It is no secret that the shipping industry is experiencing hard times; lackluster global demand and an oversupply of vessels have caused shipping rates to plummet. The industry has seen once predominate players like General Maritime go bankrupt while others look like they are on the verge including Eagle Bulk (EGLE) and Excel Maritime (EXM). Often in times of crisis, not only do major industry players get hurt but so do the suppliers to the troubled companies. I see the trouble spreading to bunkering companies, specifically, Aegean Marine Petroleum (ANW). Aegean is an over levered trading business combined with restrictive debt covenants and poor cash flow generation; I see a high likelihood the equity value could fall 75% to $1.50 within 12 months.
If you're not familiar with bunkering business, basically bunkering is the shipping term for "gas station in the ocean." The companies buy bunker fuel (i.e. marine fuel) from suppliers like refiners and oil companies and deliver it out to ships in the ocean. For this service, bunker companies make a spread or a small mark up on the fuel. Since the gross margins are only 3-5%, the companies need to sell millions of tons of fuel per year to cover operating expenses. In addition to grocery-store like razor thin margins, the companies accept credit risk because they deliver the fuel before collecting the cash.
Short Investment Thesis:
- Deteriorating industry fundamentals
- Morphing business model into an over levered asset heavy storage business
- Poor asset utilization
- Consistent negative cash flow from operations
- More levered than appears
- Overstated book value
- Strangling debt covenants: leverage and current ratio
- Questionable accounting treatment
- Significant valuation along with sell-side estimates too high
Shipping companies have to combat low day rates and high fuel costs. At the same time, bunkering companies are suffering from "slow steaming," which means the vessels are driven at slower speeds to conserve fuel. Since shipping customers usually pay for the fuel used during the charter they are demanding the vessels take a few extra days as long as the trip consumes less fuel. In addition, slowing global GDP requires fewer goods need to be shipped around the world.
Changing business model
Over the past few years, Aegean has grown a tremendous amount. Since 2008, Aegean has increased the number of vessels 250% from 23 to 58. The company has accomplished this by an aggressive vessel purchase program as well as purchasing a bunkering company to have access to new markets. Further, Aegean is constructing a few on-shore storage facilities so it can hold inventory. In my eyes, once a small, asset-light trading business is morphing into a large, asset-heavy, high fixed cost storage business, the result leaves the company susceptible to adverse business conditions. Just this week, a competitor based in Singapore, Chemoil, announced it was divesting its subsidiary, Chemoil Storage Ltd. The company stated in the press release, "The company believes that structural changes that have occurred in the marine fuels market will in the future favour an asset-light business model that is more able to respond quickly to volatility in volumes and margins."
The problems in the business are showing up in several areas.
As the fleet has grown, bunker sales volume has not kept up. Industry and business headwinds are making Aegean's business more difficult, even as the company is growing into new markets. Since Aegean must take on the credit risk of its customers, the poor health of global shipping companies has put additional stress on sales volume growth. To illustrate this, the volume per average number of bunkers is down to 500 tons per day, the level where the company was in the height of the financial crisis.
As utilization has decreased, so has the operating leverage of the company. Fixed costs have grown faster than EBITDA, reducing EBITDA as a % of Gross Spread from 84% in 2004 to 32% in 2011.
Further, more EBITDA is coming from non-core business like voyage revenue and "other revenue" which is basically brokerage fees paid to Aegean for bringing bunker sales together. As a % of total revenue, these two sources were 8.6% in Q2 2012 up from 5.9% in 2009. Growth in these non-core businesses increase EBITDA because they are much more profitable than bunker sales.
Aegean's gross margin has been declining for years, from 7.5% in 2006 to 3% today. The company has been growing expenses from additional overhead and increasing interest costs from a larger debt load. Currently the operating margins are sub 1%. In addition, Aegean capitalizes the maintenance costs (dry docking costs) and consistently underestimates them, further reducing real profitability. Dry dock expenses were underestimated by $929k, $4.3m and $2.8m in 2009, 2010 and 2011 respectively. Going forward, future dry dock costs will be trending higher due to the growth in the fleet.
