EGLE: Expansion woes in a bear market

Eagle Bulk (EGLE) may continue to have good long term prospects, but it is clearly feeling the pain of its unfortunate timing decision to expand and leverage up at top of the market asset prices.

EGLE is now facing the consequences of its massive fleet expansion at the top of the dry bulk boom. It is suffering from reduced profitability and high debt. New charters appear to be ranging between $8,500 to $10,500 per day, which is reducing free cash flow and making it harder to service debt. General and administrative expenses have risen considerably on latest company estimates, impacting negatively on profitability.

Cantor Fitzgerald and DnB Nor Bank have recently downgraded the stock to 'sell'.

I have differed from other GLG analysts on EGLE, primarily out of my concerns over the consequences of their massive US$ 1.1 billion deal with Alba. This ambitious expansion prior to the substantial fall in rates is causing them a lot of grief. Order cancelations expose them to forfeiture of deposits and losses.

On a positive note, however, EGLE still appears to hold a significant part of a large financing facility and its financing needs appear covered in 2009 and 2010 for its order book. On the other hand, steel prices have fallen considerable and is likely to lower future replacement cost of new tonnage and impact negatively vessel values.

Of course, EGLE is not alone. Many of its peers are suffering from similar problems or worse.

The outlook ahead depends on the efficacy of various government 'stimulus' plans on the dry bulk market, particularly infrastructure projects.

Aftermath of Spendulus

The present form of this stimulus plan is probably about the best that one could expect from Beltway politics. Whether this spending contributes to a productive recovery that outweighs the increase in public debt remains to be seen. I also think that it risks being a dead letter unless more progress is made cleaning out the banking sector.

The key to these matters lies in the Geithner speech on Tuesday, which indicates a continuation of the US authorities’ policies to fudge and delay in cleaning out the banking system to put things in order. For political reasons the preference has been to keep large banks alive on taxpayer money. When Geithner revealed the massive additional bailout sums in mind, I believe this really frightened the financial markets. These sums make the Obama Stimulus Plan pale in comparison and add to the major issue of the future: how these massive federal deficits and increase in public debt are going to be financed and the eventual debt monetization. Even Summers and Geithner concede this is an issue.

The longer the US delays in repairing the financial system, the more likely an L-shaped recession with a prolonged period of economic stagnation. I suppose the Beltway is praying that the Stimulus Plan will somehow reverse things and soften the bank losses so they will avoid having to resort to more orthodox means to clean up the financial mess and face potentially losing most or all of the taxpayer money already injected in many sick banks.

The conundrum down the line is how - if an L-shaped recovery of prolonged sluggish growth emerges - the US is going to monetize its significantly increased public debt load that moves to EU levels of GDP?

The US Authorities have been placing heavy bets against this scenario. If the dice fall against them, they will have the unenviable choice of either raising taxes in a sluggish economy or tolerating a policy of high inflation to devalue the government debt. The inflation path will jeopardize the public debt refinancing with foreign creditors.

The EU with high public debt and large entitlement programs has been locked into this misery for many years now. They are partially subsidized by the US for their defense spending needs. They are permanently constrained to relatively tight money and an overvalued currency to be able to roll over their large public debt loads. How will the US face this scenario plus the substantial weight of military expenses that their allies are unlikely to share?

I would add that there is likely to be less future capacity in major markets for US treasuries. The ME is suffering from low oil prices and the aftermath of their grandiose real estate and refinery projects. There is heavy speculation on rising oil prices in the futures markets, however.

More significantly the FE has been burned from the collapse in their export markets. Countries like China are diverting their cash reserves for their own stimulus programs to shore up domestic demand; otherwise they face dangers of social unrest. With this and a collapsed export market, they have less to lend to the US. Longer run they may have less incentive to continue to do so, seeing their interest to develop their own domestic markets as a more reliable base for their economic expansion.

I think that we live in a period of challenges and rapid changes.

