Landmark shareholder victory against Eagle Bulk management and directors for abusive and excessive executive compensation

Eagle Bulk Shipping has been one of the poorest performing shipping stocks in its peer group.  From lofty levels in excess of US$ 100 per share in its salad days, the stock crashed below US$ 20 in the fall of 2008.  From then on, it has been a slow attrition with charter party defaults, bank covenant violations and loan restructuring agreements with the stock presently trading at US$ 3,56.  Latest quarterly results were losses of US$ 3 million for the 2nd quarter 2013.  Yet its management sat at or near the top of shipping’s executive pay lists  for years.  Its directors who were earning more than their counterparts at large Fortune 500 companies without offering any oversight.  Shareholders who have lost literally their shirts appear to have succeeded to force Sophocles Zoullas and his management team to roll back their pay to more reasonable levels, albeit still quite high for such miserable value destruction and bad performance.

I have signaled Eagle Bulk at a very early stage back in January 2009 as a potentially problematic company: “EGLE: Conflicts between sound business principles and Wall Street 'value-building' concepts” http://amaliatank.blogspot.gr/2009/01/short-term-wall-street-objectives-can.html.

Its management followed an antiquated vessel provider business model with heavy dependency on third party charterer counter risk.  They scaled up their fleet at lofty values in large block deals, exposing the company to serious problems with loan to value covenants when the shipping markets crashed.  Eagle Bulk was badly exposed to the Korean Lines bankruptcy, with little transparency for years as to their charterers and counter party risk profile. 

If Eagle survives today as a zombie shipping company, this is by the mercy and desperation of their bankers, particularly the Royal Bank of Scotland, who did a trend-setting debt for equity swap last year  http://amaliatank.blogspot.gr/2012/06/eagle-bulk-in-trend-setting-equity-for.html to keep them alive.

Miraculously, tenacious shareholders managed to rebuff Eagle’s attempts to have their legal action thrown out by summary judgment in November 2011 and despite the high hurdles facing plaintiffs under Marshall Islands law. Eagle Bulk management executive pay practices were so abusive and egregious that facts suggested a “quid pro quo” arrangement may have existed between Eagle officers and directors, thus barring Eagle from using a so-called “business judgment” defense.  This has led to the present compromise agreement with Eagle management pending final court approval. 

The major bullet points are truly eye-opening in terms of the money and benefits that management had been extracting from the company despite its dire financial condition with its creditors and serious operating losses:

•    Cancellation of all stock options (180.704) granted to Eagle officers and directors between 2008 and 2011.
•    Shortening the expiration to five years from 10 for 1.4 million options granted to the Zoullas brothers in 2012, with an estimated US$ 1 million savings to Eagle.
•    Limiting average compensation to non-management directors to US$ 240.000 through 2015, compared to US$ 432.000 in 2011.
•    Limiting executive compensation through 2015 to the average paid by five peer companies — Dryships, Diana Shipping, Excel Maritime, Navios and Genco Shipping — rather than “prior practice of paying at the top of the industry”.
•    Requiring Eagle to bill Zoullas’ private Delphin Shipping US$ 237.000 for services it has rendered, and tightening dealings between the two “to ensure that Mr Zoullas does not derive an unfair advantage.”
•    Terminating the 2011 equity incentive plan and 4.3 million shares that could have been issued under it.

Among other practices in Eagle Bulk adding insult to injury is Zoullas appointing his brother Alexis as President making this listed company a family affair.

Lenders and other shareholders should rejoice, as Eagle still faces a difficult struggle to stay alive with continuing operating losses until dry bulk markets recover. 

Here below is a comparative graph of Eagle Bulk share performance with peer dry-bulk companies over the last five years:

Eagle is one of those at the bottom of the chart.  This case reinforces my concerns about a competitiveness problem for Greek listed shipping companies compared to non-Greek peers in terms of return on investment.  Pacific Basin, for example, in Hong Kong makes Eagle management look rather ridiculous and amateurish, not even worth their revised remuneration levels.  The best performing Greek peer company is Angeliki Frangou’s Navios Holdings, one of the very bright exceptions in the Greek market.

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.

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.

