Shipping Revisited: The Good, The Bad, & The Ugly

This is a follow-up on the article written in March. I decided to follow that thread, and see where it led. On the surface, shipping companies make for great bargains. Eagle Bulk was one of them, selling at less than book. Below, I've outlined how industry characteristics and risks can heavily influence an investment decision for an individual company.

The Good:
The shipping industry has been plagued by over-ordering for over a decade. The IMO's new global sulphur cap (to be introduced in Jan 2020), will act to eliminate older tonnage. How? By 2020, it is estimated that around 3% of the global fleet will have scrubbers. This means 3% of the global fleet will be off-hire between now and then. The majority of those are still waiting to get their exhaust gas cleaning units installed, causing a restriction in supply. The regulation will also impact the demand side.  Because the spread between high sulphur fuel and low sulphur may most likely widen in the future, vessels fitted with scrubbers will have a significant competitive advantage over those that don't, given their fuel efficiency and lower fuel costs. Eagle Bulk has ordered 18 scrubbers for its vessels, which the company expects to retrofit to its ships over the next three years during scheduled drydockings. The company seems to be taking advantage of this secular trend. In addition, it has begun divesting vessels older than 15 years as part of a major renewal program.

Shipping companies are frequently thought of as melting ice cubes. While it may be true for most, Eagle Bulk is able to cover fixed costs, including depreciation. In a back-of-the-envelope estimate, let's take the average ship, bought for $23 million, to have a depreciation charge of roughly $2 million annually. Put in terms of a daily expense, and taken together with recurring maintenance, that comes out to $4,387 in vessel expenses per diem. With an average day rate of $12,199 (Supramax ships, but extend it to Ultramax as well), you have a cushion of $7,812. Seems pretty good, right?
Now take a worst case scenario by averaging the bad years for day rates and expenses. That comes out to $10,648 - $5,628 = $5,020.

How close is this model to reality?

The Bad:
Too bad the model doesn't include restructuring, vessel impairments, interest expense...etc. They're very real expenses, and they're practically unavoidable. It's a bleak reality.

2018 numbers look good mainly because revenues are at a peak. As a result, this causes earnings to inflate as well, which gives a good starting boost to cash flow. As seen on the cash flow statement, operating CF has not been able to cover recurring maintenance.

Cash paid for interest, maintenance, new vessel purchases, etc. all comes from financing activities.

This doesn't include the credit facilities from which the company extracts liquidity (see supplemental cash flows section). All that to say, shipping, however efficient, is an incredibly capital intensive business that will require supplemental support, and is far from a self-sufficient business. By incurring significant leverage, Eagle Bulk is prone to interest rate risks, liquidity risks, & solvency risks, especially due to poor debt and interest coverage by unstable cash flows.

The last point I want to make here is that when valuing a shipping company by its balance sheet, always keep in mind that its assets are the purest commodity. There is virtually no room for differentiation (although some of this changes with IMO 2020), and each company will have little room for negotiation on the rates charged for each trip.

And The Ugly....
ZIRP/NIRP have been toxic in keeping corporate zombie companies alive. Shipping companies are the perfect example of this, kept alive by incentives to build more ships in hopes of earning the ever elusive return on volume. Debt is cheap and subsidized by government agencies.

But taking on leverage acts as a double-edged sword. Shipping companies got burned in 2014, and had to file for bankruptcy, Eagle Bulk being one of them. Although Eagle is less leveraged than they were in 2014, I still don't see a margin of safety. They're just not deleveraging fast enough, and nor can they.  Unlike some mining companies, they're operations will always require a significant amount of funding from debt.

Unfortunately, even when shipping companies go bankrupt, oversupply remains a problem. Vessels are still used until they're scrapped at around 20 years. This translates to new supply having trouble coming online, since it'll take some time until the ordering from 2012-2016 will need to be replenished.

On top of that, shipping is the net destruction fo capital through the full cycle, as per an EVA analysis. Rates of return are razor thin, if existent at all, and don't cover the cost of capital over time.

Usually it's a bullish sign to have significant shareholders, such as private equity and distressed debt firms with large stakes in the business. It's not a good sign however, if there's a civil suit going on between two private equity companies, and then having one company go bankrupt. Such is the case with Eagle Bulk, and the conflict between GoldenTree Asset Management v. EB Holdings II.

And last, but least on the list of plain ugly risks is insurance. Compliance is above 80%, which means the risks of not complying are very high. Firms face vessel detention, massive fines, and even crew imprisonment should they not comply with regulation. Fines are followed by insurance rates spiking, and the inability to get charters, putting a company at a significant disadvantage to its competitors. None of the above has happened to Eagle Bulk yet, but just to be safe, they pay $1 billion per incident. The stakes aren't small here.

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