Changes in perception of Shipping Risk

We are now well into the fall season. The expected rebound in rates has been tepid. There is growing concern that the slowdown in global growth is structural and not temporal. Integration of economic activity across borders beginning to plateau. The vast pool of low-cost workers in China is no longer available and the credit-driven expansion cycle based on large state-sponsored infrastructure projects has reached its limits. In time, the impact on seaborne demand volumes and travel distances is likely to be profound. There may be a rise of regional production centers that shortens seaborne distances. Commodities prices are softening. Freight rates and secondhand prices may stay low for some years. Risk perception towards the shipping industry is changing, making it harder to raise money in capital markets. Investors playing a short-term asset game may find it difficult to exit with the expected profits. 

 My concern since the 2008 financial crisis is that the central bank policies of low interest rates, quantitative easing and flattening of yield curves is compressing risk premium and distorting asset pricing, which has been spilling over into the shipping industry. Weak commercial bank balance sheets have led to a zombification of the shipping industry, keeping lame-duck companies alive and second-hand prices artificially high.

Current shipping industry environment characterized by:

• Deflation and weak demand, low profitability, frequent credit defaults and limited bank finance availability.
• An inflow of speculative money into shipping assets, searching for yield from resale at marked-up prices with a cyclical shipping recovery. · 
• Preference for new ordering rather than industry consolidation of existing tonnage since asset prices are not marked down and remain stubbornly high in relation to present earning capacity.

To sum this up, zero interest rates together with chronic shipyard overcapacity has caused an inflow of investment money into new building shipping assets exacerbating over supply of tonnage. Weak economic recovery and slowing growth in emerging markets does not generate sufficient increased cargo volume to absorb the tonnage overhang. This puts the shipping industry into a vicious cycle of prolonged secular stagnation. 

The world shipping fleet age profile in bulk commodities dry bulk and tanker tonnage is composed of modern vessels and a dwindling number of scrapping candidates. Useful life of shipping assets is shrinking and ships are now going to the breakers at earlier ages. This has led to increasing asset impairment charges on older second hand tonnage that are highly unlikely to be recouped in current marginal freight markets. Buying older bulk carrier shipping assets is no longer a risk free investment secured by scrap value. 

On the other hand, speculative orders of new tonnage in projects like Scorpio Bulk carries more risk than normally perceived because new building prices may begin to soften again in the next few years. The price of steel has been steadily weakening, making potential replacement cost lower. In the meantime, Scorpio Bulk efforts to develop a chartered fleet for an operating company prior the new deliveries has resulted in operating losses due adverse arbitrage and compressed earnings margins. New deliveries in a period of slack demand and softer replacement cost would create a perfect storm that no one in this venture was originally prepared.

Industry consolidation in mergers like the Oaktree-generated merger of Excel Maritime into Star Bulk is no industry panacea. This is a drop in the bucket in terms of the overall fragmentation in the dry bulk sector and does little to consolidate pricing power.   The speculative new ordering at Star Bulk in open employment positions offsets pricing power.

This is an operation - like Scorpio Bulk - with a highly concentrated position in dry bulk shipping assets. Present returns on shipping assets are low. Profit margins frequently cannot cover depreciation expense. The whole investment exercise depends on the degree and timing of a cyclical market recovery and sufficient financial liquidity to turn over the assets at marked up prices to lock in the capital gains profits on assets.  No shipping investgment can make acceptible returns without asset gain on market uplift in future years.

Case in point is Scorpio Tankers - heavily exposed to the MR product tanker sector and underperforming with the eco-ship argument - where the only appreciable profits have been capital gains from VLCC's sales and potential sale of the Dorian shares from the LPG sector, which has performed well this year.

There are pockets of better quality shipping business in the tanker sector and specialty trades like gas shipping. But there always hangs the Damocles sword of shipyard over capacity where earning margins can be put under jeopardy with new ordering that quickly leads to softening of freight rates. We have seen this in the LNG sector very recently.  Rates are beginning to soften in the LPG sector after a very good run this year.

