Genco Shipping and Trading Ltd GSTL
December 14, 2005 - 12:21pm EST by
tickles879
2005 2006
Price: 17.32 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 438 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

GENCO SHIPPING AND TRADING LIMITED

SUMMARY

Genco Shipping and Trading is a recently formed drybulk shipper that offering certainty in near-term cash flows from a portfolio of locked-in charters that provide the company with operating margins greater than 50% for 2006.

The company trades at less than 6x forward earnings. Yet Genco’s low post-IPO leverage masks its real earnings per share potential. Management’s intent is to use the availability on its Libor + 0.95% revolver to purchase additional vessels once bargains can be found in the market. The purchases will be accretive to earnings and will boost Genco’s leverage to an appropriate level. I believe current Wall Street estimates fail to reflect the earnings accretion that can be achieved in this manner.

The slightly softening market conditions for drybulk shipping that may occur due to new supply coming in 2006 can be a positive for Genco. With 77% of its 2006 voyage days already chartered at above-market rates, moderating spot rates would not have a major impact on 2006 results. However, moderating vessel purchase prices could present good opportunities for Genco to invest using its substantial liquidity. Supply conditions are expected to tighten further in ’07 and ’08.

In the long-run, abnormal returns in shipping are achieved by investing wisely in assets and operating with high service levels to customers. The ability of a drybulk shipper to stand out in both arenas will be enhanced in the volatile rate market that is being driven by development in China and India. Common shareholders have good company at Genco—shipping entrepreneur Peter Georgiopolous, Chairman and founder of General Maritime, owns 53%. Astute purchases of new vessels during 2006 and astute timing of long-term charter signings could serve as a catalyst to the stock.

THE NUMBERS

$17.32/share x 25.3M shares = $438M market capitalization
$110M debt (9/30)
$47M cash and equivalents (9/30)

$480M enterprise value
$100M EBITDA run rate under in-place charters
- 77% of 2006 voyage days are fixed at above-market rates

GAAP book value $13.72/share
My estimate of book value, adjusted for fair market price of vessels: $15.73/share
Present value of in-place charters over current spot rates: $1.66/share
Adjusted NAV per share (fair market vessels + existing charters): $17.40/share
Note: This essentially represents a current liquidation value for Genco.

Additional sources of upside to equity:
Continued favorable charter rates at least through YE 2008
(i.e., we’re not going back to 90’s rates as some fear)
Appropriate level of leverage increases cash flow yield for equity
Ability of management to positively impact ROIC

Street estimates:
2005 – $3.31 eps
2006 – $2.77 eps
Dividend yield: 13%

My estimate:
2006 - $3.00-$3.50eps

THE COMPANY

Peter Georgiopoulos oversaw the growth of General Martime from a single-vessel privately owned company to a leading operator of VLCC tankers. GSTL was incorporated in September 2004. In December 2004 GSTL acquired 16 drybulk carriers from the China National Cereals Oil and Foodstuffs Corp (COFCO), with the last vessel being delivered in June 2005. The average age of the vessels was 8 years versus the average age of the world fleet of 16 years. All vessels were built in Japanese shipyards with good reputations for quality. In addition the fleet has three groups of sister ships, vessels of virtually identical sizes and specifications. The use of sister ships is a strategy Georgiopoulos applied effectively to improve utilization rates and service levels for customers of General Maritime.

The vessels were acquired free of charters. Fourteen were quickly signed to long-term charters to reputable customers and two (Genco Leader and Genco Trader) were placed on short-term charters expiring July 2005. The Leader and Trader are operating on time charter contracts that expire by January 2006, and Genco is well positioned to lock them in longer term at current charter rates.

The company raised funds through an IPO this summer when the market was very hot for new shipping issues. Shares were offered at $21. The proceeds were used to retire debt that was used to acquire the fleet from COFCO.

One additional Handymax, the Genco Muse, was acquired after the end of the third quarter for $34.5M and delivered in October, bringing the total fleet to 17 vessels. Fifteen of the vessels remain on time charter contracts with average remaining life of 1.2 years as of September 30, 2005.

Post-IPO, the company has been seriously under-leveraged for an asset-intensive, steady cash flow business. The company has about $340M liquidity in the form of cash and about $310M available on its revolver at Libor + 0.95%. The terms of the revolver seem very favorable, on the strength of Peter Georgiopolous’s reputation and equity investment in Genco.

