Quick Take on Frontline Limited (FRO)

Hemen Holding Ltd, a company indirectly controlled by trusts established by John Fredriksen controls one-third of Frontline. The company has a total of 74 vessels as of the end of the 2nd quarter of 2011 excluding six new buildings on order: Very Large Crude Carriers Double Hull (VLCC DH) – 44, Very Large Crude Carriers Single Hull (VLCC SH) – 3, Suezmax DH – 21, and Ore-Bulk-Oil Carriers (OBO) – 6. They are valued at around $2.6B in the books – around $35M per ship. This is fairly reasonable – new builds are valued upwards of $100M, five-year old VLCC are assessed at $76M, and 10 year-old at around $40M – the latter valuation has come down significantly in the last six months because of low tanker rates. Scrap values are upwards of $20M. Frontline’s tanker fleet has an average age of 11 years compared to the industry-wide average of 9 years.

Break even rates for Frontline stands at $29.8K for VLCC, $24.8K for Suezmax, and $21.7K for OBO. For 2010, VLCC rates averaged $45K. For 2nd quarter 2011, the average rates quoted are below the lows for the last twelve years with VLCC at just $8K per day, and Suezmax at $13.5K per day – the 1st quarter averages were $20K/day and $19.8K/day respectively. Third quarter rates are expected to be in the same range. This accounts for the large loss reported. The key factors contributing to low rates are: a) Oversupply of ships estimated to be around 50 - ~10%, b) oil demand is low because of global slowdown, and c) The decision by the International Energy Agency (IEA) to temporarily release 60 million barrels from global strategic petroleum reserves proved negative for tanker demand and we noticed a decrease in long-haul imports to the US. Further, the current international situation has delayed the economic recovery and future oil demand might suffer. The rates peaked in July 2008 when it commanded $177,000/day. At that time, a 5-year-old supertanker went for $162M.

Frontline has seven new-buildings (Five VLCCs and two Suezmax) on order for delivery in 2012 and 2013 (after accounting for 4-5 months delay). They have paid around $200M out of the total order of $650M. The $450M remaining is expected to be financed - $145M is secured and the rest are un-drawn. If business conditions continue to worsen, this can turn out to be a risk – they will lose money (up to the $200M – one secured deposited), if they cannot come up with the $450M when it comes time for delivery. Below is the Capex projection for the coming years:


Frontline has around $540M of current assets and around $400M in short-term liabilities. The current capex requirement is stable. Below is a look at the balance sheet over the last three quarters:



The vessels are valued at ~$2.6B which comes to around $35M per ship – this may be about right, as the average age of the fleet is around 11 years. Total debt MINUS cash-on-hand is comparable to this figure. There are 80M shares outstanding and the net equity is around $720M. So, the liquidation value should be around $9. Frontline is trading at a 50% discount to current liquidation value. The seven ships on order will result in a cash-outlay of $450M between now and 2013. Also, at current rates, the company will take substantial losses at roughly the $25M run-rate. These factors may be contributing to the depressed market valuation of Frontline shares.

Fair Value Estimates:

Fair value estimates can’t be estimated well as the business shows negative earnings for the current year and next year.

Checklist:

  1. Is it a business I understand very well squarely within my circle of competence? – Mild yes.
  2. Do I know the intrinsic value of the business today with a high degree of confidence? – No, the business is very volatile.
  3. Is the business priced at a large discount to intrinsic value today and in two to three years? – Don’t know.
  4. Would I be willing to invest a large portion of my net worth into this business? – No.
  5. Is the downside minimal? – No.
  6. Does the business have a moat? – Frontline has 74 ships – but, the market is very fragmented. Eventually, Fredriksen who controls the company might attempt to consolidate and that could result in significant moat. Until then, no moat.
  7. Is the business run by able and honest managers? – Yes.
  8. How much is the Margin of Safety? – A good investment needs good downside protection – do not know.
  9. Is it a simple easy to understand business? – Yes. 
  10. Are the revenues and cash flows of the business sustainable? Are you looking at normalized earnings or boom-time earnings? - NA.
  11. Is it a Graham Net/Net play? – Bought below net working capital. Special Situation – good downside protection and chance of high returns, but probability is very low - Cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) - total liabilities. No – it is a large negative number (540M + 0.75*80M+0.5*60M-3B = -2.37B).
  12. Is the company’s business becoming unregulated that could cause the moat to quickly evaporate? – NA.
  13. Assets to Equity – Is the company too leveraged? – the ratio is very high and so is highly leveraged (3.8B/760M)
  14. Could the company have made bad lending decisions? – Bank specific – NA.
  15. How much will high unemployment and recession hurt the business? – Global recession will hurt the business as oil shipments will go down.
  16. Is the investment correlated to one or more of your existing holdings? – Holding many businesses that are correlated can result in an un-diversified portfolio – Yes, the portfolio has DryShips (DRYS), another shipping company.
  17. Can this business be decimated by low-cost competition from China or other low-cost countries? – NA.
  18. Is this a win-win business for the entire ecosystem? – Yes.
  19. How much leverage does the company have?, What are the covenants? Are they recourse or non-recourse?, etc. – Do not know – the company is leveraged and can run into trouble if things worsen – but, JohnFredriksen   is expected to infuse cash if needed.
  20. There are five questions on management - Management Compensation? Interests of Management – Is it aligned with shareholders? Management’s historical track-record? Does Management have a large stake in the company? – generally positive opinion on management.
  21. Unions & collective bargaining issues related questions – Does the company have union issues? – No.
  22. What is insider sentiment? - Insiders – Monitor significant insider buying & selling activity to find out.  John Fredriksen is expecting a collapse of the tanker rates and so is bearish on the stock.

Summary & Recommendation:

John Fredriksen predicted that the tanker market will plummet in the next two years in June 2011. He also said once that happens, he will start buying. In hindsight, that was an indicator for shareholders to get rid of Frontline and wait for a cue from him to get back in – he will probably infuse cash into Frontline at a future point when it will become necessary – he indirectly owns 33% now. So, an obvious strategy might be to hold off on purchasing any shares right now but instead wait for cues from insiders to make a purchase decision.

Related Posts:

1. Dry Bulk Shipping Companies & Baltic Dry Index (BDI) – Comparative Stock Analysis.


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