Description
Long FRO (Price = 38.10, Short NAT (Price=29.78), Short VLCCF
(Price=24.65)
I am proposing an arbitrage opportunity between Frontline Ltd (FRO -
long) , Nordic American Tankers (NAT - short) and Knightsbridge Tankers
(VLCCF - short). A powerful catalyst supporting this trade is the splitting of FRO into two listed entities on June 17 2004. The reason for the split is management’s desire to achieve a higher market rating for FRO. There are also a few medium term catalysts that will support the short leg of the trade.
Note:
(1) There have been very good write-ups on both FRO and VLCCF which
should be read to expand upon this analysis.
(2) In this report, the reference to shipping rates refers to rates for modern VLCC's. Suezmax rates are assumed to be 20% less than the VLCC rates.
Arbitrage Trade
----------------
The basis of the trade is as follows:
- FRO has a market cap of $2 800 million, it's assets consist of 35 VLCC's
and 27 Suezmax ships.
- VLCCF has a market cap $421 million, it's only assets are 5 VLCC's.
- NAT has a market cap of $289 million, it's only assets are 3 Suezmax's.
Therefore, if I were to buy FRO and simultaneously sell 7 VLCCF's and 9
NAT's, I would be long 35 VLCC's and 27 Suezmax's for $2 800 million and
short 35 VLCC's and 27 Suezmax's for $5 548 million (7*$421 mil + 9*$289
mil) for a hypothetical profit of $2 748 million. As the market is rarely
this generous it is necessary to examine the trade in more detail.
Analysis
----------------
Reasons for the divergence in value include:
- Profitability and operating risk
- Financial Risk
- Quality of the fleet
I will argue that the operating models of the companies are similar. I will
then make adjustments for the age of the ships and financial structures in
order to derive a realistic arbitrage profit.
Similar Operating Models
------------------------
All of the above companies are focused on the long haul transportation of
crude from producing nations to consuming nations. They are the classic price takers in a market characterized by extreme volatility. Management deal with this volatility by agonizing over the splitting of revenues between the spot market and long term (time) charters.
More specifically:
- Frontline has traditionally focused on the spot market. (37 of
the 62 ships are currently traded in the spot market.)
- VLCCF's "sweet heart" profit sharing arrangement with Shell ended in
February 2004. The expiration of the contract forced VLCCF to adopt a riskier (reduced floor) and less profitable revenue model. The new model is typical of the shipping industry and bears a close resemblance to FRO's revenue model. (Refer to Appendix 1 and MOAB840 report
for more details on VLCCF's "old" and "new" revenue model).
- NAT's "sweet heart" deal with BP ends in October 2004. Following BP's decision not to renew the contract, NAT began exploring alternatives for their ships. Developments to date indicate that NAT's new revenue model will in all probability resemble those of a typical shipping company. (Refer to Appendix 2 for a complete description of the "pre-October 2004" versus "post-October 2004" revenue model for NAT.)
In summary, the unusually generous BP and Shell charters allowed NAT and VLCCF to enjoy revenue models characterized by a minimum revenue stream while sharing in 100% of the profit, "floor-kicker". The termination of these charters will force both companies to adopt revenue models similar to those employed by FRO and other shipping companies. Given that the future operating models for all three companies are expected to be similar it appears unlikely that the difference in value is due to differences in profitability and operational risks.
Adjusting for financial structures and assets
----------------------------------------------
While no adjustments are required for the operating models, adjustments are needed to account for the difference in assets and financial risk. The approach I use to make these adjustments relies on the creation of a hypothetical balance sheet. The hypothetical balance sheet is derived by multiply VLCCF's Q1 2004 balance sheet by 7 and NAT's Q1 2004 balance sheet by 9. Further, as both these stocks have recently gone ex-div I will adjust the balance sheets for the payment of the Q1 2004 dividends.