THE CHARTERS

I will summarize the vessel charters here and leave you to the filings for additional details. In short, the fleet consists of the following vessels: 5 Panamax, 7 Handymax, and 5 Handysize. Time charter rates are as follows:

Panamax: approximately $29K per day for 4 vessels, with one older vessel at $17K
Handymax: approximately $24K per day for 6 vessels, with one older vessel at $18K
Handysize: $17K per day for 5 vessels

The existing charters range from 20-60% above current spot rates. Many were signed in 2004 when rates were driven to historic highs due to strong demand for drybulk shipping and tight supply of ships, exacerbated by historically high levels of port congestion.

As those of you experienced in shipping stocks know, there is enormous operating leverage in the rates. Genco’s daily operating expenses per vessel run at approximately $2,600 per day. Genco’s daily rate breakeven levels are estimated as follows:

$14,737 per day is adequate to maintain breakeven FCF after quarterly $0.54 dividend
$5,903 per day is adequate to maintain breakeven FCF without a dividend
$10,213 per day is adequate to maintain GAAP breakeven

Clearly Genco’s valuation is sensitive to rate assumptions for 2007 and beyond. From what I understand of the supply and demand fundamentals, there is reason to be optimistic that rates will not return to the lows some will remember from the 1990’s.

SUPPLY AND DEMAND FUNDAMENTALS

* The demand outlook is for mid- to high-single digit growth on economic growth and the continued industrialization/urbanization of China and India

Demand for drybulk shipping is strongly tied to the level of economic activity in the world. Global production and trade are key demand factors. Recently the industrialization and urbanization of China and India have been key drivers of demand for drybulk shipping. China requires iron ore imports in order to produce steel; China and India have both become net importers of coal; and grain shipments to both countries have also been increasing rapidly. In addition, increasing proportions of global trade are moving longer distances, especially the Brazil to Southeast Asia route. A reversal of these trends is difficult to imagine in the medium- to long-term. During the 1990’s (when charter rates were low), iron ore and coal ton mile demand was growing at a sluggish 1% rate. With the increasing growth industrialization of China and India, it is difficult to see ton mile growth returning to such a low rate in the near future. As we will see, even a modest 4-5% growth rate through 2008 is more than sufficient to outpace supply.

* Supply will be limited in the medium-term

Supply of drybulk vessels to the world market is a function of new vessel deliveries and vessel scrapping. The world supply of drybulk vessels is approximately 6,040 vessels comprising about 341 million dwt of capacity. The orderbook for new vessel deliveries is well-known in the industry and provides a comprehensive view of vessels that will be delivered in the next several years. Scrapping levels vary year-by-year; recently scrapping has been almost non-existent in the market due to the relative attractiveness of completing expensive repairs to old vessels vs. charter rates that can be attained on those vessels. The result is that there is a ‘backlog’ of older vessels that are ripe for scrapping at any soft patch in the rate market, keeping pressure on net new vessel supply in future years.

Major shipyards capable of producing drybulk carriers are working at capacity and have given priority to orders for higher-value-added, more complex vessels that drybulk carriers where the shipyards can earn a higher margin. New shipyards eager to win drybulk vessel contracts will eventually be built, but the time horizon for that is beyond 2008.

The following supply forecast is provided by DryShips (ticker: DRYS). Based on what I have read regarding the industry, I believe it is reasonable:

2006 E 2007E 2008E
Year End Fleet 358.9 370.7 380.6
Deliveries 22.9 17.1 15.0
Deletions (scrap) -5.9 -5.1 -5.1
Year Avg Fleet 375.9 382.7 390.5
% Growth Rate 4.7% 3.2% 2.6%

Supply growth is forecast to peak in 2006, while most Genco vessels are still on charter. This will create relatively favorable timing next year for Genco to acquire vessels at reasonable prices.

The supply/demand balance has been impacted favorably in 2004 and 2005 by port congestion. Vessels tied up in ports are not available to take on new cargoes. This should continue to favorably impact the supply/demand balance, as the only solution is to increase port capacity which is a multi-year endeavor.

* Vessel replacement will be costly in the long-term

If you buy the commodity bull argument that the coming years will see intensified competition for limited global resources, in particular energy and raw materials for steel making, the manufacture of steel drybulk vessels will become more expensive. A rising replacement cost for vessels will help keep upward pressure on rates in the longer-run, as will the growing backlog of aged vessels that ultimately will be scrapped.

What do these factors taken together suggest? Over the next 20 or so useful years of operations for Genco’s vessels, the next few are already chartered out at very attractive rates; the next few after that are likely to be chartered at very attractive rates (the existing charters will come up before new supply arrives to the market); and when new supply does arrive beyond 2008, it is likely to be at substantially higher replacement cost than current vessels—propping up the longer-term charter rates.

