I recently had the opportunity to analyze two types of securities issued by Diana Shipping (NYSE:DSX), namely the 8.875% series B perpetual preferred shares (DSXPRB), and its 8.5% senior notes due on May 20th, 2020 (DSXN). There has been a broad consensus among shipping analysts that these securities offer an attractive low-risk, high-yield profile. Both have consistently traded at or above par.
This should not come as a surprise: Diana Shipping has long been considered the safest play among publicly traded dry-cargo shipping companies. It has high levels of cash reserves and low levels of debt among its peers and vis-à-vis its market capitalization. Such conservatism has allowed the company to sail through a prolonged bear market dating back to 2011.
Which brings the question: If Diana Shipping is in solid financial footing, why did it elect to raise $128 million in high-yield debt and preferred equity? As of the end of 2014, the company had $210 million outstanding in a revolving credit facility with an interest rate of 0.95%. It also had $276 million of bank term loans with a weighted average interest rate of 2.68%. Why issue high-yield securities at an average cost of more than 8.50%? To answer this question, I will take a closer look at the company's capital budget strategy.
Diana Shipping is a dry-cargo shipping company based in Athens, Greece. The company currently operates a fleet of 41 vessels with a total DWT capacity of approximately 4,650,000 MT, and an average age of 7.75 years as of June 30th, 2015. In addition, it has four vessels under construction. Based on last Friday's closing of $8.11 per share, DSX has a market capitalization of approximately $670 million.
During the past five years, the company has nearly doubled its operating fleet by growing organically. To achieve this milestone, it has relied on cash generated from operations and proceeds from long-term debt. The only exception to the rule was last year when DSX issued $65 million of preferred equity. The last time DSX had a public offering of common shares was in May 2009. Diana Shipping has not paid a common dividend since November 2008.
The company's chartering strategy has been to employ its vessels on fixed-rate charters with a typical duration of 12 to 24 months. This strategy provides cash flow visibility and avoids exposure to short-term volatility in freight markets. But it cannot provide full immunity from a falling market. As time-charters expire, the company has to replace them at lower daily rates. Case in point: During the current year, DSX has renewed charters for 24 vessels at an average TCE rate of $8,029. For purposes of comparison, the company's average TCE rate during 2014 was $12,081.
In fact, during the past five years, DSX has experienced a dramatic downward trend in TCE (time-charter equivalent) rate per day. This has resulted in an equally dramatic reduction of operating cash flow, especially when measured on a unit basis (ownership day). The reduction in cash provided from operating activities is what forced the company to seek alternative sources of funds.
To estimate a shipping company's operating cash flow, you must analyze the various components of operating cost, and calculate the break-even rate on a unit basis. The four major components of operating cost are: Vessel operating expenses, dry dock cost, G&A expenses and finance cost. To calculate the operating break-even, I have made the following adjustments to income statement figures:
I have excluded stock compensation expense from G&A expenses because it is a non-cash item. For the same reason, I have omitted amortization of deferred finance costs. However, I have included any realized gain or loss from financial instruments (for example interest rate swaps) and any preferred dividends in the calculation of finance cost.
A shipping company typically enters into an interest rate swap or other derivative instrument to economically hedge its interest rate exposure. Any realized gain or loss from such instruments should be included in the calculation of finance cost.
Diana Shipping does not hedge its interest rate risk with the exception of an interest rate collar, which matured in May 2014. Realized loss from financial instruments in 2014 was $310,000.
A shipping company issues preferred shares for a number of reasons, including obtaining financing on a non-amortizing basis. In the eyes of debt holders preferred shares are treated as equity since preferred shareholders have a junior claim vis-à-vis debt holders.
However, in the eyes of common shareholders, preferred shares are treated like a liability since preferred shareholders have a senior claim over common shareholders. I have therefore included preferred dividends in the calculation of finance cost. For the same reason, I add preferred equity to long-term debt when I calculate a company's total liabilities.
In February 2014, Diana Shipping issued $65 million of preferred equity that pays 8.875% per year. Accrued preferred dividend in 2014 totaled $5.08 million. On an annualized basis, the company is expected to accrue $5.769 million in preferred dividends.
Operating surplus or deficit equals TCE minus the break-even rate. The calculation of operating margin based on the above methodology yields a result that is similar to operating cash flow. The only major difference is that my methodology includes the effect of preferred dividends, whereas operating cash flow based on US GAAP excludes it (preferred dividends as per US GAAP are considered a financing cash outflow).
The calculation of operating margin based on the above methodology reveals that TCE is its single most important driver. In fact with the exception of finance cost (which can vary depending on vessel acquisition cost and degree of leverage), all other operating cost components are relatively stable. For example, vessel operating expenses and dry dock costs are typically expected to grow 2% per annum.
The break-even rate for year 2014 for DSX was $8,709. Assuming this break-even rate, what is a realistic operating cash flow target for this year? According to my estimates, the company's present average TCE rate is approximately $9,759. Based on the above, I expect that DSX will generate an operating cash flow between $15-$20 million for the year. For comparison purposes, please note that during the first quarter of 2015, DSX generated $8.4 million in cash flow from operations.
Now, it is time to construct a capital budget for year 2015 to determine if Diana Shipping will have a funding surplus or deficit. To construct the budget, I have assumed an operating cash flow target of $17.5 million. I have also adjusted the company's contractual obligations for 2015 to reflect all vessel acquisitions, new-building orders, loan commitments, and proceeds from senior notes year that have occurred since the beginning of the year.
Based on the above, Diana Shipping is expected to have a funding deficit of approximately $10 million for the year. Given that cash reserves at the beginning of 2015 stood at $210 million, DSX should not have to raise any funds during the remainder of the year to finance its existing new-building program. However, if the company decides to acquire additional vessels in the future, it would be interesting to see how it will pay for them.
Since May 2014 DSX has been buying back its shares, signaling that they are undervalued. Last year, DSX purchased back 2.8 million shares at an average cost of $8.91 per share. So far this year, it has purchased an additional 413,804 shares at an average cost of $6.46 per share. The stock may have rebounded off its 52-week low of $6.02 (it closed last Friday at $8.11), but it is still trading at a level where the company was a buyer not so long ago. Does this mean an equity offering is not in the cards at the moment? I would like to think so, but I cannot rule it out.
To summarize, Diana Shipping has done a superb job to organically grow its fleet without having to issue fresh equity. However, during the past 18 months, the company has issued $128 million in high-yield securities, reflecting deteriorating cash flows from operations to fund its growth. Given that operating cash flow is not currently expected to contribute more than $15-$20 million on an annualized basis, the company might have to tap capital markets to supplement its funding requirements. When this happens, it will be interesting to see whether DSX will issue common equity or rely again on high-yield securities.
Disclosure: I am/we are long DSX.
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.
Additional disclosure: I am also long DSXPRB