"The years teach much that the days never know" - Ralph Waldo Emerson.
"It's always darkest before pitch black" - Kelly Robinson (I Spy)
On June 15th, I wrote an article (found here) on Star Bulk Carriers Corp. (NASDAQ:SBLK) describing why I was buying the Star Bulk Carriers Corp. 8% Retail Notes due 2019 (the "Notes", symbol "SBLKL"). Several commentators (the "critics") criticized the analysis as well as the claim that Star Bulk's assets will be sufficient to ensure the value of the Notes, attempting to refute the logic of my earlier article. In addition, one critic published an article (after I began this one) on SBLK and SBLKL with a different perspective (found here). The purpose of this follow-up article is to address the core issue of the disagreement and allow the reader to make her or his judgment about which thesis is correct.
The core of the disagreement between the author and the many critics revolves around the following comment by another contributor: "The fleet is worth tremendously less than what 'book value' purports".
As you will see below, both the author and the critics agree that the actual value is less than the book value; however, the core of the disagreement revolves around the degree to which that actual value is less than book value. My argument is that, for the critics to be correct, there must be an unreasonable overvaluation of the book value relative to the "real" value, and there is significant evidence (e.g., recent market transactions) that conflict with the draconian discounts being assigned to the fleet by the critics. I further argue that while the source of my financials are highly transparent, tracing the roots of my argument to the most recent balance sheet and financial data, the financials provided by the critics to support their arguments lack that same transparency while appearing to be unrealistically negative. Finally, I argue that steps taken by SBLK to improve its financials have been inadequately recognized by the critics (i.e., impact of 2016 sales of ships on the balance of assets to liabilities).
The author will conclude with a confirmation of the conclusion of my earlier article: there are sufficient assets to backstop the value of SBLKL which provides sufficient margin of safety for the purchase of the "Notes", providing a significant upside of a 28% total return (at the time of the earlier article) for which the manageable risk (a risk significantly less than claimed elsewhere) is more than compensated. SBLK has taken a number of steps not reported by the critics to mitigate the risk and has a number of tools at hand to provide additional improvement to the balance sheet.
Ultimately, it will not be the predictions that matter, but rather the value of SBLKL on Nov. 16th, 2019 (the day after redemption). On that day, price is truth and concludes all arguments.
Revisiting the Underlying Value for SBLK and SBLKL:
Let's begin (again) with the latest full balance sheet for SBLK published which is the balance sheet at the end of 2015, which was the basis for the previous article:
The thesis of my argument was that there were more than enough assets to backstop the value of the 8% Star Bulk Carriers Notes due 2019 (SBLKL), with equity representing greater than 50% of capitalization. I indicated that "there are assets backstopping the face value of the Notes with a substantial margin of safety", but stopped short of providing the additional detail (found below) as to why those assets would be sufficient. With the arguments included below, the earlier article would have become far too long and unwieldy.
To reiterate, the argument is about the extent to which the "fleet is worth tremendously less than what 'book value' purports" and the extent to which that value is, or is not, sufficiently discounted to represent a threat of impairment to the Notes.
So let's make this simple for everyone. Let's recreate a balance sheet with only current assets (cash equivalents) and "ships" as opposed to PPE, plus all of the liabilities included in the balance sheet above. This way, no one is distracted and we can focus on the few critical issues (cash, value of ships and total liabilities):
Please note that I have zeroed out $155,825 in assets to simplify the argument down to a few illustrative specifics (much of the $155K represents advances on future vessels) while keeping all of the liabilities. However, I can dispense with these assets and still make my case that SBLKL is well-backed by assets.
Prior to considering whether SBLKL is indeed backed by assets, we can further refine the scenario balance sheet by published transactions subsequent to year-end 2015 (i.e., subsequent to the latest balance sheet):
The receipts for the sale of six ships, representing nearly 8% or so of the total existing fleet, were documented in press releases by SBLK. No book values (i.e., "carrying values") were offered in the press releases, and I could only trace back the carrying cost of three of the six ships sold, which were existing ships (Deep Blue, Indomitable, Obelix) for which their carrying costs were found on p. 85 of the F-20 2015 Annual Report. In addition, although I could not find the value of the "newbuild" vessels in the 20-F 2015 Annual Report, they were sold at prices consistent with the book value of other similar vessels (with carrying costs typically in the $36-$37M range, with some sporadic exceptions). That is, transactions carried out in 2016 were done so at essentially book value or at prices consistent with book value for similar vessels. We will return to this point.
