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Market observer with legal background and interest in financial services, physical commodities trading, shipping and irrational exuberance. Values entrepreneurship and good governance, may also use some behavioral investment/contrarian criteria.
  • Depreciation Policies for Some Listed Tanker Companies - Euronav an Outlier 1 comment
    Jun 27, 2011 2:41 AM | about stocks: EONVF, EONVY, FRO, TNP, GMRRQ, TNK, OSGIQ, NAT, NNA
    NOTE - this note has been updated since originally posted.

    This is a sister post to http://seekingalpha.com/instablog/927562-adjusted-return/186005-depreciation-policies-for-some-us-listed-drybulk-companies. Reiterating some of the material of the prior post, the two assumptions affecting the depreciation rate are a) the estimated useful life of a vessel, expressed in years and b) the residual or salvage value based on scrap iron price per lightweight ton (lwt or ldt). (The constants for each company are each vessel's acquisition cost, built year, acquisition date and lightweight tonnage. Method is straightline.) Longer useful life periods or higher residual value assumptions both reduce depreciation and increase reported income. Conversely, shorter useful life assumptions or low residual values both increase depreciation costs and reduce reported income.
     
    As a non-cash cost depreciation is often ignored. Many companies focus on EBITDA, which excludes depreciation, as a preferred performance metric. It is also true that the market value of a shipping asset can vary considerably over its lifetime, so that banks and investors look directly to market values for covenant and valuation purposes. However, while depreciation policy may not be in itself material for valuing a company, it is an indication of aggressive/conservative accounting treatment and perhaps hidden values, in particular during an economic downturn.

    Below is a list of depreciation policies adopted by certain listed tanker companies, for their tanker vessels (not FSO, FPSO, LNG vessels etc):

                        Useful life/Salvage value
    Euronav:     20 years/0
    Genmar:     25 years/$175 per lwt
    Frontline:    25 years/$271 per lwt
    Navios Acq:25 years/$275 per lwt
    Tsakos:      25 years/$300 per lwt
    OSG:          25 years/$300 per lwt
    Teekay Corp:  25 years/NA
    NAT:         25 years/$4 million per vessel (all double hull Suezmaxes, say 14,000 lwt) 
    Sovcomflot: 25 years/$490 per lwt

    The U.S.-listed group maintains relatively uniform policies but I was struck by Euronav's estimate of 20 years for useful life and zero scrap value. Why would they use such a conservative policy?

    A couple of hypothetical examples illustrate the point: Two tanker companies, TCA and TCB take delivery of 5 newbuild VLCC each during the same year, purchased at a price of $120m per VLCC for a total of $600m for each company. Each company sells 10m shares at $20 in an IPO in order to finance the equity portion of the vessels, the rest covered by bank finance; all vessels are entered into the same externally managed pool. TCA uses Euronav's 20 years/0 residual value depreciation policy, TCB, a variant of the Sovcomflot policy, say 25 years/$500 per lwt. We assume that each VLCC weighs 40,000 lightweight (scrap) tons to get some round numbers - that's a $20m residual value for each TCB vessel.

    TCA's depreciation expense will be $30m annually over 20 years, reducing the book value of its vessels to zero. TCB's depreciation expense will be $20m annually over 25 years, reducing book value to $100m, which may or not be the scrap value at the time. All other things being equal, the difference is a $10m annual hit to the income statement of TCA compared to the one of TCB, for exactly the same ships. With revenues and cash earnings exactly the same, that is a $1 per share difference in reported income until year 20. The situation will reverse in years 21-25 or will result at a $100m one-time gain at year 20 for TCA if they decide to scrap (and assuming the scrap price is indeed $500 per ton).

    Assume now a similar scenario where these ten VLCCs were 5-year olds bought at the same prices prompt delivery during the same year. TCA will now report a $40m annual depreciation charge over 15 years while TCB will report a $25m charge over 20 years - the gap widens to a $15m or $1.5 per share difference in reported income.
     
    Considering that Sovcomflot is being groomed for an IPO it is no wonder they use accounting policies that increase reported income.

    On the other hand, perhaps Euronav is on to something. Oil majors, large independent refiners and international oil traders have their own vetting processes for tanker vessels, requiring modern, well-maintained and efficient vessels. As the global fleet now becomes increasingly younger, and adding oversupply in the mix, even somewhat older tonnage will be left chasing spot trips with second-class operators. Scrapping will come earlier, useful lives will have to be shortened. Frontline used a 20-year useful life estimate until 2000.
     
    Depreciation policies are not determinative but the Euronav outlier made me look closer into the company, reasoning that due to extreme depreciation their book values could actually already reflect the current depressed market values. I've posted a brief summary on Euronav as a separate instablog.
     
     
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    Author’s reply » I am now long Euronav after the drop following the Q2 preliminary results and hope for continuing low rates so that opposition weakens. Euronav's results include higher depreciation costs than its peers, based on a perhaps more realistic 20 year expected vessel useful life. They have relatively minor purchase commitments with flexible shipyards. Compared to say, OSG and FRO, they have much lower or no charter-in commitments over the next years, which I believe is very important in a low market. They have a stable shareholder base of two traditional shipping families (I also like the support of insiders to OSG here). No dividend but hopefully a two-year double.
    21 Jul 2011, 01:26 PM Reply Like
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