Star Bulk Redux (Time To Book Gains)

February 24, 2017 1:54 AM


I like to invest in commodity sectors that are currently losing money but at an inflection point. The companies tend to be undergoing a winnowing process with lots of bankruptcy and dilution for existing shareholders. While this may sound terrifying for some investors, this process sets up the next bull market for that sector as it consolidates players, reduces capacity and often eliminates debt. More importantly, with assets in that sector valued at a substantial discount to replacement cost, there is little likelihood of future supply entering the market. For investors, it tends to create unique opportunities to buy durable assets at a fraction of replacement cost, which offers good downside protection once you can ascertain that a bottom has indeed been reached. However, identifying a sector going through a washout is easy, the key is finding out when the sector is likely to turn around. Fortunately, this is all based on supply and demand. If you can predict the interplay of the two, you can have huge wins. Over my career, I have found some of my largest gains by looking at these sorts of opportunities.

As I’ve written about dry bulk shipping and Star Bulk Carriers (SBLK) in particular, let’s talk about that sector. Here’s some quick math (keep in mind that these are very rough numbers).

A brand new Capesize bulk carrier (known as a cape) would cost you $37 million; have a lifespan of roughly 20 years and a residual scrap value of $5 million. Therefore, its daily depreciation cost is $32 million of total lifetime depreciation/(20 years X 365 days) = $4,384 in daily depreciation cost.

The industry averages about $5,000 a day in operating costs and an additional $1,500 a day in allocated SG&A. Therefore, to simply cover your cash operating costs, you need Time Charter Equivalent rates (TCE) to at least equal $6,500 ($5,000 in operating costs + $1,500 in allocated SG&A). This is one key number. However, that would be like driving as an Uber with only enough revenue to pay for gas, with nothing left over for auto lease payments, much less profits.

The more important number is the break even on a vessel over 20 years (despite what people tell you, depreciation is a very real expense that operators and lenders look closely at). Here, you need TCE to at least equal $10,884 per day ($4,384 in daily depreciation + $5,000 in daily op-ex + $1,500 in daily allocated SG&A). This is another key number. Unless TCE is expected to be at least $10,884, no one would dare even think to buy a new cape as to do so would guarantee losses for the next 20 years.

Bulk 1

However, there’s more that goes into it. Almost all ships are financed. A bank won’t lend you money in the hope that you barely squeak through life and pay them back. They want to make sure that you can cover interest costs along with amortization of principal along with a margin of safety. Basically, the bank wants to be confident that you’ll be paid at least $13,000 over the 20-year life of the boat before they’ll cut you a loan. This is the final and most important number. Effectively, there will be no new supply until TCE hits $13,000. In effect, you have 3 key numbers, $6,500 is operating break even, $10,884 is EBITDA break even and about $13,000 is financed break even with a slight return on investment.

A commodity industry is pretty easy to analyze; the key is to figure out where supply and demand will be over the next few years and you will make a fortune. We just determined that no new supply will be ordered until TCE consistently stays above $13,000 for a long enough period of time to tempt banks to finance new construction. Simultaneously, we know that existing supply shrinks each year as older, inefficient vessels are scrapped and new costly regulations come into effect. Based on current supply and demand, we know that current rates are slightly above the operating break-even level—this means that companies can sort of cover their operating costs and interest expense, but not much else. The boats are still losing money if you factor in depreciation, but the companies can survive if they have their debt position in order. With, no new supply coming after the 2017 deliveries that were ordered a few years ago and no new ordering until charter rates stay above $13,000 for at least a year, it pretty much guarantees that there won’t be new deliveries until 2020 and probably longer. This is because you need at least $13,000 for a year to get banks comfortable, then 2 years to build a boat. As of right now, TCE isn’t $13,000 so this is all moot on the supply side. Meanwhile, older vessels are constantly getting scrapped—which likely means that net supply may actually shrink after the 2017 deliveries. You now have a potential window starting in 2018 to see charter rates recover and stay elevated for a number of years until new supply comes.

bulk 2

Over time, a combination of population growth and economic growth will lead to increased demand for dry bulk shipping—much like it has over the past few centuries. If supply is restricted, demand will eventually normalize rates.

Now, the final step is to ask what SBLK will earn at $13,000—basically the break-even level for new supply in the sector. Here’s the fun part.

During the fourth quarter of 2016, SBLK’s (TCE) was $8,202 on 67.8 average vessels and the company effectively made about 5 million in income after interest expense—but before depreciation and other non-cash costs. If you assume that TCE is $13,000, there’s $4,798 in added revenue at almost no cost. Multiply that by 72 average boats expected starting in 2018 (they are pretty much fully paid for) and you have $126 million of incremental income. That’s a big number on the roughly quarter billion market cap when I first wrote about it—heck, that was half the market cap. Add the $20 million annualized run-rate from the fourth quarter to the $126 million of incremental income and you are at $146 million. Unfortunately, you still need to subtract the $82 million in depreciation, giving you $64 million in income at $13,000 TCE. If you then put a 10 multiple on that and you have a $640 million market cap. The shares are currently at a $530 million market cap.

