General Maritime Corp.
I first learned about the oil tanker industry in "The Dhandho Investor," a book by value-oriented hedge fund manager Mohnish Pabrai. The book itself is a good, quick read, providing a high-level primer on value investing fundamentals with Pabrai's "twists" — amount to put into any one idea, the concept of probability of outcomes and expected value — based on his experience as an investor and entrepreneur of Indian (sub-continental) heritage. In the book, he discusses how he made north of 55% in a few short months by betting on Frontline Ltd. (FRO), the largest U.S.-based company in the oil shipping industry, back in in 2002-2003.
The oil shipping industry is actually quite interesting. There are 30 or so public pure-play tanker companies, but the size (in revenue and number of ships) of these companies falls off really quickly after the 5 largest. There are under 5,000 oil tankers worldwide, with only ~500 of the largest class (VLCC). These companies' services are essentially perfect substitutes. The customers are large oil companies — think Exxon (XOM), BP (BP), or Shell (RDS) — that want to transport large quantities of oil around the world. Oil tankers remain the most cost-effective way to transport oil across large distances. Competition is based on availability — supply of boats available for a particular voyage on a particular date for a particular length of time. Harking back to my microeconomics class during my salad days in college, this situation suggests a perfectly competitive industry, with pricing driven down to marginal cost. While this may be true on average over time (average returns on invested capital trend toward weighted average cost of capital), pricing is extremely volatile. Pricing — the spot market day-rate to rent a tanker — has a year-to-year standard deviation of over 50% and has varied by as much as 700% in the last 10 years. This is because pricing is influenced by supply of boats and demand for oil transportation, which in turn is driven by oil prices and the supply/demand for oil, which, as we well know, is also extremely volatile. For example, in 2008, spot market rates for VLCCs spiked at over $180,000 per day, then crashed to under $75,000 in three months before rebounding to $160,000 in another three months. For reference, in 2010, VLCC day rates averaged ~$25,000.
In the last 10 years, when day-rates collapse at or below operating costs (~$9,000/day), companies bled money trying to cover interest expense and G&A (for General Maritime, the fully loaded break-even average day-rate across the fleet is ~$18,000). However, when day-rates spike above a level to cover fixed costs, these companies gush cash. Several companies in the industry are set up to dividend out this excess cash when times are flush. For example, General Maritime issued a $12 "special dividend" in 2007 while issuing a cent a quarter in 2010.
Companies attempt to mitigate this volatility by managing supply through commissioning new ships (the newbuild rate), buying or selling used ships (there is an active second-hand market for tankers), and/or scrapping older ships. However, while price and demand can change very quickly, supply is much slower to react given lead-times in all of the above activities.
Finally, the industry is flush with data; there are several industry-specific investment banks and other research providers that publish spot market rates, fleet size by type, new orders, and second-hand market prices for free on their websites.
My investment thesis is pretty straightforward. General Maritime is a pure-play oil tanker company of sufficient fleet size (38 vessels) and vessel mix (spread across largest to smallest classes of oil tankers) that is the most undervalued in terms of asset valuation (details below) and "normalized" (to the extent you can ever normalize earnings in this industry) earnings power value. On either measure, it is currently undervalued by at least ~50%.
The companies in this industry are all suffering because of low spot market rates across vessel classes that have persisted since the second half of 2009. Dividends have been cut and earnings have been negative. I believe that prices are likely to rebound in 2011 and beyond (details below) and even if prices take much longer to recover, downside risk is low. Specifically, rates are near a 10-year low and if prices recover to even 75% of the median spot price of the last 10 years, General Maritime can issue a generous dividend (dividends have averaged north of $1 per share over the five years prior to 2010, not counting the special dividend discussed above), and the stock price will eventually approach intrinsic value. If prices stay low, the company can weather the storm for two years minimum by using cash on hand, cash flow from operations (enough to defray direct operating costs), and by selling (either outright or via sale-leaseback) vessels. Management recently completed a sale-leaseback transaction on three boats, which has provided enough cash for at least the first half of 2011 (not counting cash on hand at the start of the year). Therefore, with a low downside risk of capital loss and a high upside potential via equity appreciation and dividends, I view this as a strong bet.
I valued General Maritime in two ways — asset valuation and earnings power value:
1. Asset valuation: I love heavy industrial companies; given my background in operations, I have additional confidence in my valuation methodology. Additionally, in cases such as this where the company is trading below book value and replacement cost, there is some comfort in knowing that if a company is forced to liquidate, the investor/owner will not lose his investment. Furthermore, in this industry, information is readily available on current and historical second-hand market values, by virtue of an active used market. The low-end of my estimate of liquidation value is $5 per share (low-end of current second-hand market value with a 15% "haircut" in the event of a rapid liquidation). The high-end is north of $15 per share. And please keep in mind that second-hard prices are 20-25% below peak price in the last 10 years, driven by lower spot market rates (meaning, less demand for tankers).