Sentiment on shipping risk is changing.  Capital market deal volume for shipping transactions is down from last year’s levels. Investment groups have moved on to other sectors. There is increasing discussion about how institutional investors are going to divest of their present shipping holdings in the current climate and how the expected mark up in asset prices for a cyclical shipping recovery may disappoint. 

I have long been skeptical of how this would ever work on any scale to repeat the boom years, not only because of the changed macro-economic conditions with slower Chinese growth rates and chronic ship yard overcapacity, but also because of the finance gap in the banking market needed to facilitate sales at higher prices. What is required is greater demand and exit of the present deflationary environment.  

This is still a work in progress for policy makers and central bankers struggling with an increasingly restless public!

Tail Risk in shipping recovery still very much present!

Lately there is a lot of capital chasing shipping assets, arbitraging on vessel prices.   Oaktree Capital is one of the high profile leaders.  Wilbur Ross was an early forerunner in the Diamond S. venture, doing the Cido deal in 2011.

It has nothing to do with business plans, building value with companies to gain competitive advantage and market share in transport and logistics services. This is pure and crude asset speculation, betting that we are at the bottom of the shipping cycle, vessel values will begin to move up and a quick profit will be made by unloading these assets on the next company, who in turn riding the cycle will hope to gain themselves on the next leg upwards until the last guy in – like a Villy Panayiotides at Excel with the Quintana merger – gets stuck carrying the candle and goes bankrupt with the losses as the market crashes.

My personal view is that Oaktree and others are desperately looking for yield without many options in the present world of ZIRP.  The FED policy under Ben Bernanke’s reflects today's conventional wisdom, trying to push asset inflation to reflate and get out of the current Great Recession aftermath of the 2008 Global financial Crisis.

Shipping assets have caught their radar.  Putting money in risky assets and companies for yield has not always gone very well in past shipping cases.  Berlian Laju, for example, just months after a massive debt restructuring with US$ 200 million in new funds and repeated earlier high cost lease deals ended in debt default just months later, illustrating the risks involved in this strategy.

Whether the present FED policies will ultimately reflate the world economy depends on future real demand for goods and services that generates cargoes for these vessels, pushes freight rates up and then vessel values increase geometrically on the future earning expectations. Until and when this happens, this speculative money is actually generating more over capacity and prolonging any market recovery in the shipping industry.

Meanwhile, we have increasing zombification of many shipping companies like General Maritime now reorganized along with TORM and Eitzen Chemical now renamed Jason, OSG/ BLT are in purgatory with their ultimate fate still in limbo.  Excel Maritime recently moved into a hopefully pre-packed Chapter 11 reorganization.  Genco and others like Eagle are tottering in the brink. The recent Baltic Trading follow on capital raise seems a back door doubling up for Genco - see my recent piece: "Peter Georgiopoulos tries to regain his lost credibility" http://amaliatank.blogspot.gr/2013/06/peter-georgiopoulos-tries-to-regain-his.html.

Their Bankers are desperately trying to keep the dead alive. In turn, speculative capital like Oaktree and others, are buying up distressed debt to keep the banks themselves alive with an increasing number of zombie banks around.  Warehousing of bad assets has become the fashion.  Commerzbank - basically a zombie institution - recently issued a statement that it does expect to sell any shipping assets because they expect the market will bring the prices up...  So why worry about any 'book' losses at current mark to market price levels, capital (in) adequacy, etc.?

Oaktree seems to have a rather chaotic investment approach with different parts putting shipping assets on their books in a rather haphazard way. After all, did it make sense or show good analysis to invest in General Maritime only months from declaring Chapter 11 and needing even more money in a second round?

Normally, investments are supposed to yield value and then second round financing is done to invest in another leg up in the private equity world.  Here Oaktree was doubling down on a bad position, which is not normally good trading practice.  The normal practice would be to lighten up and reduce exposure.  In the current 'pretend and extend' world that we live in, however, everyone is trying hard to avoid cutting losses and many actively practice 'doubling down'. 