When I first wrote about SBLK, the downside was limited as there was no new supply coming, demand was growing with potential acceleration from Trump’s infrastructure policies and I was buying the fleet at 70 cents on the dollar. SBLK was no longer likely to go bust, so it became a waiting game with a catalyst. I am good at being patient.

Will rates overshoot to the upside and lead to windfall earnings? I don't know, but as I survey the landscape, I'm looking at higher financing costs, a global dry bulk fleet that is going to continue increasing during 2017 and a company that is probably going to do little more than break even during 2017 and I therefore feel like most of the upside has happened in three months. I intended to hold this until TCE hit $13,000 but with so much of the upside having occurred, I prefer to declare victory and move on to the next investment. We’re now pretty close to fair value for this business. The shares even trade at a premium to tangible book value for the first time in years. In summary, I’ve sold my entire position after earnings for roughly a double in three months.

simpson2

When in doubt, I like to sit in cash and wait for layups. The math I’ve used above can relate to almost any commodity business and the nature of commodities lends itself to cycles that often overshoot to the downside. In fact, quite a few of the sectors that I track are likely to bottom in the near future. Stay tuned for more opportunities.

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Mexico Is Having A Yuuuge Donald Trump Victory Sale

December 17, 2016 7:40 PM


I am writing to you from Santiago de Queretaro, Mexico, where the whole country is having a yuuuuge Donald Trump victory sale. Mexico is one of my favorite countries to visit. It combines a laid back attitude, friendly people and an outstanding culinary tradition. It also helps that it’s currently one of the cheapest places on the planet—one of many reasons that I’ve spent 5 weeks here recently (Yucatan and Central Mexico thus far).

Mexico has always been known as an affordable place with cheap beer and tacos, but the last two years have taken that dynamic to an extreme. Where else is the brand new AC Marriott $42 per night? In touristy San Miguel de Allende, we booked a 2,500 foot, 2 bedroom suite on the main square for $75 a night. Food for two with a bottle of mezcal is about $30 at the most posh of restaurants. It’s verging on silly. Between the two thirds decline in the Mexican Peso over the past two years and an over-dramatized fear of violence, the tourist economy is basically running on free. They’re just happy to see you and thankfully, my Mexican fiancé can translate my pathetic gringo Spanish as we travel around.

5 year Peso

5 Year Peso Chart. 2/3 of the value is gone in just the last 2 years.

 

If you don’t have a trip planned to Mexico, get working on it. I don’t think it will stay this cheap for long. Let’s start with the obvious question—is it dangerous? I tend to like statistics as opposed to jaundiced media reporting. The USA has a 4.5 per 100,000 homicide rate. Mexico is pushing 20, or about four times as bad. Given that I’m not terribly scared in America, four times worse doesn’t seem that bad. When you dig into the numbers, you realize that much of this crime is drug related. In fact, if you aren’t involved in narco-trafficking, the homicide rate isn’t much worse than that of the USA. Furthermore, most of the violence seems clustered in a few cities and states. I wouldn’t go to Baltimore or East St. Louis on vacation, why go to the Mexican version? Strip that all out and Mexico is on par with most of America. Unfortunately, a few dramatic incidents have cost Mexico millions of visitors a year. Eventually, perceptions will adjust to reality and the tourists will flock back—especially given how affordable it is.

I have now taken two trips to Mexico during the past 10 weeks. The whole time, I’ve kept asking myself, “How do you play this?” It’s so cheap. Despite threats of change from Trump, I know this is an overreaction. Mexico is sure to bounce back and keep growing--though, the economy may shift slightly from manufacturing towards tourism due to how cheap it is to visit.

The thing is, just because something is cheap, that doesn’t mean there’s always a “play.” There’s an old adage in finance that you don’t buy the currency of Spanish speaking countries. Pull up a 10-year chart of any of these countries and it will be obvious why that adage has weight—pull up a 50-year chart and you won’t even be able to zoom in to where we are today. The Peso has overshot recently, but it’s not an asset I want to own.

