Thursday, December 18, 2008

OCNF - The perils of shifting market risks to counterparties: pros and cons in time-charter employment

Time-charters are helpful in securing cashflow, but they are not an absolute panacea for investors and bankers. Shipping companies retain performance risk. There is normally a hire adjustment annually on actual speed and fuel consumption as a opposed to the notional figures in the charter party agreement. If the vessel is in any way not fit for service, hire payment can be suspended. In bad markets, Charterers have increased bargaining power given the scarcity of employment alternatives for Owners. Charter rates can be negotiated downwards. This is risk for all shipping companies currently as long as this downturn persists, especially in sectors like dry bulk and containers where the underlying freight rates have fallen to very low levels and Charterers may be under financial pressure.

As TradeWinds reported Monday, OceanFreight suspended dividend payments in an effort to preserve capital and to possibly jump on new opportunities. Notably the company reported that its 70,000-dwt August (built 1996) will now fetch a lower rate of $16,000 per day, down from $42,100, on an existing three-year charter.

Given the current low spot rates, many listed shipping companies face the potential risk of renegotated charter rates as the market weakness persists. As an example, TOPS bought a number of bulkers at the top of the market in 2007, which they put on period time charter to cover the premium paid in the prices. EXM entered into a sizeable merger deal in the fall of 2007 at premium price levels with Quintana, who had many units on time-charter. This was heavily financed by bank debt.

Both Natasha Boyden of Cantor, Fitzgerald and Scott Burke of Oppenheimer downgraded OCNF. It was not clear whether they were more influenced by the dividend cut or the charterparty renegotiation.

Time-charters are very different from lease-model employment. Often investment presentations are misleading on this matter. Owners must maintain the units to specified standards, provide crew and supplies and are liable for related agency expenses. If the vessel cannot perform for Charterers, they have the right to suspend charter payment. If vessel performances are overstated, charterers can make claims on the vessel. In case of Charterer insolvency, Owners are obliged to deliver cargo and often to settle the unpaid voyage accounts that are Charterers' debts.

In weak markets, Charterers frequently request hire reductions. Owners are often obliged to accept these reductions for lack of other employment alternatives.

Chartering companies are a margin-based business. They may occur losses if underlying voyage results are lower than their hire obligations, making it difficult for them to carry the vessel. Charterers demand increasing discounts for the length of the charter for the risk and uncertainty of carrying the vessel.

Banks and financiers often make unrealistic and commercially imprudent demands on Owners to employ vessels on long period time charters to cover dividends and loan payments. This may result in poor risk assessment as well as impair Owners' business plans in creating shareholder value.

In any case, employment profile must be carefully assessed for each company on a case by case basis.

Monday, December 15, 2008

DryShips: Intercompany transactions, management style and potential moral hazard

US equity analyst Natasha Boyden of Cantor Fitzgerald has called "punitive" Economou's price for allowing Nasdaq-listed DryShips to cancel an order for four panamax bulkers slated for purchase from his Cardiff Maritime. In DryShips, George Economou holds the positions of CEO, CFO as well as Chairman of the BoD. 40% of DryShips is held by insiders and owners. Economou appears to have a predominate role in BoD appointments. SEC rules apparently give DRYS their blessings. Indeed it is frequent practice that major US corporations are run by friendly BoD's with close connections to management in similar fashion. This system reduces diversity in decision-making and limits shareholder rights even for major institutional investors. It appears that there is a high risk of moral hazard in this type of management and BoD structure.

George Economou frequently initiates transactions in Cardiff, his private shipping group, that he passes on to DryShips. This allows him to move quickly to enter into new business. It creates a compensation mechanism between his publicly-listed company and his private group. At a later stage, he obtains DryShips BoD approval and DryShips assumes the financing as well as the ultimate profits and liabilities of the business at a marked-up prices. These are acceptable Wall Street business practices.

In a rising market, this has benefitted greatly DryShips, which has out performed nearly all other conventional listed peer companies in P+L results. Now under present market conditions where there are serious prospects of sizeable losses, these methods open questions should the possible losses fall on investors in the public company from these transactions. Already DRYS has rolled up some substantial real losses in one such transaction and there is risk of loss in another.

Just a month ago, the DRYS BoD approved a controversial deal to acquire nine Capesize units for US$1,17 bio (in cash and shares) and two drill ships from companies reportedly under Economou control.

Now DRYS has forfeited a US$55 mio deposit to cancel the purchase of four bulk-carriers on a previous intercompany deal. DRYS has paid out an additional US$105 mio taking its total outlay on the deal to US$160 mio. All four bulkers appear to be from an Economou order at Shanghai´s Hudong-Zhonghua Shipbuilding.

reports that Economou paid around US$36 mio each for the earlier units and US$50 mio each for the two later ones, at an average cost of around $43m apiece. They maintain that Economou has thus essentially recouped that cost with the US$40 mio per vessel DryShips has paid to date.

Natasha Boyden, an analyst a Cantor Fitzgerald, raises serious questions about the deal, which saw the company pay $105m for purchase options on the vessels, which are reportedly owned by interests associated with Economou. She said: “We believe the terms of the cancelation are punitive and this transaction, in combination with the nine capesize deal in October 2008, raises serious questions in our minds as to the ability of DryShips to finance further transactions.”

The question is how major investment banks will advise their clients on risks in investments like this case.

