2023-05-30 18:44:54 ET
Summary
- The tanker shipping industry has experienced a surge in interest due to geopolitical factors and macroeconomic headwinds, with Teekay Tankers and TORM Inc. benefiting from increased demand and limited new ship supply.
- However, investing in these companies requires specialized knowledge and continuous reassessment of market conditions, and they are not growth stocks with long-term revenue sustainability.
- Despite seemingly attractive valuations, I believe challenges such as fleet renewal, debt repayment, and capital-intensive nature of the industry may limit the potential for capital appreciation for investors.
Investment Thesis
In recent weeks, a bullish zeal has swept across the tanker shipping industry, with names like Teekay Tankers ( TNK ) and TORM plc ( TRMD ) surfacing as a focus of investors' excitement. This buzz stems from several well-documented industry dynamics favorably impacting the oil shipping sector. The EU and UK's ban on Russian seaborne crude oil imports lies at the heart of the bonanza. The move, first implemented in December 2022 and further expanded in February 2023 to include refined oil shipments, has significantly disrupted tanker shipping routes, necessitating longer voyages and ton-mile demand for shipping.
These sanctions coincided with material shortage and inflation, pushing ship prices higher and leading to slower vessel demand. Shipping companies are understandably apprehensive about buying a high-cost tanker during an upcycle. Purchase managers also take into account that a ship ordered today will be delivered in 2025 and is expected to serve through 2045, a period in which global governments set to hit the net-zero emission targets. Apparently, not many shipping companies want to own an expensive tanker in a net zero world, as mirrored in today's historically low new ship builds.
Between higher demand and lower supply, shipping rates have surged. With a focus on spot-charter rates (as opposed to long-term contracts with fixed prices), TNK has been at the center of the bullish spotlight. This article doesn't dispute the favorable impact of these industry dynamics but is skeptical about the much-touted investment opportunity.
Investing in oil shipping companies is not for the faint-hearted, and it demands specialized knowledge and understanding of the sector's dynamics and continuous reassessment of market conditions. A case point is the company's approach to keeping investors up-to-date on its operations. In addition to its regular quarterly disclosures, TNK produces a monthly market insight report covering charter spot prices, which can change meaningfully from week to week.
Investors new to the sector should also bear in mind that TNK is not a growth stock. The prevailing bullish sentiment does NOT mirror expectations of exponential capacity growth or long-term revenue sustainability. Rather, industry pundits are most likely satisfied that TNK will, at least temporarily, duck a down cycle, providing much-needed relief to its balance sheet. In my view, these bullish ratings reflect a low bar of success.
Moreover, it is essential to understand the financial nuances inherent in the oil shipping sector. A considerable portion of the earnings influx created by this upcycle will necessarily be redirected toward the repayment of debts accumulated during past downcycles. By the time these debts are cleared, the industry might very well be staring down the barrel of the next down cycle. Moreover, given the aging fleet of TNK, a significant chunk of income will probably be invested in fleet renewal, a reflection of the capital-intensive nature of the shipping industry.
Although TNK has taken steps to enhance shareholder value through dividends and share buybacks, sharing the benefits of the recent upcycle, these measures are, in my view, not enough to generate the capital gains that many investors seek.
To be clear, I'm not against cyclical stocks. In fact, my portfolio includes shares in companies like Exxon ( XOM ) and Chevron ( CVX ), which operate within the realm of commodities, much like TNK. XOM and CVX are price takers of oil prices, while TNK is a price taker of charter rates. However, there is a critical factor that sets these oil giants apart, a factor that TNK lacks; the advantage of being a low-cost producer.
As low-cost producers, companies like XOM and CVX have the ability to remain profitable, even in periods of suppressed commodity prices. Their cost-efficiency serves as a financial buffer during periods of down cycles, allowing them to weather the storm until excess capacity, predominantly held by high-cost producers, is squeezed out of the market. This often leads to a rebound in prices, enabling low-cost producers to remain profitable across cycles. TNK lacks this advantage. Its recent surge in popularity stems from its exposure to charter spot rates, a strategy that essentially exchanges the security of long-term charter contracts with the high risk/reward of spot charter rates, positioning it to benefit from this upcycle, but, at the same time, exposes the company to the brutal unpredictability of the market.
Between the oil shipping cyclicality, narrow competitive moat, and limited sustainable growth opportunities, I've decided to pass on the geopolitical trade presented in TNK.
