StealthGas (NASDAQ:GASS) is a Greek-based shipping company specializing in the shipment of liquefied petroleum gas (NYSE:LPG) in the 3,000 to 8,000 CBM carrier segment. The company currently fields a fleet of 33 ships in this "handy-size" segment along with four much larger product tankers. LPG has a variety of commercial uses and is used for cooking, heating in rural areas, and as a motor fuel among other things. StealthGas is currently the largest player in the handy size LPG market and also operates the youngest fleet with a current average ship age of 10.4 years.
StealthGas is relatively simple to analyze as it is small, operates in only one type of market, and has a revenue stream that is easy to project due to future sales being locked in through long term contracts. As of their last press release, StealthGas currently has 86% and 68% of its ships under contract for 2012 & 2013 respectively. With this in mind, I have chosen the company as a case study on how in certain situations, aggressive share buyback programs can be enormously accretive to shareholder value.
As of their Q2 earnings release, StealthGas had a total cash balance of $57M against $362M of long term debt. It's worth noting that shipping companies tend to have high leverage ratios due to their debt being secured by actual, physical assets (the ships) and compared against the shipping industry as a whole, StealthGas' balance sheet is relatively strong.
Through the first two quarters of 2012, StealthGas made $14.5M in net income. Due to the fact that the company has the largest and youngest fleet in the market in which it has chosen to compete and has just completed a major ship purchasing program that started in 2007, I would make the argument that no new ships need to be purchased for the next 2-3 years. This allows me to add back the depreciation expense of $14.1M to the net income to get to a total free cash flow of $28.6M. Multiplying that number by 2 (the company revenue profile is linear) gets me to a total yearly free cash flow of $57.2M, or $2.78/share. With the share price currently hovering just below $7, this equates to a free cash flow yield of roughly 40% (65% once you back out the cash on the balance sheet).
With such a high free cash flow yield, the easiest way for company management to increase shareholder value (their ultimate goal) would be to repurchase shares. In today's current low yield environment, it is incredibly hard to find assets yielding double digit returns, let alone yielding 40%. CEO Harry Vafias reported in a 2010 conference call that his expected IRR on one of the company's recently purchased product tankers was between 8%-10%, further illustrating the advantage of repurchasing shares versus acquiring additional ships.
Put another way, the company currently trades at 45% of its Net Asset Value (NYSE:NAV). Therefore, by buying back its own shares, StealthGas would be buying back its own ships from current stockholders for 45 cents on the dollar versus paying full price for new ships on the open market. Previous ship sales by StealthGas have been close to book value, demonstrating that the asset value that the fleet is carried at is fairly accurate.
Given these metrics, it would seem obvious that the most logical action for the company to take would be to continue to direct its free cash flow into repurchasing shares until the company begins to trade much closer to its net asset value. Given the company's severe discount to both its cash flow yield and net asset value, the downside to this course of action would be extremely low.
Unfortunately, instead of doing what is in the best interests of current shareholders, the company has recently announced that it has entered into an agreement with a South Korean shipyard to buy four additional LPG ships to be delivered in 2014 for $100M. Historically, StealthGas has financed its ship purchases with 30% equity and 70% debt, so effectively the company will see a cash outflow of $30M along with seeing its long term debt increase by $70M as a result of this ship purchase.
The math behind this deal does not make sense. At current prices, StealthGas could take the $30M it is going to allocate towards this new building program, tender an offer to existing shareholders at $7.50 and retire 20% of the outstanding float. This would increase the free cash flow yield to remaining shareholders from 40% to 50%, all without increasing leverage! Management could continue to repurchase shares and increase its free cash flow yield until either the entire company is bought back or, in the more likely case, the stock price rises to reflect the earning power of the company.
Unless these four additional ships can have a similar effect on the free cash flow yield per share by dramatically increasing revenue (exceedingly unlikely), then shareholders would be much better served by management forgoing the new ships and simply repurchasing shares. I am not against renewing the fleet over the longer term but not in a current market environment where the shares are so severely discounted.
In the end, I believe StealthGas is yet another example of the importance of having CEOs aligned with shareholders. The company has seen a significant share appreciation YTD, but the rise could have been much greater if shares had been repurchased. In the Q2 conference call, Mr. Vafias reported that the company had not repurchased a single share, while at the same time stating his belief that the shares were significantly undervalued!
Warren Buffett constantly mentions the importance of coupling a wonderful business with great management; free cash flow is only as good as the capital allocators who control it and if they are working solely to further expand their empires versus doing what is in the best interest of the company owners, shareholders will ultimately suffer.