Wednesday, 26 September 2012

Diana Shipping (DSX) - don't jump on board just yet

The Market:
Shipping is a complex industry with many moving parts. What makes it complex is that supply is inelastic in the short-run and takes years to increase or decrease, and the demand for ships (a commodity) is based on the demand for other commodities (iron ore, coal, grains).

To increase supply from the natural rate there needs to be excess ship building capacity, new inflow of capital to finance the ships, and the time period required to build ships and ship yards. Demand for ships is based on the need to transport goods, mainly raw materials, which is dependent on economic cycles, fixed asset investment, regional production and prices of commodities, trade agreements, local substitutes, and other factors. Given the complexity of the beast that is the shipping industry I will not try to forecast shipping rates but present the value of Diana Shippings vessels, where they stand relative to their historical prices, and what their fair value would be if current shipping rates persisted.

Anyone looking to invest in the shipping market should know that it is an industry with extremely inelastic demand; no one is going to ship more goods because shipping rates decreased, on the other hand if there is high enough demand for a commodity, producers will ship at extremely high rates to reap the benefits of high commodity prices. This creates an extremely volatile market which can be seen from the table below:

Yearly AveragesCapesizePanamax
2006         45,139       23,778
2007       116,049       56,815
2008       106,025       49,014
2009         42,656       19,295
2010         33,300       25,037
2011         15,713       13,943
2012           6,068         8,416
Y/Y Average Change
This is a table of the average prices throughout the year therefore it doesn't capture the full volatility in the market, however the volatile nature is still quite clear. In May 2008 Capesize vessels reached their peak rate of $230,000/day and crashed to $2,300/day later that year.
So how has Diana been able to maintain positive earnings and a balance sheet with a net cash position in a horrendous shipping market.
1) They entered into long term contracts during the 07-08 period and continued to do so at opportune times over the last few years as well. Currently Diana's average rate per day for Panamax vessels is $17,500 and for Capesize vessels is $36,000. This is at a time when the Baltic average rates in 2012 for Panamax and Capesize have been $8,400 and $6,000 respectively.
2) They did a massive share issuance in 2007 at peak valuation and paid down debt, deleveraging the business during a boom rather than waiting for the bust.

Stock Price  $6.54
Shares Outstanding                        81.4
Market Cap$532.4
Total Debt$417.3
Enterprise Value$498.1

Scrap value for the vessels                          $207.9

I've built 3 scenarios for looking at the value of Diana's vessels.

First one is simply based on ship values from the 2010 Maritime Report, 2011 report is not yet available, hence prices are a little stale. Provides an EV of $932 million.

Second is based on a DCF of vessel earnings using the average rates Diana charged for contracts entered in 2012, which were $11,000 for Panamax and $18,000 for Capesize. These rates are higher than the average daily rate in 2012 because a) Diana's vessels are young, average age of just over 6 years b) they were entered at the start of the year when shipping rates were higher c) these are long term contracts, therefore include future price expectations as well. Long term contracts entered in 2007 and 2008 were at rates much lower than the daily rate. This method yields a $467million EV. So even at rock bottom rates for the entire life of vessels, they still yield a value just 6% below current EV. At this valuation ships are being priced at almost a 50% discount from their 2003 prices and a 80% discount from their 2008 prices.

Last one is another DCF using Diana's current average daily rates. This yields a value of $830 million.

Scrap ValueValue based on Maritime Report DCF Value based on  2012 Rates  DCF Value based on  Average Rates
 EV  $       207,899,276  $       932,500,000  $         467,747,595  $          829,631,186 

The Concern:
As you can see from the valuation above, Diana and its ships are dirt cheap from a historical point of view. However the concern I have is about the number of lucrative long term contracts coming to an end over the next  6 months. 15 of the 28 vessels have their contracts expiring within the next 6 months and their average rates are $17,000 for Panamax and $45,000 for Capesize. This will surely have a huge impact on earnings unless there is near term rally in rates (remember 2012 average rates are $8,400 Panamax and $6,000 Capesize). Total Operating costs are also close to $9,000/vessel per day. Diana hasn't had to face a year or even a quarter of negative earnings post financial crisis and such a scenario will definitely test the nerves of its investors. 

It may be years before excess shipping capacity is absorbed by increased demand and if you had to pick a company to succeed in such a market, pick one with a strong balance sheet like Diana. Diana has plenty of cash lying around to make purchases if and when other companies fail to stay afloat. I would however watch from the sidelines until supply and demand settles into a more favorable range. Luckily for us, we can observes this easily with the daily Baltic rates.

I did not attempt to explain the effect of additional shipping capacity on rates and it probably would be a futile activity given the number of factors which have an impact on daily rates. However I assembled a few graphs to give the reader some idea of how shipping capacity has evolved over the last few years.

Demand for dry bulk products is predominantly controlled by China with influence from Japan, European countries, and other Pacific rim countries.

Thursday, 20 September 2012

Pair Trade (Long SVN $9, Short HTHT $14.73)

7 Days Group (SVN) and Chinga Lodging Group (HTHT), which operates as Hanting hotels, are both economy hotel chains growing rapidly in China. Below is a graph of the Enterprise Value/Room ratio of the two hotel chains. The point is to see the relative price you are paying per room when investing in the two chains. The average since May 2010 has been 0.69, meaning you can buy a room in the 7 Days Group chain at a 31% discount compared to an investment in Hanting. Currently the ratio stands at 0.39, meaning a 61% discount!
Reasons for the relative valuation
  • Within the economy hotel industry, HTHT is a premium brand whereas SVN is the thrift brand. In Q2 2012 the average daily rate for a HTHT room was 180RMB vs. 155RMB for SVN.
  • Profitability wise in 2011 SVN earned 7,665RMB/Room based on EBITDA margin and HTHT earned 6,900RMB/Room.
  • HTHT has a larger % of leased and operated hotels vs franchised hotels. (HTHT owns  48% hotels, whereas SVN owns 41% of its' total rooms)
  • Even though both brands are leaning more towards franchised growth, SVN has been following the strategy more aggressively.
  • HTHT delivered a strong Q2 whereas SVN had a relatively weak quarter.
  • HTHT is still smaller with 860 hotels vs 1,130 for SVN making growth easier and faster in the short run. Addition of 100 hotels has a much bigger impact of HTHT at the moment. 
  • These are relatively small cap, illiquid, Chinese equities, with not much mainstream interest creating short-term mispricing. 
I do not expect the relative ratio to reach parity due to some of the reasons stated above, and such a move would be an opportunity to enter the opposite trade. However, the current relative valuation of the two companies is extreme and should return closer to it's historical average of 0.69. A return to the historical average represents a 77% move in the ratio, meaning there is still significant upside potential.

In order for the EV/Room ratio to reach 0.69, SVN would be valued at $16.75, meaning 86% price appreciation from current levels of $9/sh. Or for HTHT to reach the 0.69 average, it would have to drop to $8.37 or a 43% decline from current price of $14.73/sh.

Will update the ratio every month, I'll also add some share price and market cap charts to make it easier to track the pairs performance.