Sunday, January 25, 2009

A hedge fund's losses are a gain for a privately held shipping company

The financial crisis is leading to a regrouping in the shipping industry where publicly-held companies are in retreat with massive declines in share price and shrinking capital markets. This is illustrated by the recent move of Robert Bugbee and Cameron Mackey from Ospraie, a major NY-based hedge fund, to a subsidiary of the Monte Carlo-based Scorpio Group.

The Scorpio group has chosen a value-added commercial approach building a tanker pool rather than the asset expansion/ vessel-provider model of most publicly listed shipping companies. Ospraie was a major capital provider for NY publicly-listed companies. They had a sizeable portfolio of shipping shares. They have been obliged to reduce their their holdings in this sector. With listed shipping companies rolling up losses with order cancelations and impaired asset values from acquisitions made at the top of the market, sound privately-held companies stand to make a come back in the industry.

Scorpio Shipmanagement is an old established player in the tanker market. It is closed family-held business of several generations.

Contrary to most publicly listed shipping companies, Scorpio concentrated during boom years in building a tanker pool. They have a very fine group of brokers and a solid commercial base with end-users. They gave priority to investment in human resources to expand their commercial and operational capacity rather than massive scaling up in assets at bloated price levels. They did not concentrate on making quick profits nor double digit investor returns overnight. They had longer term business plans.

Where they did expand their asset base, they used cheaper European finance sources. They did not have the high transaction costs or restrictions to their business plans imposed for raising capital in US financial markets.

Presently as seen in the Bugbee move from Ospraie to a new Scorpio subsidiary in Stamford, Connecticut, hedge funds like Ospraie who have been major equity providers for NY-listed shipping companies, are now in retreat. Their massive portfolio losses due to the drop in commodities prices have forced them to start to liquidate their shipping holdings and restrict their capacity for new business.

Private players like Scorpio have a bright future in this market downturn. They are well positioned with a strong commercial base. They are not saddled with expensive asset acquisitions at top of the market prices.

They will have the opportunity to scale up with new vessels at lower prices that will give them a long term competitive advantage to many publicly listed companies.

NAT: a listed tanker company with radically different business strategy for investors.

NAT has consistently outperformed all other publicly-listed peer shipping companies. On ten-year basis it has returns of 1065% as opposed to the nearest competitor with 150%. Contrary to its peers, NAT avoids term debt and operates mainly on the spot market. It is also avoided massive scaling up asset expansion deals. It has maintained high dividend payouts to shareholders.

Shipping is a cyclical business and there is no free ride by shifting counter party risk to time charterers.

Success in the business comes from sound business principles such as brand image, a solid customer base, strong chartering and operational capacity and vessel performance quality. Good timing decisions are crucial in profitability, particularly asset acquisitions at moderate prices.

Whilst an attractive method of multiplying returns, bank leverage often creates restraints on commercial policy, impairs liquidity and increases financial risk.

The main reasons why so many recently listed shipping companies have done massive vessel acquisition deals is that they boost nominal investment returns as well as investor expectations. On the other hand, these deals result in increased leverage and exposure to losses, if asset values fall decline thereafter in weak market conditions, charterers default or renegotiate rates and orders are canceled.

NAT was never under any pressure for massive scaling up deals. Their cost structure is lean and efficient with lower operating vessel operating costs than many Greek operators. They maximized profits in good markets with spot rates.

They are in a competitive advantage with their charterers over many of their peer companies. They had no obligation to fix their units on period cover because of financial covenants or investor demands. Charterers normally prefer the flexibility to fix on shorter periods that correspond with their own business plans. For longer periods, they demand steep discounts for the risks. There is always the underlying counter party default risk in bad markets.

NAT has negligible term debt and excellent liquidity. They are now on the winning side to increase their fleet at bargain prices that further enhance their competitive advantage in the market place.

DRYS revisited

Do expectations for DRYS match up with reality? Does the DRYS BoD provide adequate shareholder oversight? Recently there have been several major transactions between DRYS and private companies controlled by the DRYS CEO. In just a few months after entering these transactions, they have resulted in substantial losses for the company.

Despite high expectations and a recent recovery in share price from a low of US$ 3.04 to an early January high in excess of US$ 16 about 10 days ago, DryShips recently issued a press release bracing investors for a net loss of up to US$431.4m in the fourth quarter. The company shares are now trading in the region of US$ 10-11.

Much of this expected loss relates to one-off payments for the cancellation of vessel purchases and disposal of a trio of capesize newbuildings. The decision to axe the purchase of nine capesizes from Economou’s Cardiff Marine could also erode the bottom line.

