Q&A: Jefferies analyst on shipping stock rout and what’s next

Giveans: “Yeah, there was a little bit of a breather in the last week or so when new cases in China were slowing and you didn’t see many cases spreading [outside of China]. That’s obviously changed in the last 48 hours.”

Crude tanker rates are up year-on-year and product tankers are said to have new demand due to the coronavirus, as excess jet fuel and other refined cargoes need to be shipped from Asia. And yet, tanker stocks are really taking it on the chin. Why?

“A lot of the tanker business is exporting to consuming nations in Europe and Asia, so when you have further spread of the coronavirus to Europe and Asia, obviously you can infer an impact.

“It’s true that tanker rates are up meaningfully year-over year. Looking at the average for February, on the crude side, rates for VLCCs [very large crude carriers, with capacity of around 300,000 deadweight tons or DWT] are 20% higher; Suezmaxes [120,000-199,999 DWT] are double; Aframaxes [80,000-119,999 DWT] are up 50-60%; and Panamaxes [55,000-79,999 DWT] are up 60-70%. For product tankers, LR2s [80,000-119,000 DWT] are relatively flat; LR1s [55,000-79,999 DWT] are up 25-30%; and MRs [35,000-54,999 DWT] are up 25-30%.

“But VLCC rates went from $100,000 a day to $30,000 a day year to date. If you told someone a year ago that VLCCs would now be at $30,000 a day, and that they averaged $65,000 a day in January-February, they’d say, ‘Oh my gosh, that’s great.’ The problem is how we got here, with people saying, ‘Oh no, the world is ending.’

“Tanker stocks came into the year with very strong sentiment. They had a record fourth quarter and there were a lot of positive catalysts: rising U.S. exports, increasing global demand, an additional boost from IMO 2020 [the regulation that requires shipping to use low-sulfur marine fuel]. But all of that has faded and now stock prices are back to where they were during the third quarter of 2019. They’re priced as if the fourth quarter didn’t happen. They’re priced as if the first quarter — which could be even better than the fourth quarter — didn’t happen.

“What we’re seeing now is an extreme correlation between tanker stocks and the daily spot rate for VLCCs. We cover a basket of 10 equities — seven crude-tanker owners and three primarily product-tanker owners — and the correlation between this basket and the daily VLCC rate has been around 95% for the past two months. It’s the most tangible headline rate so it’s like, ‘Oh, V’s are going down. Sell the stock. V’s are going up, buy.

“We think that correlation will continue, and with that, there will be short-term volatility for sure. Who knows what will happen to stock prices in the next month? Could they go down another 10%? Absolutely. But we think that in three months, six months, 12 months, there will be an improvement in rates and consequently an improvement in equities.”

Even so, given what’s going on today, isn’t it sensible to look at this kind of extreme price action and say: Why don’t I just wait and buy discounted shares later?

“Waiting is safe. I completely agree. It is very easy to sell right now, or not buy. There’s no real support for these economically sensitive, energy-related, China-exposed shipping companies. There’s no rush into these stocks. But all of our investment recommendations are for a 12-month price. I’m not saying these stocks are not going down further. What I’m saying is that I’m convinced they’re going up from these levels six to 12 months from now, not six to 12 days from now.”

Effects on capital raising and consolidation

I want to talk about the consequences of these low stock prices given that the market is pulling back so severely. What about capital raising by U.S.-listed companies in 2020? Shipping shares are now trading at even higher discounts to net asset value (NAV), so you wouldn’t want to raise money by selling common equity unless you were forced to do so in a loan renegotiation. Public company balance sheets have been repaired over the past decade, so that’s less likely to happen. Do you think capital raising could be even lower in 2020 than 2019, which was historically low?

“I don’t think capital raising will be extensive. Balance sheets have vastly improved, especially for tanker companies. A lot of them earned more in the last quarter than in the previous year. As for dry bulk, they’re burning a lot of cash, but here too, balance sheets are much improved, which is why we’re probably not going to see emergency equity [offerings]. Instead, you’ll see ongoing sale-leasebacks and maybe some outright asset sales, unsecured notes, preferred equity or converts.”