Cash Flow - Years of negative cash flows from operations
Since the company delivers the fuel before collecting payment, the balance sheet contains a large asset account, trade receivables. The business can be very cash straining in times of rapid growth or a rising oil environment, making it difficult to grow without using borrowed money. A large negative cashflow from operations occurs from the increase in trade receivables. This large cash outflow is facilitated by debt issuance reported in the cashflow from financing. Aegean has been able to execute this growth strategy through consistent increases in bank debt, mostly in the form of short-term debt from various European banks. Recently, the banks have started to put their foot down by increasing the debt covenants, forcing the company to find new financing methods. Management chooses to use debt to refrain from additional equity dilution. In Q3 2011, I learned through a sneaky little footnote on the last page of the 6-F the company has resorted to selling its trade receivables to help satisfy the short fall in cashflow.
- 4th Quarter 2011, a 11% decrease in volume should have benefited cashflow from operations (lower trade receivables), except a benefit came from a $51m sale of A/R, thus cash flow from operations was negative even as volume decreased.
- In 2011, the company sold $148m in trade receivables to bolster cash flow. Without this sale, cash flow from operations would be -$193m. (page F-20 of 2011 20-F)
- Year to date 2012, the company has sold almost $300m in trade receivables. (page 5 Q2 6-F) to fund negative cash flow (See Debt Covenants section for more information)
This strategy doesn't make sense and can't be sustained for 2 reasons:
1. The discount that Aegean must give up to sell its trade receivables (sales are nonrecourse) is much larger than the 3% gross spread the company earned on a typical bunker sale, resulting in an outright loss on millions of dollars of revenue. To make this point, I'll use the terms from World Fuel Services' (INT) 2011 10-K:
- Sale price is 90% of the sold accounts receivable balance less a discount margin equivalent to a floating market rate plus 2% and certain other fees, as applicable.
- INT retains a beneficial interest in the sold accounts receivable of 10%, which is included in accounts receivable, net in the accompanying consolidated balance sheet.
In aggregate, Aegean has sold $548m in trade receivables, netting the company roughly 88% or $482m. The difference ($66m) is more than 3 years profits that isn't showing up in the income statement, balance sheet or cash flow statement.
2. A good detail of Aegean's debt is secured by the trade receivables, therefore if the company sells the receivables, the cash has to repay the debt and cannot be used to purchase more bunker fuel.
Questionable accounting used for the sale of trade receivables
In Q1 2012, Aegean was able to renegotiate a senior secured debt issue. The banks agreed to increase the leverage ratio from .65x to .70x. I believe Aegean was able to convince the banks it was less levered than it really was by the way it accounted for the sale of the trade receivables. Aegean accounts for the financing as a sale of the trade receivables rather than a borrowing secured by receivables. There are very large implications resulting from the accounting method chosen.
After reviewing my accounting books, I used the McGraw Hill web site:
In order to account for the transaction as a sale, the follow criteria must be met:
- The receivables have been isolated from the transferor
- Each transferee has the right to pledge or exchange the assets it received
- The transferor does not maintain "effective control" over the transferred assets. Effective control would exist, for example, if the transfer is structured such that the assets are likely to end up returned to the transfer.
#3 is where I see a violation. Since Aegean collects a servicing fee, it is a clue Aegean still collects the payments from customers. This means Aegean is maintaining control. Therefore, the transaction should be accounted for as a secured borrowing, not an outright sale. What benefit does ANW achieve by accounting for the transaction as a secured borrowing rather than a sale? By painting the transaction as a sale, Aegean can present itself as less levered because the receivables are removed from the balance sheet along with the associated liability. Further, if Aegean accounted for the transaction as a secured borrowing, it would have to also disclose the age of the receivables, amount past due and any charge-offs occurring during the period. By not disclosing this information, investors can't discern if Aegean's creditors are paying their bills.
Overstated book value
For a few quarters the company has been selling its older ships to reduce expenses and raise cash. Fortunately, these data points have given investors a mark to market value for the entire fleet. As of June 30th 2012, Aegean had the vessels marked on the books for $467m, net of depreciation. Since Aegean has just completed a massive vessel purchase program, we know the value of a new vessel, $13.5m on average. If I use a 30 year useful life and $500,000 salvage value, each ship depreciates by $433,000 a year. Using this analysis I value Aegean's fleet at $383m, which is $84m less than where the vessels are on the balance sheet. A write down would trigger a covenant violation. In order to renegotiate the covenant violations, management negotiated to increase the minimum book value figure from $375m to $410m. Current book value of $487m less a write down of $84 brings book value to $403, just shy of the $410m covenant.
