We have been following for a while the tanker business and believe this is a good time for a relative play given the drop in the last few months. We believe shorting Frontline (FRO) and hedging the tanker market with a long position in DHT Holdings (DHT) is a very attractive strategy.
While FRO is probably a dead man walking (was just downgraded to $2 by DB), DHT has raised fresh equity and sorted out its debt for the next couple of years. In addition, DHT will probably use its cash balances to expand its fleet. Both companies share similar risks as they are exposed to the tanker spot market and their fleets have similar characteristics.
As part of a restructuring of Frontline in December 2011 and the sale of all of its modern vessels to a related party, Frontline restructured its leasing agreements with Ship Finance. This restructuring reduced the fixed component of the leasing payments by $6,500 per-day per-vessel and enabled Frontline to avoid insolvency. However, Frontline will pay to Ship Finance (the related party) any amount earned up to the original amount (before the rate reduction), plus 25% of the earnings above the original amount. That means that Frontline will start to receive cash from the vessels only if they are able to earn more than the original agreed lease payments. Furthermore, it will share 25% of the additional profits with Ship FInance. For example, Frontline disclosed its cash breakeven rates on VLCCs - $24,100 per day. That means that only if rates increase to more than $24,100+6,500=$30,600, Frontline will start to receive any cash, and even then, it will retain only 75% of it.
As Frontline has cash for about a year or so to operate (taking into account Frontline has significant commitments), investors in Frontline need charter rates to increase very quickly and significantly over and above the originally agreed rates in order not to burn the money left.
In addition, as recently observed, all the modern vessels have been sold to John Fredriksen's Frontline 2012 (Fredriksen is controling shareholder of Frontline and Frontline 2012 Ltd) which left the company with a relatively old fleet. Fredriksen has recently announced the purchase of 24 new tankers for Frontline 2012. As Fredriksen chose not to put his hand into his pocket and rescue Frontline, but rather buy the vessels for his new venture, Frontline 2012, we believe Frontline is of less interest to Fredriksen, and we don't expect much more than survival tactics.
As a result, we believe shorting FRO while hedging the shipping market risk through a long position in a company with very similar exposure provides a sound investment.
As DHT is less known than Frontline, we will provide some background on the company.
Who is DHT?
DHT is a Norwegian tanker owner that was spun off from OSG in 2005. In 2010 the company changed management and decided to be more of an operating shipping company and less a long-term tanker leasing company, and as such to have more exposure to the spot market. The company's long leases will be maturing between 2012 and 2018 (one vessel in 2018), and therefore will have significant exposure to the spot market - as does Frontline. Until that happens, DHT is earning above-market rates on its vessels.
DHT's share price has fallen this year from a high of $4.14 to $0.60. In addition, DHT has just raised $75 million of fresh equity in a right issuance which has contributed to the decline in the share price. As part of the investment round, Anchorage Capital invested in the company and is holding currently more than 30% of DHT.
DHT has made money each year other than 2011, in which it recorded a non cash impairment charge. DHT had positive free cash flow, and has distributed dividends each year since listing. The following is the company's financial performance since 2008:
Similar vessels and market value
DHT has just raised $75 million and is traded at a valuation of $108 million (adjusted to the conversion of the preferred stock just issued). Backing out from the market value, we can find the valuation assigned to the vessels themselves by investors.
Doing the same exercise for Frontline we find that the market is actually providing Frontline a premium over the book value of its vessels:
DHT booked an impairment loss of $56 million in 2011 and investors are valuing DHT's already-impaired book values at a 41% discount, while valuing Frontline's vessels at a 15% premium on their unimpaired book values (Frontline didn't impair any of the vessels it still operates).
Obviously the question that should be asked is, is there any material difference between the fleets of DHT and Frontline?
DHT owns 5 VLCC, 3 Suezmax and 2 Aframax vassals with average tonnage age of 11.8 years. Frontline owns 47 VLCC and Suezmax vessels with an average Tonnage age of 13.5 years. So from an age perspective they are pretty similar.
What about the values assigned by the market to the vessels? Based on our assumption on Suezmax and Aframax vessel's values ($10 million and $20 million respectively), we find that the implied value of a DHT VLCC is about $38 million while Frontline's VLCC's are valued at $37 million a piece. So also from a valuation we have pretty much similar values.
Both companies have significant exposure to the spot market price while maintaining some long-term contracts. However, a significant difference between the companies is that any change in the spot market will translates 100% into the P&L of DHT (as its vessels long term charters are ending), while Frontline needs to pay most of the excess cash flow to its leasing counterparties. Frontline and Ship Finance (a related party that finances most of Frontline's vessels) agreed to reduce the fixed component of the leasing agreement and in return, Frontline will pay a reduced fixed amount. However, any income up to the previously agreed rate, will be paid to Ship Finance. It's basically similar to a cash sweep of a bank. In addition, Frontline needs to share 25% of the income earned above the original rate.
Frontline disclosed in its Q1 2012 presentation its cash breakeven rates for 2012 (which don't include vessels on short term TC, vessels on BB, capex and balloon payments on loans):
According to this, Frontline is exposed 100% to the rates going down, will earn $0 if rates are between $24,100 and $30,600 (an example of a VLCC), and 75% of the income above $30,600.
DHT on the other hand, generated in 2011 $44 million of operating cash flow. However, as the long-term charters of DHT end, it will be exposed to the same risks as Frontline on the downside, but have 100% of the upside.
We modeled the cash flow capabilities for each company given different earnings rates for VLCC's and Suezmax's. The following is the cash flow per share we believe DHT is able to generate at different shipping rates scenarios and our long-term base scenario:
In addition, we have modeled also the same for Frontline:
Based on the current prices of DHT and Frontline, buying 8.4 shares of DHT while shorting one share of Frontline would result in a $0 cost and the following cash scenarios (cash generation of long 8.4 shares of DHT less the cash generation of a short position in Frontline):
As evidenced in the above analysis, in every market condition DHT will probably outperform Frontline and the strategy mentioned above will not require any cost and will generate significant profits.
As DHT pays currently $0.08 of dividend p.a., and Frontline does not pay any dividend, nor is it expected to be able to pay dividends any time in the future, we will collect 8.4x$0.08=$0.64 of yearly dividend for each share of Frontline sold. In addition, we believe we will gain on our short position as we believe that in less than a year Frontline wither go insolvent or near insolvency as we don't believe market rates will rebound anytime soon. We believe DHT has all the resources to survive the crisis (it has still some long term charters, no debt repayments until 2015 and about $100 million of cash) and as such we stand to gain significantly from the long position.
We are short a company that has no chance to survive/generate any profits to its shareholders (and also its founder does not believe in it as it looks) and long a company that has been restructured and has cash for expansion. In addition, we have hedged the tanker market risk and our position is generating dividends.
Additional safety for the trade:
- Buying a company that is paying a dividend and shorting a company that is not paying dividend .
- DHT has about $100 million in cash while its market cap is barely above $100 million. Frontline has about $160 million cash while it has additional significant newbuild commitments.
- DHT will most likely acquire more vessels at historically low prices with its cash balances further strengthening its earnings capabilities while Frontline will need to pay top prices for its new committed vessels.
- DHT has almost no debt repayment until 2015 while Frontline needs to repay in 2015 more than $200 million of convertible loan (which is trading at $0.67 on the dollar-or 21% yield).
Disclosure: I am short FRO.