TNP : Crisis of confidence in management

In the Dhandho Investor, Mohnish Pabrai describes how he invested in Frontline in 2002 as the stock entered a freefall. Frontline is an oil tanker operator that was under severe pressure from the low charter rates at that time, and appeared to be in danger of bankruptcy. Pabrai describes how his research showed that the Frontline’s ships were worth a lot even under adverse economic conditions, and the company could simply sell a ship if it required cash for interest payments. True, the company would be slowly chipping away at its seed corn, but Pabrai calculated that even under worst case scenarios, Frontline could hang on for several years, and surely the cyclical industry would have improved by then. The company survived, and Pabrai made a bundle. I was inspired by this example while I was looking into Tsakos Energy Navigation (TNP), an oil tanker operator which is trading at a steep discount to tangible equity.

Industry overview

The oil shipping industry is highly cyclical, and unlike popular belief, is only marginally correlated with oil prices. The dominant effect on tanker charter rates is actually tanker supply. In a tight tanker supply environment, low oil prices cause OPEC to decrease production and ship less oil, resulting in lower tanker earnings. Conversely, high oil prices tend to cause OPEC to open the spigots and ship more oil, resulting in higher charter rates. High oil prices also cause oil tankers to operate at reduced speeds to conserve fuel, which effectively decrease tanker supply. A rising oil price is also associated with steeper oil contango, which also cause tankers to be recruited as floating storage tanks. Oil is a non-substitutable good, so in periods of tight tanker supply, charter rates can go as high as $250k a day, as happened in the fourth quarter of 2007. This kind of return prompts anyone who is able to scrape together the $40-80M required to build an oil tanker to immediately commission a newbuilding, salivating at the prospect of recouping that investment in under a year. It takes 2-4 years to build a new tanker, and the new tankers predictably hit the market at nearly the same time, causing charter rates to plummet down to $5k a day, barely above ship operating costs, and insufficient to support interest payments on the ship mortgage. At that point, the industry scraps a bunch of single hull ships (by international law, single hull tankers are not allowed near American and European coasts after 2015), and equilibrium is restored amid much heartburn.

The major companies in the oil tanker industry, including Teekay (TK), Frontline (FRO), and TNP, have seen this pattern repeated many times. The key to survival is to be greedy when others are fearful, and fearful when others are greedy. Well-run operators judiciously commission newbuildings in the down cycle when construction costs are low, and never in the up cycle. The fleet is divided among time charters (fixed duration contracts) and spot charters (open market auction rates) according to the prevailing rates, and operators increase the proportion of time charters in the up cycle. To do this kind of hedging, you need a large fleet, at least above 20 ships, so small operators tend to have a high mortality rate, while the major companies, invariably public companies which are able to raise capital from stockholders, have done relatively well. Unlike most dividend-paying companies, the industry has a long tradition of paying variable dividends based on earnings, so dividend yields swing around wildly. For tax and liability reasons, these companies are essentially holding companies for the ships, typically incorporated in Bermuda. Ship management is contracted out, often to captive management companies owned by the CEO, an arrangement that is favored for legal reasons but also presents conflicts of interest. Because of the limited recourse of stockholders under Bermudan law, and the conflicted management structure, faith in management is critical in this industry, so the fallout from a loss of faith can be severe.

Industry bullish thesis

There is a bullish thesis circulating that the oil shipping is just about done with its down phase and is about to enter another up cycle. The 2009-2010 years have been excruciating for the industry. In addition to the financial crisis decreasing oil demand worldwide, especially in North America, the newbuildings commissioned before the crisis started to come online during this period. Furthermore, a typhoon struck a major shipscraping yard in Bangladesh in 2010, leading to a slowdown in shipbreaking. The only saving grace during this dismal period is a spell of oil contango in 2009. Still, with no new ships commissioned during the past 3 years, the bulk of the pre-crisis newbuildings already online, and with the destruction of single hull tankers continuing apace, analysts predict that the current 10% over-capacity is poised to shrink further. The major fly-in-the-ointment of this thesis is that the bulk of oil consumption growth in the future is going to be in China, which is closer to the Middle East then America, and so requires only about half the tanker fleet to transport an equivalent volume of oil. Furthermore, the Chinese government has mandated that at least 25% of China’s oil consumption be transported by domestic shipping companies. Given that Chinese policy tends to be opaque, it is difficult to predict the amount of tanker supply that will be soaked up by China in the future.