Banks distorting vessel values by keeping zombie shipping companies on life support, possibly delaying market recovery

According to Scorpio’s Robert Bugbee, bank deals like the recent Royal Bank of Scotland (RBS) equity for debt swap keeping their lame duck client Eagle Bulk (EGLE) on life support may actually be prolonging any meaningful market recovery. Instead of fleet renewal with this second hand tonnage moving to financially healthier and more efficient operators, this may encourage another round of speculative ordering for ‘econ-type’ tonnage financed on favorable terms by Asian banks to promote vessel exports and delay any recovery in rates for another two years.

“The problem is that the banks cannot afford to take write downs and private equity provides no better solution than the present operators,” Bugbee said. This keeps asset prices artificially high in markets where underlying cash flow from operations simply does not support these price levels. “This is combined with little available credit to buy second-hand tonnage and relatively low pricing for more efficient newbuildings, which will deliver at a later date and thereby avoid the present weak market. And these may have access to Asian finance.” Bugbee’s conclusion: “The result is that it’s probable that — on a ‘relative-return’ basis — fresh industry equity will continue to order newbuildings, thus lengthening the recovery process.”

What is ominous presently is the Chinese slowdown in growth rates, falling steel production and lower scrap prices. This may impact negatively vessel values. Not only will there be more fuel efficient designs, but replacement cost will fall.

Generally, commodities prices are soft and falling. This does not bode well for freight rates and cargo volume.

The stronger healthier shipping companies may adopt a similar strategy to some of the large liner companies like Maersk where they look to move into new technologically advanced tonnage that allows them to operate at lower cost than their beleaguered and financially-stretched competitors in a war of attrition. In this manner, they keep and expand their market share maintaining their earnings margins by efficiency and low financial cost, letting their competitors slowly bleed to death as they are slowly marginalized under their crushing debt stock and heavy financial expense in a prolonged weak freight market.

The only thing that could turn around this downward spiral is increased demand. Indeed so far, demand has been relatively firm as opposed to the shipping crisis of the 1980’s and the main issue is over-ordering. The wager in RBS lame duck support deals like Eagle restructuring is a speedy market recovery than brings up asset prices and improves cashflow.

Asset inflation has been a driving force in the shipping industry for many years now along with the Chinese double digit growth story. Should this environment change structurally, the industry (and its bankers) would be open to some severe readjustment shocks.

Eagle Bulk in trend-setting equity for debt exchange

After the TORM restructuring earlier this year, we now see another “equity for debt” exchange deal between Royal Bank of Scotland (RBS) and its beleaguered client, Eagle Bulk Shipping (EGLE).  RBS takes warrants for conversion into a 19.99% stake in EGLE.  To reduce the effects of dilution on shareholders, only one third of the shares can be cashed immediately.  There are share price triggers of US$ 10 and 12 per share for the cash out of the remaining shares in two tranches.  This sort of deal sets a new precedent for the shipping industry to keep weak companies alive a significant runway for a market recovery.

EGLE is carrying a crushing US$ 1.2 billion debt load, which was the result of massive block deal to expand its fleet at the peak of the boom cycle. As many shipping companies prior the 2008 financial crisis, EGLE preferred to expand its fleet by paying a premium to a private shipping company for a package deal rather than generating directly its own business for added value. The deal resulted in higher term debt leverage. Then with deteriorating market conditions, the company faced declining hull values and asset impairment charges as well as loan covenant violations as vessel values dropped below hull coverage ratios. The last two years, EGLE has been plagued with charter party defaults, declining revenues, growing operating losses. It is a highly leveraged player at the wrong time and place of the cycle.

This year, EGLE has seen considerable press about protracted negotiations with its senior lenders. Recently, EGLE and RBS settled a dispute over defaults to the huge loan and won a repayment holiday into 2015. The bank also offered up a new facility to the tune of US$ 20 million. An integral part of the deal was that the RBS would take a substantial equity share in the company as detailed above.

Doug Mavrinac of Jefferies was reportedly ebullient about the deal :

“Given that EGLE shares are effectively a call option at current levels, we believe the agreement is very attractive as it significantly lengthens the runway time for the market to improve and removes bankruptcy risk over the medium term,” he added:

“We also believe the move has positive implications for other large dry bulk shipowners regarding the banks' willingness to work through debt issues.”

Whilst I would agree that this deal sets a useful precedent for other troubled owners, I am not so sure that it is as beneficial to shareholders as he describes. I find this a bit like having your cake and eating it, too.

