Frontline FRO
December 31, 2002 - 10:16pm EST by
2002 2003
Price: 8.85 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 667 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Frontline is the largest VLCC tanker company in the world and was an idea I posted over one year ago when coincidentally it traded almost exactly at this price ($8.87 vs. $8.85). While Frontline's tangible book value has not changed much in the meantime (still at $15.24/share and therefore trading at 0.58x tangible book), the outlook for tanker rates is the best it has been for several years despite limited worldwide economic growth. Frontline’s stock price gives the value investor the unusual combination of a cheap price to hard assets with extraordinary near-term operating results ahead and therefore provides a double margin of safety for a company uninformed investors believed was going bankrupt in the third quarter.

The key to understanding why Frontline will earn large profits for the next few quarters lies in the crude inventory levels reported every Tuesday with the API numbers. During the last spike in rates two years ago the US inventory level stayed in a band between 275mm barrels and 290mm barrels from 1/00 to 3/01 (with one two-month spike during early 2000) and reached an all-time low (at the time) of 276mm barrels before rocketing to 325mm in 6/01. The VLCC tanker rate in that timeframe almost quadrupled from $28,000 per day (the five-year average) at the beginning of 2000 to $100,000 briefly in 11/00 before breaking back down to $20,000-$25,000 level by 6/01. During that time (2000 & 2001) FRO earned about $8.50 per share or what the share price is now.

The high crude oil price brought on by the impending war with Iraq lately created an entirely different environment for tanker rates and crude inventory levels. US crude levels held up around 325mm barrels for about one year from 6/00 to 6/01 (with one dip to 300mm) and tanker rates stayed down below their norms given continuing disappointing economic growth and a mild winter in the US. However, the high oil price and negative implications for growth brought on by the stock market slide in June created a situation whereby refiners stopped ordering crude and ran down their inventory levels while hoping to buy cheaper crude later. Yet the crude price kept rising and tanker rates kept falling until crude inventories hit a new all-time low of 273mm barrels in late September---just when FRO was hitting its lows in the middle of the devastating crash of Europe’s stock markets.

What has happened since tanker rates declined to 15-year lows in September ($10,000/day or so briefly) is that they are now near two-year highs ($75,000 or so). Frontline’s share price dropped all the way down to $3.22 at one point despite having over $15/share of book and having assets that could be sold piecemeal to realize the book per share and create cash for the company. Investors clearly were extrapolating the all-time low tanker rates into the future and predicting that low economic growth would continue instead of realizing that FRO’s fortunes were tied to crude inventory levels that were finally about to cause a huge change in rates. However, I have learned that tanker companies are poorly understood by the stock market and therefore often do not trade according to economic realities.

Now Frontline has recovered somewhat to $8.85 yet is set to earn about $1.10 if rates for the company average about $32,700, something the company indicated to us was possible. However, since rates have continued rising and since there is some lag between fixings and quarterly reporting (about 3-4 weeks), we believe rates will more likely approximate $44,000 or higher for the first quarter and allow FRO to earn almost $2.00/share---during the first quarter alone!

There are two good reasons why this is likely to happen: first, the API numbers just came out today and the US crude inventory level just dropped to 277.5mm barrels (9.1mm barrel drop vs. 2.1mm expected) and is once again near the lows; second, Venezuela’s oil strike has completely upset the balance in crude markets and shows no signs of resuming production to anything close to its typical 14% share of US supply. The Venezuela situation is just now showing up in the crude inventory levels and should continue to take it down to all-time lows over the next few weeks---a historic indicator for frantic ordering by refineries who are too low on oil and must pay any price for tankers to get them required crude. Indeed, no one really knows how low the US can run before outages appear in the system and more seriously disrupt the US economy. In any case, it appears that tanker rates will remain high for several months regardless of economic growth or the stock market---and it has been a bonus that the US is finally getting a cold winter that is also generating additional demand.

Other things to know:

· FRO is levered and has only $175mm of current assets ($85mm of cash) vs. $1.43 bn of debt ($213mm short-term) and another $252mm of capital leases. The leverage made uninformed investors believe FRO was going bankrupt yet the company has gotten deferments from its banks on most of its repayments if need be. In fact, FRO will be retiring about $45mm of principal per quarter and therefore deleveraging while rates stay high.
· FRO’s two top managers bought shares in October, one of which is also a 40%+ owner of the company.
· FRO does not pay income taxes as it is based offshore.
· Excess cash for the fourth quarter we project to be about $65mm AFTER debt repayment and capex; for 1Q ’03 at $44,000 blended rates it would be $135mm.

I am happy to discuss all other items left out of this discussion or the October ’01 submission in the Q&A below.


US Crude inventory levels will continue to all-time lows over the next month as Venezuelan crude shortfall is realized and tanker rates will stay at two-year highs possibly into the second quarter; FRO's high operating leverage and $3.00/share earnings potential during Q4 and Q1 combined with $15.24/share book will cause share price to rise substantially from here.
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