UPDATE - Just this afternoon (11/14/13), Whitney Tilson's T2 Capital Partners announced a short position in GNK using put options. [www.gurufocus.com]
Oaktree Capital Management: The original post’s first and most prominent “Risks and Counterarguments” was that Howard Mark’s Oaktree Capital Management held a (very small) long position in GNK. Known to be a smart and risk-averse investor, Mark’s equity stake might give a short-seller pause. However, thanks to a recent GuruFocus update, we now know that Oaktree has sold off its entire stake in the company. A possible speculative explanation for this turn of events can be found below.
Debt Situation: As reported in the original article, nearly all of GNK’s debt was reclassified in May 2013 as a current liability, due to the fact that GNK is in default of certain loan covenants. The company recently hosted its third quarter conference call (recording of call here) and reported its results from operations and its outlook for the industry.
A very interesting discussion followed, however, during the Q&A session with analysts. Representatives of the company (CEO, CFO and Chairman) made clear that they were not going to discuss or describe the ongoing negotiations with lenders, consistent with their past practices. Nevertheless, the analysts pressed them quite hard on the topic. One analyst went so far as to say that [paraphrasing the Wells Fargo analyst] it was common knowledge that “large blocks” of the company’s debt were being traded and were no longer in the hands of banks, but instead were purchased by “non-traditional” entities (read: distressed debt investors).
This is not a new assertion, having been voiced as far back as May of 2013, but the company clearly (albeit implicitly) acknowledged that “non-traditional shipping investors” were scratching at the door: The CEO said that they were in discussions with “anybody who owns the debt,” not just the banks.
The analysts continued their very delicate dance with management about debt, probing several times as to which “options” the management might be considering. Again paraphrasing the Wells Fargo analyst, the company was asked if a “new equity raise” was actively being pursued. The CEO responded saying that another equity offering was not possible because the balance sheet had to be completely restructured and it is “difficult to raise equity” without knowing how that restructuring would happen. By “restructuring,” are we to infer “complete recapitalization?” If so, how would existing equity likely be treated? None too kindly.
Perhaps the most telling response from the company, however, came earlier when a different analyst snuck in a question in the context of a more general discussion on the industry outlook. The company was explaining how certain indicators were pointing upwards in terms of scrapping and orders, as well as rates. The analyst asked whether the company’s “lenders” had the same rising optimism or if the company was still having to face a “conservative” lending group. Before the CEO could respond, the chairman jumped in and said clearly, “The lenders are still conservative,” i.e. that they have not yet bought into the idea of an industry rebirth from the ashes.
Covenant Waivers: The Citibank analyst continued the dance, asking about the loan covenants and the company’s discussions and progress on coming into compliance with them before the expiry or securing a continued waiver. The CEO referred to the waiver expiring in March 2014 and said that not only were the waivers ending, but a $48.5 million “amortization payment” was due. As reported previously, GNK negotiated relief from both principal and interest payments through March 2014, at which time a large principal payment would be due. [Note: the original article referred to covenant waivers expiring in December 2013, as per the company’s annual report. No explanation was given, or found after research, as to why March 2014 is now the waiver expiration date.]
Later, in response to questions from the Imperial Capital analyst, the CEO stated that GNK is required to hold a minimum cash balance of $39.7 million against the company’s current cash balance of $57 million. This leaves only $17 million available for the amortization payment of $48.5 million due in March 2014. As we already knew, the company exists now, and will exist in the future, only by the grace and patience afforded to it by its creditors. Presumably, the “conservative” lenders must be very impatient to see their principal and quite worried about the company.
Outlook on Rates: Despite the company’s arguments during the conference call, BDI rates (see chart on the BDI index) have weakened somewhat and hover around $1,500. The Deutsche Bank analyst asked about the company’s outlook for rates, particularly as the Freight Forward Agreements (FFA) pointed to weak rates in 2014. The company replied that such contracts are “not a good indicator” of future rates. What? If FFAs are not a good indicator, and if they are being bought and sold by the most sophisticated and informed in the business, then what is a good indicator?
As a commenter on the original article pointed out, Wilbur Ross has recently been quoted as being constructive on the industry and on rates, having just signed purchase contracts for four new-builds. However, more specifically, he said, “Shipping rates will recover by the time the new ships are built” [emphasis added]. Delivery is not supposed to occur until 2015. Can GNK survive until 2015?
General Maritime Corporation: In continuing the research for this short thesis, I came across this gem that encapsulates many of the previously voiced concerns quite nicely. It is the case study of General Maritime Corporation, which was chaired by none other than George Georgiopoulos, the current chairman on GNK. That is, he chaired it until it went bankrupt in 2011. In a fascinating memento of the history of the bankruptcy, the GMC website is still available as it stood pre-petition. Specifically, examine the “competitive strengths” page, which lists “Experienced Management Team,” “High Quality Vessels”and “Market Foresight.”
Does this sound eerily familiar? If so, it is because those are the same sorts of competitive strengths that GNK itself lists as differentiating factors. You can read about the restructuring of GMC here, and learn that the general equity class was, not surprisingly, “impaired” (i.e. wiped out) in the bankruptcy, as were several layers of creditors.
A key item to note, however, is the role that Oaktree Capital Management played in GMC’s bankruptcy. Oaktree was the lead creditor that arranged the bankruptcy plan whereby it injected equity and restructured debt. It is doubly curious that Oaktree exited its GNK equity position, in that it may be preparing to wait out the inevitable and then, as with GMC, step in to grab the company on the cheap during bankruptcy.
Purely speculation, of course, but the history of GMC points to an interested possibility here. It is worth noting and restating that GNK owns a minority economic interest in Baltic Trading (NYSE:BALT), but has absolute voting control (more than 50% of votes). So, should Howard Marks be involved in the bankruptcy of GNK, he would not only get control of GNK but would get control of BALT as a kicker.
Summary: The short thesis has been reconfirmed by recent events and information. I would still not recommend shorting the stock outright, as the risk-reward ratio is unfriendly (i.e. if GNK bounced back to even half of book value, a short would get killed). Instead, the play, in my opinion, is in put option contracts. The downside is the premium paid for the puts (-100%), but the upside is the strike price. Depending on the expiration date and strike price of the puts, at current prices the payout is somewhere between 4x and 10x.
A word of caution – I am not an experienced short-seller and I truly believe that the -100% payout is actually the most likely of outcomes. But, the upside is quite attractive and therefore my position has been and continues to be a very small part of my portfolio.