SFL - SFL Corporation: Return Of The Income Juggernaut Notable Upside Ahead

2023-08-24 09:00:00 ET

Summary

• SFL has a two-decade track record of substantial dividends and traded between $15-$20 range for much of the 2010s, but offshore and COVID woes drove several dividend cuts from 2017-2020.
• SFL has now completely turned around. Its balance sheet is the strongest in company history, asset quality is top-notch, and the previously beleaguered offshore assets are now seeing strong tailwinds.
• A handful of recent contracts (Hercules rig and car carriers) will more than double excess free cash flow into 2024.
• SFL has raised payouts five times in the past two years, and I believe they're just getting started.
• I expect several more dividend increases in the next 6-12 months, and I expect a dividend payout of $0.30-$0.35/qtr by the end of 2024. Our current "fair value estimate" is $13, with potential for $15-$17 by late 2024.

Note: Climent Molins contributed significantly to parts of this report and he's also long SFL.

SFL Corp Overview

SFL Corp. (SFL) is an income vehicle with a 20-year track record with a core business model of financing vessels via leasing and profit-sharing agreements. SFL is heavily backed by shipping legend John Fredriksen , who owns approximately 26M shares via Hemen Holding. Due to Fredriksen's involvement and control, SFL has close financial ties with several related firms including Frontline (FRO) and Golden Ocean (GOGL). These ties have traditionally led to strong profits over SFL's 20-year history and SFL has been one of John Fredriksen's best performing vehicles. However, SFL was over-exposed to Seadrill in the 2010s and the subsequent collapse of the offshore sector led to a series of counterparty bankruptcies .

SFL's quarterly dividend previously fell from a peak of $0.45/qtr in 2015-2017 to a depth of $0.15/qtr in 2020 as the offshore bankruptcies were further compounded by COVID uncertainties. SFL had previously spent a large portion of the 2010s trading between $15-$20/sh as shares were bolstered by income investor enthusiasm. Ironically, I believe SFL has a healthier balance sheet, a healthier asset base, better diversification, and stronger prospects today than at almost any time in the past 15 years, yet shares trade considerably below the averages of the last decade.

Upside Potential: $13.33-$17.50 by Late-2024

SFL has roughly 126M net shares outstanding for a current market capitalization of about $1.36B. SFL has an active share repurchase program and its current dividend payout is $0.24/qtr, for a yield of about 8.9%.

I expect that SFL will likely raise their dividend substantially over the next few quarters to achieve a likely payout range of $0.30-$0.35/qtr by late 2024. If SFL trades at a 8%-9% yield range on these improved payouts, this presents a potential share trading range of $13.33-$17.50 ($15.42 midpoint) by late 2024. SFL therefore offers expected one-year upside potential of over 40% at the midpoint in addition to anticipated income over the duration (total return potential of over 50% by the end of 2024). SFL is one of our top Value and Income picks at Value Investor's Edge and represents a cornerstone of my current income portfolio.

The Return of the Income Juggernaut

SFL prides itself on a strong track record of shareholder returns. The upcoming payout in September will be their 78th consecutive dividend, with cumulative payouts likely approaching the $3B mark by next year.

SFL has a 20 year track record in the shipping industry, which is monumental compared to most peers. Despite operating in a very volatile industry, SFL has historically maintained a solid balance sheet and asset diversification has helped blunt the worst of the seasonality. Although SFL hit a temporary snag around the 2008-2009 financial crisis and was forced to cut payouts 50%, they subsequently returned to growth and raised the dividend 11 times between 2010-2015 ( full dividend history ).

SFL was hit with a double-whammy in the late 2010s as their largest offshore assets were upended by back-to-back Seadrill bankruptcies and COVID-19 uncertainties drove the situation from bad to worse. The challenging environment led to management's conservative decision to cut the dividend as low as $0.15/qtr. However, the firm has now completed a monumental turnaround and the once beleaguered offshore assets are now two of their most promising cash flow generators for the rest of this decade.

SFL has raised their dividend payout five times over the past two years ($0.15/qtr to $0.24/qtr) and I believe they are just getting started. I expect another string of steady dividend increases over the next year or two, and I believe we are likely to see a quarterly payout of $0.30-$0.35/qtr by late-2024. The rest of this report highlights the significant contract upside from the Hercules rig and car carriers, addresses SFL's recent earnings report , and concludes with our current 'fair value estimate' of $13/sh and potential for $14-$17+ by late-2024.

