In his 2003 Annual Meeting, Mohnish Pabrai discussed his thesis for his investment in Frontline Ltd (USA) (NYSE:FRO). I see a number of parallels between HAWK now and FRO then. Here is an extract from the transcript:
Frontline (FRO) is company I’d like to talk about because it is an interesting datapoint on how I look at businesses. Frontline is in the crude oil shipping business. About 2 and half years ago if you asked me if I had any competency or knowledge of the crude oil shipping business, I would say that I knew nothing about the business or industry. In 2001, I was just looking at a list of companies that had high dividend yields. One of the screens I look at is companies with high dividend yields, which sometimes means some sort of overhang which is dropping the price below where it should be.
If I looked at Value Line today, I would probably find three or four companies that have a dividend yield of 10%-12%. In 2001 I noticed there were two companies with a dividend yield over 15%. Both were in the crude oil shipping business. One was called Knightsbridge (VLCCF). I wanted to understand why they had such a high dividend yield. So I spent about a month studying the crude oil shipping business.
When Knightsbridge was formed a few years ago, they ordered a few oil tankers from a Korean ship yard. Each of these VLCCs (Very large Crude Carrier) and Suezmaxes costs about $50-70 million a piece and it takes 2-3 years to build one. The day the tankers were delivered they had a long term lease with Shell Oil. The deal was that Shell would pay them a base lease rate (say $10,000 a day per tanker) regardless of whether they used them or not. On top of that, they paid them a percentage of the delta between a base rate and the spot price for VLCC rentals.
For example, if the spot price went to $30,000/day, they might collect $20,000 a day. If the spot was $50,000/day, they’d collect say $35,000/day etc. The way Knightsbridge was set up, at $10,000 a day; they were able to cover their principal and interest payments and had a small positive cash flow. As the rates went above $10,000, there was a larger positive cash flow and the company was set up to just dividend all the excess cash out to shareholders – which is marvelous. I wish all public companies did that.
When tanker rates go up dramatically, this company’s dividends goes through the roof. This happened in 2001 when tanker rates which are normally $20,000-$30,000 a day went to $80,000 a day. They were making astronomical profits at the time and the dividend yield went through the roof – but of course it was not durable or sustainable.
That’s why the stock didn’t jump up significantly. Then next week it could drop. It is a very volatile business. But I studied the business because I was just curious. But in investing, all knowledge is cumulative and makes the analytics much faster the next time around. At the time I studied Knightsbridge I also took a look at half a dozen other publicly traded pure plays in oil shipping.
Last year, we had an interesting situation take place with one of these oil shipping companies called Frontline (FRO). Frontline is a company that is the exact opposite business model of Knightsbridge. They have the largest oil tankers fleet in the world, amongst all the public companies. The entire fleet is on the spot market. There are very few long term leases. They ride the spot market on these tankers.
Because they ride the spot market on these tankers, there is no such thing as earnings forecasts or guidance. The company’s CEO himself doesn’t know tomorrow what the income will be quarter to quarter. This is great because whenever Wall Street gets confused, it means we can make money. This is a company that has widely gyrating earnings.
Oil tanker rates have varied historically between $6,000 a day to $80,000 a day. The company needs about $18,000 a day to break even. Once rates go below $18,000 a day, they are bleeding red ink. Once they go above $18,000, about $30,000-$35,000, they are making huge profits. In the third quarter of last year, oil tanker rates collapsed. There was a recession in the US, and a few other factors causing a drop in crude oil shipping volume. Rates went down to $6,000 a day. At $6,000 a day, Frontline is bleeding red ink badly. The stock appropriately went from $11 a share to about $3, in about 3 months.
If you spent some time studying Frontline, you would find that they have 60 or 70 ships, and while the rates had collapsed for daily rentals, the price per ship hadn’t changed much, dropping about 10% or 15%. There was a small drop in price per ship, but nowhere near the price the stock had dropped; the stock had dropped over 70%.
Frontline has a liquidation book value of about $16.50 per share, which means if they simply shut down the business sell all their ships, shareholders would get about $16 a share. If you take the collapsed ship price, you would still get $11 per share. If one could buy the entire business for $3/share, one could turn around the next day and sell the ships and clean up. While the stock was at $3, the company insiders were furiously buying shares.
When you looked at the numbers, they had plenty of cash. They could handle $6000/day rates for several months without a liquidity crunch. Also, if they sell a ship, they raise $60-70 million. The total annual interest payments are $150 million. If the income went to $0, they could sell a few ships a year and keep the company going.
In addition there is a feedback loop in the tanker market. There are two kinds of tankers. There double hull and single hull tankers. After the Exxon Valdez spill, all sorts of maritime regulations were instituted requiring all new tankers to be double hull after 2006 because they are less likely to spill oil. The entire Frontline fleet is double hull tankers.
But there’s a huge number of these single hull rust buckets built in the 1970s. If the double hull tanker spot rate is at $30,000 a day, the single hull tanker is at $20,000 a day. Oil that gets shipped from the Middle East to China or India, for example, is on single hull tankers. But Shell or Mobil, etc., will avoid leasing a single hull tanker because it is an enormous liability if they have a spill. The third world is nonchalant about importing oil on single hull tankers, and all the double hull tankers come to Europe and the West. But when rates go to $6,000 a day, the delta between single and double hull disappears.
The single hull tankers stop being rented because there’s no significant delta in the daily rate. Everyone shifts to double hull tankers at that point. The single hull tanker fleet goes to zero revenue in a $6,000 a day rate environment. When it goes to zero revenue, all these guys who own the single hull tankers get jittery; they can sell these tankers to the ship breakers and get a few million dollars instantly. They know that by 2006 their ability to rent them will decline substantially. There is a dramatic increase in scrapping rate for single hulled tankers whenever rates go down.
It takes four years to build a new tanker, so when demand comes back up again, inventory is very tight. There is a definitive cycle. When rates go as low as $6,000 and stays there for a few weeks the rise to astronomically high levels – say $60,000/day is very fast. With Frontline, for about seven or eight weeks, the rates stayed at under $10,000 a day and then spiked to $80,000 a day in Q402.
I started buying around here ($5.90). Again, not smart enough to buy at the very bottom. I bought on average price at a price of $5.90 per share, which is about half of the $11/$12 per share you would get in a liquidation. Now Frontline’s price is about $20 a share because tanker rates are at $60,000 a day – people are in a euphoric/greedy state. But once we got past $9, approaching $10, I started to unload of the shares. The whole thing happened in a very short time period – resulting in a very high annualized rate of return.
We had a 55% return on the Frontline investment and an annualized rate of return of 273%. Frontline is a good example of why I am hesitant to share ideas because we will see this again. Oil tanker rates will go down and at the last meeting a bunch of investors told me, “We are watching now.” The more people that are tuned in, once it gets to $8 or $9, the more the buying – reducing our gains. But that is an example of a Special Situation investment in a company with negative cash flow.