Description
Summary:
Stelmar Shipping is less than a year away from completing an expansion plan that will increase its fleet from 31 to 41 vessels. The company’s heavy spending on this expansion has masked its ability to generate free cash flow. In the first three quarters of this year, Stelmar generated $60 million of free cash flow (22% annualized yield on $364 million equity market cap), however this was all earmarked for fleet expansion. Upon completion of the expansion in September 2004, Stelmar should (conservatively) generate sustainable free cash flow of over $90 million per year.
Recognition by the market of Stelmar’s free cash flow should lead to a higher valuation. For the first time in the company’s history, this cash will be available for return to shareholders. In October, Stelmar signaled its willingness to return capital when it initiated a dividend policy. The dividend yield is 2.3%, and the CFO has indicated that it will likely be increased next year. The company will also use its free cash flow to reduce debt, make selective vessel acquisitions, and possibly buy back shares.
The company is not as cheap as it was a couple months ago, but despite the recent run-up, I still think this represents very good value.
Company Overview and Investment Rationale:
Stelmar owns and operates oil tankers, which it leases to major oil producers and traders. Stelmar’s current fleet consists of 18 Handymax, nine Panamax, and four Aframax ships. It will take delivery of six new Handymax and four new Panamax ships over the next nine months.
Stelmar and a couple of its peers have been posted on VIC in the past (Stelmar by nantembo629 in July 2001; other postings include FRO and OMM). I refer you to those write-ups and the companies’ 10-Ks for more background on the industry.
Stelmar operates what I would characterize as a decent business model in an otherwise crappy industry. The oil tanker industry in general is capital intensive, highly levered, and wildly cyclical. You can make a lot of money as an investor if you time the cycles well, but you can also lose a lot if you are wrong.
An investment in Stelmar does not entail this sort of cyclical risk because Stelmar leases most of its ships on long-term time charter contracts. This provides a visible revenue stream that is fairly (but not entirely) insulated from market cycles. This revenue stream, combined with a very predictable cost structure, generates consistent profit and free cash flow. Stelmar has been profitable in every quarter since its founding nine years ago.
Stelmar’s time charter contracts vary in length from six months to five years. The company presently has at least 23 of its 31 ships on time charter (probably more than 23, but that is all I can verify). Including the ten new ships it will soon acquire (three of which have already been signed to multi-year time charters), Stelmar has secured time charter coverage for 86% of its net operating days in 2003, 51% in 2004, and 26% in 2005.
While these numbers may look too low to support the claim of visible revenue, I believe they will be much higher in a few months. Stelmar has ten ships coming off charter in the next six months (six in December). The current charterers (tenants) generally have until one month prior to expiration to decide if they will renew their contracts. Only after a charterer declines to renew can Stelmar try to lease the ship to a new charterer. If historical trends hold, many of these will renew, and those that don’t should be signed to new charters relatively quickly. If all ten ships are renewed or signed to new charters, the coverage numbers increase to approximately 75% for 2004 and 50% for 2005. On average, the rates on the ten charters due to expire are at or below current market rates.
In addition, Stelmar is currently in negotiations to charter all six of the new Handymax vessels. If these are signed to charters prior to delivery, coverage increases an additional 10% for 2004 and 15% for 2005.
Stelmar is different than most of its peers in that it primarily owns smaller, refined product carriers (as opposed to larger vessels that carry unrefined crude oil). I think this is positive for a couple reasons. Lease rates for product carriers have historically been more stable than those for crude carriers. Also, demand for transport of refined products should increase independent of oil production because new oil refinery capacity is increasingly being located in lower-cost and less-regulated regions (Latin America, Africa, Asia), away from major consumption regions (USA, Western Europe, Japan).
Management:
Stelmar is run by a professional management team that has significant industry experience. CEO Peter Goodfellow and non-executive chairman Nick Hartley each have over thirty years experience in the shipping industry – Goodfellow with Shell Tankers and Esso Petroleum, and Hartley with BP Tankers. The founder Stelios Haji-Ioannou is no longer directly involved in management or as a director, though he and his siblings continue to own slightly more than 25% of the equity. The board consists of Goodfellow, Hartley, CFO Stamatis Molaris, a Haji-Ioannou representative, and three independent directors.
Valuation:
Most analysts value tanker stocks based on NAV, book value, and earnings. I prefer free cash flow, which I define as net income plus D&A minus capex and working capital (in other words, cash available for dividends, share repurchases, debt reduction, and acquisitions).
Based on the traditional measures, and according to estimates from Jefferies, Stelmar is trading at 119% of NAV versus an average of 125% for its seven publicly-traded peers. Stelmar trades at 106% of book versus an average of 114% for its peers. Stelmar trades at 7.4x 2003 earnings and 5.9x 2004 earnings, versus peer averages of 6.0x and 7.8x, respectively. I would argue that Stelmar’s earnings are worth substantially more than its peers because Stelmar’s results are far more stable.
