After a relentless, 68% total-return rout since May 2009, many are ready to throw in the towel on Nordic American Tankers Ltd. (NYSE:NAT) shares. Indeed, in an article from February 12th, Lambros Papaeconomou cited NAT's practice of financing large dividend payouts with secondary share issuance and debt when he called Nordic a "sucker's bet." Is it?
Sucker's Bet? Not So Fast... Nordic American Tankers Ltd. owns, operates, and charters a fleet of 20 Suezmax oil tankers, with one more purchased and delivery expected by June 2013. Headquartered in Hamilton, Bermuda, NAT was incorporated in 1995 as the equivalent of a master limited partnership, purchasing three Suezmax tankers and providing them to BP Shipping on a bareboat charter, or a charter in which BP Shipping paid NAT a set rate and bore all responsibility to maintain and operate the vessels. Since 2004, when the BP arrangement expired, NAT has operated its growing fleet primarily through spot charters, where NAT is paid a higher, single voyage charter rate and is responsible for all voyage and operating costs.
Papaeconomou and other critics have a point. Since 2008, Net Income has plunged from $118 million to -$73 million while the number of diluted shares outstanding has risen by 60% (see chart).
Through it all, NAT has continued to pay out large dividends which have far exceeded Net Income, Cash Flow from Operations, or even non-GAAP EBITDA, which had closely tracked the total dividend payout prior to 2008 (see chart below).
Indeed, NAT has financed both the dividend payouts and the now nine vessels it has purchased since 2008 primarily through secondary share offerings and borrowing and not through operating cash flow. This effect is visible in the chart below, which shows large, offsetting swings in Cash Flow from Investing (e.g. ship purchases) and Financing (e.g. Net Share Offerings and Borrowing, offset by Dividend Payouts) which seem relatively unrelated to the evolution of Cash Flow from Operations (see chart below).
So, is NAT an unsustainable "sucker's bet," as Papaeconomou and other critics assert? No. I believe that the tanker market is nearing the bottom of a deep cyclical downturn, sharply depressing charter-hire rates and ship values and that the causes of this downturn are gradually being worked out. With shares hovering near multi-decade lows (see chart below), I believe that NAT is positioned to benefit from a cyclical upswing in the tanker market, rallying to a fair value of $15.76 - an 80% increase from current levels - or higher over the next three years.
Tanker Market Dynamics - Icarus Rising
The years 2004-2008 were "salad years" for the tanker market. Anemic - and sometimes negative - growth in the tanker fleet during the 1990s resulted in favorable charter-hire pricing during the ensuing commodities boom and strong fleet growth (see chart below).
Increased returns from the strong charter market caused tanker valuations - such as the 5-year old used tanker prices shown in the chart below - to rocket higher, taking the share prices of tanker owners such as Nordic American with them.
However, as the chart above shows, the interaction of an overheated surge in new tanker construction and the Great Recession caused charter rates and valuations to plummet back to earth.
Now, slowly, the imbalances of the mid-to-late 2000s are working their way out of the system. The total tanker order book, comprising Ultra Large Crude Carriers (ULCCs), Very Large Crude Carriers (VLCCs), Suezmax tankers and others, has fallen from a high of 44.4% of the total fleet in 2009 to just 10.7% in 2013 (see chart below). New Orders have dropped from an average of 14% of the fleet from 2004-08 to an average of just 2.7% of the fleet in 2011-12. And, Deliveries, which occur at a lag to new orders, have also declined from 12.4% of the fleet in 2009 to 7.2% in 2012.
The picture is similar when we drill down to the Suezmax tanker market specifically - broadly represented by the 120-199,999 million dry weight ton (dwt) segment - which has seen both total fleet tonnage growth and new order growth decline in line with the overall tanker fleet (see chart below).
These factors, while slow moving, are indicative of ongoing moderation in fleet growth and normalization in the market, which should benefit charter-hire rates and NAT profits.
NAT Revenues and Valuation Metrics - Up From the Ashes
The collapse in the overall tanker market showed up in Nordic American's revenues and profits. Indeed, Voyage Revenue / Vessel / Day fell from over $50,000 in 2008 to under $15,000 in 2011 before rising to roughly $18,000 in 2012, still near major cyclical lows.
During that time, total company Operating Expenses, which include Vessel Operating Expenses, General & Administrative Expenses and Vessel Depreciation/Impairment, remained relatively steady at an average of about $22,500 per vessel per day.
Plunging revenue and relatively stable, semi-fixed costs added up to sharply negative net income in 2011 and 2012 and negative EBITDA, which excludes Depreciation and Impairment, in 2011. Indeed, Return on Equity averaged -7.9% in 2011-12, down from an average of 16.1% during the previous 8 years.
The period of cyclical-low revenue and profitability has predictably caused valuation metrics to crater. Both the Price / Sales and Price / Book Equity ratios are near all-time lows (see chart below).