The one-two punch to massively higher operating results and expected dividend increases is outlined below:

Catalyst #1: Unprecedented Oil Rig Turnaround

Offshore companies have lately been on a tear as the market digests the improved market environment. Just check out three of the major comps:

• Noble Corp ( NE ): +65%
• Transocean ( RIG ): +125% y/y
• Valaris ( VAL ): +54% y/y
• Average of Comps: +81% y/y vs. SFL -1% y/y

SFL has two major rig assets, yet the market has given them zero credit so far. SFL is down 1% y/y and down about 4% from late-August 2022. This price performance is baffling, but I believe this presents an incredible opportunity for those who are paying attention now.

Although SFL is not solely a rig operator, the company owns a large jack-up rig, the "Linus," and a semi-submersible ultra-deepwater rig, the "Hercules." Despite the improved market environment and sentiment, SFL has failed to catch a bid alongside sector strength and the stock is down 1% y/y while almost all other rig stocks have skyrocketed. The offshore rigs shifting to a tailwind is a significant change in fortunes, especially considering the back-to-back Seadrill bankruptcies were the root cause of SFL's previous dividend cuts.

The "Linus" is employed on a long-term contract with ConocoPhillips until 2028. However, the contract is market-adjusted on a semi-annual basis. On the recent Q2 conference call , management acknowledged that although the performance of the vessel has been steady over the past few quarters, we should expect a positive contribution if market balances in the offshore sector continue to tighten as there are semi-annual rate adjustment (i.e. this is a very likely additional free cash flow catalyst during 2024). The Linus generated an average TCE of $209k/day during Q2-23 which albeit not outstanding, represents decent cash flow. Although we do not expect higher rates for 2H-23, we could feasibly see a rate of $250-$300kpd during 2024, which could add an additional $15-$30M to DCF.

The "Hercules" recently underwent its scheduled drydocking coupled with a comprehensive renewal/upgrade program which cost roughly $100M and resulted in the asset being out of commission throughout the first half of 2023. Since the vessel was not generating any revenue (but still incurred operating costs), it weighed materially against SFL's H1-23 performance. Anyone looking at SFL's Q2-23 or Q1-23 results is completely missing the strength as we expect FY24 results to blow FY22 and FY23 out of the water.

The Hercules began its new contract in Canada in mid July, which will drive substantially better firm-level performance in 2H-23. Once the current contract is complete, the Hercules will be deployed in Namibia for 115 days. Finally, the Hercules will return to Canada to start the recently announced 200-day campaign for Equinor (for $100M, equating to a TCE of approximately $500k/day under moderate mobilization/demobilization assumptions).

Overall, considering the new Hercules contract started in mid July ($50M revenue over a duration of 135 days), the positive contribution for Q3-23 could be estimated at around $27.8M, or about $0.22. In other words, the Hercules' contribution for Q3-23 can single-handedly cover 92% of SFL's current distribution, and the profit margin in 2024 is nearly twice as large yet.

Catalyst #2: Significant Free Cash Flow via Car Carriers

Car carriers have been one of the hottest shipping segments over the past year, and market balances remain extraordinarily tight so SFL was able to recently re-charter two of its assets, the "SFL Composer" and the "SFL Conductor," at greatly improved terms. Each vessel was fixed for a minimum of three years and the two ships are expected to generate $155M in revenue (which equates to a daily TCE of around $70k/day).

The EBITDA contribution from these two assets is expected to quintuple (5x!) when comparing expected FY24 results to FY22/FY23 averages. Assuming an EBITDA breakeven of around $9-$10k/day, we believe the incremental delta on the new contracts should contribute nearly $11M per quarter, or $0.08-$0.09/sh, to quarterly free cash flow.

SFL has several car carrier newbuilds to be delivered over the next year, including two vessels throughout H2-23 and two more in H1-24. Considering the vessels were first contracted when interest rates were lower, we expect the positive FCF contribution to be fairly limited in the near term, at least until interest rates decline or the debt load is reduced, but we should still see a slight uptick in quarterly contribution between Q3-23 and Q2-24.