Did Genmar ever really have much intrinsic enterprise value as a shipping company beyond its physical assets to warrant the Oaktree "investment" in recapitalization??? I would say no!

Peter Georgiopoulos  never really thought of Genmar as an enterprise - at least in the sense of a logistics transport business serving customers in carriage of cargo.  Peter G. was and is foremost an asset speculator.  He ignored strategic positioning for Genmar to gain market share, improve earnings margins and generate growth through retained earnings. Employment was just a means of holding his assets rather than serving and building a customer base. His biggest sin was ignoring trends in the tanker market and new growth areas. His mindset was on trading assets.  Others like TK Shipping and his nemesis 'Big John" Fredriksen handily outperformed him and provided superior performance to their investors.

In the case of Petros Pappas, the Oaktree approach is to fund Pappas like a bond trader. Pappas has a successful record in asset trading. Oaktree has Pappas like a stock picker in different vessel classes. Pappas trades largely on his own instincts with his own money on a 50-50% basis with Oaktree. His own skin in the game satisfies Oaktree for the moral hazard. Neither Pappas nor Oaktree are looking to build businesses or really have any business plans at all beyond the asset trading.

A recent Tradewinds interview with Lazard’s Head of Shipping, Peter Stokes, sheds a lot of light on this matter. In fact, I am amazed and somewhat gratified to see someone like Stokes, thinking and saying publicly, many of the same things that I have been saying privately and publically when I was recently a keynote speaker at the Hong Kong shipping forum.

Stokes sees two basic scenarios ahead (see "Bungled QE exit could 'burn out' ship values" http://www.tradewindsnews.com/weekly/w2013-06-21/article319083.ece5)):

• Scenario A: - conventional wisdom ‘muddle-through’ recovery in the next few years that is likely to be subpar in quality, partly because of so many trying to ride the coat tails of same scenario.  If everyone is arbitraging, then each is cancelling out the other in any meaningful price action.  Further this self-defeating over time in creating over supply with a new wave of speculative ordering that will grow with any upwards price movement.  There is too much speculative money and too much yard overcapacity.
• Scenario B - complete collapse with another leg down, where investment firms like Oaktree, shipping banks, etc. experience painful and unavoidable losses. The zombie shipping companies finally die. Assets are written down to true values and finally there is a proper shipping recovery based on an industry shake up where only the fit survive: much dreaded Joseph Schumpeter’s ‘creative destruction’. 

A  preview of scenario B is the recent reportage in Tradewinds about an apparently unsuccessful attempt by Wilbur Ross, First Reserve, etc. to float an IPO in the Oslo capital markets for their Diamond S venture that was built on a huge block purchase of product tankers from Cido a few years.  My previous two pieces on the Diamond S venture make interesting reading in retrospect: 

• "Does the CIDO deal mean tanker values are on the upside?" - http://amaliatank.blogspot.gr/2011/08/does-cido-deal-mean-tanker-values-are.html.

• "Diamond S. a new business model for shipping?" - http://amaliatank.blogspot.gr/2011/08/diamond-s-new-business-model-for.html.

Obviously, the latter Scenario B would be a devastating setback for governments (especially the European Union political elite) and many financial institutions.  Such an outcome might ruin their careers and threaten the integrity of their institutions. On the other hand, they are slowly running out of resources for the constant backstopping. “Pretend and extend” credit policies with the massive socialization of losses is far more costly than they are representing to their voters.  So far little of this has proved helpful to an economic recovery. Only the US has had some relative success, but their boost in energy resources may be a more substantive driver in this tepid recovery than FED financial engineering pulling on strings.

The two key elements ahead that may affect shipping asset prices are the US and its tapering to wind down the FED asset purchases and the Chinese restructuring, given that the Chinese marginal rate of investment is unsustainable and the losses are corrupting their banking system. The US and Chinese both realize that this needs to be done and it is unavoidable, unlike their EU counterparts with their “muddle through” theories, eternal dissention and dream-world mentality resembling Mann’s Magic Mountain novel.

