This is a response to Douglas E. Johnston's recent, well-reasoned article on Teekay Tankers Ltd. (TNK) here. In the article, Mr. Johnston makes the bullish case that TNK is now cheap with limited downside risk and substantial upside as the tanker market corrects over the next 2 to 3 years. He believes the company will withstand the current low spot and time charter ("TC") rates through 2014, as it has a strong balance sheet and it should generate enough cash to cover its operating expenses and debt repayments. He sets out his assumptions for a discounted cash flow analysis that comes up with a $5-6 current valuation. He believes that the current actual book value of the company is around $4, not $7.90 per GAAP numbers, based on the current value of the fleet.
I have been watching this stock off and on for about 2 years now and looking for a point to get in. In preview, I believe there is still significant downside at this time, and there is a high degree of uncertainty about the future of the tanker market, so now is not the time to jump in.
Let's start by looking at the company's strategy. The tanker market and the shipping market in general are highly volatile. TNK seeks to mitigate the downturns of the market by having a portion of its ships under TC to provide steady revenues. Of the 28 owned vessels, 15 are currently under TC at rates about 60% above 3Q spot prices, which are typically the lowest of the year. The other 13 vessels are deployed in ship pools that maximize spot charter revenues. The goal is to have this mix of revenues allow TNK to survive in depressed markets and excel in high rate environments. The TK group (TK) is an excellent operator, with extensive experience in all types of markets. This strategy should work, unless there is an extended period of low rates and the TC's expire, forcing those ships into lower rate spot pools that do not generate sufficient cash flow to cover operating expenses and debt service.
The real money in shipping is made by buying ships low at distressed prices and selling in strong markets when rates and ship values are high, in short classic value investing. Extraordinary returns are not made from cash flow. Investing in ships is the same as investing in real estate. One buys the asset cheaply and attempts to generate sufficient cash flow to pay operating costs and debt service until the asset appreciates. This is where the great shipping fortunes have been made.
Shipyards are subject to similar volatility. When demand is low, they drop prices significantly in order to keep some production going, so they can cover fixed costs. Similarly, prices of used vessels drop significantly in times of low demand. The equity investor may be able to make outsized returns by investing in shipping companies at low asset valuations and where the company has the cash flow generating power to survive the low point of the cycle and benefit from the upswing in rates and new build costs. Higher new build costs translate into higher used ship values. This strategy requires discipline and patience. One has to buy at the bleakest point and be prepared to wait out a turn in the market. It is impossible to predict the timing of a turnaround; however one can assume that one will happen at some point.
In "normal" environments, spot rates are higher than long-term TC rates; however in today's market, the situation is reversed. The industry suffers from over capacity as a result of over building 3 to 5 years ago in anticipation of rapidly growing emerging market demand (in China) and a strong world economy. Today's rates are not only depressed; so are ship values. This is what makes TNK an interesting investment. However, based on 3Q numbers, TNK is barely generating any distributable cash flow ("DCF") after reserves for dry-docking and debt service. 4Q rates and revenues are predicted to pick up due to seasonal demand, but the company expects the rate increases to be very short-lived.
More importantly, the remaining term of the TCs is only about 1.5 years. Seven of the 15 ships under TC will expire in '13 and enter the spot market unless their charters are renewed. Currently, TC revenues account for 63% of the total. Spot rates in the 3Q averaged $12,900 per day or 63% of the average rate of $20,500 on the TC fleet. If these ships fall into the spot pool by the end of '13, quarterly TC revenues will decline from $32m to $20m, and TC revenues will account for only 52% of total revenues. A $12m drop in quarterly revenues will cause DCF to be negative by approximately $10m (3Q DCF was $1.3m).
While supply and demand may come more into balance in '13, it is doubtful spot rates will return to sufficient levels to return the company to positive DCF. This is a worst case scenario, and TNK may be able to extend charters, although probably at lower rates. Looking at it another way, cash flow from operations in 3Q was $20.3m vs total dividends paid of $30m, and this does not take into account debt service or dry docking. TNK does have over $300m in liquidity between its cash and revolving credit line, which does not expire until 2017. However, the company is not self-sustaining at this moment.
One way to confirm how bad the market is now is to look at Nordic American Tankers (NAT). This company's fleet is all Suezmax ships on spot hire and has almost no debt. Their strategy is ride the spot market without using leverage and buy ships in down turns and reap in good times. NAT has negative operating earnings and negative EBITDA. They are bleeding cash and borrowing to pay the dividend. Not a sustainable model.
Analyzing the net asset value is another way to view whether the stock price is really cheap and sufficiently low to provide a margin of safety. I based the current fair market value of TNK's fleet on numbers from a Morgan Stanley shipping industry outlook from January 2012, admittedly a bit out of date. Ten year old Suezmax $31m, Aframax $21m, MR $18.9m, and LR2 $22m. Adding up the values of the 28 ships plus the value of the other assets and subtracting debt and other liabilities, I come up with a revised book value of a bit less than $1 per share. This compares with a GAAP book value of $7.90. Clearly, my numbers are old and could be underestimated. I am trying to get updated numbers. But, to get to $4, the value Mr. Johnston uses, I would have to increase the value of the ships by 40%. Therefore, I believe there is meaningful downside from the current price of $2.80 and insufficient margin of safety.
In conclusion, I think this company may be the best operator in the tanker market. They employ a conservative strategy designed to get them through bad times like the present. I think there has to be upside from here 1 to 2 years out. However, I do not think there is a sufficient margin of safety from the NAV, there may be deteriorating revenues and cash flows in '13 if TC are not renewed and there is a possibility that the world economy and that of China may not grow as much as anticipated (to say the least). So being the conservative guy that I am, I am going to wait for greater clarity on renewals or for the stock price to decline closer to NAV. I write this in the spirit of collaboration and welcome any comments or thoughts, especially about my NAV calculation. By far, my greatest errors are ones of omission not commission so this may be another example. Thanks again to Douglas Johnston for taking the lead with a very well reasoned analysis.
