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A Look at the Cheap and Growing Scorpio Tankers

This tanker company might be an undervalued gem

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Oct 18, 2021
Summary
  • Rising tanker rates have produced windfall profits for the firm
  • Further growth next year could be a value catalyst
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I have been following Scorpio Tankers Inc (

STNG, Financial) for around a decade. I even owned the stock at one point in 2013, as I thought the company looked undervalued compared to the balance sheet value of its assets. I was right in the short term, but management's poor capital allocation decisions caused irreparable harm to the balance sheet over the next few years.

A lot has changed

A lot has changed for the organization since then. Most importantly, over the past 24 months, there has been a significant increase in tanker rates around the world, generating windfall profits for Scorpio and its peers.

The company has had a unique advantage because almost all of its fleet operates entirely in the spot market. This means it can quickly take advantage of rising rates, with its fleet of 131 relatively modern vessels. This blessing can also be a curse. If spot rates suddenly collapse, there will be nothing protecting Scorpio from lower earnings.

Another advantage the company has over its competitors is the installation of scrubbers on its vessels. To conform to regulatory requirements on fuel, shipping operators have had to install scrubbers to allow ships to arbitrage between different fuel types to achieve lower costs and produce less pollution. The alternative is to use a low-sulfur fuel oil, which can be expensive and is not available in all ports. Around 75% of Scorpio's fleet has been fitted with scrubbers, which compares with less than 50% of some peers.

Higher spot rates and a fleet advantage are two reasons why the company is currently experiencing a boom in profitability, but they are unlikely to last for long. As such, we have to look at the company's long-term potential and where it will go from here.

A cyclical sector

Shipping is a cyclical industry, and trying to time the cyclical turns is part of investing in the sector. It is tough to invest with a buy-and-hold mentality considering the peaks and troughs that have dominated the shipping industry since its very beginning.

One way to reduce risk is to charter vessels on long-term contracts. This is an avenue Scorpio has been pursuing. In August 2021, the company agreed to acquire a minority interest in a portfolio of nine product tankers. These tankers are currently on long-term time charter contracts greater than five years. The company acquired 6% of the outstanding shares in this venture for $7.2 million.

Another way to smooth out the peaks and troughs of the industry is to maintain a strong balance sheet. Scorpio uses debt, but it refinances its vessels using a repayment profile. Under this profile, when the vessel reaches about 15 or 16 years of age, the vessel is debt-free. Each vessel has a useful life of 25 years.

The company is continually refinancing vessels to unlock liquidity, which provides cash for growth and other corporate purposes such as share repurchases, debt retirement and dividends. It is an approach that allows the business to continue growing and expanding without putting too much strain on the balance sheet.

Conclusion

Overall, Scorpio Tankers looks to be in a relatively strong financial and operating position. Despite this, the stock is trading at a price-book ratio of less than 0.5. That looks cheap.

Without a catalyst, however, shares in Scorpio could remain depressed. So what could wake up the stock? The global economic recovery could contribute to higher spot rates on the global tanker market, which would increase cash flow and profits.

Wall Street is already forecasting a significant increase in earnings for 2022. Based on these estimates, the stock is trading as a forward price-earnigns ratio of just under 7. This earnings growth could be the sort of catalyst the market needs to drive the stock higher.

Disclosures

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The views of this author are solely their own opinion and are not endorsed or guaranteed by GuruFocus.com
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