Tuesday, December 9, 2008

TeeKay LPG Partners (TGP) and its prospects

TGP is a spin off in Wall Street fashion the last few years. OSG and FRO have also done spin-offs. In this case, the parent company is very much in control.TK is a major world player in the tanker sector. They shun the VLCC market. Their concentration is Suezmax and Aframax units. They are also active in the product sector. The gas business is a relatively new segment of their operation, started in 2004. TK is also in the offshore business. In TGP, their concentration is in LNG units and secondarily LPG units (mainly small vessels on order). They have combined this fleet with a flush of 8 Suezmax tankers.

The LNG market traditionally has been plagued by excessive expectations. The saving grace is the high entry cost and needs for operational expertise that keep the number of players restricted. Nearly all the vessels are on long term charter. The spot market is very small but expected to grow to about 30% of the fleet over the next five years. The charterers are major oil companies so counterparty risk is minimal. The spot market is small.

LNG ships are immense capital investments. The LNG industry is based largely on a series of virtually self-contained projects made up of interlinking chains of large-scale facilities, requiring huge capital investments, bound together by complex, long-term contracts, and subject to intense oversight by host governments and international organizations at every state of the process.

Global LNG demand and demand projections generally remain strong, with base case demand projected to grow by more than 70% from 2007 to 2012, and supply projected to grow by more than 80% over the same period. Average annual trade volume growth to 2012 is 9% for low case, 12% for base case, and 16% for the high case scenario. In the short term, the limiting factor on LNG trade continues to be tight supply. LNG supply project development might be slowed down by this financial crisis. The large amount of new liquefaction capacity is scheduled to come online in 2009-10 and there is danger of excess supply, hopefully of short duration but subject to the fall out of the current economic mess, plunging energy prices and spreading recession.

2008 will set a new record for LNG tanker fleet growth, with 55 or 56 newbuilding deliveries. Most 2009 delivery slots are filled, and yard capacity is becoming tight for 2010 deliveries as well. We can assume moderate additional ordering of up to 4 million m3 capacity (20 vessels) for delivery in 2010, and slightly more for 2011. These are exceptionally difficult contracts to cancel.

So far tanker rates have not suffered the catastrophic plunge of the dry cargo and container sectors. In fact, tanker rates are currently firming with seasonal demand. The LNG/ LPG rates are also steady. What has plagued the sector and particularly TNG is inflation in operational expenses (crew costs and repairs). Whatever the external environment, most of TGP’s fleet is contracted on period rates with escalation provisions for operating costs. Also important is financial expense with their large capital commitments. TGP management seems to have done a good job in containing these expenses and planning their FCF; but in the current financial turmoil, this is an area of risk.

Last August, S&P dropped Teekay’s corporate credit rating from “BB-plus” to the next lowest rating of “BB”, signalling that the company faces major long-term uncertainties but is less vulnerable in the near-term. Not unexpectedly, it is the LNG and Offshore business that is the major source of this debt due enormous capital requirements.

In TGP, there is both bank debt and lease commitments. TGP has a very conservative employment profile matching the debt obligations with long-term employment contracts with first-class charterers. They also have negotiated a very good debt profile as well as covered their financing needs for their newbuilding commitments. They seem to have reasonable margins for debt coverage obligations and in any case, it is less likely that these specialized units will be prone to the same collapse in value as commodity tonnage like bulk carriers. The real risk in asset depreciation is the thin resale market especially in distress situations should the contract commitments be impaired – which is the case for all specialized tonnage.

All in all, TGP has an attractive fleet, good employment and management. Shares are trading at very low levels. The major risk is the impact of the financial crisis on future product demand, especially in view of the fall in energy prices. It is also a potential M&A candidate given the entry barriers in the sector.

EXM and debt covenants after the QMAR merger - conflicts between Wall Street IPO structuring and longer term business-building

Capital markets have brought substantial benefits to Greek Shipping. Quintana was a successful dry cargo startup that was sold at a very good time. The business model suffered from the restraints of capital market IPO's, but it was very well managed within these limitations. IPO investor strategy is generally very short term. There are substantial conflicts between the investor appeal and creation of a sound business. The acquiring firm Excel Maritime EXM is now facing the longer term challenges of establishing a sound business. Its first priority is to deal with the high leverage from the LBO in the face of substantial decline of asset prices and a dismal freight market.

Quintana was the ideal combination of commercial and financial partners. The major driver was a well-established US coal trader, who had an existing relationship with a major private equity firm.

Shortly after some initial bulk carrier purchases, the company launched an initial IPO. Some months later, the company entered into a massive scaling up operation, acquiring a large fleet. They chose to finance this with a PIPE offering investors discounted share price to buy into the operation. The issue was structured with high dividend payout against long term employment. Growth was achieved largely by financial engineering rather than free cash flow and commercial market penetration, which would have certainly taken longer.

Timing proved auspicious and the market in 2007 sharply exceeded expectations. Share price rose in excess of actual earnings and FCF. QMAR reaped less benefit in the P+L than share price. The fleet was on fixed rates albeit with some profit sharing. Typically the time charter earning were a fraction of the prevailing spot rates; whilst operating expenses were rising sharply with the boom times.

The major shareholders put the company up for sale to cash out. They got attractive terms from Excel Maritime with a nice cash payout and exchange of shares in Excel, accompanied by BoD and management positions. In turn Excel financed the deal with heavy debt finance. Currently EXM is said to being carrying US$ 1,6 billion in debt.

Currently Excel must manage this debt in severe market downturn and sharp fall in vessel values.

There are real conflicts between Wall Street desire for quick profits and sound business principles. The challenge is to reconcile these conflicts to build a sound business.