US Stimulus Plan: crank economics and high risks ahead

The US is moving into uncharted territory with the massive new stimulus and bail out plans of the Obama administration. There is no serious economics input in this legislation. The spending is not properly targeted. The tax cuts are badly constructed. The benefits are minuscule in relation to the future drag on the US economy from the massive increase in public debt.

This comes on top of the Paulson-conceived TARP and the huge increase in the balance sheet of the FED with quantitative easing, which is a euphemism for printing money. Accrued liabilities on entitlement spending the US like Medicaid and Social Security remain a politically taboo subject with sums involved than dwarf the bailout and stimulus plans.

The EU is the best reference for the where things seem to be headed in the US. Europeans are far more cognizant than their American counterparts of financial risk. EU members have been struggling for many years to stay afloat and remain competitive in a global economy with high public debt loads and large entitlement programs. The result has been relatively high structural unemployment and slow growth rates. This is based partly on policies of an overvalued Euro and very rigid rules on monetary expansion.

Americans have enjoyed the status of having a reserve currency and unlimited finance for their deficits. The US played a major role in Far East economies as a vast consumer market. So countries like China, who started to generate large trade surpluses, had every interest to finance the US deficits. It was trade finance as well as a means to keep their currency low. This boosted their exports into the EU. This model did not prove sustainable however. The credit bubble in the US burst and it unleashed a systemic financial crisis. US households are over leveraged and savings rates are very low. The US is a major debitor country.

Even countries in recession like Italy with big public debt loads, have the benefit of high savings rates, for example, and a comparatively healthier banking system than the US.

The issue today is where these massive US bailout programs that entail huge deficits and raise public debt to European levels will lead us? Is this a serious panacea or is it just simply trying to pile new debts on old debts resulting in an even bigger financial pyramid that eventually collapses? Are the US authorities seriously addressing their imbalances and putting their house in order? Personally I consider the US to be a far greater risk than the EU in this crisis because of the consequences of failure.

If eventually the US programs do fail, it will have far reaching effects. So far so good since US treasuries provide the US an extremely cheap source of finance. DnB Nor Bank is projecting weak markets and contraction until the 2nd semester of 2010 with a weak recovery thereafter. If however market perception of US sovereign risk changes, there could be some big problems ahead. A fall in the US dollar and a sovereign risk problem would be a nightmare scenario much worse than the subprime crisis.

I believe that the Obama administration is acting more out of political expedience than economic logic. Unfortunately the new US President has scant knowledge of economics and public finance plus unproven administrative skills. The heavy weights in his economics team like Geithner and Summers appear to be acting more like politicians than economists. Neither of them seems to have made more than scant effort to construct a serious stimulus plan with the US Congress nor do they appear to have done any serious vetting of the legislation before approval.

Sadly only a minority in Washington seem to have any sense of the risks involved. So it is very likely that the new US administration will be spending most of their future chasing their tails to clean up the mess that is being created. Summers, of course, escaped having to deal with the dot.com crisis as Treasury Secretary the last time around, becoming President of Harvard and passing the problem on to the Bush Administration.

What is needed is to break up the present bill into smaller parts by function. Priority should be given to stabilizing and cleansing the financial system. The stimulus spending and tax cuts should be carefully constructed with cost/ benefit analysis in relation to the future liabilities in the increased public debt load on the US economy and tax increases. Quality of work is far more important in rebuilding credibility than speed of action and political speeches to impress.

The risks are presently for an L-shaped economic recovery with a long period of slow economic growth ahead.

DAC: Perils of large order book of container vessels in a bear market

An analysis of Danaos (DAC) in the current market downturn. The challenges of rapid growth in a bear market environment. DAC is similar in fleet size and order book to Seaspan (SSW). There are a large number of competing liner shipping companies, who market their vessels to a limited number of liner operators. The key issue is whether the liner operators, under pressure from falling demand and financial losses, be able to carry the all theie present chartered units and absorb such a large orderbook.