In terms of free cash flow, I expect Stelmar to generate roughly $80 million in 2003, $85 million in 2004, and $90 million in 2005. The free cash flow in 2003 and 2004 is already spoken for, as Stelmar will use it to finance the acquisition of ten new ships that it will take delivery of between now and next September. Following September 2004, Stelmar will for the first time generate free cash flow that will be available for return to shareholders (versus fleet growth).
My projections take into account the terms of existing time charter contracts, and assume that all other ships lease in the spot market. The tables below outline the daily spot rate assumptions that underlie my projections. The assumptions apply to 2004 and 2005 (2003 is based on YTD actual numbers).
To clarify definitions, spot rates are those quoted daily for specific trips lasting a few days to a few weeks. Time charter rates are for contracts that range from a few months to several years. In general, time charter rates do not dip as low or rise as high as spot rates over a cycle.
Model Assumptions:
Handymax $12,000
Panamax $14,000
Aframax $17,500
Current Time Charter Rates (Q3 earnings call):
Handymax $13,500 - $14,500
Panamax $16,500 - $17,500
Aframax NA
Current Spot Market Rates (Jefferies & Co.):
Handymax $19,000
Panamax $20,000
Aframax $30,000
10-Year Average Spot Rates (various sources):
Handymax $13,250
Panamax $14,750
Aframax $22,000
To provide an idea of the sensitivity of free cash flow to these numbers, a downside case that assumes $2,500 less per day (for ships in spot market) results in free cash flow of roughly $65 million in both 2004 and 2005. This is still an 18% annual yield on the current equity market cap. An upside case that assumes $2,500 more per day results in free cash flow of about $100 million in 2004 and $120 million in 2005 (27-33% yield).
Risks:
1. Downturn in tanker lease rates. Stelmar is not entirely immune to the spot market, but it is insulated. As discussed above, there is some risk over the next six months as several contracts expire. Those who are uncomfortable with this risk might want to wait until early next year to get involved. I’m okay with it for the following reasons: (1) with a couple exceptions, the rates on the expiring leases are below the current market; (2) Stelmar has proven adept at renewing and signing new time charter contracts; (3) management said on the Q3 earnings call that the demand for time charter contracts looks quite strong, and they are now seeing opportunities for more and longer contracts than in the recent past, and (4) the winter tends to be a strong season for product tanker rates.
2. In my view, the biggest risk is that management does something foolish with its newfound and uncommitted free cash flow. I don’t actually think they will do anything dumb, but I do worry that they might continue to buy ships even if shareholders would be better served by a share repurchase or dividend. As with all shipping companies, there is a danger that this management team is more motivated by the size of its fleet than by its share price. One can’t rule out the possibility that they will continue to do what they know best (buy ships).
I had been much more concerned about this before the company initiated its first dividend in October. I view this as an important signal that they are willing to return capital to shareholders.
This risk is also somewhat ameliorated by the fact that they have historically been pretty disciplined in their fleet expansion plans. Even if they do decide to direct all free cash flow into new ship purchases, they should be able to hit their minimum return on equity target of 15%. Thus, the downside case here still results in decent returns, though not as good as a direct return of capital to shareholders.
3. Leverage and interest rates. Stelmar had $440 million of net debt at the end of September. This equals 56% of book capitalization, 4x net debt to LQA EBITDA, and 6x LQA EBITDA to net interest expense. I expect net debt to peak at the completion of the expansion in 2004 at around $600 million, which will equal 61% debt/cap, 5.5x net debt/EBITDA, and 5x EBITDA/interest.
This amount of leverage is normal for the industry, and is within management’s desired range of 55-60% debt/cap. Given the comfortable interest coverage and stability of earnings, I don’t think this level of leverage presents a danger.
Stelmar has numerous loans, all of which are secured by its ships and bear floating interest rates tied to LIBOR. The current cost of this floating-rate debt is less than 2.5%. Stelmar has fixed one-third of its debt at 5 1/8% through several swaps and a cap arrangement. The CFO told me he could fix the rest of the debt at below 4.5%, but that he is unlikely to do so in the next six months.
Because of its preponderance of floating rate debt, Stelmar would be vulnerable to an extreme and sustained increase in interest rates. Again, I don’t think this presents a big danger because of the comfortable coverage ratios and the low probability of an extreme move in interest rates.
4. General industry risks such as accident, oil spill, etc. Stelmar insures against loss of property but not against loss of hire (business lost while fixing a ship). In terms of liability related to pollution, Stelmar carries insurance coverage of $3 billion per ship per incident, with a deductible of less than $200k. It is important to note that all of the major oil spills have involved old, single-hull vessels. Of the 41 ships Stelmar will own after receiving its new ships, 34 are double-hulled, six are double-sided, and only one is single-hulled.
Catalyst
Catalyst:
The generation of significant free cash flow (25% FCF yield) following the completion of Stelmar’s fleet expansion plan in September 2004. For the first time in the company’s history, this free cash flow will be available for debt reduction, dividends, and share repurchases. While this turning point is nine months away, it is likely that the market will recognize it prior to it actually happening.