The hypothetical balance sheet will then be compared to FRO's Q1 2004
balance sheet after stripping out ITC. (ITC is a "passive" investment that
was consolidated for the first time in Q1 2004. Before this ITC was treated as an off-balance sheet entity, which is more appropriate for
this analysis.)
Definitions used:
Net Working Capital (NWC) = Current Assets - Current Liabilities
Enterprise Value (EV) = Market Cap + Debt - NWC(adjusted)
VLCCF Q1 2004 Balance Sheet (Summarized)
========================================
Assets
NWC(reported) $ 55 mil
Dividend (Q1) $ (34 mil) === > $2.00 * 17.1mil shares
NWC(adjusted) $ 21 mil
Vessels $ 315 mil
Debt $ 140 mil
Equity(adjusted) $ 196 mil
NAT Q1 2004 Balance Sheet (Summarized)
======================================
Assets
NWC(reported) $ 14 mil
Dividend (Q1) $ (16 mil) === > $1.70 * 9.7mil shares
NWC(adjusted) $ ( 2 mil)
Vessels $ 126 mil
Debt $ 30 mil
Equity(adjusted) $ 94 mil
Hypothetical Q1 2004 Balance Sheet (9*NAT plus 7*VLCCF)
=======================================================
NWC(adjusted) $ 129 mil
Vessels $ 3 339 mil
Debt $ 1 250 mil
Equity(adjusted) $ 2 218 mil
FRO Q1 2004 Balance Sheet
=========================
NWC(reported) $ 665mil
Vessels $ 2 685 mil == >Incl Invest in Assoc
Debt $ 2 197 mil === > Incl Lease Oblig
Equity(adjusted) $ 1 153 mil
We are now in a position to compare FRO balance sheet to the hypothetical
balance sheet. The comparison highlights the difference in financial structure and the difference in the book value of the vessels. The following steps adjust for these differences in order to derive the arbitrage profit.
Step 1: Assume that we buy 100% of FRO for $2 800 mil.
Step 2: To upgrade FRO's vessels would require an investment of $654 mil
($3 339 - $2 685). (Note, the average age of FRO vessels is 8 years. The
purchase dates range from 1990 to 2003. All of NAT's and VLCCF's ships are
7 years old. A careful analysis of the ship register indicates that the
$654 to be spent on the upgrade is reasonable.)
Step 3: Use $536 mil of the Net Working Capital (NWC) to repay debt.
Step 4: Inject $411 mil into FRO for the repayment of debt.
The above steps create an exact replica of the hypothetical balance sheet
for a total cost of $3 865 mil. ($2 800 + $654 + $411). The market
currently values this structure at $5 548 mil resulting in an arbitrage
profit of $1 683 mil.
Potential Catalysts
====================
Catalyst 1: Plan to Unlock Value
--------------------------------
An examination of Enterprise Value to Q1 2004 EBITDA for tanker stocks
indicates that FRO is trading at a substantial discount to it's piers:
FRO = 9 * Q1 EBITDA
TK = 15 * Q1 EBITDA
VLCCF = 16 * Q1 EBITDA
OMM = 19 * Q1 EBITDA
SJH = 31 * Q1 EBITDA
NAT = 19 * Q1 EBITDA
TNP = 21 * Q1 EBITDA
GMR = 13 * Q1 EBITDA
OSG = 15 * Q1 EBITDA
Management are concerned about the low rating and have implemented a
plan, which they believe will boost FRO's low multiples. The plan
involves splitting FRO into two listed companies : Ship Finance (SFL) which will own 47 ships and Front Line Shipping (FRO) which will own the
remaining 15 ships.
(For the details on the split refer to Appendix 3. )
The key question is whether the bifurcating of FRO will unlock value.
Management's argument is that "other industries, characterized by long
lived assets have unlocked value by performing similar transactions.” (Hotel, Utility and Pipeline operations) The intention of the split is to create a "more efficient pricing of capital instruments by appealing to two different classes of shareholders." SFL with it’s predictable cash flow is targeted at investors seeking a yield, while, FRO will appeal to investors wanting a "pure play" on the shipping cycle.