Admittedly, I am strongly influenced by my friend Michael Pettis in China. I believe Chinese growth will ultimately disappoint.  The volatility concerned that Pettis expresses about the very large Chinese speculative position in commodities worries me given the potentially negative impact on shipping markets. So I would not be surprised about Stoke’s concern about further drop in shipping asset prices, driven by lower replacement cost in steel, etc. All this shipping investment is predicated on Chinese growth reflating the markets again – lots of very concentrated risk if this does not pan out.

See "Crunch Time: Why low growth is China's new normal" http://www.foreignpolicy.com/articles/2013/06/27/credit_crunch_time_china_low_growth_new_normal

On the other hand, the politicians, particularly the EU elite – our PM Samaras with his never ending Greek success story being the success story of the Eurozone – and Oaktree Capital are really betting the house that the worst is over and there will be happy days again with a robust recovery in just a few months.

Former colleagues of mine like the present Head of National Bank of Greece, Alex Tourkolias, saying that a shipping recovery will lead Greece out of its crisis and John Platsidakis of Intercargo, saying that two years from now the Greek debt crisis will seem like a bad dream gone away are lately exhibiting lots of boosterism.

In Hong Kong, by contrast, the shipping circles were subdued and cautious about a quick recovery in the markets.  Some companies like Pacific Basin have been aggressingly buying newer second-hand units, but these purchases are to renew their fleet and backed against a substantial cargo book, not the kind of overt and open speculation mentioned above by the likes of Oaktree.

So who knows? Stokes and I could be incorrigible pessimists and totally wrong. All I can say is that I still see a lot of tail risk around in shipping and elsewhere.

Why not a derivatives market in vessel asset values?

Shipping investment projects have always been mostly asset plays rather than new business models to serve customers more efficiently in the transport of cargo. The Greek shipping industry craves for investment in physical assets as opposed to the Norwegian asset-light cargo operator model with chartered-in tonnage often on purchase options. Profits are generated from moving in and out of assets in the shipping cycle. Cargo transport operations remains secondary in the process mainly to keep holding costs down. Lately investment firms have also gotten into the game, teaming up with operating companies to acquire shipping assets.

Would not it be easier and more efficient to develop a derivatives market for this process rather than taking on all the headaches of physical asset ownership?

The latest version of this asset play concept is the Oceanbulk Carriers partnership between Petros Pappas and Oaktree Capital with the purpose of picking up distressed dry cargo shipping assets and eventually making profits on market recovery. Petros Pappas has an excellent record as one of the most successful asset players in the Greek shipping community, having sold off most of his dry cargo fleet in the heady boom years of the late 2000’s to the point of even moving out of basic ship management and operations.

There is no doubt that the dry cargo business is currently under severe stress. The sector has been plagued for years with a historically high vessel order book on expectations of infinite Chinese growth with their insatiable appetite for commodities imports and incessant speculation in commodities resources. The Chinese themselves have become major shipbuilders with huge expansion of yard capacity, mainly for dry cargo vessels. It did not take much of a drop in Chinese growth rates in 2012 and some inventory destocking to send dry cargo freight rates tumbling.

As this point, several high profile listed dry cargo companies like Genco (GNK) and Excel Maritime (EXM) are on the verge of bankruptcy, plagued by asset prices falling below loan outstandings and cash flow problems to service the debt payments. Unlike Asian competitors like Pacific Basin with large cargo books, these companies themselves started as asset speculations. They leveraged up with debt to expand their fleets in large block purchase deals, playing the market cycle.

Excel Maritime went to the extreme of merging very unwisely with another asset play, Quintana (QMAR) shortly before the 2008 global financial crisis and reportedly taking on US$ 1 billion additional debt to finance this transaction. The motive to merge for the Quintana stakeholders backed in part by First Reserve private equity was to realize their asset position for profit because their operating profits were restricted by long term time charters and this kept their stock price from appreciating as much as they would have liked to see. Just the announcement that they were planning this move caused a bounce in their share price.