DAC's most recent investor presentation shows a current fleet of 39 vessels with an orderbook of 31 units. Danaos projects +150% contracted fleet growth. The major issue is how will this new tonnage be employed, whether there will be order cancelations and the impact on company earnings forward. Are past record rates of investment return sustainable in this business model based on insatiable long-term charter demand from liner operators and low funding costs in this new business and financial environment?

Container markets have been weakening since the first signs of US recession in 2007. The market was sustained for a period by increased EU traffic in part due to Euro appreciation. With the financial crisis in the fall 2008, the bottom fell out of the market. Major liner operators were already struggling with high bunker prices but then demand collapsed for cargo with the hard landing in Asia economies. Liner companies started redelivering vessels on charter termination. Many liner companies are rolling up financial losses and there will be increased counter party risk ahead with the potential of defaults and charter renegotiations.

As of fall 2008, DAC has a debt equity ratio of 50% and US$ 1 billion in liquidity, putting it in a good financial position. Its commercial management is prudent. It has a good spread of charterers with well-established liner operator names. The charter renewals are staggered.

Its share issue policies have recently been a bit contradictory. Danaos announced in the fall 2008 a share repurchase program, but then in January 2009 made an SEC filing for a supplementary issue to raise an additional US$ 1 billion. The company seems to be maximizing its options. In current market conditions, there is likelihood that the funds will be raised by the ATM technique rather than sold in large blocks to investors.

Its challenges are the decline in market asset values and falling charters rates. This means that its current fleet asset value is declining and charter renewal rates will be at lower rates. The credit markets for senior debt finance are tight and finance costs are rising. This puts in question the viability of the fleet expansion program of 31 vessels in the next few years.

DAC is not alone in their expansion plans. It is about the same size as Seaspan, which has a fleet of 35 units with an orderbook of 33 units. So far SSW share value has been recovering somewhat better since December 2008 lows than DAC, which shows a weaker chart pattern. Seaspan has an employment portfolio of seven liner companies. Indeed there are 17 additional competitors with orderbooks, too. Six of them have comparable large fleet expansion plans.

Their business model as ship providers is heavily dependent on liner company charterers. Will the liner companies be able to carry DAC and its competitors in current market conditions and absorb the large orderbooks of contracted tonnage? If something gives here, DAC will suffer and it will not be alone.

ATM share offering: another 'bail-out' technique to recapitalize shipping companies

'At the market' offerings (ATM's) are a means to raise capital in bad markets. Ailing publicly listed shipping companies are using this technique to raise capital to recapitalize their impaired balance sheets. These offering when used to pay down debt and recapitalize are highly dilutive. Investors should scrutinize carefully the longer term prospects of these companies. At best they may end up owning half their original share of the company with an eventual recovery. At worst, they may lose everything if recovery is slow to come to the shipping markets.

ATM share offerings are the latest technique in financial engineering to raise capital in bad markets. When trying sell a large chunk of shares in current market conditions, the investment market is selective. Many institutional investors are looking for opportunities to buy into companies at substantial discounts to prevailing share price. ATM offerings allows publicly listed companies to "dribble out" shares into the market.

Because the trading process is blind, investors have no idea whether they are buying existing shares or new shares being marketed by an underwriter. With no pressure to complete an issue within a day or a week, companies can proceed at their own pace and - ideally - have some control over what price the shares are sold at over weeks or months. Recent increased trading volume in a number of listed shipping ompanies like Navios (NM), Oceanfreight (OCNF) , Ship Finance International (SFI) and DryShips (DRYS) may be due to ATM share offerings rather than increased trading volume.

Since many publicly listed companies especially in the dry bulk sector are under pressure from their senior lenders to pay down debt in conformance to their debt/ asset coverage covenants, investors need to vet carefully these companies before taking large positions. Raising additional capital to pay down debt is a form of bailout in these cases.

Some companies will recover and this will prove an attractive placement. In other cases, companies will fail. All this depends on the length and depth of the current shipping recession.