In addition, the company has a significant amount of goodwill and intangibles ($58m) on the balance sheet. I have been surprised to see how reluctant the company has been to write down the value of both as macro fundamentals have deteriorated. To achieve this, the company has recently reduced the weighted average cost of capital used in the annual test for impairment. Impairment to both assets as well as PP&E would be detrimental to the value of the company. Most importantly, Aegean's debt contains cross default protection so if one issue is in violation, all issues immediately mature.
Strangling debt covenants
As I mentioned earlier, Aegean's lenders have been increasing the covenants on the debt. As of the 2011 20-F, the company was in violation of two covenants, the current ratio and leverage ratio. Recently, the company has successfully negotiated with its lenders to lower the current ratio from 1.15x to 1.10X and raise the leverage ratio from .65x to .70x. In turn, the company has agreed to increase the minimum book value amount from $375m to $410m, which is very close to being violated.
Other questionable accounting practices
I have been astonished at Aegean's questionable accounting practices over the 3 years I've been following the company. Some of the questionable things I've seen are:
- A total revamp of the income statement last year. Details of the sources of revenue and expenses were both added to footnotes - I think to hide that more gross profit is coming from non-core businesses.
- Very low absolute levels of bad debt provisions, even as trade receivables have grown along with revenues. Bad debt expense is $300,000 in a given quarter.
- Aegean's gross spread computation includes its subsidiary Aegean Oil's margin.
Like other over levered shipping companies, Aegean is trying to defer dilution and stay "afloat" through the global recession. I think management is going to be forced to bite the bullet and raise equity capital. The company will need cash for upcoming capital expenditures for the on-shore storage facility in Fujairah and Jamaica. As of June 30, 2012 the company is committed to $40m through 2013 and has $148m in long-term maturing in 2013.
Option 1: Issue equity at a discount to book value
If the company could issue equity, which I think it can but I'm unsure of the price, shareholders would be diluted by 39% assuming the company raised $100m at $5.25 (19m shares). This would give the company enough cash to satisfy upcoming capital expenditure requirements as well as provide some working capital to grow volume.
Option2: Sell off more non-core assets
Recently the company has been slowly selling off older vessels to lower expenses and also raise cash. The problem with this strategy is the older vessels are only worth $1 million dollars each but on record on the balance sheet for much more and the company is handcuffed by the minimum equity value covenant. This is evident is the past few sales, the company took a book value hit in 3 of 4 vessel sales. I believe the company has roughly 11 vessels it could sell, all vessels older than 20 years, which could fetch the company $12m. This isn't a viable strategy because book value would take a $25-30m hit.
All the risks I have pointed out and the stock still trades for 10.1x EV/ Trailing EBITDA and 13.6x trailing earnings, which are overstated by capitalized dry docking costs. I think sell-side analyst estimates for 2013 growth in profitability (EBITDA growth of 26% and operating growth of 41%) are too high. I'm not smart enough to know what accounting tricks the company has up their sleeve but I know profitability and cash flow is only driven by two factors: gross spread and volume. The company has little control over gross spread, already at the top of its range, due to competition investors can't count on gross spread increasing, well unless management lowers the bar and assumes greater credit risk. This leaves us with volume growth. Given the company is so levered, Aegean will have to increase its debt because it can't shorten its cash conversion cycle fast enough to generate enough cash to purchase more bunker fuel and the company can't increase leverage because its creditors are already beginning to tighten lending terms. The best thing the company can do is shrink, unwind its trade receivables into cash and raise equity before it's too late.
My 12 month price target is $1.50 per share. In order to get to my target price, I had to make a few assumptions. I assume the company will be able to roll over the upcoming senior secured debt issue in January, albeit at very restrictive terms. At year end, I factor in the company will not be able to get away one more year with writing down the value of the goodwill and intangibles resulting in an impairment of $40m. In addition, I assume similar impairment of PP&E of $60m. Lastly, I assume the company will do a massive dilution equity raise of $100m at $5.25.
In January 2013, one of the company largest debt issues comes due. This particular issue is also the most restrictive of all the debt. I will be paying close attention to the size and terms of the deal. An increase in the interest rate and the covenants will be bad news for the equity holders. In addition, I can see an eventual write down of the goodwill as well as a future equity raise further pushing down on valuation of the company's book value.