Contrary to their mission statement to focus on distressed assets, the Oceanbulk-Oaktree venture recently decided to place new orders rather than to wait for opportunities in existing tonnage. At the same time, their new business development director and former investment banker, Hamish Norton, recently gave a dry bulk presentation at an industry forum in Athens where he sagely noted that the continued drybulk order book risks putting off any market recovery for another year yet in the sector. So ordering additional dry cargo vessels would at least appear to be contributing to more industry distress and counter-productive in hastening any market upturn in rates.

Perhaps a vessel asset futures market – if feasible – would be a more efficient tool for these cyclical asset plays. The ship derivatives could be based on standard type bulk commodities vessels, just as the Baltic Freight index is based on standard voyage routes. Banks could use the derivatives in order to hedge their loan exposure, reducing their credit risks to shipping companies. Shipping companies could hedge their asset purchases against fall in value and impairment charges. Hedge funds and institutional investors could take speculative positions on rising and even falling asset prices.

The beauty of a derivatives market for ship values is that it would not entail any ship ordering. Shipping companies could go back to the fundamental business of transporting cargoes for their customers. Because the derivatives market would allow for both long and short positions on vessel values, it might even assist in providing a reduction of vessel asset price volatility. Positions could be taken and unwound very quickly.

All this would relieve investors from the trouble for these cumbersome partnerships to buy physical assets, the need for bank finance, the travails of ship management and needs to charter the vessels with risks of charterer default, etc., only to lead to a game of musical chairs on market recovery to sell the assets or the shares in the company to the next guy with a mark-up.

Of course, the last guy in the chain like Excel Maritime in the Quintana merger or Berlian Laju (acquiring Chembulk from AMA at a sizeable mark-up), is invariably left holding the candle, facing bankruptcy as the market sours.

The shipping industry would become more of a logistics business, but is it not what it was supposed to be in the first place?

Greek listed shipping companies have a competitiveness problem with their peers in terms of investment returns

One of the biggest problems in Greek-listed companies is that many have been trailing on profitability. This was recently brought home in excerpts from Fearnley report tracing these companies from 2000 onwards that was recently published in the Tradewinds.

Vancouver-based TeeKay LNG (TGP) delivered a 10% return for its investors but Livanos-controlled GasLog (GLOG) late in the game is presently at -3% returns. Tsakos (TEN) with scant returns of 5% against TeeKay (TK) overall at 14%. Peter Georgiopoulos (GMR) went into Chapter 11 largely wiping out common shareholders.

The same goes for dry bulk company listings. Palios-controlled Diana Shipping (DSX) with negative returns as opposed to Danish-based Norden (DNORD) with 38% returns. Fredriksen’s Golden Ocean (GOGL) secured a 19% return for its shareholders, whereas Panayotides’s Excel (EXM) and Zoullas’s Eagle Bulk (EGLE) have lost money for their shareholders with negative returns. Both companies have had serious financial problems.

Why have so many of these Greek-controlled listed companies delivered such poor results for their shareholders?

Admittedly, the shipping industry as a whole has been under a lot of pressure lately with difficult market conditions. This has placed management under stress with extraordinary challenges. Greek shipowners are relative new-comers to capital markets. Traditionally, Greek companies have been closed private family businesses. Most privately-held Greek shipping businesses have been performing well in current difficult market conditions.

The Greek listed companies were mainly start-ups. The only case of a mature company was the Angeliki Frangou’s acquisition of Navios as a platform and she has since managed the business well, outperforming her compatriots. The start-up companies were all on the vessel provider business model, providing ships and crew for charter employment. They had no cargo books. Conceptually, they were cyclical asset plays with high dividend payouts to entice investors. This situation was fueled by the remarkable rise of China with its double-digit growth rates, insatiable appetite for raw material imports and its burgeoning export market to the EU and US in finished goods.