Inevitably, no one is going to come out whole in this unless the dry bulk markets improve, the company becomes profitable again, debt is paid down and vessel values rise. The Chinese growth cycle in infrastructure investment seems to be at an end. There are far too many ships. Scrap and steel prices are falling. There is a potential issue about new ship designs with lower fuel consumption.

EGLE remains badly exposed due to bad investment decisions of the past. Not only has management failed in delivering value to shareholders, but there have also been concerns about continued high remuneration levels despite the poor results. Added to this, the lenders now have an equity share in the upside, which means less to other common shareholders.

With Supramax rate expectations of US$11,000 per day on average the outlook still looks challenging. Prior this restructuring agreement, even market improvement expectations of US$ 13,000 perday for spot earnings in 2013 were not sufficient to service the crushing US$ 108 million debt maturities falling due.

So is EGLE an attractive company to buy as opposed to invest in peer dry bulk companies with better management performance, market position, lower leverage and healthier financial results?  Probably not!

EGLE is going to have to prove itself to be credible again.  This will take time and luck.

Eagle Bulk once a Wall Street darling now facing forced sales

At the outside of the 2008 meltdown, Eagle Bulk with its emphasis in handymax tonnage was considered one of the safest bets of shipping stocks. Sophocles Zoullas was well-regarded in NY financial circles. Kelso, who originally banked the venture, had made very good money. Yet the business model had flaws and this is now coming to light.

Eagle Bulk concentrated on supramaxes, where there has been excessive ordering. The smaller vessels in handy sector with more flexibility in port access and variety of cargoes are outperforming.

It was a start-up company with little initial intrinsic value. It has been heavily dependent on charterer counter parties for fleet employment. Only recently has it been developing a commercial department for a contract base. Eagle has always been very secretive about its management, vessels and employment compared to peer companies. Early this year Eagle received considerable adverse publicity when it was discovered the company had significant exposure to Korean Lines, a major charterer who went bust, declaring reorganization.

Shipping is a capital and labor-intensive business with basically low returns on asset. The historical benchmark has been between 10-15% with leveraging. The challenge is how to bring this up to acceptable levels for investors, who are looking for 20-30%. Since shipping is a cyclical business, this can be done in part with timely investment and divestment decisions.

Capital cost is very important. These dry bulk issues, however, were structured with generous dividend payouts, precluding significant reinvestment of free cash flow. New business had to be financed by costly new equity raises. Eagle had few options but a large block purchase strategy to scale up and claim accretitive returns on multiples from a rapidly growing fleet.

The company chose to buy the business from another owner who had ordered a large block of vessels and wanted to resell them at a considerable premium for profit. The expectations from the transaction propelled Eagle’s share price to new highs. This was very good for Kelso, the private equity firm, which sold off shares in timely fashion; but not very good value for investors who bought into low margin business with marginal returns on residual value.

When conditions changed from fall 2008, Eagle had a high cost asset base and too much debt. This precluded any bargain hunting for vessels at lower prices. They put their efforts trying to rearrange and rationalize their order book, where they were over exposed. They had the financial capacity to do new business only through a joint venture through Kelso.

Eagle has a high break-even for its vessels due mainly to very high administrative expenses and interest cost. Executive compensation has been lavish over the years. Despite this, the Group managed to stay in the black until recently. The bad market conditions this year have depressed asset values leading to loan covenant violations. At present, their net worth is close to negative. Presumably the pressure from lenders is to encourage timely recapitalization or asset sales to reduce debt. Oaktree recently bought a small share. Eagle has got a long and risky road ahead of them for recovery.

Domino effect in Dry Cargo Market?

The dry cargo sector started the year badly in 2011 with the KLC bankruptcy and reorganization. The US bankruptcy fillings in NY Federal court name three major previous shipping failures: Britannia Bulk, Armada and Transfield as counterparties, all of which went bust in the wake of the financial crisis. Its collapse created shockwaves in the dry-cargo market with Eagle Bulk, Golden Ocean, Paragon and Goldenport Holdings among those with vessels on hire to the cash-strapped company.

KLC is a major Korean shipping company controlling a large fleet of both tankers and dry cargo vessels. Its dry cargo operation is divided into five groups: Cape team, Panamax team and three tramper teams. They are major charterers for numerous listed dry cargo companies like Eagle, for example, who depended on them for the employment of many of their vessels.