What about assets benefitting from a weakening currency? In property, if you can borrow at a reasonable rate in a depreciating currency and get paid rent in US Dollars, you’re going to make a fortune. Unfortunately, for most foreign property companies, rents are long-term and struck in depreciating local currencies. However, the hotel sector is largely immune to this. They can adjust their room rates daily. Fibra Hotel (FIHO12: Mexico) and Fibra Inn (FINN13: Mexico) have both borrowed in Mexican Pesos. Right now, the rates they’re receiving are silly. Look up some of their hotels on the internet--$20 here, $30 there. This is because there is a lag in how fast they can re-price room rates to take advantage of the decline in the Peso—especially as many of their customers are business travelers with budgets in Pesos. However, their costs are mostly fixed, the assets were built with pre-depreciated currency—they’re now worth much more in current Pesos than it cost to build them. The supply of new hotels will slow as it costs much more in current Pesos to build new ones—all the old ones have a massive competitive advantage until room rates fully reset. Meanwhile, due to Trump’s victory and the decline in the Peso, Mexican hotel REITs are being priced like something awful is about to happen—instead, a weaker Peso is a huge boon to them.

In terms of valuations, I don’t think annualizing current quarter cash flow is the correct measure to look at—as room rates in Mexican Pesos will likely rise in future quarters. That said; they trade at about ten times pro-forma AFFO and pay pro-forma Q4 dividends around 9% adjusted for stabilization of new assets. That’s very cheap for a property company with minimal leverage. With mostly fixed costs, I can model these companies to be trading for more like 6 to 8 times AFFO looking forward a year—due to a normalization of hotel rates on a fixed cost structure. A more typical measure of valuation in the hotel industry is price per room. Adjusting debt for rooms still under construction, these companies trade at enterprise values of around $30,000 to $35,000 a room, while comparable rooms cost at least twice that to construct in Mexico. This would imply that they trade for less than half of replacement cost. Interestingly, the Mexican hotel market is much more fractured than the US market. As the market consolidates, there are lots of hotels that can be purchased for 10 cap rates—even before economies of scale at a larger REIT increase the returns. Given the low leverage at both of these companies and how cheap debt is, there is likely to be continued growth as these companies take advantage of distressed players and make highly accretive acquisitions.

Fibra Inn

Fibra Inn priced in US Dollars since the IPO

Fibra Hotel

Fibra Hotel priced in US Dollars since the IPO

 

In summary, I have started small positions in each—I’m looking for further declines before I really add size. Deep down, I don’t think they’ve bottomed yet. However, they’re very cheap based on almost any metric you can use. They have growth pathways and the re-adjustment of room rates over the next few quarters should flow through the cash flow statements. Meanwhile, due to dividends, you’re paid well to wait. No one ever gets the exact bottom and Mexico is stunningly cheap, incredibly close for Americans and I expect that travel will increase as a result.

Over the next few quarters, one of two things will happen—either Trump and Mexico will reach an acceptable solution on trade where the currency recovers and average daily room rates reflect something closer to historical rental rates in Mexico when priced in US Dollars or the cheapness of the country drives more tourists and occupancy increases, while room rates are re-priced closer to previous dollar rates. Either way, I see RevPAR in US Dollar equivalents increasing dramatically over the next few quarters. In any case, I’m celebrating Trump’s victory with cheap cerveza, a cheap hotel room and two very undervalued REITs. I continue to seek out other opportunities in Mexico (stay tuned).

 

Disclosure: Long FINN13 and FIHO12

Categories: Current Investments
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Oil Services Update

December 15, 2016 12:16 AM


Back in August, I noted that oil looked to be making a right shoulder and that I was buying a basket of oil service companies as many of these companies, particularly in the offshore service, space traded at tiny fractions of NAV. Since then, most of my basket made new lows before rallying strongly in the past few weeks. The companies in my basket are now up 20% to 80% since I wrote about them in August. With Trump's focus on making America great again, I've now exited all of these positions in order to focus on companies that will benefit more from strong economic growth--as opposed to simply the price of oil and demand for oil services.

Despite the recent rally in the market, I'm finding great values in interesting places. Stay tuned for more updates.

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Believe In America (Part II)

December 1, 2016 2:44 AM


When the Central Bankers started printing money in 2009, I knew they wouldn’t be able to stop before they took things to an unimaginable extreme. When you’re in government and your policy isn’t working, you keep pushing harder—like your career is at stake if you fail. When China embarked on a massive infrastructure binge to re-ignite economic growth in 2008, it was obvious that once started, this would also continue for quite some time. What they’ve learned is that US $1 trillion a year just doesn’t kick-start an economy like it used to. This is why I don’t think Trump’s US $1 trillion infrastructure spending plan will stop at that. What’s $100 billion a year over ten years when the Chinese are doing a trillion a year? It just won’t create the sort of job growth needed.

With Trump at the helm, we can be proud that America is leading the western world in a new trend. You cannot fix an overleveraged economy with artificially low rates—you need spending on infrastructure. Trump realizes that. When America starts spending others will follow—just like they followed us with QE. What happens when everyone starts spending? Well, you’re going to need a lot of stuff and someone has to move that stuff around.

