I will have to admit to being an avid CNBC viewer. It should not come as a surprise then that I was right there in front of my TV to witness the interview with Nordic American Tanker's (NYSE:NAT) CEO Herbjorn Hanssen on February 8:
The interview sparked my interest in the company for several reasons:
- At some point in 2011 I got out of the tanker and shipping industry and have been considering re-entry on multiple occasions, but never had the chance to do the due diligence analysis.
- The CEO was highly upbeat and optimistic, touting his company and assuring of company performance and wondrous 15% dividend. Paired with Jim Cramer's high praise in January 13th Lightning Round, this certainly looked promising -- a solid high yielder has its place in any portfolio.
- Lastly, as the interview progressed, shares spiked from session lows of $10.20 to more than $12.75 in a matter of minutes -- a 25% move, adding $225M to company's market cap. With nothing but the CEO's commentary to prompt the move higher, it raised a question in my mind: is the market so disoriented that a five-minute speech is enough to change investors' perceptions?
With Nordic American Tanker as the primary focus of the article, I will analyze how it compares to its competitors in the sector and whether the industry as whole is worth chasing after in this environment.
I have never been an NAT shareholder, but I am familiar with the shipping and tanker industry: I have had experience with Capital Product Partners LP (NASDAQ:CPLP) and Ship Finance Limited (NYSE:SFL), a close partner of Frontline Ltd. (NYSE:FRO) -- a direct competitor to NAT.
While these three companies are quite distinct from each other, they do overlap within the oil services segment and have very similar financial structures. I believe this broader scope of coverage will provide a more thorough perspective of NAT's investment risk and available alternative opportunities.
My conclusions from research into management's message, NAT's financials and comparison to SFL and CPLP are presented below.
The "all others" industry
In general terms, the business model is fairly simple. Companies first finance acquisition of vessels (tankers, cargo ships, rigs, etc) through debt and equity issuance. They then enter into long- or short-term contractual obligations with consumers that need to transfer cargo globally.
At the end of the day, these rental fees make up the revenue stream. Maintenance and D&A expenses are subtracted, along with all other operational and incentive overhead. This results in a net free cash flow that is used to pay interest on debt, and the remainder distributed to shareholders. Hence, the high yield on the shares.
In a booming shipping economy, this provides for a major tailwind. As more and more products need to get shipped, demand for tankers and cargo ships rises, causing full utilization at increased daily rates greatly enhancing profit margins. Higher margins result in higher distributions. Higher distributions attract more investors and earlier shareholders benefit twice -- from share price appreciation and the higher dividend payouts. What a factor to praise and lure in new investment!
So what happens when capacity is exhausted, while there is still demand in the market? You got it -- build more ships! How do we fund these ships? Well, there is rarely cash-on-hand to finance such acquisitions or investments. Companies either dip into their credit facilities or issue equity to raise cash. Of course, these deals are always "immediately accretive" (it's still the boom phase) and there is never a problem to secure this funding. Debt is often replaced with equity down the road anyway (to maintain lower leverage), but distributions remain stable since revenues increase from added capacity.
But the shipping industry is cyclical just like most other demand-supply driven sectors. Eventually, demand flattens and matches capacity. Eventually demand even tends to go down, exposing shippers to overcapacity, idle ships and lower daily-rates. All while the shareholders are still expecting their distributions and debt holders expect their interest payments. I will revisit this a bit later.
CPLP and SFL vs. NAT
Before diving into NAT's financials and reports, I decided to take a look at how my old holdings compare. I wasn't really surprised to see both CPLP and SFL were even worse off.
There are reasons that justify underperformance compared to NAT (that I will elaborate on), but for now this confirmed my initial suspicion -- it is the industry that is doing poorly and not a specific company. That left only a single question to be answered: Is Nordic American Tanker in fact DIFFERENT from all other shippers?
I'd like to start with just very basic numbers (source: finance.yahoo.com):
|Market Cap ($B):||1.11||1.10||0.39|
Just a very quick analysis of the above table already gives us some insight into the companies and the differences between them.
For one, clearly CPLP is a much smaller enterprise, entailing more risk, which in turn justifies its horrific performance in 2016 and subsequently, its extensively high yield.