What about consolidation through so-called ‘ships for shares’ deals, with private equity groups selling fleets to already-listed companies in return for stock?  With stock now trading so far below NAV, is this less likely?

“It’s a lot easier to do when your stock’s trading at or near NAV. If you’re stock is trading at a 30% discount to NAV and you tell the seller, ‘We’ll do ships for shares at $12,’ it’s easier if your shares are trading at $12 than if you’re saying, ‘Our equity really should be trading at $12.’”

What about the effect of stock-market turmoil on buyback programs? Wouldn’t management be in the same boat as equity investors, i.e., they look at today’s plunge and say: I’d better wait?

“You’ve heard some of the tanker owners saying this on recent [quarterly] calls. In my view, CEOs like buybacks more than CFOs. CFOs are more conservative. Their goal is: Don’t go bankrupt and have cash on hand to weather any storm, whereas CEOs might say, ‘Our share price is at multiyear lows and a huge discount to NAV so we need to take advantage of this.’

“I think if you have free excess cash flow, share repurchases are a good idea, but if you lever up in this market to do an aggressive repurchase, you won’t be rewarded. It comes down to leverage ratios and debt profiles. If your net debt-to-cap is 30% and you have no debt repayments for three years and you have very little capex and your shares are trading at a 40% discount to NAV, then yes, absolutely [repurchase shares].”

Even on a day like today?

“There are only a handful of companies in a situation like that, but yes.”

Longer-term consequences

Finally, I want to look at the longer-term consequences of the outbreak on ocean shipping stocks. From a supply perspective, ships are built in three countries: China, South Korea and Japan. There are now outbreaks in two of those countries, which should reduce new ship supply. Plus, in addition to uncertainty over future carbon-emission rules slowing orders, coronavirus should further reduce the contracting pace. After all, if you’re watching the news today, why would you order a ship?

“On the supply side, we’re seeing force majeure at shipyards in terms of newbuilding construction and further delays on scrubber retrofits [to comply with IMO 2020 rules]. Normally we see slippage in newbuilding deliveries of 20-25%; this year it will likely be greater. Plus, we’re seeing more slow steaming because of the combination of higher fuel prices and lower rates, as well as more scrapping. All of this is good for supply growth this year — because you want lower growth.

“The lack of newbuild ordering over the next six months or the next year will be beneficial for supply in 2021 and 2022. If you look at the newbuild ordering, we’re only 60% done with the quarter, but even if you double the orders so far, it’s extremely low.

“There have been 700,000 DWT of dry bulk ships ordered so far. Let’s say there will be 1.5 million DWT for the quarter, which I don’t believe will be the case. Since the first quarter of 2010, there has been only one quarter with less than 1.5 million DWT — the third quarter of 2016 — and the average quarterly orders were 12 million DWT.

“For crude and product tankers, 1.5 million DWT have been ordered so far this quarter. Let’s double that and say there will be 3 million DWT in the whole quarter. You haven’t seen that [ordering so low] since the first quarter of 2016 and before that, early 2011. Since the first quarter of 2010, an average of 7 million DWT of tankers were ordered per quarter.

“The orderbook-to-fleet [ratio of ships on order versus ship on the water] is the lowest it has been in 20 years. And if you look at all the constraints — coronavirus, the environmental regulation issue, capital constraints at European banks — it is really encouraging on the [vessel] supply front, both in the short and the medium term.”

The supply side of the equation does look great, but then again, it often comes down to demand. If you assume the world doesn’t end, we get past coronavirus and there’s going to be a recovery. A lot of executives are pointing to the V-shaped recovery, where there’s a huge post-virus surge in demand. My devil’s advocate question would be: We don’t know how long the virus period will last and how much economic damage will occur, so is it assured that when this all ends, there will be enough stimulus and demand firepower left to fuel a V-shaped recovery?

“The demand outlook is certainly a wildcard, due to the coronavirus and global trade issues and other things. But I would say that because of the positive situation on the supply side, the hurdle for demand to eclipse supply growth is now much lower. So, yes, demand is uncertain, but we’re in a better market situation today than if we’d had negative demand shocks three to five years ago, back when the supply growth was 5% or more for the next few years.” More FreightWaves/American Shipper articles by Greg Miller