KLC’s needed US $186.94 mio in February to repay debts and meet operating expenses. At the same time its liquid assets totalled only US$ 60.66 mio. Operating income was insufficient to cover these amounts. Its red figure for the whole of 2010 was KRW 328.6 bn (US $291.55 mio), which added to a loss of KRW 584.1 bn in the previous 12 months.

They had tried unofficially to renegotiate some of their charters. KLC earlier sent out 60 to 70 letters to shipowners seeking to revise charter contracts in a bid to stay afloat, but of course, owners resisted. Hard pressed companies like Eagle had little room to give. KLC is already facing six separate legal battles in the US and others are expected to make similar claims. It also has 47 ongoing arbitration disputes. KLC began receivership proceedings in Seoul in mid February a couple of weeks after filing for court protection.

Erik Nikolai Stavseth, an analyst at Arctic Securities, said in his morning note: "In light of the weak market fundamentals and cautious outlook on the dry bulk sector, we maintain our view that more situations like Korea Line are likely to emerge." Platou Markets forecasts utilization and earnings in the dry cargo sector to decline. They estimate a 10-20% decline in asset values depending on vessel type, but note that dry bulk stocks reflect a softer market ahead to a greater extent than tanker stocks. On the other hand, dry cargo owners like Michael Bodouroglou of Paragon maintain up upbeat view that the market will strengthen in the 2nd half of the year and pressure on vessel values will be minimal.

Prevailing forecasts for the world economy in 2011 suggest somewhat lower growth than in 2010. It is therefore likely that seaborne dry bulk trade will also increase more moderately than in 2010. Last year China’s imports grew less than expected, while imports to the rest of the world were significantly stronger. World market prices for iron ore will be of vital importance for how much China will source from the international market. Sailing distances for iron ore, soybeans and forestry products are also expected to increase somewhat due to higher South American exports to Asia. The imbalance in trade between the Atlantic and Pacific Basins will continue to widen. It is also possible to expect slower speed due to high fuel prices and excess ship capacity. All this provides a scenario of stronger growth in tonnage demand compared with cargo volumes in 2011.

What continues to plague the dry cargo market is the huge orderbook overhang and flood of new deliveries into the market, creating a chronic oversupply that depresses freight rates. In 2010, about 77 mio dwt of new ships were delivered from yards and 4 mill dwt of converted tankers entered dry bulk operation. Only 6 mio dwt were scrapped. On a yearly average basis, the active dry bulk fleet grew 12.5% from 2009 to 2010. By segment, the fleet above 100,000 dwt expanded by 23%, while vessels ranging from 60,000 dwt to 99,999 dwt grew by 9%. The 40,000 dwt to 59,999 dwt segment rose by 13%, while the fleet below 40,000 dwt increased by only 4%.

Around 140 mio dwt of new ships are scheduled for delivery in 2011. From previous years, we can assume a 60% slippage, some 85 mio to 90 mio dwt of new ships will start operation. Scrapping is a function of the ships’ earnings, but assuming 15 mio to 20 mill dwt will be sent to breaking, a fleet growth rate in the region of 14-15 percent seems plausible. This far outpaces demand projections of seaborne dry bulk trade increasing by 6% to 7% from 2010 to 2011.

Eagle/ Kelso partnership: constraints and options

Eagle is presently limited at best in its ability to acquire new vessels, even at distressed levels with constraints to pay half of any future equity raises to reduce debt. By the Kelso partnership, Eagle CEO Zoullas will work with Kelso to pursue vessel purchases on a private basis but will pay commercial and technical management fees to the public company for any bulk carriers acquired. Eagle will have right of first refusal on any bulker the private venture wants to buy.

Eagle has fared relatively well in the crisis so far but not without some setbacks. The block expansion deal with Alba Shipping at the top of the market prices put them into this crisis with the pain of overvalued vessels, some charterer defaults, some order cancellations and over-leverage putting them in violation of their senior debt covenants.

Management did its housekeeping to put things in order. It raised last month US$ 100 mio cash by share sales, which represents a modest share dilution compared to some other peers. It amended its credit facility with lender Royal Bank of Scotland (RBS). The non-amortizing facility has been reduced to US$ 1.2 bn from US$ 1.35 bn, with Eagle also shouldering a higher margin of 250 basis points over Libor, plus the above-mentioned obligation to pay half of any future equity raises to reduce debt.