On the other hand, NAT trades at the highest P/E ratio (which could be good or bad) and is the most financially stable, having the lowest debt-to-equity and highest current ratios.
Is NAT truly different?
So here is a quick list of my takeaways of the major advantages as communicated by management:
- NAT has very high liquidity and low debt.
- NAT has grown its cash flow and earnings, as well as increased its dividend in FY 2015
- NAT operates just a single type of tanker (Suezmax), which lowers maintenance overhead and expenses
- Low oil price environment is great for the oil tanker industry
I would like to tackle these individually below.
1. High liquidity and low debt.
There is little to argue here. At least among the three companies, NAT by far has superior liquidity position. Even if I bring in Frontline (P/E: 11.77), it still has a leverage ratio of 74.
This is good in any potential downturn in the industry or in case of rising rates, as servicing debt will not have as big of an effect on NAT as it will on its competition.
2. Operational excellence
Well, if NAT is doing well, what about SFL and CPLP? I pulled up the latest reports for all the companies and ran through the numbers (SFL has yet to report its fourth quarter, thus I'm using only three quarters of 2015 results).
|Op. CF Growth:||+204%||+77%||+7%|
No argument here either. While all three companies increased revenues and cash flow, year-over-year NAT clearly outperforms SFL and CPLP. A whole lot of it is attributable to that next bullet point -- unitary oil tanker exposure. I will discuss that later, but there is another important financial aspect to consider.
As a rule-of-thumb with majority of high distribution companies, dividend distributions have to be covered by operating cash flows. Let's see how these fared in 2015:
|Investments in Vessels:||187.4||403||207.9|
There are a few things to take away from here as well:
- All three companies generated enough operating cash flow to support the dividend payouts.
- Another observation is that all three companies invested in new vessels, with SFL leading the pack with ~2x invested compared to others.
- Lastly, NAT and SFL financed their vessel investments with debt obligations while CPLP issued equity.
Summarizing: we are witnessing a booming industry with visibly rising demand. Both NAT and SFL increased dividends in 2015. All three companies reported the "strongest" spot markets in a while with higher charter rates year-over-year. NAT is doing better than CPLP and SFL, which is reflected in higher share resilience to the downside declines and higher valuation (P/E), suggesting a perception of lower risk from the investor community.
3. The Fleets
Here is where I think a lot of the dominance of NAT's performance can be explained.
As mentioned before, NAT operates specifically in the oil tanker business, owning a total of 26 Suezmax tankers (24 employed, 2 under construction), which really simplifies the operational model and decreases maintenance costs.
In a high production of oil scenario, this is the place you would want to be, onee that will generate most return to the company and the shareholders.
On the other hand, SFL owns 18 tankers, 22 dry bulk, 20 liners and 10 offshore vessels with additional 6 vessels under construction. I believe this exposure to oil drilling and coal industries explains the significant weakness in SFL shares. The fact that three rigs are chartered to Seadrill (NYSE:SDRL) and the leverage the SFL is exposed to amplifies the risk and concerns.
CPLP owns 20 product and 4 oil tankers, 9 container vessels and one bulk-size carrier. I couldn't find much in the financials or the conference call transcript that could explain the 40% decline in less than 1.5 months. Except for one line that could mean a whole lot:
We continue to monitor the slowdown in certain key routes of the container market at a time of increased supply of container vessels, which has negatively affected container charter rates and asset values, as well as the heavy ordering for crude tanker vessels in 2015.
Which sets me up for the last bullet point from above:
4. Low-priced oil and high-volume shipping
The question is whether it's here to stay.
The shipping industry, just like most others, is cyclical. And the low-price high-volume environment that NAT is enjoying will not remain this way forever. In fact, while in the short term it may even benefit from increased Iranian oil production, in the long term the volume is bound to go down, independent of oil prices.
Essentially, there are two paths from current production volumes: (A) OPEC and Non-OPEC do coordinate and there is a production cut, or (B) they don't coordinate, prices drop even further and a whole lot of producers go bankrupt.
The current market scenario is a stalemate for Saudi Arabia: current prices are insufficient to break US shale, yet unsustainable for the Saudis themselves as they are operating at a loss and the cash burn will have to end. They either have to give up the policy of low prices and agree to the cuts to improve their own financials, or force prices lower to push US producers into Chapter 11. Thus independent of where the prices go, the volume of shipments is unlikely to be sustainable at these levels for much longer.
