John Fredriksen's 10% Dividend Machine: No, Not Seadrill Or Frontline

| About: Ship Finance (SFL)
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Ship Finance International Limited (NYSE:SFL) is a major vessel owning company listed on the NYSE. The company has an operating fleet of 62 vessels and rigs, and has contracted to acquire seven additional newbuilds. The Company has a significant portfolio of long-term fixed charters, which is the backbone of SFL's business, with 10 years weighted average charter coverage.

SFL was formed in 2003 as a subsidiary of Frontline Ltd. (NYSE:FRO), a major operator of large crude oil tankers, led by shipping tycoon John Fredriksen. In January 2004 the company bought a fleet of 47 vessels from Frontline, comprising of 23 Very Large Crude Carriers - VLCC -, 16 Suezmax tankers and eight OBOs.

Since that time Ship Finance has diversified its asset base from two asset types - crude oil tankers and OBO carriers -, to eight asset types today including container vessels, dry bulk carriers, chemical tankers, jack-up drilling rigs, ultra-deepwater drilling units and offshore supply vessels. Ship Finance has a total of 15 customers, of which Frontline, Deep Sea Supply (OTCPK:DSSPF) and Seadrill (NYSE:SDRL) are directly or indirectly controlled by Hemen Holding Ltd, a company controlled by trusts that have been established by Fredriksen for the benefit of his immediate family. You can find SFL's complete fleet list here.

Ship Finance's strategy is to pursue medium to long-term fixed rate charters, which provides the company with stable future cash flows. Ship Finance's customers typically employ long-term charters for strategic expansion as most of their assets are typically of strategic importance to certain operating pools, established trade routes or dedicated oil-field installations. The company is also seeking to enter into charter agreements that are shorter and provide for profit sharing, so that SFL can generate incremental revenue and share in the upside during strong markets.

Most of Ship Finance's tanker and OBO vessel-owning subsidiaries have entered into fixed rate management agreements with Frontline Management, a subsidiary of FRO. Under the management agreements, Frontline Management is responsible for all technical management of the vessels, including crewing, maintenance, repair, capital expenditures, dry-docking, vessel taxes, maintaining insurance and other vessel operating expenses.

Seven of SFL's container vessels are chartered on bareboat basis, to Horizon Lines (HRZ) and an Asian operator, meaning the charterer is responsible for the technical and operational management of the vessels. Four container vessels are on a time charters, whereby SFL has outsourced technical management of two vessels to CMA CGM and the costs to Ship Finance are fully compensated by CMA CGM through an adjustment in the charter agreements.

Some of SFL's recent transactions of note:

- January 2011: Acquisition by SFL of the 2007-built jack-up drilling rig Soehanah for an agreed purchase price of approximately $152 million. The rig was delivered in February 2011 and commenced a seven year bareboat charter back to the seller.

- May 2011: SFL contracts four newbuild 4,800-TEU container vessels for delivery in 2013. The vessels have been chartered to Hamburg Sud for seven years from delivery.

- June 2011: Seadrill exercises a pre-agreed purchase option for the jack-up drilling rig West Prospero. The purchase option price was $133.1 million.

- December 2011: SFL agrees with Frontline to amend certain chartering agreements after Frontline goes through a restructuring to avoid bankruptcy. Ship Finance has agreed to temporarily reduce the charter rates by $6,500 per day per vessel from 2012 through 2015, and thereafter revert to previous charter rate levels. Frontline has paid a cash compensation of $106 million to Ship Finance. In addition there will be a cash sweep feature, whereby Ship Finance will receive 100% of vessel earning up to the old base rates. The old profit share arrangement has been improved from 20% to 25%, and will be calculated from the old threshold levels. Of the $106 million upfront payment, $50 million is a non-refundable, early payment of profit split for revenues above the old threshold levels. The cash sweep and the profit split will be payable on an annual basis, as before.

Rating agencies expect Ship Finance's liquidity sources (including operating cash flows, surplus cash balances, and committed bank financing for newbuilds) to exceed liquidity uses (capital spending, mandatory debt repayments, and dividends) by about 1.3x during H2 2012 and H1 2013. Liquidity sources will continue to exceed uses, even if EBITDA declines by 15%.

SFL's bank covenants require it to hold at least $25 million in cash, cash equivalents, or available in long-term committed facilities at the end of each quarter and to adhere to certain minimum value clauses. Other covenants in Ship Finance's corporate senior secured bank facilities and $449 million high-yield notes include restrictions on payments, investments, and the incurrence of new debt. The covenants include requirements for the company to maintain an equity-to-asset ratio of at least 20% at the end of each quarter and consolidated current assets minus consolidated current liabilities of $0 or better. The company is in compliance with all the covenants, has sound relationships with its lenders, and a satisfactory standing in credit markets.