The challenge for these newly-listed companies was that shipping is an old-fashioned labor and capital intensive industry with relatively low returns on assets. The traditional benchmark for a good ship acquisition deal is 15% return on asset on the basis of 60% leverage with cheap bank finance. This is not a big margin to cover the unforeseen if results do not work out as well as planned nor would this satisfy normal institutional investor return requirements of 30% returns for start-ups and 20% returns on existing businesses. Covering the risk profile with longer term employment from charterers entails a discount on the charter rate for the counter party risk transfer. This sort of arrangement creates additional challenges, capping further market upside in a rising market where there is premium on vessel values and lowering financial returns.

Capitalizing on magic of the China growth story for cargo, these companies could only entice investors on rising earnings multiples from fleet expansion. The concept was double the fleet with large block vessel acquisition deals. Presto: double the profits! Most of these companies expanded their fleet by buying fleets from existing private shipping companies. Peter Georgiopoulos was a forerunner with his tanker deal with privately held Metrostar in the early part of the Millennium. Indeed for some private Greek shipping companies like Metrostar, it became a lucrative business to sell their tonnage to listed shipping companies at premium prices. Eagle Bulk, for example, expanded in the same fashion in the dry cargo Supramax sector, doing a large block deal from another Greek private company rather than building the business themselves.

Ironically, this concept with investors came to a halt two years ago with a repeat deal that Peter Georgiopoulos did with Metrostar to expand and renew his Genmar tanker fleet. Investors loved the deal and gobbled up the supplementary share offering at par with no discount for the risks involved. Unfortunately, the tanker markets came under pressure shortly thereafter. General Maritime strained to secure bank finance to complete the deal. Ultimately, GMR went into Chapter 11 and investors literally lost their shirt. This debacle was a cold shower for institutional investors in shipping deals. Criteria for new money became more demanding. Institutional investors started to press for deep discount entry prices. The best placement source shifted to day-trader retail investors who, could care less whether their stock picks were solvent or their business strategies made any sense. 

All these deals were cyclical asset plays. No one cared about earnings margins or value creation from competitive advantage other than a large fleet. Profits were generated from rising freight market expectations. If you were lucky, you would sell the assets down the line to another shipping company in a game of musical chairs. Excel Maritime (EXE), for example, bought out Quintana in a merger shortly before the 2008 financial meltdown. Excel was obliged to raise a great deal of bank finance to complete the deal. Stuck in the chair when the music suddenly stopped after 2008, Excel has been reeling with liquidity problems and bank covenant violations ever since. The main shareholder was obliged put in additional cash from his personal money for recapitalization to keep his lenders happy and at bay. It is no surprise that Excel Maritime has been for its shareholders neither a profitable Norden nor Golden Ocean, but rather a source of painful disappointment.

An unfortunate derivative of these asset plays is that they distracted Greek managers from moving into other more profitable growth areas like gas shipping and offshore. Peter Georgiopoulos (and his investors) missed out entirely entirely these opportunities.  Instead Georgiopoulos moved into similar dry bulk asset plays in Genco and Baltic with poor investment returns. This ultimately ruined his tanker business where other competitors like TeeKay Shipping comfortably trumped him in the tanker markets with their franchise in shuttle tankers and nice play in LNG shipping, rewarding their investors handsomely.  His management team involvement in Aegean Marine Petroleum (ANW) (albeit his personal role here may be more of a figure-head position) does not appear to be getting any better results in the fuel supply business where competitors like World Fuel or Glencore-controlled Chemoil have much better share performance for their investors.  (See the below article with comparative stock charts and discussion of business strategy)

The future of Greek shipping lies in regaining competitive advantage and better earnings margins. Greece entering the Eurozone was a big structural setback for its shipping industry. It put its management and ship repair companies in a high cost, slow growth currency zone with a 30% premium over the US dollar. Shipping industry revenues and customer base are mainly with emerging market countries with exactly the opposite strategy of cheap currencies following the US dollar to foster their export markets in goods and services.