Fleet Age and Size
TNK boasts a fleet of 55 vessels, largely composed of midsize ships, with one exception being the Hong Kong Spirit, a Very Large Crude Carrier "VLCC" with a capacity of 319,000 deadweight tons "dwt." Nonetheless, a typical tanker in TNK's fleet has a capacity range between 109,000 to 160,000 dwt.
Despite the fleet's strength in numbers and capacity, one must not overlook its age. The average age of TNK's fleet is 14 years.
More importantly, TNK has a significant concentration of vessels built between 2009 and 2011, which impacts the timing and cost of future maintenance and scrapping requirements, reflecting the realities of the shipping industry's wear and tear. With such a concentration, one would expect a choppy retirement of vessels around 2030 unless TNK renews its fleet before that time. Below is a comparison between TRMD and TNK's vessel build dates, showing a steeper cumulative histogram chart for TNK compared to its peer.
Shareholder Returns
TNK seems to be trading at appealing valuations with a PE ratio of 3x and an implied earnings yield of 30% annually. However, investors should be mindful that while, on the surface, these figures are alluring, it is critical to understand the complexities of the underlying business model. TNK falls under what I often characterize as the "ice cube business model" - a company that requires continuous capital expenditure just to stay in business. This business model is prevalent in industries like biotech, where constant investment is needed to replace therapies that go off exclusivity/patent period. Similar to a patented drug, a vessel is expensive to procure and has an expiration date.
Moreover, a significant portion of the recent surge in earnings is being deployed to fix legacy issues. TNK dedicated a significant portion of the recent earnings surge to aggressively repay debt while allocating a smaller piece for dividends and share buybacks after years of suspension. The first dividend distribution (for holders of record May 19, 2023) is due next month and comes at a quarterly rate of $0.25 per share, which sums up to $1 per year, equating to a mere 2.7% annual yield.
Looking closer at its recent strategic moves, one can't help but notice that TNK is also leaning away from the vessel lease buyback arrangement, a financing method often plagued with significant interest obligations, which has been attracting interest from private equity funds, known for their hunger for yields, opting for full ownership of its vessels. To that end, TNK has proactively expanded its credit facility by $350 million, providing an additional liquidity cushion to buy back its vessels. Kevin Mackay, the CEO of TNK, articulated this strategy during the Q1 2023 earnings call, stating:
We have also finalized a revolving credit facility for up to $350 million to refinance 19 vessels as we continue to exercise purchase options on vessels in sale-leaseback arrangements.
Thus, despite these seemingly attractive valuations, I remain skeptical about the potential for capital appreciation. While earnings figures suggest high potential returns, it is essential to understand that a significant portion of these earnings is dedicated to strategic initiatives like debt reduction and fleet consolidation. Nonetheless, this cycle bodes well for stability and survivability, offering an interesting proposition for those investors inclined towards cyclical sectors with a long-term perspective that wagers on the ability of TNK to generate enough value in good times to smooth out what, in many cases, has been value-destruction during tough times.
How I Might Be Wrong
It is important to acknowledge that every investment thesis, however strong, is subject to uncertainties, and mine is no exception. While I have reservations about TNK's potential as a long-term opportunity, there are several factors that could prove me wrong.
First, the strategic measures such as aggressive debt repayment and execution of repurchase options on vessels under the lease buyback arrangements could improve TNK's financial resilience over time, potentially allowing the company to better weather down cycles, thus, boosting its appeal as a cyclical investment.
Second, TNKS's recent dividend reinstatement, although relatively modest (notwithstanding the special dividend), could be the start of higher dividend payments going forward. If the company's capital allocation policy continues to evolve in this trajectory, investors likely stand to gain from their investment in TNK.
Summary
Amid a lively investor fervor and enthusiasm in the tanker shipping industry, it's vital to keep our perspectives grounded. The recent bullish attention around TNK and TRMD doesn't necessarily mirror a long-term growth trajectory. Although these two companies happen to benefit from geopolitical dynamics and macroeconomic headwinds limiting new ship supply while ton-mile demand increases, one should also take into account the challenges hindering TNK's ability to share these gains with shareholders. The shipping industry is capital intensive, and TNK has a portion of its ships that need to be replaced soon, requiring significant capital.
Moreover, TNK has accumulated debt, either through lease buybacks or borrowing in the past down cycles. This debt needs to be paid to prepare for the upcoming downturn. Finally, investing in TNK requires a continuous and detailed analysis of market conditions, potentially defying the purpose of retail investing, which is typically passive and diversified across various industries, as opposed to being focused on one demanding sector such as oil shipping.
For further details see:
Teekay Tankers: A Cautionary Tale Amid Industry Hype