After several months, the dry bulk sector has showed recently some activity. There was some demand for Capesize tonnage from resumed imports of iron ore to China. Capesize units have been badly hit with a large number of semi laid-up units. Panamax and handysize units remain at previous levels. It remains to be seen whether this is just a bear market rally or it will lead to a longer term recovery. The changing balance in Chinese macroeconomics from their current hard landing makes the near term difficult to predict. There still a large order book overhang despite cancelations.

NM: good logistics model, complex financial structure

A careful analysis of NM requires examination of its commercial and financial risks in the current financial crisis. NM recently has had its stock downgraded by several analysts. The company is carrying a large number of chartered in vessels in addition to owned fleet. NM has made a sizeable investment in coastal South American trading. In the long run, NM may be poised for growth. Short term if dry bulk market conditions do not improve and South America has a hard landing in the current financial crisis, management may have its hands full. A lot depends on the length and severity of the market downturn in the dry cargo sector as well as the general financial crisis.

NM has an interesting logistics model that differentiates them from many other publicly listed dry bulk operators. Navios was originally a spin off of US steel has a reputation of being one of the most sophisticated dry cargo operators in the market place.

Bought out a few years ago by Greek shipping interests through a SPAC, the new management acquired last year Horamar, an Argentinean company in the market of inland waterway cargo transportation in South America with a fleet of more than 100 vessels.

NM stock started to slump after this acquisition. Several analysts like Natasha Boyden of Cantor expressed disappointment. Boyden felt that the company’s complexity and opaque accounting treatment was often discouraging to investors.

The latest quarterly earnings report that came out last November indicates a reasonable debt/ equity ratio and good term employment through 2009 starting to fall a bit in 2010 unless renegotiated earlier.

Navios in fact controls a much larger fleet of 53 vessels of which 25 are owned and 28 are chartered in. The chartered in vessels are an additional liability in poor market conditions as there is the risk that voyage results may be less than the charter rates that NM has to pay out. This was the main reason for the recent Britannia Bulk bankruptcy. In such case, NM could be exposed to possible trading losses, drain on free cash flow and face the need to renegotiate charter rates with owners under threat of bankruptcy proceedings such as the Armada Group in Singapore.

Recent economic articles indicate that South America may face new difficulties in the financial crisis. Ecuador is in financial default and Argentina, where Horamar is established, is one of the economically weaker countries in the region. Further debt defaults in the region may affect adversely their inland transport business. There may be increased political instability with populist governments in Venezuela, Bolivia and Ecuador spreading to other countries in the region.

South America is definitely an emerging market growth story with long-term potential. Of course, Navios has some valuable end user client relationships and a solid customer base.

A bailout plan for the shipping industry?

YA Global is effectively bailing out OceanFreight, who has seen its vessel asset prices plummet and sought a waiver with its senior lenders for the default in their asset coverage covenants. This model of recapitalization of the OceanFreight balance sheet could be used as public policy to promote the recapitalization of the US banking industry by private funding.

OceanFreight scaled up their fleet at top of the market asset prices in the dry bulk shipping cycle boom. This was partially financed by senior bank debt. Since the financial crisis last fall, freight rates have plummeted for dry bulk vessels and some routes have been below cost. A growing number of vessels are in semi-laid up status, waiting for orders. Vessel values have fallen by 60% on the average. Older tonnage is close to scrap value. Many companies are forfeiting their deposits and canceling new yard orders.

This in turn has impaired the OceanFreights balance sheet. The market value of the fleet no longer conforms to the limits of their senior debt asset/ loan coverage covenants. They have also faced charterer rate renegotiation demands of period employment contracts down to market levels. YA Global offered OceanFreight an innovative solution where it puts fresh funds in the firm that are used to pay down term debt and recapitalize the balance sheet. In return YA Capital is taking an equity share in the company with an agreed pricing formula.

This type of solution could be adopted by public policy to encourage greater participation of private investment funds to recapitalize the US financial industry. The US government could offer tax concessions to induce investors to place more of their funds in US banks for the needed industry recapitalization.

The advantages would be the conservation of taxpayer money for other pressing needs, less public debt burden and smaller government intervention in the banking industry where there could be serious conflicts of interest on credit extension.