cbm LPG vessel; three Medium Range product tankers; and one Aframax crude tanker. Additionally, it has one 5,000 cbm newbuild LPG vessel scheduled for delivery this month and two 7,500 cbm LPG vessels scheduled to be delivered in 2012. Throughout the economic crisis, Handysize LPG vessels maintained their value because TCE rates remained stable. Under current market conditions, the value of these vessels should increase as charter rates strengthen. Further, upon receiving the product and crude tankers, Stealth Gas immediately put these vessels on long-term bareboat charters, extending to 2015 for two of its product tankers and its Aframax crude tanker.
Since the value of Stealth Gas’ LPG vessels has not fluctuated erratically over the last three years and management prudently put its product and crude tankers on longer-term bareboat charters, today’s large discount to its estimated NAV provides investors with a substantial margin of safety. Even in a difficult rate environment, a private owner of this company could sell all of the vessels, pay off debt, and walk away with considerably more than the current $90 million market capitalization.
During a recent conversation with the CEO, Harry Vafias, he estimated the liquidation value of the company was in excess of $11/share.
Over the past two years in an environment where many shipping companies saw operating income from vessels turn negative, Stealth Gas remained profitable at the operating level. The company’s sporadic quarterly losses stemmed from onetime events. For example, in 2009 the company cancelled the delivery of a Medium Range product carrier and consequently forfeited a $5.75 million deposit and incurred a $10.75 million cancelation fee. Additionally, over the past two years, the company recognized losses of $11.5 million on derivative contracts. In 2010, Stealth Gas paid an extra 2 to 3 percent in interest to convert half of its floating debt to fixed rate contracts. We believe, however, the company wisely hedged a substantial portion of its interest rate risk. In a rising interest rate environment, these losses should reverse themselves. Finally, as of December 31, 2010, the company hedged JP¥2.7 billion, or approximately $33 million, related to newbuilding construction costs in Japan shipyards against an increase in the yen versus the dollar. We believe Stealth Gas has been conservative, not speculative, and the losses it recognized are not indicative of its true operating capabilities.
Last year, Stealth Gas generated revenue of $111.4 million with gross earnings of $50.4 million on a total of 13,835 voyage days (total days vessels are available for charters). The company had an average of 38.6 vessels, operated at 98.3 percent fleet utilization, and realized an average TCE daily rate of $7,064/day. Cash flow from vessels was $59.4 million. Over the next two to three years, assuming firmer TCE rates -- which are based on the Handysize LPG sector’s newbuild orderbook and scrappage rate (see graph 3) as well as expected growth in demand for the transportation of LPG -- and a stable fleet, we think Stealth Gas can generate over $115 million in revenue and $70 million in gross margins annually. This is a gross profit margin of just over 60 percent.
Stealth Gas achieved similar results in 2008 with average TCE rates of $7,588/day. We expect gross margins to improve more than revenues because the main cost drivers — bunker fuels and labor expenses — should not rise as fast as charter rates. Further, we expect additional vessels to move from spot market employment to either time or bareboat charters in the future. This action will reduce the amount of voyage and operating costs associated with each vessel in the fleet.
Stealth Gas is headed by an ambitious and aggressive CEO who has a hands-on approach and knows the minutiae of buying, selling, and operating vessels. Vafias has personally bought or sold more than 220 vessels, a record in his home country of Greece. To appreciate Vafias’ trading acumen, consider one of his first trades. At the age of 20, he bought a 19-year-old Panamax oil-bulk-ore (OBO) carrier on the open market. Senior industry professionals told him not to do so because it was risky and no charterers at the time wanted OBOs. Vafias put in a low bid of $2.5 million. He was the sole bidder and thus bought the vessel. It was vetted and then chartered out for six months for $18,000/day as a double-hull Panamax crude tanker. Vafias sold the vessel for $5.5 million nine month later, netting a 250 percent return. Vafias also has the discipline not to buy into an overvalued market. He has bought vessels when rates were lower and then sold them once rates recovered. In the mid-2000s he abandoned the very large crude carrier segment in order to focus on the Handysize LPG sector and take advantage of the low volatility of charter rates. Vafias is willing to take risks when buying vessels; nevertheless, he favors having longer-term time charters for vessels before they hit the water—something, we suspect, more shipping companies wish they had done three years ago.
With strong fundamentals in the Handysize LPG carrier sector and skilled management, we believe Stealth Gas’ true value will be recognized by the market. The open question is when. We suspect the market will not be able to ignore Stealth Gas’ growing asset base and large free cash flows for much longer, particularly as more vessels are re-leased at today’s higher rates. Vafias stated that at the current share price he would not issue shares and dilute current shareholders. Vafias personally owns 20 percent of the company’s outstanding shares; thus his interests are aligned with other shareholders. He also stated with the share price below $5.00 he may buy back stock. Stealth Gas is willing to sell older vessels should the opportunity arise. We think Stealth Gas will use the free cash flow from operations and vessel sales to purchase newer Handysize LPG vessels and/or opportunistically invest in a related segment of the shipping industry. We think as investors begin to appreciate the improving economics and operating leverage of the Handysize LPG shipping sector during a rising rate environment the share price will more closely reflect the company’s intrinsic value.
Disclosure: I am long GASS.