Management also disclosed an interesting tidbit on the recent conference call: The new ships do not begin formal employment until they are delivered to Germany, so SFL will receive a "bonus" benefit of a spot voyage from Asia to Europe before the 10-year contracts start with Volkswagen. Given how ludicrously strong the current car carrier market is, this means there is the potential to add around $4-$5M in "bonus" free cash flow.

Just the aforementioned Hercules contract and the two legacy car carriers will singlehandedly cover more than the entire current dividend payout and would easily support a raise to the $0.30-$0.35/qtr range by late-2024, especially when combined with contributions from the 4x oncoming car carrier newbuilds (fixed on 10-year contracts to Volkswagen). If the Linus is also capable of securing improved rate adjustments during 2024, then even $0.35/qtr might be on the conservative range as we head into 2025.

Q2-23 Earnings: Deceptively Low

SFL reported Q2-23 adjusted EBITDA of $100.9M from consolidated subsidiaries, plus $7.8M in adjusted EBITDA from 49.9% owned associated companies. Net profit was $16.9M, or $0.13/sh, which included a few non-cash items. Overall operational performance was aligned with our expectations as we are primarily looking for improvements in late-2023 and into early/mid 2024.

The 1H-23 results are considerably misleading since SFL had its oil drilling rig, the "Hercules," in maintenance and upgrade drydock throughout most of the past six months, which has considerably reduced net income and FCF generation. The "Linus" remains on weaker contract rates and none of the improved car carrier contributions (2x new contracts and 4x incoming newbuilds) have kicked in yet.

Limited Near- and Mid-Term Chartering Risk

Considering SFL is a leasing company, the primary risks are counterparty credit quality and future re-chartering levels. However, I believe these concerns are overblown considering their near-term exposure is almost nil, with only seven dry bulk vessels and one containership trading on spot markets (which are already at low rates).

In early 2024, SFL has a 2001-built and a 2002-built 5,800 TEU vessel coming off-contract, followed by the "Asian Ace," a 2005-built 1,700 TEU coming off-charter in Q2-25, and seven 2002-built 4,100 TEU vessels coming off-contract in Q3-25. The company has some other containerships with extension options starting around 2025, but we expect most of those to be exercised considering those are generally legacy contracts at normalized rates (i.e. SFL did not benefit from the surge in containership rates throughout late-2020 to early-2022).

Furthermore, besides the vessels mentioned above, SFL's containership fleet is relatively young and should be able to secure employment in virtually any scenario. SFL is very secretive about their precise charter backlog, but they do provide an infographic highlighting when vessels are expected to come off-contract, as well as a fleet list indicating current employment profiles. However not much additional insight is provided on contract terms (such as the TCE).

Although SFL is a bit secretive about their charter backlog and I would prefer if they would disclose the exact rates for each vessel (which would make financial modeling much more straight forward), there are obvious competitive and corporate sensitivities involved. Overall, I expect limited negative y/y impacts from containership charter expirations in 2024 and 2025, especially since SFL had limited benefit during the previous upsurge. Additionally, I expect several of those ships to be sold for demolition, which will improve company-wide breakevens due to lower operating expenses and balance sheet improvements.

Fair Value Estimate: $13.00, Potential to $14-$17+

SFL is one of our top current Value and Income Model picks with a current "fair value estimate"' of $13.00, which represents 21% upside to what we believe is a fair value today . SFL has been held back in the market due to backwards looking markets, analysts, and investors who have not yet properly accounted for surging car carrier and offshore cash flows. There is also some technical resistance around current prices, which offers longer-term minded investors a gift to accumulate at bargain prices.

I believe investors and the general markets will finally "wake up" once the dividend raises start pouring in, which I expect to occur throughout 2024. By late-2024, I expect to see a quarterly payout between $0.30-$0.35/sh. If SFL trades at a reasonable yield range of 8-9%, this would imply a potential trading range of $13.33-$17.50/sh, which is $15.42 at the midpoint.

Although I can never guarantee outcomes in a particular stock, this firm has a 20-year track record, I have personally known the management team for many years, and I have strong confidence in this position as a cornerstone of my income portfolio.

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