Last week, the Baltic Dry Index (BDI) hit a two year high following one of the worst bear markets in the index’s history. This bear market was caused by a crushing glut of ships that were ordered during the bull market of 2006 to 2012, but delivered en masse from 2010 onwards. The last of this glut should come in online in 2017. After that, there are almost no ships on the order book, meaning almost no more new deliveries until 2020—as it takes about 2 years to build a ship. So, a sector that has seen double digit tonnage growth crushing charter rates will now enter a period of no tonnage growth or even contraction as older boats are scrapped. At the same time, more stuff will suddenly need to be moved around on its way towards becoming infrastructure.

BDIY

Baltic Dry Index is finally showing some life after making a multi-decade low at the start of this year.

 

My favorite company in this sector is Star Bulkers (SBLK: Nasdaq), which owns 68 bulk carriers today. After a two year period of declining asset values, repeated equity raises and forced ship sales, the business has stabilized. The loans have finally been restructured. There won’t be any more forced ship sales. Instead, you have one of the world’s lowest cost operators with a fully financed fleet that will grow to 73 ships by early 2018. Based on current BDI rates, they should be making good cash flow for the first time in two years. I expect charter rates to come off a bit over the winter, as they often do, but even then, SBLK should be roughly cash flow neutral—nothing like the past two years where charter rates didn’t even cover operating costs. Effectively, you have a long-dated call option on demand for bulk shipping recovering at a time when supply should finally cease.

You can buy the shares today for just a bit over $5 while net tangible book per share, should be a little over $7 based on current vessel values. Of course, vessel values are currently highly distressed and should charter rates increase, vessel values should increase dramatically. Additionally, $476 million of equity was raised in the past two years, with roughly two thirds of it put up by management and noted value investment group Oaktree Capital. I like it when the insiders keep buying and at a market cap of $289 million, you can buy the whole company at 60% of the price that they thought was appropriate for their investments in less than the whole company. You’re paying less than the insiders paid, less than the boats are worth and the BDI is going to continue rallying because Trump intends to make infrastructure great again.

Disclosure: Long SBLK, Short SBLK puts

Categories: Current Investments
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Is This The Right Shoulder?

August 18, 2016 5:54 AM


Everyone is asking: “Is this is the right shoulder in oil?”

I know, I’m not a chart guy, but I certainly respect charts for entry points. Sentiment on oil is awful. Inventory is high. Refined inventory is off the charts. New supply is expected from all sorts of countries. Yeah, I’ve heard it all, but so have the charts. Here we are, and it sure looks like oil is forming a 2-year inverted head and shoulders (H&S) reversal.

oil H&S

Look at the S&P Oil & Gas Exploration & Production ETF (XOP:NYSE) for the past 6 months. When oil took a $10 drop in July, the XOP barely even flinched. In my experience, when you’re coming out of a commodity bear market, the producers tend to lead the commodity higher.

xop chart

It’s been approximately 2 years since oil began its slide from nearly 100. A lot has changed at the producers and it makes sense that they’re starting to outperform. They’ve dramatically cut costs, reduced exploration spending and focused on debt reduction. The survivors now have stronger balance sheets. Plenty of their brethren didn’t make it.

If you think oil is coming back, you can go and chase these producers, but there’s a sector that really interests me and that is the oil services sector where many sub-sectors are still bouncing along their multi-decade lows—or making new lows as I write this. Many of these companies have just reported awful quarters. Their businesses are down dramatically, their cash flows are a mess—many of them are blowing covenants and some even have scary “going concern” notices in their financials.

Why shouldn’t these companies suffer? Producers are focused on paying down debt—they’re doing everything possible to stop spending. However, if there’s one thing that I know about the oil companies, it’s that they’ll start to spend if oil starts to rally. They can’t help it. That’s what oil companies do. De-levering is boring.

I’m not going to tell you that buying highly leveraged service companies with covenant breaches and revenues that are down by half in the past year is a “sleep well at night” sort of investment, but I think that a basket of them can be. I bring this up, because many of these companies trade at less than 20% of book value and book value is mostly made up of equipment that is only a few years old. Heck,some of the offshore service companies trade at less than 10% of book. Even better, many of these companies have already taken a few rounds of impairments to their book value. Hence, true replacement value is even higher. Sure there’s debt, sure there are going to be hiccups and a few more scary quarters, but these guys have also been cutting costs for 2 years. Plenty of competitors have already failed and been liquidated. If there’s going to be a bounce-back in business it will flow to the survivors' bottom line in a hurry. If that happens, I don't see why these service companies can't trade back to book. In fact, for most of the past few decades, they’ve traded at a premium to book. I don’t want to name names, because I’m pretty sure a few companies in my basket will go to “oil services heaven” but if I'm right, a few 10-baggers will balance that out. The question then is: "Is this really the right shoulder?"  

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