The three vessels existing in 2015 were included in the "Ships" line and were sold at a total of $97,300 (See "Current Ships" column above). Therefore, the simplified "scenario balance sheet" would be modified by subtracting the carrying cost of the ships from the "Ships" line and adding the cash received to the current assets line, to wit:
The $97,300K cash received for the three existing ships has been added to the current assets line and a like amount has been subtracted from the "Ships" line.
The remaining three ships (i.e., the "newbuilding" column) would not be sales included in the existing inventory; rather, they would be sales of ships being built and the receipts for those ships would be most appropriately used to offset upcoming obligations for payment completions of these ships. This would reduce the outsized upcoming obligations for untimely shipbuilding about which both the critics and the author are concerned.
Now, we can look at the degree to which the value of Star Bulk Ships needs to backstop liabilities. As we do so, let us assume that the Star Bulk Retail Notes are the junior-most debt instrument to avoid bickering around who gets paid first. It won't matter.
Here is the revised balance sheet if the available current assets are used to offset total liabilities. Many critics have argued that we cannot use book value of the "Ships" line to offset liabilities, but no one has argued that current assets are worth anything other than face value (and it would be ridiculous to do so), therefore:
As noted above, the core critique has been that the "fleet is worth tremendously less than what 'book value' purports". OK, got it. I agree that in this environment, book value is higher than "fair value". However, for my thesis to be incorrect, the fleet has to be massively less than what book value purports (i.e., less than 41% of what has been reported). This is an exaggerated discount with which I take issue. In addition, if one considers the $321,000K impairment already taken in 2015 to address "overvaluation" of book value relative to actual value, such a discount is even more unreasonable. As we will discuss below, such unreasonable and draconian discounts tend to be applied near cycle bottoms.
So the first argument is that the values of the ships would need to have been discounted to an unrealistic basis in order for the debt to be affected, even if the actual values are somewhat lower than book value. Indeed, there could be a substantial discount to the book value (and probably is) without the value of the debt to be affected.
The second argument is that such a severe discount would conflict with the market transaction data referenced above. Nuclear winter may be coming, the sky may be falling and the value of ships may be going to zero, but the recent market transactions suggest something different. Six ships have been sold during this quarter's (1Q) financial period (to be reported), all of which took place at either book value or values consistent with typical book values. In turn, this argues that a reasonable valuation is much closer to book value than a massive 60% discount.
The third argument that the debt is not impaired is the equity price itself. The Notes rank senior to the common shares in the capital structure and will have priority in claims against Star Bulk Carriers Corp. before any claims by the common would be satisfied. The result is that if the Notes are impaired, the common shares are worth zero. Indeed, with a market value of $3.31 on today's close (06/23/2016) and about 44M shares extant after the reverse split, there exists about $145M of common equity. This represents a buffer for the value of the Notes and would be a number much closer to zero if the critics were right about there being a risk of impairment for the debt (making the value of the common zero).
An Alternative View:
As stated above, there has been recently published an article with an alternative view on the future of SBLK and SBLKL (referenced above) with a much more negative view on the value of company, SBLKL and its future. The author is a highly followed, very experienced author having written nearly 200 articles. Be that as it may, I have some concerns about this publication:
The article indicated that the fleet value was $786,210K and was obtained from a firm highly recommended and praised by the author. I have no doubt that this company does a very professional job, is knowledgeable about the shipping industry and is an important source of this information. However:
a. It is not clear to me the nature of the calculation used to establish the value of the ships, other than that they included "recent sales transaction, newbuild cancellations, and newbuild deferrals", which I would have expected in any calculation. One is not provided the framework used to calculate value (Replacement Value? Present Value based upon cash flow? Other method?). The value appears with no background or context and that context is critical in order to know how to use these estimates (or determine that they are not applicable for the purpose for which they are used).
b. Parallel with item a. above, it is also not clear to me the core purpose for these calculations. These values were taken from a web site highly recommended by the author, but it was not made clear for what purpose these numbers are typically used. Indeed, if these calculations are to guide for tactical purchase or leasing of vessels with a very short-term focus, that is a very different purpose from a strategic calculation of value for an asset (or a fleet) that will be held for 25 years over which time TCE rates will vary significantly. We are given a number with no perspective on how it is calculated or for what purpose it was calculated.
