Ship Finance International: Q4 Results Show Strength
- Ship Finance announced solid results for the fourth quarter 2017, despite some weaknesses in the shipping and offshore drilling industry.
- The company benefited from a recovery in the dry bulk shipping industry, receiving $162,000 in profit sharing revenues.
- Seadrill now has a solid restructuring plan that should have minimal impact on Ship Finance long-term and this plan was already priced into the stock.
- The company's payout ratio is quite high, but it is generating sufficient cash to cover its dividend so it is arguably sustainable.
- Ship Finance has one of the best dividend yields in the market and appears to be rather underappreciated.
On Tuesday, February 27, 2018, Bermudan shipowner Ship Finance International (NYSE:SFL) announced its fourth quarter 2017 earnings results. Overall, these results were surprisingly good, particularly when we consider the relatively weak markets in both shipping and offshore drilling. However, Ship Finance does not directly participate in either industry; rather, it owns ships and drilling rigs and leases them to companies that do. In this regard, it is a finance company and not a shipping firm. The company also has a long history of rewarding its shareholders generously, a tradition that it continues in the fourth quarter of 2017.
As my long-time readers are no doubt well aware, it is my usual practice to share the highlights from a company's earnings report before delving into an analysis of those results. This is because these highlights serve to provide background for the remainder of the article as well as provide a framework for the resultant analysis. Therefore, here are the highlights from Ship Finance's fourth quarter 2017 earnings results:
- Ship Finance reported total operating revenues of $96.102 million in the fourth quarter of 2017. This compares favorably to the $93.673 million that the company brought in during the previous quarter.
- The company had total operating expenses of $57.461 million in the fourth quarter, representing a slight increase over the $56.435 million that it had in the third.
- One of Ship Finance's largest customers, offshore drilling giant Seadrill Limited (SDRL), announced a global settlement in its Chapter 11 cases following the close of the quarter. There were no significant changes to terms affecting Ship Finance from the initial RSA.
- Ship Finance received its first profit share income from eight Capesize dry bulk carriers on long-term charters. This point to improving market conditions for this portion of the fleet.
- The company reported total net income of $20 million, which works out to $0.20 per share. This compares quite unfavorably to the $29 million that the company earned in the third quarter of 2017.
As mentioned in the highlights, Ship Finance saw its operating revenues increase quarter-over-quarter. The company's total charter revenues also increased from quarter-to-quarter although to a lesser degree ($150 million to $152 million). One of the reasons for this is that the company benefited from a profit sharing agreement on eight of its dry bulk carriers. The market for dry bulk shipping improved substantially from the third to the fourth quarter and this resulted in the shipping revenues generated by eight of the company's Capesize vessels leased by Golden Ocean Group (GOGL) to increase to the point where Ship Finance got to share in the profits. This generated an extra $162,000 in incremental revenue for the company. The improvement in the dry bulk market also resulted in the company's Handysize bulk carriers trading in the spot market generating additional revenues with the average time charter equivalent rate going from $6,700 per day in the third quarter of 2017 to $9,000 per day in the fourth.
Without a doubt, one of the things that most concerned shareholders in Ship Finance over the past several months was the fact that one of the company's major customers, Seadrill Limited, was involved in a Chapter 11 restructuring proceeding. These proceedings could have threatened some of the company's lease agreements with Seadrill. On February 26, 2018, Seadrill reached a global settlement with its unsecured and secured creditors, including Ship Finance. Under the terms of this agreement, Ship Finance will reduce the contractual hire rate for its three rigs that are currently leased to Seadrill (West Linus, West Hercules, and West Taurus) by 29% for five years. After that period, the rate will increase back to the original rate plus an amount that allows Ship Finance to eventually get all the money that it was originally owed. Therefore, while this agreement would temporarily reduce the company's revenues; in the long run, it will still get all the money that it originally would have. This arrangement is naturally subject to Seadrill being able to recover of course, but given the fact that the conditions in the offshore drilling industry are slowly improving, this seems quite likely.
One of the more disappointing things in this report is the decline in net income quarter-over-quarter. As noted in the highlights, Ship Finance had a net income of $20 million in the fourth quarter of 2017 compared to $29 million in the third. This is even more interesting when we consider that the company's operating income actually increased quarter-over-quarter, going from $37.583 million to $38.641 million. We can see that here:
Source: Ship Finance International
The primary reason for the decline in net income appears to be due to two items. The first is that the company made much less income from its derivative holdings in the fourth quarter than in the third. Unfortunately, the company does not state exactly what these derivatives are in either the earnings report or in its conference call but presumably, they are interest rate swaps that Ship Finance is using to protect itself against the financial risks inherent in the fact that its debt is for different terms than its charters. In addition to this, Ship Finance also saw a loss from "other financial items." Once again, it does not state exactly what these items are. Presumably, this loss was also due to derivatives but as there is no corresponding cash outflow associated with it, we can assume that it is a mark-to-market adjustment of some assets and therefore, does not actually represent money leaving the company.
A final thing that investors might notice and be concerned about is the fact that Ship Finance declared a dividend that is greater than its net income. In the fourth quarter of 2017, Ship Finance declared a dividend of $0.35 per share but its net income was only $0.20 per share. This gives the company a payout ratio of 175%, which is far above the level that analysts typically consider sustainable. However, as I have explained in the past, net income is subject to any number of non-cash adjustments that have little impact on a company's ability to generate cash and return money to its owners and creditors. A far better motive to use to evaluate this capability is free cash flow, which is defined thusly,
"Free cash flow is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value."
A company's free cash flow is the money that it uses for such things as paying down debt, executing stock buybacks, and paying dividends to shareholders. It is thus the most important metric to use to determine whether a dividend is sustainable or not. In the fourth quarter, Ship Finance had total operating cash flows of $44.692 million and no capital expenditures. Thus, its free cash flow was $44.692 million in the quarter. As of December 31, 2017, the company had 102,930,873 shares outstanding. A dividend of $0.35 per share would thus cost the company approximately $36 million or roughly 80.5% of its free cash flow. This figure is arguably sustainable, although it does leave the company with limited capital for growth but Ship Finance has historically not been particularly focused on rapid growth.
The fact that the company does pay out so much of its cash flow to its owners and has been largely ignored by the market has resulted in a stock with a very impressive dividend yield. As of the time of writing, shares of Ship Finance trade hands at $14.63. This thus gives the stock a dividend yield of 9.57% at the current price, easily one of the highest yields in the market. In addition, Ship Finance has a long history of paying a respectable dividend yield, although it has not always increased:
This is due to the company's stated dividend policy of paying out approximately 80% of net income to its investors in the form of dividends. Please note that it does specifically say net income and not free cash flow, and thus, both the third and fourth quarter 2017 dividends were well above the stated policy. However, management believes that the current level is sustainable and that appears to be the case based on cash flow.
In conclusion, Ship Finance's results show that the company continued to be a solid high-yielding play for an investment portfolio. It appears that the dark clouds hanging over the firm due to the financial problems at Seadrill have largely been resolved (although, the stock may still have some worries priced in) and the company has begun to benefit from improvements in the dry bulk shipping market. Overall then, this appears to be a company worthy of further research.
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