Ship Finance International: Diversification Is Key To Overcoming Challenging Oil Market

| About: Ship Finance (SFL)
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Ship leasing company Ship Finance International (NYSE:SFL) is facing a challenging oil market due to lackluster global growth, a glut of non-OPEC oil, and a surplus of capacity. For a company whose primary business is owning and leasing out a fleet of crude oil tankers under long-term, fixed-price contracts, this market reality represents a big problem. Now fortunately, because of the firm's long-term contracted $5.8B revenue backlog, SFL is doing a good job staying afloat in the choppy market.

Yet with tanker markets likely to remain weak for the next 12-24 months, it is important for SFL to think about other self-help revenue strategies. The most important of these initiatives to date for the company is its move to diversify into the dry bulk, transportation container, and oil drilling industries (as evidenced by its recent move to acquire four container ships for example). This diversification of revenue streams is a critical part of maintaining SFL's massive $0.39 per share per quarter dividend.

Even here though, SFL may face an unexpected headwind, as recent commentary from Noble (NYSE:NE), Transocean (NYSE:RIG), and other deepwater drillers suggest that the offshore drilling market could be facing weaker day rates over the next year. SFL's recent move to acquire a harsh-environment jack-up drilling rig is not ideally timed (though granted these jack-ups aren't facing the same lease rate pressures as older generation rigs are in the Gulf of Mexico and other areas). On the other hand, there is a reasonable chance that demand for product tankers will actually improve due to increased demand for US diesel fuel.

Ship Finance hasn't always been so diversified. The company dates back to 2003 when it was formed as a subsidiary of the ill-fated Frontline (NYSE:FRO). When SFL started it took on a large pile of debt and purchased a fleet of 47 ships, before going public on the NYSE in June 2004. Today the company owns a total of 59 ships and rigs including 15 Very Large Crude Carriers (or VLCCs), 11 container vessels, 12 oil/ore/bulk vessels, 7 Suezmax vessels, six offshore supply vessels, one jack-up drilling rig, two chemical tankers, two car carriers, one drillship, and two semi-submersible vessels. The point here is that while SFL is still very dependent on the oil market (especially if we lump in the "pausing" off-shore drilling market), it does have other cards to play as well.

The thing that differentiates SFL from most shipping companies (and what got me interested in the first place), is that the company is in many respects more of a finance company than a ship company (the order of its name notwithstanding). Ship Finance International doesn't actually ship anything… at least not directly. Instead the firm charters its ships to actual shipping companies under medium and long term agreements.

In particular, SFL leases 28 of its ships to FRO under long-term non-cancelable time charters at fixed rates. This of course has saddled the unfortunate shareholders of FRO with a heavy effective debt burden; FRO must find a way to profitably use the ships regardless of market conditions. (This has almost certainly been a major factor in FRO's extremely lackluster share performance since the Recession.) To be fair, SFL did agree to reduce the day rate on each of these vessels by $6,500 per day from 2012 through 2015 (after which rates will revert higher). As long as FRO is around in 2015 and beyond, this should provide a nice boost to bring SFL's income back up again in the medium term. This will be important as SFL is continuing to expand its fleet.

As of September, the firm had an additional 8 container ships under construction. These ships should help to offset the years long decline in revenues that SFL has been experiencing. These revenue troubles mainly stem from a weak economy and should reverse once the global economy improves convincingly. For now though, revenue has declined at a ~9% CAGR since 2008, while operating income has fallen at a ~11% CAGR, and assets have declined at a 3% CAGR. This has also been accompanied by a fall in long-term debt ratios with the LTD-to-capital ratio falling from 82% at the end of 2008 to 56% at the end of 3Q2013.

As much of a challenging five years as it has been for SFL, most shipping firms have had it much worse. While weak tanker rates resulting from a slow-growing global economy and an overcapacity of ships have hurt SFL, they have truly hammered the rest of the industry. Many shipping firm's stocks hover at or below $5 a share, and not so long ago it looked as if some companies might be facing bankruptcy. The Baltic Dry Bulk Index has started to move higher though, and with it hopes for both Ship Finance and the dry bulk industry (and perhaps the crude transport industry in time).

For long-term investors contemplating putting money into SFL, today is not a bad choice. While shippers and the global shipping market are a long way from fully healed, SFL has made significant progress on diversifying its fleet, its contract backlog looks very strong, and at recent prices, SFL looks pretty inexpensive based on estimates for 2014 EPS of roughly $1.45/share. At recent prices around $16.50, this gives the stock a forward P/E ratio of around 12X. This is a bit above historical norms, but that's not surprising given the economy is healthier today than it has been in years (though granted it's still not overly robust by long-term historical standards). And with the broader market trading around 16-17X, SFL is comparatively cheap. Further, while the company's prospects for profit growth next year are not as good as the overall market, and serious capital appreciation for SFL shareholders may be a while off, the $1.56 a year dividend is a pretty good consolation prize for patient investors. Given that, conventional long-term investors should give a serious look to this unconventional stock.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SFL 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.