c. The valuations provided represent massive discounts to valuations resulting from several recent market transactions.
d. Even if the valuations provided are correct, for the sake of argument, they fall short of describing a company having the negative equity required to impair the debt at this point. Taking the fleet value provided, $786M, and comparing it to net liabilities as calculated above of $680M (net of the sales of existing ships during the 1Q), that leaves $106M in net assets, relative to the revised liabilities net current assets including 1Q'16 transactions. This is still a long way from a negative equity. Add in the $50M operational cash flow loss for 2016 as estimated, one still exhibits a $56M positive cash position at the end of 2016. Yes, continued purchase of vessels may require additional financing or an equity raise, but there is $111M secured from the three newbuilds sold (please see chart above) and some reduced valuation was already anticipated in 2015 as part of the $321M impairment decision.
The alternative article also contained two sections about SBLKL with which I disagree, to wit:
e. "The ETNs are unsecured debt, so they are extremely risky at this point. The upside of SBLKL is that it gives Star Bulk some equity raising flexibility with the banks since the SBLKL class is absorbing the majority of the risk at this point."
No, it isn't. SBLKL is not absorbing a majority of the risk at this point. Unsecured debt does not mean that the company does not need to keep the creditors whole. Unsecured debt typically indicates that there are not specific assets that are used to secure the value of the instrument, but the debt represents a lien against the assets of the company overall and is an obligation of the company. In addition, it is senior to the common shares in the capital structure and has first call on assets ahead of the common in a liquidation or bankruptcy. In fact, SBLKL does not 'provide any upside in that it gives SBLK equity raising flexibility'; more likely, it might be the reason that SBLK is compelled to raise equity to avoid a default. If SBLK defaults on SBLKL, it finds itself in a liquidation process, the first step of which will be to take the common shares to zero, avoiding that only if SBLKL is made good. Subsequently, if this process follows the normal path, a recapitalization process would occur through which SBLKL creditors may well become the new equity owners of a re-capitalized company (along with new investors providing additional capital). That is, even in the case of a default on SBLKL, the Notes holders may well realize a recovery greater than the current market price for the Notes.
However, there is an extremely high probability that none of this is going to happen. Oaktree Capital Group (NYSE:OAK), the majority shareholder with about 52% of the common float, will not allow this to happen, since as it owns the majority of the shares, it has the most to lose. Oaktree is very experienced in bankruptcy and liquidation, knowing full well what it can and can't do. Checking the Oaktree Capital Group's cash position, it has cash in hand of roughly three to four times what it would take in my opinion to fully "equitize" SBLK, creating a very well capitalized entity. (Full Disclosure: I own Oaktree Capital Group in my IRA).
Please be sure to understand: the common shares are bearing 100% of the risk until their value is at zero. After that point, there is a potential issue with impairment of the Notes. However, not only is SBLKL not bearing the majority of the risk at this point, it is bearing none of that risk and the common is bearing 100% of it (until the common value is exhausted).
f. Since $50M is unsecured, SBLK could potentially bargain for up to a 75-80% secured debt to assets and issue a smaller amount of fresh equity.
I don't exactly know what this means, but SBLKL represents a liability to SBLK, must be repaid and stands senior to the common. From the banks' point of view, it would likely not blow back on them as they will typically have secured debt with assets that securitize their loan (up to the value of those specific assets incorporated into the specific loan facility). They will be viewing this as another liability. It won't necessarily be their problem, so they might loan more money, but it will definitely be the company's problem (actually, the common shareholder's problem) which will make it a bank concern (requiring yet tighter bank facility covenants, more assets or other additional demands).
The Notes also have covenants that protect the creditors as well, even if there are not specific assets set aside to back the Notes; specifically, these covenants require certain balance sheet metrics to be maintained. Yes, the company could likely get more money from banks through borrowing against what unencumbered assets they may have, but at some point, either the debt service or a failure to meet the Notes' covenants could trigger a default. If the company defaults on the Notes, the value of the common will melt away like snow hitting warm ground. Again, Oaktree will not let this happen; as a consequence, SBLKL will be made good.
I commented above about the importance of context for the valuation of ships. The following chart will illustrate why:
This graph, found on a Hofstra website profiling the history of transportation and the Baltic Dry Index, shows the valuation of the BDI throughout its history since 1985.
