Wednesday, January 14, 2009
Wednesday, 14 January 2009
There have been a lot of articles lately claiming that Genco and other dry bulk shipping stocks are trading at extremely low levels at the moment and will undoubtedly move significantly higher. Paradoxically, in some way, GNK looks even more expensive than on May 16, 2008 when it was trading at all time high of $84.51 a share. Main points of those, claiming low valuation of GNK are low trailing P/E ratio, forward P/E, PEG ratio, Price/Book ratio and low current stock price versus the high of the year.
Low trailing P/E is primarily the result of a sudden rise and subsequent fall to a more realistic level of dry bulk shipping rates. Baltic Dry Index (BDI) shot up from 500-2000 range, where it was for years to over 11000. That spike actually started only in 2006. In January of 2006, BDI was at about 2000. It was extremely volatile for the next two years, rising to over 11000 in mid 2008, only to fall back to sub 1000 levels recently. Abnormally high rates resulted in huge profits for dry bulk shippers. Now it is only history, so 2008 earnings should only be considered as a one-time gain. However, this is not the only reason for low trailing P/E.
When freight rates shot up 5 times in 2006-2007, nobody in the shipping industry had any doubts that this spike was temporarily. A vessel for immediate delivery was priced twice as much as a similar newbuild vessel coming from the shipyard two years later. The reason is that half of the price was going to be repaid by abnormally high rates that were expected to last till mid 2009, when a massive number of newbuild ships were to hit the water, bringing BDI back to reality. Unfortunately, such situations are not addressed by GAAP yet. Public shipping companies, like GNK, in reality paid for one-time gains when buying ships in 2007, but recognized them as operating income, significantly inflating reported earnings.
Forward P/E ratio is meaningless mostly due to the same reason. As I wrote above, during the spike in the rates, the consensus opinion was that extremely high levels were going to last till mid to late 2009. So, some customers preferred not to take the risk of further price escalation, but to get ships on long-term charters at present high rates. This way, Genco fixed about 67% of its fleet for 2009. For 2010 this percentage is significantly lower and for 2011 it’s just about 17%. These rates are not sustainable, so such contracts should only be considered as one time gains as well.
PEG ratio also does not make any sense, because apparently, no growth in earnings is expected for GNK in the foreseeable future.
Price/Book ratio is not of great use either. It reflects only historical prices of the acquired vessels, but they are very volatile. According to industry sources, values of dry bulk vessels went down about 70% since May of 2008. Unfortunately, the fleet is not marked to market in the balance sheet.
How to value a shipping company then? The only logical way is, in my opinion, to calculate NAV. Above or below the market contracts should also be taken into consideration, of course. A dry bulk shipping company is, after all, just a set of ships. It's not really different from a closed end fund in this sense. Some premium or discount to NAV is warranted for superior or inferior management, but it should be reasonable anyway.
Dry bulk vessels are very standardized assets, so it is not that difficult to evaluate their market value. Some reputable ship brokers publish their estimates, and information regarding recent deals in S&P market is also available. I developed a DCF based model that allows calculating estimated market value of any dry bulk vessel. Input parameters are based on recently reported deals in the market, so, the results are quite accurate, in my opinion. The values of above the market charters are calculated as discounted cash flow of the difference between the rate of these charters and current market expectations according to FFAs (forward freight agreements).
So, the market value of GNK's fleet is about $1161.9 mln. and the value of above the market charters is about $466 mln. It includes four newbuild capesize vessels (Hadriane, Maximus, Claudius, Commodus) that were not delivered yet as of 09/30/2008.
According to the latest 10-Q report, GNK had current assets of $220.8 mln., current liabilities of $31.1 mln. and long-term liabilities of $1155.1 mln.
To calculate NAV, the following adjustments must be made:
$31.5 mln. was paid as dividends in November, 2008
$385.6 mln. will have to be paid on delivery of 4 remaining capesizes
$23.9 mln. is unrealized net loss on Jinhui Shipping investment from 9/30/2008 till 1/09/2009
So, net debt of GNK is $1155.1 + $31.1 + $31.5 + $385.6 +$23.9 - $220.8 = $1406.4 mln.
The debt is significantly greater than the market value of the fleet, so GNK is in deep violation of loan covenants. One of covenants says that “the aggregate Appraised Value of the Vessels shall be at least 130% of the aggregate amount of all Loans“. The company is going to have a difficult time renegotiating the loans with the lenders, but it’s really another story.
According to the numbers presented above, NAV of GNK is
$1161.9 mln. + $466 mln. - $1406.4 mln. = $ 221.9 mln. or $7.04 per share.
So, GNK is currently trading at a premium of 163% to NAV. I have been following GNK for several years and this premium is at an all time high at the moment. When GNK stock hit an all time high of $84.51 in May, 2008, the premium was also above 100%. But now it is even higher.
I could hardly imagine any serious and reasonable long-term investor buying GNK shares at current prices, if he can buy a dry bulk ship instead, sign a contract with a ship management company and have ROI almost three times higher with significantly lower risk.
Very few of us can afford buying a capesize vessel, of course, so the reason to buy GNK as a long-term hold for some people may be the hope of a dramatic reversal in the dry bulk shipping market that will lead to dry bulk vessel values doubling or even tripling. After all, the values tumbled by 70% very rapidly, so why can they not come back?
The most widely used argument in favor of such a dramatic scenario has become the recent uptick in the BDI from the low of 663 to the current level of 872.
Actually, this rise has always been expected by the futures market. For example, according to Imarex website, on 12/10/2008, when BDI was 691 and Jan 2009 BDI futures were trading at 1550. On 01/09/2009 Jan 2009 BDI futures closed at 1375, lower than that. Such action is quite explainable. BDI is calculated using market rates on different shipping routes. Currently, rates on some routes are deeply below break even on operating basis. It's pretty clear that shipowners are not going to charter their ships at operating loss forever. However, in case of oversupply, the rates will not be able to stay for a prolonged time at a level, significantly higher than operating costs.
Another widely used argument is that China will come back soon and send shipping rates flying again. Chinese imports may start to rise again later this year or at some other point in the future, but it does not necessarily mean higher shipping rates.
Shipping rates are just a product of supply and demand. If demand exceeds supply, rates may start flying through the roof. The only restriction is how much end users can afford to pay for shipped commodities.
If supply exceeds demand however, the rates are going to fluctuate around operating costs.
There was shortage of dry bulk ships to carry iron ore to China in 2006-2008, but that problem has already been addressed. A new class of ships (VLOCs) has emerged and it is going to completely cover the Brazil-China route by 2012. The largest Brazilian miner, Vale, has recently confirmed its plans. Dry bulk fleet was renewed and dramatically expanded and new massive shipyard capacity has been developed. The number of newbuild dry bulk vessels that are going to hit the water in 2009 and 2010 is huge.
It looked huge even before worldwide recession became apparent. Imagine the size of oversupply given the slowdown. Some of the orders for 2010 and beyond will be canceled, but it is already too late to cancel orders with 2009 deliveries.
While shipyards were expanding dramatically in recent years, worldwide demolishing capacity is quite low at the moment. It will keep a lid on scrapping prices and rates. Apparently, the number of scrapped dry bulk vessels, especially in larger segments, is going to be just a fraction of newbuilding deliveries in 2009.
So, is GNK an oversold value play or a new small bubble in the making? I believe the latter looks much more logical. Time will tell.
Source: Seeking Alpha