The biggest reason to believe that management have done their homework on
the "new structure" is that the CEO, John Fredrickson, owns 40% of the
stock. He must be convinced that this type of transaction has been
successful at unlocking value in similar circumstances.
(SFL will be listed on the NYSE on June 17 2004. Shareholders of FRO on
June 17 2004 will receive 25% of SFL and the $5 Q1 dividend. FRO will
retain the remaining 75%, which it intends to distributed to shareholders
or sell during 2004.)
Catalyst 2: Dividends and Strong Shipping Rates
-------------------------------------------------
FRO reported record Q1 2004 results on May 28 2004. A dividend of $5 was
declared to shareholders registered on the June 17 2004.
On the Q1 conference call management indicated that they had locked in 80% of their Suezmax's and VLCCF's at rates averaging $39 000 and $55 000 respectively for the second quarter. Subsequent to the conference call shipping rates have exceeded these averages which means that the Q2 dividend will be close to $2.50 per share.
The dividends and the continued strength in shipping rates
will support the long leg of the trade.
Catalyst 3: VLCCF shifts to a riskier and less profitable revenue model
-----------------------------------------------------------------------
The full impact of the termination of the Shell charters will be revealed in VLCCF’s Q2 earnings announcement.
Using estimated shipping rates of $55 000 for Q2 (see above) implies that the VLCCF’s Q2 revenue will be 18% less than the revenues under the Shell
charter. This could surprise shareholders who are extrapolating the previous operating model in their valuations. Using a more realistic rate of $35 000 per day generates a fair value of $15 for VLCCF.
Catalyst 4: BP's charter with NAT ends in October 2004
-------------------------------------------------------
NAT's charters with BP end in October 2004. The impact of VLCCF's Q2
announcement may prompt NAT'S current shareholders to downgrade their prospects for NAT.
The fact that NAT's current stock price reflects future maintainable shipping rates of $57 000 per day (Appendix 3) creates a suspicion that investors are extrapolating recent trends and are ignoring the "boom-bust" characteristics of the shipping industry. Any event that exposes this error is bound to be very rewarding for the short leg of the trade. Using rates of $35 000 per day drops NAT's value to $18 per share.
(Note: (1) VLCC rates of $57 000 approximate Suezmax rates of $48 000 per day. (2) Anecdotal evidence that the market is extrapolating recent trends is supported by errors made by NAT and VLCC investors in 2002. On this occasion investor pessimism resulted in values way below the intrinsic value of the stock despite the fact that the intrinsic value was supported by guaranteed cash flows from BP and Shell.)
Conclusion
==========
In order to keep this analysis to the point I have not discussed
the ratio of long short positions for the arbitrage trade. (I will do this
if requested.)
A substitute for the arbitrage is the long short trade based on relative
valuations. The long leg will be supported by management’s efforts to
unlock value. Any success at achieving the ratings enjoyed by it's peers will generate substantial profits for the long leg.
The short leg offers protection from the volatile shipping rates
and provides exposure to "expensive" stocks that have moved to less
profitable and more risky business models.
===========================================================================
APPENDIX 1: VLCCF's Revenue Model
===========================================================================
VLCCF had chartered all 5 VLCC's to Shell for:
($32 569 - opercosts) + 100% * max(0 or spot - $32 569)
The charter ended in February 2004 following Shell's decision not to extend it. The current arrangements for the ships are as follows:
- 2 ships @ ($30 000 - opercosts) + 50% * max(0 or spot- $30 000)
- one Ship @ $31 000 - opercosts + 0% profit share
- The remaining two ships operate in the spot market.
===========================================================================
APPENDIX 2: NAT's Revenue Model
===========================================================================
Since it inception 7 years ago NAT has chartered all 3 Suezmax's to BP for
(22 000 - opercost) + 100% * max(0 or spot-22000) where opercosts =$8500
per day.
