Investment overview
The crude oil and product tanker market has witnessed relatively challenging times as spot rates for tankers have declined from highs. The decline has been primarily due to the oversupply of tankers in the near term. The long-term outlook for the market, however, remains robust. I see the current industry downside as an opportunity to accumulate some quality stocks.
Scorpio Tankers Inc. (STNG, Financial) is the world’s largest eco-spec product tanker company. Its stock has declined by 17.4% year to date as spot rates for product tankers have taken a hit.
This downside is a good opportunity to accumulate the stock.
Scorpio Tankers has 76 product tankers in operation with an average age of 2.3 years and has six new tankers for delivery. By the first quarter of 2018, the company will own 82 eco-design product tankers.
Valuation perspective
Based on the company's asset valuation, Scorpio Tankers is significantly undervalued. While asset valuation mostly applies to a liquidation scenario, I am discussing this because the company has a young fleet that can deliver value in the long term. If the market capitalization is well below the asset valuation, the stock deserves consideration.
As of March, the total book value of the company’s vessels (including those under construction) was $3.1 billion. For the same period, the company’s net debt was $1.9 billion. This would imply debt-free valuation of $1.2 billion. Scorpio Tankers is currently trading at a market capitalization of $840 million.
Clearly, from an asset valuation perspective, the company is attractive. I believe that as industry sentiments recover (potentially in fiscal 2018), the stock can see 30% to 50% upside in the next 12 to 24 months.
Strong fundamentals
Although the industry outlook remains sluggish, Scorpio Tankers has maintained strong fundamentals. With a good cash buffer, high financial flexibility and decent cash flows, the company is well positioned to navigate the challenging period for the industry.
To put things into perspective, Scorpio Tankers reported total debt of $2 billion and net debt of $1.9 billion in March. With debt-to-capitalization of 59%, however, the company’s financial flexibility remains high.
Further, it is important to note the company has only six new product tankers for delivery by the first quarter or 2018, and that involves investment of $176 million. With $129 million in cash buffer and likely operating cash flow of $135 million for fiscal 2017, Scorpio Tankers is fully funded for capital investments without further leveraging.
While the companyreported negative free cash flow for the first quarter of the year, I expect it to be positive in the coming quarters, potentially contributing to deleveraging. It is also important to note the company’s cash flow was lower in the first quarter due to declines in spot rates. When spot rates improve, Scorpio Tankers is well positioned to deliver cash flow in excess of $300 million.
With a young fleet and primary operations in the product tanker segment, I see bright days ahead for the company once spot rates begin trending higher.
Industry outlook
One of the key factors that contributed to the decline in spot rates was a large number of new tankers coming into operation. New tanker orders have declined significantly since then. According to one of the company's presentations, orders currently stand at a 20-year low. This will allow the market to readjust. I expect spot rates to trend higher in the next 12 to 24 months.
At the same time, I believe companies will be looking for a finer balance between spot contracts and term contracts. This will increase the revenue visibility going forward.
It is important to mention the world seaborne refined products trade has increased at a compound annual growth rate of 4.4% from 2000 to 2016. With U.S. exports of finished oil products on a rise, I expect favorable industry dynamics.
Globally, there is significant refinery capacity expansion that is lined-up for the next five years. If global economic growth remains steady, there are strong reasons to be bullish on the product tanker industry.
Conclusion
Scorpio Tankers has been beaten down to oversold levels and the company’s valuations are compelling. While industry recovery will likely be gradual, it makes sense to accumulate this fundamentally strong stock at current levels.
In the next 12 to 24 months, it would not be surprising to see the stock move higher by 30% to 50% if broad markets remain supportive.
Disclosure: No positions in the stock.