Enterprise Value, or the sum of market cap and debt, is at a multi-year high versus average EBITDA due to the collapse in profitability.
But, when looked at through another lens, the ratios of enterprise value to both the number of vessels and remaining vessel years (using a 30-year average life) in Nordic's fleet are at or near all-time lows.
Valuation - $15.76/Share
Because of the swings in free cash flow (see cash flow chart above) and the asset-based nature of NAT's business, I used a multi-stage dividend discount model to calculate fair value, checking it against a residual income model and relative valuation metrics.
The table below shows a 10-year picture of Nordic American's business, including major balance sheet, income statement and cash flow metrics.
I used a two-stage dividend discount model where I: 1) Projected the number of vessels, voyage revenue / vessel / day, the EBITDA and Net Income margins, Dividends Paid and the number of diluted shares outstanding out five years; 2) Discounted dividends using the cost of equity; 3) Estimated the terminal value at the end of five years using the cost of equity and a sustainable growth rate (e.g. Terminal Value = Dividends*(1+Sustainable Growth Rate) / (Cost of Equity - Sustainable Growth Rate); and, 4) Discounted the Terminal Value back to the present (e.g. end 2012/early 2013) using the cost of equity. I assumed that the dividend payout would be 1.01x EBITDA, the long-term average prior to 2009.
I constructed my valuation scenario assuming a slow rebound from cyclical lows consistent with historical experience and used a 12.5% cost of equity, which is higher than the CAPM-derived cost of equity (2.8% 20-year bond yield, 5.8% equity risk premium, beta of 0.8), but consistent with average Morningstar hurdle rate estimates.
Finally, I estimated a sustainable growth rate of -27% by multiplying the 15 year average Return on Equity of 11.1% by the retention rate, or one minus the average dividend payout ratio of 342%.
The result, even with the negative sustainable growth rate, was an equity valuation of $828.2 million and a share price of $15.76/share, 83% above the 5/30/2013 close of $8.59. If NAT's share price converges to fair value over a three-year period, this would represent returns of 22% per year (see table below).
I then estimated a Residual Income valuation model for NAT in order to control for the effect of NAT's high, and potentially unsustainable, dividend distribution policy. Residual Income is an approach that adjusts current book equity by the discounted amount of net income achieved over and above the amount required by the cost of equity, taking dividend distributions out of the equation.
To estimate the model, I started with the projections for vessels, revenue and profitability above, then: 1) Projected book equity using a trend for book equity / vessel; 2) Multiplied book equity by the 12.5% cost of equity in each period to get a required net income number; 3) Subtracted the required net income from the actual/projected net income in each period to arrive at a residual income value; 4) Discounted residual income using the cost of equity; 5) Estimated the terminal value at the end of five years using residual income for that year, the cost of equity and a sustainable growth rate as above; 6) Discounted the Terminal Value back to the present (e.g. end 2012/early 2013) using the cost of equity; and 7) Added the discounted residual income amount to the 2012 book equity to achieve a current valuation.
The result was an equity valuation of $604.4 million and a share price of $11.50/share. While this is lower than the value derived from the dividend discount model, it still represents a 34% premium to the 5/30/2013 closing price of $8.59, or over 10% appreciation per year over a three-year period (see table below).
As a final check, I ran the dividend discount model for straight 10-year average revenue/profitability projections for the five future years ($12.98/Share) and projections that capped out at the 10-year average after a multi-year adjustment period ($10.96/Share). Both were lower than the $15.76 base case, but consistent with the basic thesis.
I also projected the path of the relative valuation metrics shown above over the period and applied them to the financial projections from the base case, resulting in an average valuation in 3 years time (2016) of $24.05/Share (see table below).
Averaging these methods together produces an average value of $15.05/Share, which is very close to the $15.76/Share base case valuation.
While revenue, profitability and valuation metrics for NAT have been discouraging over the past three years, I believe that current revenue/vessel and valuation/vessel metrics are at the bottom of the cycle and that a cyclical upturn is coming, based on the normalization of the tanker market after the excesses of the mid-2000s.
The risk to this view is that negative dynamics continue for longer in the tanker market, perhaps driven by a global economic slowdown, impacting NAT's ability to generate profit and cash flow. While this scenario is possible and worrisome, I believe that it is already priced into NAT shares. And, with financial leverage (Assets / Equity) of only 1.34x, a debt-to-equity ratio of 0.32, and an acid test ratio (Cash-and-Equivalents / Current Liabilities) of 3.7, I believe that NAT has the financial staying power to weather a longer cyclical bottom.
I recommend purchasing Nordic American Tankers at or around the current price of $8.59/Share, or on any further dips if price continues to follow the current downward channel in the near term (see chart below).
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in NAT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.