BP recently declined to renew this charter which ends in October 2004. In
response NAT have begun to explore "new" opportunities for their ships. To
date, they have entered into a 5-year charter for one of their ships at
($25000 - opercost) + 0% profit share, where opercosts = $7 333 per day.
The fate of the remaining two ships following the October expiration is
unknown, but, a recent press release hinted that these ships will be
traded in the spot market.
Clearly, the "new" revenue model is much riskier (a reduced floor price)
and less profitable (0% profit share on a third of the fleet.)
===========================================================================
APPENDIX 3: Details of the Split
===========================================================================
FRO will split into two listed entities on June 17 2004: Ship Finance (SFL) and Frontline Shipping -FRO(new).
SFL
---
SFL will own 47 ships. These ships will be leased to Frontline Shipping for the remainder of their useful lives at the following rates:
- VLCC: $25 575 + max[0 or 20%*(spot-25 575)]
- SUEZMAX $21 100 + max[0 or 20%*(spot-21 100)].
In addition, SFL will fix its costs by paying FRO(new) $6000/ship/day plus
$20k/ship/per annum to cover all operating and administration costs. In return, FRO(new) is required to reserve $250 mil in cash to guarantee payments to SFL during a slump in the shipping cycle.
Although SFL will only be listed on the NYSE on the June 17 2004, the Oslo
listed FRO (FRO.OL) is already trading ex-SFL and the $5 dividend. Hence, the implied value for SFL can be determined by comparing the NYSE price to the Oslo price and adjusting for the dividend.
Oslo Price(NOK) NOK 209
Oslo Price($) $ 30.00
Dividend $ 5.00
NYSE Price $ 38.10
Implied Price for 25% of SFL $ 3.10
Implied Price for 100% of SFL $ 12.40
SFL Market Cap $ 910 mil (73.5 * $12.4)
A DCF analysis was used to determine the implied long term shipping rates reflected by the $910 mil valuation. The guaranteed income stream due to SFL is disclosed on page 12 of a recent SEC filing.
(www.sec.gov/Archives/edgar/data/1289877/000104746904018082/a2135540zf-4.h
tm). Discounting these cash flows at 8% and adjusting for debt implies a basic value of $610 mil for SFL.
This means that the implied value for the 20% profit share is $300mil.
Discounting this profit stream by 10% and assuming shipping rates of $55
000 for 2004 implies an average future shipping rate of $38 000 for the
years following 2004.
There is a strong possibility that SFL trades above this value following the listing on the NYSE if investors value the "floor plus kicker" earnings stream similarly to those of NAT and VLCCF. In SFL’s case the guaranteed minimum cash flow after debt repayments is $100 mil. In addition, current shipping rates imply a further $100 mil per annum from the 20% profit share. The guarantee plus immediate award could prove irresistible to yield investors.
Frontline Shipping (FRO-new)
------------------------------
FRO(new) will retain 15 ships and will operate the 47 SFI ships. The stock
should display the usual ship industry characteristics and is intended to
appeal to investors seeking a "pure play" on the shipping cycle.
Subtracting the $910 mil valuation for SFL from the current market cap of
$2 800 mil values FRO-new at $1 890.
Performing a similar DCF analysis to the above implies that the market cap of FRO(new) reflects future shipping rates of $35 000 per day.
DCF for NAT and VLCCF
------------------------
The DCF analysis was also used to derive the implied shipping rates discounted by the current NAT and VLCCF valuations. The future shipping rates reflected by the current market caps are $57 000 and $50 000 respectively. These rates are substantially above the future rates expected for FRO and the $35 000 ten year average.
The trade could therefore be viewed as an arbitrage between "cheap"
and "expensive" shipping rates.
Catalyst
1) Frontline splits into two listed companies on June 17 2004.
2) A dividend of $5 for shareholders registered on June 17 2004 and an additional $2.50 for Q2 2004.
3)VLCCF's Q2 earnings announcement which will reflect the full impact of the termination of the very generous Shell charter.
4) BP's generous charter with NAT ends in October 2004.