Scorpio Bulkers Inc. - Like A Bull In A China Shop

| About: Scorpio Bulkers (SALT)
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Scorpio Bulk Carriers Inc. (NYSE:SALT) announced earlier this month its largest new-building order in a series of orders placed by the start-up dry cargo company during the past six months: A contract to build 22 dry bulk carriers for almost $1.2 billion. The latest order raised the tally of the company's new-building program to 74 vessels at an aggregate contract price of approximately $2.8 billion.

The latest order came on the heels of a fully subscribed initial public offering in New York, where Scorpio Bulkers raised just over $350 million in gross proceeds issuing 35,995,000 common shares at $9.75 per share. The company has so far raised $1.2 billion in gross proceeds in three private placements and the IPO.

The vessels under construction will be delivered to Scorpio Bulkers over a two-year span beginning in the second quarter of 2014. However the bulk of the orders (57 vessels) are scheduled for delivery during the second half of 2015 and first half of 2016. The orders are almost evenly split among three DWT sizes: Ultramax (60,000 to 64,000 MT), Kamsarmax (82,000 MT), and Cape (180,000 MT).

The audacity of the new-building orders is accentuated by the fact that the management team of Scorpio Bulkers has no prior history in the dry-cargo shipping industry. In addition, the company plans to trade the vessels in spot-oriented commercial pools that are yet to be formed. All of these will be happening while the same management team is busy integrating 65 new-building product tankers and crude oil carriers into the fleet of sister company Scorpio Tankers Inc. (NYSE:STNG).

Is this folly or sanity? Only time will tell whether Scorpio Bulkers will become the most successful story this side of Frontline Ltd. (NYSE:FRO), or be blown apart. But if potential investors like the odds for a strong recovery in dry cargo shipping over the next two years, they may want to take a good look at Scorpio Bulkers.

The timing of the company's orders is anything but fortuitous. Asset values reached a low point early last year and have been rising ever since. For example, asset values for five year old Supramax, Panamax, and Cape vessels have risen 31%, 31% and 37% respectively during the last year.

In the following graph I have presented the historical value for a five-year old Cape. There is a high degree of correlation between the value of a new building resale, and a five-year old vessel. Likewise, there is a high degree of correlation among values of different size bulk carriers.

Could asset values move higher from this point forward? In the graph I have illustrated that a further 35% increase in Cape asset values is definitely within the historic norm, even after we exclude 2007 and 2008 as outlier years. On the other hand a reduction of 20% will lead us back to the 10-year historical low point. I must confess that given the supply-demand forecast scenarios for the next two years I like the odds for a further 35% increase in asset values.

How would a 35% increase in new-building resale values affect the company's net asset value? Before I calculate the corresponding NAV, I would like first to look at the funding gap of the company's new-building program. My goal is to assess whether Scorpio Bulkers could reasonably rely on debt finance to bridge the funding gap, without having to rely on subsequent equity offerings.

Scorpio Bulkers had a pro-forma tangible net asset value of $1.147 billion as of December 9th, 2013, as adjusted to include the net proceeds from its IPO. That figure included approximately $251 million in advance payments for its vessels under construction and $896 million in available cash. The company's remaining capital expenditure (MUTF:CAPEX) requirements were $2.510 billion (including the January 2014 order). Based on the above, Scorpio Bulkers had a funding gap of approximately $1.614 billion or 58% of the contract price for its new-building program.

The company has indicated in its IPO prospectus that its intends to maintain moderate levels of leverage of not more than 60% of the value of the company's vessels. Therefore Scorpio Bulkers has the capacity to finance the remaining CAPEX requirements entirely with debt and still be under the 60% loan to value ratio. In fact, the company has already secured a commitment for a senior secured credit facility for up to $330 million.

Scorpio Bulkers has 137,390,411 shares outstanding. This figure includes 4,155,000 restricted shares already issued to members of the company's management team. But it excludes about 2,000,000 additional shares that will be issued to related entity Scorpio Services Holding Limited (SSH), upon delivery of the new-building vessels. The approximately 2,000,000 shares represent an arrangement fee (read commission) to SSH for a job well done negotiating the terms of the new building acquisitions. It is a payment-in-kind equivalent to $250,000 per vessel or $18,500,000 in total. SSH is partly owned by members of the company's management team.

Based on 139,390,411 shares outstanding, Scorpio has a current NAV per share of $8.23. If the resale value of its new-building vessels were to increase 35% over the contract price, Scorpio Bulkers would have a net asset value of $15.16 per share, or 54% higher than its current stock price.

Please note that the only tangible assets of Scorpio Bulkers are cash in hand and advance payments made to the shipyards for its vessels under construction. The company has no other assets and to this date it has not incurred any liabilities. With regards to its cash position, please note that Scorpio Bulkers had $171 million available cash as of September 30th, 2013. Since then it has raised $291 million in a private placement in October, and $325 million in its IPO last December (which included the exercise of the underwriters' overallotment option)

Investing in Scorpio Bulkers may be attractive at its current price level, but it comes with many risks attached. Scorpio Bulkers currently has no vessels in operation and there exists no information regarding its operating cost structure. What's more, its daily operating cost will include generous management fees paid to related entities that are higher than industry norms. I am also very skeptical about its ability to efficiently trade 74 vessels of different types in the spot market. If the second half of 2014 turns out to be a pivotal time for freight markets, Scorpio Bulkers will not be able to generate any material free cash flow, since it is scheduled to take delivery of just two vessels during the year.

In contrast, dry cargo shipping companies with current spot market exposure and moderate debt levels (i.e. no bankruptcy risk), like Baltic Trading Limited (NYSE:BALT), Star Bulk Carriers Corp. (NASDAQ:SBLK), or Safe Bulkers Inc. (NYSE:SB), have the potential for substantial free cash flow generation. I plan to look at the valuation of each of these companies in future articles.

In summary, Scorpio Bulkers has managed to go from zero to one hundred in less than twelve months. Since its incorporation in March 2013 it has grown to a serious contender in the dry cargo shipping industry, sporting a market capitalization of almost $1.4 billion. Despite its over-ambitious $2.8 billion new-building program, it has raised sufficient equity funds to keep its leverage ratio below 60%, without the need for any further equity offerings. Should freight markets and corresponding asset values continue their mean reversion during the next twelve months, Scorpio Bulkers could easily see a 50% appreciation in its stock price.

Disclosure: I am long BALT, SB. 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.