Greece is tied to the mill stone of a low-growth economic zone that is getting progressively poorer as time goes by.  It is also facing significant fiscal drag from massive barrage of taxes due to an unsustainable debt overhang held by EU government creditors in debt peonage.  The PSI+ debt restructuring bankrupted local Greek banks, severely limiting bank credit for small-medium Greek shipping companies.  The aggressive high tax environment may even ultimately eliminate the tax-free offshore status of Greek shipping companies. A Eurozone venue means continued higher administrative and crewing costs for Greek seamen than Far East competitors. Greek companies will struggle to compete with peer vessel management companies in business friendly places like Singapore free from these issues.

Given erosion of their cost structure, Greek shipping companies may have to focus more and more on niche markets and new growth areas to make up for their higher operational cost structure and sharp competition from foreign competitors with more disciplined growth strategies with emphasis on earnings margins, investment returns and risk profile on the business that they develop.

It is fair to say that this cyclical downturn in shipping markets will also open new opportunities in asset play strategies for those who have the wallet, financial backing  and patience. In these cases, the first-ins and early-outs are generally the most fortunate. The last-ins get caught when the music stops. Too many Greek listings proved to be in this category.

Excel (EXM) restructuring results in massive share dilution

The EXM restructuring resulted in massive share dilution. Absent a significant upturn in the dry-bulk market over the medium term, the Panayiotides family capital injections of US$ 45 mio at a deep discount of US$ 1.75 per share left little, if any, equity value remaining in the company for public shareholders. Yet the stock share value has been soaring due the market perception that the company has been relieved of immediate default risk. Excel shares are worth approximately 60% of the previous valuation after the equity dilution but the risk of going to zero is diminished.

The EXM loan workout plan got mixed reviews with stock analysts and even one downgrade after an earnings announcement.

The successful waiver negotiations and principal repayment deferral were seen as positive signs for the viability of the group. It demonstrates that banks are swilling to work with shipowners and do not yet have an appetite for seizing vessels Generally things tend to get nasty later in the downturn cycle as weak market conditions persist and banks start looking to liquidate the losses to get them off their books.

As it stands now, the Panayotides family's stake in Excel increases to 47% from the previous 11%, and boosts the overall share count by 69%. Excel shares are worth approximately 60% of the previous valuation after the equity dilution but the risk of going to zero is diminished. The negotiated waivers and deferments essentially remove the possibility of foreclosure until 2011, widening the time horizon for recovery. Further the restructuring terms give the group enough cash liquidity to pay for newbuildings (US$ 110 mio) and debt repayment (US$ 207 mio) out of an expected cash flow of roughly US$ 300 mio.

A successful outcome depends on future market conditions. If conditions remain weak and the group is plagued with a new rash of charterer defaults, they could be looking for a new capital infusion down the line. If conditions improve, there could be real potential for shareholders to recoup some of their losses.

Most analysts cautiously kept their previous ratings. The day after the bulker owner posted a US$ 329 mio quarterly loss, however, Maxim's Charles Rupinski cut his rating on Excel's New York-listed shares from "buy" to "hold". He stressed that EXM continues to be a highly volatile play in the dry-bulk industry, especially as its recent debt restructuring gives the company further staying power in terms of liquidity over the next several quarters; but cautioned that with its high debt load, the company will need sustained improvements in the overall dry-bulk market to work as a value proposition.

Quintana Merger runs amuck for Excel Maritime - a Wall Street parable

Senior debt lenders are now putting maximum pressure on Excel Maritime for new injections of capital for restructuring. In a previous piece "EXM and debt covenants" that I published in September 2008, I had outlined the risks that the Group had undertaken in acquiring Quintana. It seems that these risks have now come to roost. Excel may be taking nearly a $1bn write down on its equity, which would nearly wipe out the shareholders' position!

Quintana was an extremely successful Wall Street 'value' play for its shareholders and management. In business, shareholder value means intrinsic competitive advantage in the market place. On Wall Street, value tends to mean short term gain from building up shareholder expectations and cashing out on shares ASAP at advantageous prices. There is huge space between these two concepts nearly as vast as the oceans. It leads to conflicts all the time between corporate management on the one hand and private equity firms and investment banks on the other hand. It is very common that investment bankers and private equity firms impose conditions on corporations that are not ideal for management in building sustainable competitive advantage for their shareholders.