As of H1 2012, SFL had about $101 million of unrestricted cash and about $40 million of securities available for sale. The company is expected to generate about $420 million of operating cash flow (after cash interest costs) in 2012. This includes cash flows from fully owned, but unconsolidated subsidiaries. As of H1 2012, short-term debt repayment obligations total about $385 million, and capital-expenditure commitments for ordered vessels due for delivery in 2012-2013 amount to $224 million, for which the company obtained committed funding of $198 million, resulting in a required cash contribution of only $26 million.

It should also be noted that Ship Finance has bulk refinancing needs, with about $1.1 billion in bank loans related to drilling rigs and a $274 million bond maturing at various dates in the second half of 2013. Based on SFL's track record, the company should have no problem to arrange funding for its debt instruments well ahead of their maturities.

SFL's senior unsecured debt is rated 'B+', two notches lower than the corporate credit rating. This is a result of the contractual subordination of the company's notes to the unrated senior secured bank facilities. The notes contain a change-of-control clause, which could trigger early repayment if the company were sold. All of the company's vessel-owning subsidiaries have issued supplemental indentures with joint and several guarantees in favor of the senior unsecured debt.

Despite a difficult world shipping market since 2008, characterized by weak growth in global demand, oversupply, a credit squeeze, and low shipping rates, SFL has been able to hold its own. Ship Finance remains exposed to counterparty difficulties, as recently experienced with Frontline. It should always be considered that SFL may have to deal with delayed payments or non-payment of charter agreements by counterparties from time to time. It also remains important to keep an eye on debt on account of sizable vessel acquisitions.

Jefferies raised its price target on Ship Finance last month, as Dahlman reaffirmed its buy rating in a research note. SFL's recent Q2 2012 results easily exceeded consensus. Net income for the quarter was $61 million or $0.77 per share. Included in the results was a $21.2 million net book gain relating to the Horizon Lines debt restructuring. So net of this book gain, adjusted earnings were $40 million or $0.50 per share, exceeding the consensus estimate of $0.37 by 35%, and primarily due to higher than expected cash sweeps from the revised profit sharing agreement with Frontline and lower than expected interest expense.

Aggregate charter revenues recorded in the quarter, including 100% owned subsidiaries accounted for as investment in associate, was $185 million. This includes the $16.3 million of cash sweep from Frontline. The EBITDA equivalent cash flow in the quarter was $151 million or $1.91 per share. There was a full cash sweep effect of 23 out of 28 Frontline vessels and nearly full cash sweep effect on 5 vessels. The aggregate contribution was therefore $0.21 per share in the quarter.

In addition, there was also an accumulation of profit share in Q2. The amount represented $600,000 or $0.01 per share approximately. Due to the $50 million prepayment of future profit share that Frontline made in December 2011, the company will not recognize profit share revenues in the profit and loss statement until accumulated profit share is in excess of that amount. With the profit share accumulated in Q2 2012, the threshold is now reduced to $48 million.

Ship Finance currently has $5.5 billion of fixed rate order backlog, equivalent to approximately $69 per share, of which 40% is with companies with market cap in excess of $5 billion. These numbers are with the Hong Xiang charters excluded - those charters have been terminated -, and include only the reduced base rate from the Frontline vessels. Expectations for cash sweep, profit share and rechartering at the end of current charters are not included.

Looking at the segments where cash flow will be generated, offshore is still the biggest contributor with 46% or approximately $2.5 billion. Tankers now represent 34% of backlog, approximately $1.9 billion. This is not only Frontline, but also includes tankers chartered to other customers. With the termination of the Hong Xiang charters, which represented 2% of backlog, bulkers now make up 6% of the portfolio, and containers 14%.

In anticipation of a possible gradual recovery in the shipping market in the coming years, the primary reason to invest in this Fredriksen company is its generous 10% dividend at today's price. Rather remarkable considering that Fredriksen's other dividend machine Seadrill, operating in a booming contract drilling market, offers investors an 8.2% yield at present. SFL declared a cash dividend of $0.39 per share for Q2 2012, $1.56 on an annual basis. The company has now declared dividends for 34 consecutive quarters and paid out $13.75 per share or nearly $1.1 billion in aggregate dividends since 2004. You can find SFL's dividend history here.

Even in today's shipping market we can confidently consider that Ship Finance International's rating, liquidity position, and dividend is sufficiently supported by management's policy of maintaining an ample cash balance, a strategy of pre-financing vessels on order, proactive treasury management, and largely stable contracted cash flows. This stability in both charter revenues and operating costs continues to support the Company's long term distribution capacity going forward. And that's what every dividend and income investor wants to hear.

Disclosure: I am long SDRL, SFL. 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.