There are two aspects about this chart, both of which are important:
First, the more obvious point is that the current state of pricing can be found at the extreme right of this chart. Please note that we are at a historically low point, if not the lowest point, in BDI pricing throughout the entire 30-year period.
Secondly, of equal importance but may have been overlooked, prices at either the lows or highs do not remain at either place for very long. Indeed, they don't seem to stay anywhere for long. Therefore, taking current pricing and extrapolating it into the future, using it to calculate a discounted cash flow/NPV, is unlikely to provide a real assessment because, for the last 30 years, that is not how the market has behaved. This is another specific example of a very general trend; that is, markets of all kinds do not allow one to sell at the highs or buy at the lows for very long.
Extrapolating the current market pricing into the future to calculate a value would not represent normal market pricing behavior; therefore, the values calculated from such an approach would also not be expected to provide a real estimate of the value of the assets. Of course, it may be that prices will flatline and, in a completely unprecedented way, go straight out from this low pricing point; perhaps, this time will be different.
In order to generate a more realistic view of vessel values, one needs to use more of a cycle-average rate in order to value ships for this purpose. Only where the calculation is being used for immediate individual transaction might be such an extrapolation be useful; alternatively, one might use it where the company involved does not have enough cash to survive the quarters needed to get the benefit of the changed (higher in this case) price.
One of those critical of my previous article suggested that I should have "stayed in my own lane" as I was not an experienced shipping analyst. That is very good advice.
Indeed, this is advice I took forty-four years ago when I "picked my lane", focusing on analysis of capital-intensive, cyclical businesses. Specifically, I began to focus on financial analysis and investment in highly cyclical businesses requiring intensive investment in long-life assets, even as their business pricing and revenue would vary wildly throughout the life of the asset. This began in the commodity chemical businesses owned by oil companies, broadened to the oil companies themselves, then expanded further into mining and other resource activities, real estate and, yes, shipping (especially of these same commodity materials). At a later time, I began to work in the chemicals (and related) businesses (not in a financial role) and, over those intervening four decades, I have experienced several commodity cycles along with the rest of you.
You and I have seen the same behavior over and over again: unreasonable exuberance, unsustainably high product pricing and overpaying for assets or businesses at the top of the cycle, followed by rapidly declining business, unsustainably low pricing, shedding of assets at ridiculously low prices at the bottom of the cycle and depressed business leaders. Over and over again.
We are in another cycle, even if the amplitude of the cycle is greater than earlier cycles. While I may not know the bow from the stern of a ship, I know cyclical behavior, the view at cyclical bottoms and the impending sense each time that "it is always darkest before pitch black". With all due respect, this is exhibited in some articles as overly dour views of asset values (e.g., ships) and hyperbole in discussing concerns about shipping companies. Sure, this time, it may be different and maybe this time, ship values will decline to zero...
...or not. In my view, like many other times, "this time, it's the same". Low prices will provide the solution to low prices, weaker participants will drop out or be merged with stronger participants and a recovery will occur. When? I have no idea but I would expect that the more severe the downturn, the faster resolution is likely to occur (due to a more rapid market clearing).
Others have other clearly defined views disagreeing with mine; however, my view, which I have tried to make as transparent as possible, is that Star Bulk has assets to backstop the value of the Notes, that Star Bulk has the cash flow and assets to survive this downturn until the next recovery, in the case of a problem that the company (or its lead shareholder) has tools to strengthen its balance sheet (indeed, it has already done that by selling ships at prices double what the critics are claiming as their value) and that, while no one can guarantee success, that the Notes are offering a very high return relative to the risk. As noted before, I have also put my money where my writing is, investing 30-ish% of my (non-retirement, value account) assets into SBLKL.
I doubt that I will have convinced the critics, but there is a path of resolution to decide the matter. As of Nov. 16th, 2019 (the day after redemption of the Notes), price will be truth and the matter will be concluded. We will determine on that day if, yet again, "This time, it's the same".
Buy Star Bulk Carriers Corp. 8% Notes due 11/15/2019 (the "Notes") at prices up to $16/share.
Disclosure: The author is long SBLKL and this position represents a significant percentage of the author's assets.
Disclaimer: No guarantees or representations are made. The Owl is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult an investment advisor.
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.
Additional disclosure: As stated in a disclosure in the text, I own a significant position in SBLKL. It is a security not picked up by the disclosure system, thus this additional note. I also have a position in Oaktree Capital Group in my IRA.