For additional industry background, see Genco’s IPO prospectus as well as the investor relations materials provided at the Genco and DryShips Inc. (DRYS) websites.

WHAT COULD GO WRONG

A sharp decline in vessel prices in the near term (’06, before the existing charters expire) could be a positive for Genco: the company would have an opportunity to add to its fleet at reduced prices with hopes of a later rebound in rates as supply tightens in ’07 and ‘08. However, a sharp decline in vessel prices near the time of the existing charter expirations could prove challenging to Genco’s ’07 outlook (and sentiment on the stock in ’06). For the supply/demand reasons stated above, I do not see this as being a likely scenario. However, the following occurrences could upset drybulk supply/demand in the near term:
• Significant economic slowdown in China / India
• Significant unexpected relief of port congestion

BETTER EQUITY RETURNS THROUGH INCREASED LEVERAGE

Genco management has stated its intention to use the availability on its revolver in order to purchase additional vessels. Indeed, not too aggressive assumptions can lead to a doubling of Genco’s fleet over the next several quarters through the use of increased leverage.

While management is very actively seeking additional vessels to purchase, it has shied away from purchases recently due to high asking prices. At the Goldman Sachs 2nd Annual Shipping Conference (11/29/2005 – the following link will hopefully work: http://customer.talkpoint.com/GOLD006/112905a_cs/agenda.asp?day=Tuesday) the company was optimistic that vessel prices were beginning to moderate and opportunities would arise to purchase vessels at prudent prices. “Prudent” for the company means that charter rates support a 20-25% cash-on-cash return on investment in the first 1-1.5 years.

To give some sense of the impact that additional leverage can have on the earnings available to equity holders given current market rates and asset prices, take the following scenario of purchasing a new vessel using 65% debt / 35% equity:

1 5-year old Panamax purchased for $35M
Purchase made with $22M debt, $13M cash (equity)
Chartered at current rate: $17K / day, 92% utilization = $5.7M annual
Less Interest on $22M @ libor + 0.95% = $1.2M
Less depreciation & amortization = $1.8M (note: maint capex is much lower!)
Annual free cash flow available to equity = $2.7M
Annual free cash flow yield: 21%+

Similarly, the following illustrates 2006 earnings power if GSTL simply levered up the existing fleet:

Bring leverage to 65% by adding $200M debt
Use debt proceeds to purchase 11.8M shares of stock at $17/share
New shares outstanding: 13.5M
$72M 2006 operating income on existing fleet*
Less interest obligation at Libor + 0.95% (say 5.5%) = $11M
= $61M earnings or $4.52/new share
* - assumes current spot rates attained after individual charter expirations

I’d also note that the above back-of-the-envelope calculation does not account for the fact that during 2006, with its existing fleet, nearly $100M of EBITDA would be generated that could pay down a substantial portion of the supposed $200M debt by the end of the year.

Given Genco’s long-term charter strategy (low spot market exposure), low cash breakeven points for the vessels, and substantial near-term cash generation, leverage can be increased significantly without adding significant bankruptcy risk to equity holders.

VALUATION

The handiest way to value Genco is to project 2006 cash flows and assume a certain charter rate for each class of vessel in perpetuity thereafter. For 2006, my model assumes that the company is able to purchase 1 new Panamax, 1 new Handymax, and 1 new Handysize each quarter. The Panamaxes are bought for $35M each, the Handymax for $30M each, and the Handysize for $27M each. 2006 would rack up as follows:

$100M EBITDA – existing vessels contribution
$35M EBITDA – contribution from vessels acquired in ‘06
$135M EBITDA
($16M) net interest expense
$119M cash flow in 2006

A full year with the expanded fleet in place would generate roughly $128M EBITDA with about $20M net interest expense, implying $108M cash flow. I believe this is a reasonable forecast for 2007 and 2008. For 2009, I assume that somehow new supply comes on stream and rates return to levels that support only GAAP breakeven in perpetuity (fleet average $10,213 daily rates) which would equate to approximately $67M EBITDA. I apply an 8x multiple to the terminal cash flow number and discount the equity cash flows at 12% per annum. The result is an equity valuation of $552M or $21.82 per share. Projecting current rates in perpetuity for 2009 forward raises the valuation to $35/share. I think the real value of the shares is somewhere in the middle.

Catalyst

Purchase of additional vessels at attractive prices in 2006
Appropriate balance sheet leverage that will accompany purchase of additional vessels
Earnings in excess of consensus estimates for 2006
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