So what happens in the downturn when shipping demand drops?
First, when demand flattens and the supply of tankers is abundant, the decline in charter rates occurs. Then, as demand starts to decline, you witness overcapacity which eventually results in scrapping of older vessels. In extreme circumstances, your net profits and cash flows may even turn negative.
So how do you manage those situations when you have debt interest obligations and "consecutive" dividend distributions, low cash liquidity and negative profits?
I've pulled up several end-of-year reports for NAT:
|Investments in Vessels:||73.8||7.0||2.7||91.5||194.4|
|Credit Facility (Net):||0||0||20||155||75|
And here is the true picture. The picture that explains it all:
Whenever there is insufficient cash flow to finance distribution of dividends, all high-yield companies turn to the only two available sources of financing: additional debt obligations and equity dilution.
The Fly in the Ointment: "Oil Storage" Fears
In the interview, around the 4th minute, Michelle Caruso-Cabrera, CNBC Correspondent, floated the speculation by some analysts that oil tankers are used for storage in this environment. The sharp and abrupt denial from Mr. Hanssen that this is not the case comes as especially surprising in light of the following excerpt from Q4 2014 press release:
In recent weeks we have also seen a return of the contango trade where oil traders from time to time buy oil, store it in tanker vessels and sell it for future delivery at a profit, normally in one operation. This is taking transportation capacity out of the tanker market and is in turn increasing rates.
While I'll give the company the benefit of the doubt that things might have changed over the year, I don't believe that's likely. If at the end of 2014, companies were willing to store crude oil at $55 in hopes of selling it at a higher price, I would only expect them to store even more when crude trades at $30. If that logic holds, than the number of "storage tankers" would probably be much higher today.
The Bottom Line
First of all, I want to point out one important factor: in a world where a 10-year T-Bill yields 1.75%, anything that yields over 10% simply can not be considered safe. You don't need to have a finance degree to understand that the delta between the "safe" and "unsafe" yields is exactly the risk factor, be it liquidity, market or any other type of risk.
An increasing yield on a high-dividend stock is a signal of one of the following: either a company boosted its dividend, and assuming risk factors remained the same, investors will quickly bid the share price up to historical yield levels; or the share price has fallen and is unable to come back up, which means investors are fearful of a looming dividend cut, pre-positioning the share price to correspond to historical yield once the cut does occur.
That said, NAT is in fact one of the safer choices in this high-yielding sector. It has a very reasonable leverage ratio, lower operational costs (due to unitary fleet structure) and the most profitable market segment in the shipping industry at present time.
While SFL has been my all-time favorite, it has heavy exposure to offshore drilling and specifically Seadrill, which raises a big red flag. Paired with very high leverage ratio, I would even question SFL's dividend sustainability in the long run. CPLP seems a less risky play, yet the 25% yield implies market expectations for a dividend cut. Without clear understanding of why should that happen, I would remain on the sidelines as it seems I'm missing a key risk factor.
But the question is always about valuation. If everything looks so good, why have shares declined more than 25% this year alone?
The "slim" distribution model is a "boon and bane" all at the same time. It enables companies to outperform the market in favorable conditions and becomes detrimental when business is lousy. NAT is presently in the boon period, enjoying the outcomes of oil producer misery and forced elevated shipments to compensate for falling oil prices.
But that cycle in the shipping industry may be peaking today, and I'm inclined to believe the market is starting to price-in the saturation, with expectations of lower volumes of oil to be shipped as well as potential global recession driving diminished demand for goods in general. And in that scenario, the rates may eventually trend down, certain ships and tankers end up idled or scrapped, and delivery of newbuilds will get postponed, essentially trapping invested funds.
If you are a long-term investor, current price levels do present an attractive opportunity to begin establishing a position. And of the three companies analyzed, I would choose NAT as my first pick given its superior balance sheet. But the volatility in oil and the overall market may cause further double-digit declines for all participants in this industry.
Make sure you can stand the swing in prices without abandoning your position. Otherwise, I would suggest remaining on the sidelines and seeking safer (lower) yielding securities.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.