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As an investment analyst, I prefer to avoid the term "arbitrage" as finance academics harp on the "risk-free nature" of the definition. As an economist and a realist, there is almost never a truly "risk-free" approach to investment, so I definite arbitrage as rather "an expected profit through market transactions."

The last time I publicly pushed a company as a "Solid Arbitrage Opportunity" was Dry Ships (DRYS) last fall. My editor's choice article broke down the financial construction of this company, and thus far, my pick has returned 44.6% (vs. S&P 500 of 21%) and peaked with a return of 67% on 14 Feb (vs. S&P 500 of 16.9%). I mentioned a personal target of $4, which I have revised up to $4.50 to include additional revenue upside from their Ocean Rig (ORIG) subsidiary.

Investing in unloved and volatile markets is not easy- it takes a high degree of patience. However, when an investment presents itself with a net asset valuation that is far above the offering price, it is much easier to feel secure. I believe that Euroseas (ESEA) offers both large upside (80%) and financial stability (current ratio of 1.93 and 4X forward OCF).

Balance Sheet Analysis:

$46.35M in cash and other liquid assets vs. $18.84M in current liabilities gives ESEA a current ratio of 1.93.

$51.35M in total cash and liquid assets to cover $18.84 in current liabilities and $63.13M long-term liabilities results in $30.62M of net debt covered by "book valued" vessels of $251.5M. ($237M + $14.5M invested in Euromar).

Fleet Valuation:

Panamax (5 @ 12, 14, 15, 19, & 24 yrs): = 54.5M total

Multipurpose (9 Containers / 1 Handysize @ 11-22 yrs): (4.3M - 16.8M valuations) = 71M total

Core Fleet Valuation: $125.5M vs. book carrying value of 237M (53% of actual book)

14.28% of Euromar (10 Containers @ 5-13 yrs): 179.8 @ 14.28% = 25.68M

Total Fleet Valuation: $151.2M - $10M committed to Euromar= $141.2

Equity Discount:

With a market-valued fleet of $141.2M to cover net debt of $30.62M, Euroseas has an adjusted equity valuation of $110.58M (compared to book equity of $212M) or approximately $3.56 per share. If ESEA traded at market value, there is 82% of upside.

Cash Flow Valuation:

In 2011, Euroseas produced operating cash flows of $17M, offset by $13.47M in loan repayments and $8.44M in dividends paid.

In 2012, Euroseas will produce similar operating cash flows, with my prediction at $15M, offset by $13.33M in loan repayments, $6.22M in dividends, and approx $4M from sale of vessel for scrap.

With a forward OCF of $15M, ESEA is trading at a multiple of approx. 4x. There aren't very many companies that sell for around 50% of true book that also offer 4x forward OCF.

Dilution Possibility/Exodus of Massive Shareholder:

Over the past 3 years, ESEA has issued only 910k net shares so dilution has been a non-issue; however, on 24 February 2012 a prospectus was issued which grants ESEA the right to issue up to $400M in common shares, preferred shares, debt securities, warrants, purchase contracts, and units. $400M appears to reference already issued shares (approx. 32M @ $12), and the new prospectus was only issued to satisfy legal requirements for a major shareholder who is "jumping ship" with 11.18M shares. This unnamed owner represents 36% of ESEA's capitalization.

An earlier filing from 10 February, provided a warning signal that an investor was leaving, but I does not appear that the market noticed this minor release on the EDGAR system.

ESEA shares have lost $0.967 since 24 Feb, or approximately 48.8% of their value (note: 5 cents of this fall is in relation to ex-dividend). The fall is likely due to selling pressure by the "massive shareholder." If he sold at the average volume of 93.7k, and assuming 100% of the market was made by the seller, it would take 119 days to close the full position at average volume. It appears that the seller is pushing through on a faster pace as April 2 witnessed 755k shares trading hands at approx. $2.04 (January 2010 was the last time such a "massive" volume was recorded.) Related investor flight due to an extremely weak insider signal could also be contributing to the decline.

My personal take is that the seller is under massive personal financial pressure and is simply selling his equity stake to raise cash. Rather disappointing for this individual to see his stake value plummet from IPO of $134M to Prospectus of $32.7M to market reality of approx $22M.

Investment Approach

I recommend buying ESEA for any price below $3, with my personal target set at around $4. The only negative side to ESEA is the age of the vessels; however, this has already been accounted for through market valuations.

The only red flag (and a big one) is the exodus of a majority shareholder; however, I believe this is due to personal financial constraints rather than a lack of confidence in the company. Unless the books are cooked (doubtful due to history of financials, and unflattering time contracts), there is no other reason for an insider to sell out.

With an 80% upside in market-adjusted equity valuation alone, I see no reason not to take advantage of this arbitration opportunity.

Source: Euroseas: Arbitrage Opportunity And Strong Cash Flows