The Kelso agreement appears fairly structured in terms of interest conflicts. Eagle has right of first refusal on any bulker the private venture - called Delphin Shipping - wants to buy. It also gets a "first look" at any bulkers Delphin acquires and decides to place on charter. Whilst probably a good thing for Kelso and Zoullas, it is neutral for Eagle.

Some cheer for Eagle (EGLE)

Eagle (EGLE) deserves a break given the beating it has taken lately on its share value. There has been some steady improvement in the Baltic Shipping Index, but 2009 remains a difficult year to predict. Eagle has made some progress, but the the shipping crisis is not yet over. It is also faces some formidable competitors.

Natasha Boyden's upgrade plus a general market short-covering rally led to a phenomenal bounce in Eagle's value. There is currently amazing market volatility in shipping share prices.

Yet Eagle reported fourth-quarter profits of US$9.16 mio, down from US$16.3 mio a year earlier. Operating expenses leapt by 139% to US$43.5 mio. The company finished the year with US$9.21 mio in cash out of US$1.36 bn in assets. It had US$790 mio in long-term debt.

I have sometimes been at loggerheads with Boyden. My views tend to be closer to Jonathan Chappell at JO Morgan, who has done some interesting analysis on free cash flow (FCF) as a means of stock evaluation. In these treacherous markets where there is high risk of bank and charterer defaults, I feel this is an especially important indicator.

In this case, I think that Boyden has things pretty much on the mark with EGLE by revising her price target down to US$ 3 and repeating her concerns about company debt, but maintaining optimism about Eagle Bulk's strategy and supramax focus. I would add that EGLE has a good management team.

In a larger perspective, however, EGLE has formidable competition. Larger and longer established groups like Norden and Pacific Basin have stronger balance sheets and more fleet diversity. Where they really outshine EGLE is their very strong employment portfolios and direct end-user relationships. They also have greater economies of scale and lower operating costs. Pacific Basin, for example, is located in Hong Kong and uses extensively Chinese crew.

On the other hand, they have got more exposure on new buildings (albeit their finance needs are covered) than EGLE and extra liabilities from chartered-in vessels.

All of these companies have their hands full in maintaining employment at rates that give them a comfortable cash margin and renegotiations with the yards to push out new building delivery dates and possibly get some price reductions.

DnB NOR Bank projects net (less scrapping) Handymax fleet growth to be a record 21.7 %and 16.8% respectively in 2009 and 2010. So these are challenging times in this current slow growth environment, waiting for various government stimulus plans to have effect.

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.

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.

Will Eagle cut dividends?

Eagle has an ambitious newbuilding program ahead in a weakening freight markets and tight credit conditions. It has maintained a generous dividend policy, which is conditional to meeting its debt covenants. It should look to strengthen its balance sheet in current market conditions and the brewing world-wide recession. It should consider seriously cutting dividends until market conditions improve.

Eagle is a well managed group that specializes in the handymax/ supramax sector of the dry bulk market. It has a modern fleet and favorable break-even levels compared to competitors.

This sector of the market has less rate volatility than the larger Panamax and Capesizes. The vessels carry a wider spectrum of cargoes. They serve emerging economies, where growth is likely to remain relatively high.

The tonnage supply situation is more balanced here. The age profile of the world fleet in this size is the highest in the dry bulk sector. There is better potential for scrapping, especially in poorer markets. There are also better prospects for newbuilding cancellations. Many smaller 'Greenfields' yards service this sector. These yard may not have the financial capacity to delivery. There is a higher probability of order cancellations than the larger vessels.

Eagle's latest earnings report (5 November 2008) was very positive. Profits increased 50% over the second quarter with a growing fleet. On the other hand, cash was down from US$ 153 mio to 33 mio due investing activities (newbuilding tonnage).

Eagle is carrying a considerable amount of debit (US$ 858 mio revolving credit facility). It has heavy newbuilding obligations (34 Supramax vessels which will be delivered between 2008 and 2012). This is more than double the current fleet of 21 units. It has a conservative employment policy with period time-charters, but this is prone to risks of charter rate renegation and even possible Charterer defaults in bad shipping markets.

For this reasons, my view is that Eagle would be best served to reduce or even cut entirely its dividends, using its free cash flow to support its asset investing activities, until market conditions improve.