Company overview

Tsakos Energy Navaigation (TNP) is a family majority-owned tanker operator based in Athens, Greece, with a listing on the NYSE. Greece has a strong maritime tradition and commercial shipping is the largest industry in Greece after tourism. TNP has approximately 50 ships, ranging in size from VLCCs to Handysize, compared with some 76 ships for FRO, and approximately 150 for TK, and has generally been regarded as a well-run company. Management seeks to place at least two-thirds of its ships on time charters to decrease earnings volatility, and has committed to paying out 25-50% of earnings as dividends. The company also has a policy of keeping a well-balanced and young fleet, typically selling its ships before 8 years old. All of TNP’s vessels are double hull, and many have ice-breaking and/or offshore loading capabilities. The average age of the fleet is 6.9 years, substantially below the industry average. The company has also acquired a LNG carrier with an eye on the expected increase in natural gas shipping. The company is also substantially less leveraged than its peers, with a debt ratio of 64% of assets, compared with 90% for TK and 80% for FRO. Actual ship operations is contracted out to Tsakos Management, of which CEO Tsakos (son of the founder) is the sole shareholder. Tsakos Management had previously managed around 70 ships (some were not TNP’s), but the company intends to merge with Columbia Shipmanagement, a German company which previously managed around 200 ships. The combined management companies will have increased buying power and lower crew costs, and is expected to result in savings for TNP. TNP also insures its vessels against routine maritime hazards (piracy, ship running aground etc.) through a captive insurance company, which reinsures the risk through major London reinsurers.

Crisis in confidence

In October 2010, TNP completed a 7.5M share offering at $11.30 per share, raising some $85M “for general corporate purposes”, substantially diluting the 37M shares outstanding. Reaction to this news ranged from apoplectic to murderous rage. At that time, shareholders were already upset that the stock is trading at a multi-year low of $15, near the nadir reached in 2009. They were angered to find that management was selling shares at a steep discount to the market price, and then further upset to find that some parties may have had access to insider news resulting in a sharp uptick in short interest just before the deal. And to top it off, 15% of the new offering went to Tsakos family members, giving the impression that management was selling themselves cheap stock for unspecified purposes. This came shortly after widespread media portrayal of Greek citizens as kleptomaniacs, and conspiracy theories were floated about how the Tsakos family is trying to steal the company from under minority shareholders to compensate for the recent decline in their Greek holdings. Shareholder reaction was fast and furious. The share price immediately dropped below $10, despite the secondary offering being 20% oversubscribed.

Two months after this fiasco, the company announced that it was using the $85M to buy two Suezmax class shuttle tankers which have been chartered out to an oil major. This did not appease shareholders. Many complain that the company sold expensive stock to buy cheap ships, when they should be doing the reverse, selling ships to buy back the cheap stock. The stock remains at its depressed price, trading at a sharp discount to its tangible equity.

Is management a bunch of crooks?

No doubt, in doing the secondary share offering, the Tsakos family also incentivized by an opportunity to convert some of their euro holdings to a form more resistant to Greek devaluation. However, I give management the benefit of doubt and believe that they were primarily driven to finance the two ships promised to an oil major with expensive equity in order to preserve a longstanding relationship. Firstly, major shipping lenders have announced 40-50% cuts in loans to the industry, so it is unsurprising that the company is having problems financing with debt. Secondly, the amount raised is slightly below that required to buy the ships, suggesting that management is aware of how expensive the equity is and the need to issue a minimum amount of it. Thirdly, the Tsakos family owns 40-50% of TNP before the stock dilution, and the recent plunge in the stock price has more than wiped out any gains they could have realized from buying stock at a below-market price. And lastly, stealing the company from minority shareholders would shut the family out from the stock market, and possibly even the debt market, for a long time. Shipping is a capital intensive industry, and without access to capital, growth will be severely restricted, so the Tsakos family would be trading a one-time gain for future growth. Indeed, there are signs that management is aware of how ridiculous the stock price is. CEO Tsakos have recently publicly suggested that vessel sales would be a way to close to the gap between TNP’s stock price and its true value. And a recent 13G filing showed that several of the Tsakos family investment vehicles are holding substantially larger amounts of TNP stock compared to the amounts disclosed in the 20F filing in Dec 2009, suggesting that stock is being bought back by the family.

Valuation

While peers such as TK and FRO are trading at 25% and 150% premiums to their book value respectively, TNP is trading at a 40% discount. A part of this valuation discrepancy comes from the higher leverage of TK and FRO, which gives them a higher return on equity. And FRO’s CEO is extremely well-regarded in the industry, which gives another boost to FRO’s stock price. Still, at a market price of around $450M, with around 50 ships, TNP’s vessels are being valued at around $9M per ship. This is a clearly ridiculous valuation, even in a down cycle. The incredibly low valuation is especially apparent when you consider the quality of the TNP’s vessels, which are all double hull, and substantially younger and more capable than the TK and FRO fleets. Recent sales of vessels have all resulted in capital gains for the company, suggesting that depreciating the ships on a straight-line basis over 25 years is too aggressive during the early years, when a proven ship can be sold at close to its construction price. So the book value of TNP probably somewhat understates the true value of the vessels.

Disclosure : I own shares of TNP