There is also an unrealized mark-to-market interest rate swap loss of approximately US$177m. Finally there is discussion of a possible write down associated with the Ocean Rig acquisition.

These losses can be classified into two categories: 1.) Risky asset acquisitions from CEO's private company to DRYS and 2.) risky business decisions outside of core business with a major impact on the group as a whole.

Shifting assets between a company that is privately held by the CEO to the publicly listed entity that he manages raises a number of issues. On a positive side, perhaps the CEO is using the private company as a business incubator and the public entity as the financing tool. On the other hand, there are questions about BoD oversight, especially concerning risk management and financial losses so soon thereafter.

The transactions between the public and private entities have been done through stock, debt and cash exchanges. The order cancellations that have led to the losses have been negotiated with cash, stocks and warrants between the respective entities. This makes evaluation difficult and does not assist with transparency.

The offshore diversification into deep water offshore drilling merits some attention. This is an activity that is new and totally outside the purported business of DRYS as a dry bulk cargo transport. It entails huge asset investments in offshore drilling platforms that dwarf the investment in the dry bulk vessels as well as significant increase in debt leveraging of the group. The CEO's private company has been heavily involved in developing this business, too. The results of this operation will have a major impact on the future of the company. Whether this activity can be spun off as a separate listing depends very much on future conditions on Wall Street as well as future expectations for this sector now that oil prices have fallen below US$ 50.

On the market upside DRYS was an outperformer with strategies that outpaced peer companies. So far on the downside, it has been a rough ride.

Saturday, January 17, 2009

EGLE: Conflicts between sound business principles and Wall Street 'value-building' concepts

Short-term Wall Street objectives can conflict with longer term goals to build a sound business. Being solely a vessel-provider and relying on a customer base of a limited number of charterers can lead to a high degree of counter party risk. High dividend pay-outs secured by time charter employment comes with a price as there is a trade-off to building value by a broader commercial base and a higher cost of funds for growth. Expansion is necessary to build up a company but buying deals from others with a mark-up is not always the most productive means to create business with value.

Eagle Bulk has been generally a well run business. The timing of Sophocles Zoullas was very good to enter the market and start this business. He chose the most conservative sector of the dry cargo market where there is the need for more industry consolidation and tonnage renewal was indisputable.

The weaknesses of the investment proposition are in the massive scaling up at premium asset prices and the vessel-provider model, out-sourcing the commercial side to time-charterers without trying to build some presence with end users. Admittedly there are established groups in this sector who do have their own contract base and direct relations with end-users, but this only adds to the weakness of the investment proposition as far as the commercial aspect is concerned in the competitive landscape. The company shifts rate risk to charterers at a price but it cannot escape counter party risk in adverse market conditions. Further EGLE chose to scale up at the peak of the market on the basis of these charters.

According the latest 'Tradewinds' article, the company does not give out the names of its charterers. This is not helpful to investors in assessing counter party risk. 'Tradewinds' states that an October 2007 loan agreement with RBS shows four Dwt 53,000 units and nine Dwt 58,000 units going on charter to KLC, which is now staving off bankruptcy and renegotiating rates. The question is whether these are charters on actual vessels under EGLE operation or new buildings to be delivered. Further EGLE has recently taken steps to cancel a number of its newbuilding contracts.

The Wall Street firm, who backed Zoullas with investment funds, was strongly oriented to time-charter income. EGLE had little option but to try to build up their company with time-charter employment. Further they had to maintain high dividend payments to satisfy their investors. This capped their earnings in the strong markets that ensued. It prevented them from moving into the operational and commercial side of the business and kept them at a distance from end-users. It also left them with limited free cash flow for further asset acquisitions, forcing them to raise additional capital and leverage up into order to expand their fleet.

Whilst US financial firms stress 'value' in their investments, I never understood how buying a deal like EGLE did in 2007 from Alba Maritime did much in that respect. After all Alba placed the orders for the bulk carriers and - according to 'Tradewinds' - even negotiated time charter employment with KLC, which is now struggling to avoid bankruptcy, that they passed on the EGLE as part of the deal. EGLE could have considered doing something similar themselves. Instead they bought the business from Alba and paid them a handsome profit as a US$ 1,1 billion deal. The scaling up did inflate expectations and share value for a while, but was this solid business building? Time will tell.

Now in this weak market, EGLE has been obliged to cancel a number of new building contracts. KLC is looking to renegotiate down the charter rates for their own survival. For the time being, Eagle has a limited customer base with counter party exposure in the aftermath of a large scaling up at high asset values. In the end, it depends on the strength of their charterers to carry the existing contracts in this difficult market.

It is not any easy situation for any dry bulk owner ahead.