In the case of Quintana, the price of obtaining private equity PIPE support for their scaling up in the Metrostar deal was the need for low paying long term charter employment to support a large dividend payout. Even on that basis, the PIPE was sold at discount. The financial interests were simply not interested in building a company. They saw the operation as a junk bond transaction or in other words an asset speculation play.

When dry bulk markets soared in 2007 beyond expectations, the only way for QMAR shareholders to benefit was to sell the company and cash out. A charter party default case last fall concerning one of their vessels illustrates their predicament. The subcharter had fixed their unit on a voyage basis at rates in excess of US$ 100,000 per day. The vessel had been let and relet several times with multiple charterers in a chain. Quintana was only receiving US$ 30,000 per day on the vessel as owners. The perils of the vessel provider business model are ending up as a cheap source of capital for commercial operators to make big profits.

They successfully got out in the fall of 2008, which was very fortunate. At the time, there were doubts that their counter party Excel could even execute the deal. The subprime crisis has first broken out and it was beginning to have an impact on the banking industry. Excel had to arrange a massive senior debt facility in excess of US $1 bn to finance this transaction.

In retrospect, I suppose one might ask what was in the minds of the Excel BoD when they approved the M&A deal given the risks involved. The only value in the merger was the QMAR fleet that was locked into low-paying charters. In essence they were paying premium prices for the vessels whilst the underlying intrinsic value of the company was low - an unattractive combination.

Whilst many on Wall Street would likely castigate my constant emphasis on value beyond steel in shipping, I think that this case illustrates the perils in ignoring business fundamentals and seeing every transaction as an asset speculation. For a company, assets are only a means to an end. The bottom line depends on what management does with them to build a business.

Now EXM shareholders are facing an impairment charge and the need to recapitalize that may significantly dilute their interests. Stamatis Molaris, the CEO, recently resigned. The major shareholder, Gabriel Panayotides, may be obliged to sell his controlling share in Torm to cover the losses. Ironically, Torm is a 120 year-old Danish shipping company that has considerable intrinsic value.

Despite this dire situation, EXM shares soared over 10% in Friday trading. It will be interesting to hear the earnings announcements on Monday and see the market reaction.

More charter party defaults at Excel (EXM)

Excel Maritime (EXM) is under further pressure from counter party risk problems. Its remedies are limited. It is likely to have to live with the problem until market conditions improve.

EXM argued strongly to its investors that one of the strong points of the Quintana (QMAR) merger was the heavily contracted employment profile. QMAR scaled up in 2006 with a massive vessel purchase deal from Metrostar that was backed with Bunge employment. The market in 2007 outperformed all expectations and QMAR's stock rose but the company free cash flow benefited only very mildly because of the conservative employment profile. This led QMAR shareholders to market the company for sale.

EXM paid a substantial price but they reasoned that QMAR's charter contracts would improve their secured coverage of their existing employment profile.

Presently EXM is understandably very vexed about accepting charter renegotiations. I have always argued that in bad markets, legal remedies are only a partial fall back. It all depends on the charterers capacity to pay and other employment opportunities available (which diminish as market conditions get worse). If the charterer is not solvent and risks bankruptcy, there is really no legal remedy. Owners often have a vested interest to assist their charterers in these situations. Each charterer relationship has to be viewed on its merits.

The most important thing in a bad market is to keep the vessels moving. Often voyage charters are safer from a credit risk standpoint, but this requires strong chartering and operational skills as well as a sufficient fleet size.

Bottom line: EXM probably did not sufficiently price the risk factor in the M&A deal. At the time, vessel pricing was virtually free of risk discount. The break even levels were far in excess of the industry median, which is a natural fall back level in this highly cyclical business. The secured employment was only a partial hedge with counter party risk.

This acquisition was heavily financed by senior debt so any shortfall in free cash flow from charter party renegotiations could potentially raise problems in servicing debt.

QMAR was wise to sell out and partially cash in their profits at the time.

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.