2. Earnings power value: As mentioned above, the EPV is north of $15 per share at the 10-year average spot market day rate and north of $5 per share at 75% of these rates. The big difference in EPV is because of relatively high fixed costs and resulting operating leverage.
I believe the market has overreacted to the recent low rates and the stock is undervalued by ~50%+. When day rates rebound, the stock will approach intrinsic value. Given the company's dividend policy and the fact that 12 leases will be switching from time charters (pre-negotiated rate) to spot rates in the next two years, General Maritime is well-positioned to take advantage and reward investors from any recovery in market pricing.
I am not a macro investor. I think attempting to understand, let alone forecast, macroeconomic drivers is difficult if not impossible. Nonetheless, I wanted to get my arms around how 2010's spot market pricing looked in the context of historical prices; what factors drive prices; and how likely prices were to rebound in 2011 and beyond.
I spent a few nights (yes, I need to get out more) analyzing patterns in spot market pricing, fleet size, new orders, scrap rates, second-hand prices, all by vessel class and the price of oil. Of course, when looking at a large number of variables with a relatively low number of data points (~15-20 years' worth of data — "what's your n???"), false patterns can emerge caused by seemingly non-random samples in a string of random numbers; correlations driven by an outside common factor; or a correlation but no causation. At times, I felt like John Nash in "A Beautiful Mind." For the record, I mean the scene where he sneaks out into the shed and loses his mind trying to find patterns in newspaper articles, not the scenes where he is a genius. Just so we're clear.
Anyway, a few interesting patterns emerge that, while not conclusive (lower R squareds), at least suggest that spot pricing may recover in the near to medium term. In the last 15 years, in periods of decreasing spot market day rates, the total number of new orders decreased (year-over-year), the number of vessels scrapped increased, and the second-hand pricing decreased. It usually took one to two years to rein in suppl; then spot markets tended to recover. Similarly, oil prices appear to be correlated to spot market rates and to second-hand prices; when oil prices are high, spot prices and second-hand values tended to follow. None of this is that surprising; if oil prices drop, then it makes sense that day rates and second-hand values will also drop. And if day rates drop, it makes sense for companies to reduce fleet size (less new orders, scrap older vessels). These factors are at least correlated. Well, in 2010, while fleet size grew by ~7%, most of this was in the smaller tanker classes. In 2009 (latest data available), new orders placed dropped by ~80% year-over-year and 2011 new tanker deliveries are forecasted to be ~25% below the 2010 pace. Scrap rate of tankers increased by 90% 2009 year-over-year, while second-hand values dropped by 25%. In 2010, spot market rates were at ~50% of the median rate in the last decade. Finally, oil averaged ~$60 per barrel in 2010. So far in 2011, oil appears to have recovered to ~$80/barrel. So, between rising oil prices and constricting supply, I believe day rates are poised for recovery.
As with all investments, General Maritime has its risks. Spot market rate: The biggest risk is that the day rates stay at the 2010 average level for an extended period of time. While this is unlikely given historical volatility and volatility in drivers, this would mean General Maritime (and all companies in the industry) will slowly bleed cash.
Debt: General Maritime is heavily leveraged, with total debt to assets of ~70%.
Issuing shares: General Maritime issued ~30 million shares in 2010 (increasing float by over 70%). Moreover, one of the covenants in the debt agreements has a provision whereby General Maritime must issue more shares to raise capital in the event certain conditions have not been met, such as EBITDA/debt ratio. This would obviously dilute any ownership interest. General Maritime is poised to issue an additional 23 million shares; I factored the dilutive effects in my valuation.
I sincerely believe there is no way to predict where spot market rates will go, near term or long term. However, rates are currently well-below historical averages and I think it is unlikely that rates will stay this low indefinitely, given historical volatility, volatility in drivers and global uncertainty as it affects the oil industry. For example, the recent turmoil in Egypt led to rumors that the Suez Canal may be closed, which caused a spike in day rates for VLCCs, since more would be needed to go around Africa if the Canal cannot be used. And with General Maritime's ability to fund operations through cash on hand, cash flow from operations, and sale or sale-leasebacks of vessels, the company can stay solvent for a long time (at least two years just via sale-leasebacks of unencumbered vessels). Therefore, I view downside risk of permanent loss of capital as low.
I view General Maritime as a solid buy. We have a chance to buy $5-15 per share of asset value for $2 and change. We are buying at time when spot rates are very low in historical context, protecting us to some extent against "negative randomness." We know how volatile industry pricing is; any spike in prices — "postive randomness" — only benefits us. While there are risks, I view the chance of permanent loss of capital as very low and the chance of signficant gain — either through capital appreciation or future dividends and ideally both — as high. To quote Pabrai, "...heads I win a lot, tails I lose a little." Sounds like a bet I'd be happy to make every day. I am long General Maritime.