Ship Finance: Calm waters or rough seas?

by John Buckingham, editor The Prudent Speculator

The shares of marine shipping concern Ship Finance (SFL) have been brutalized after concerns arose about its exposure to former parent Frontline (FRO).

While investors are in no mood these days for any questions about credit, we believe that Ship Finance will successfully navigate the current situation and prove to be a solid long-term investment.

Recall that Ship Finance was spun out of Frontline, with the company now a major ship-owner with a fleet of 69 vessels.

It fleet includes 25 crude oil and two chemical tankers, five oil/bulk/ore and 15 container vessels, 11 drybulk carriers, six offshore supply vessels, one jack-up drilling rig, one ultra-deepwater drillship and two ultra-deepwater semi-submersible drilling rigs.

Most of the vessels are employed on long-term charters, with Frontline on the other side of the charter for 28 of its vessels.

Alas, Frontline recently announced that if the current market environment doesn't improve, it would likely need additional funds at the first of the year in order to meet its cash obligations.

That news led Moody's to further cut its debt rating (because of concerns over its exposure to Frontline via its profit-sharing charter deals) on Ship Finance.

While we don't doubt that Frontline's expected restructuring will negatively impact SFL's near-term cash flow, as this would likely involve a reduction in charter contract rates, and could ultimately lead to a trimming of the whopping $0.39 per share quarterly dividend, we don't believe that it will be devastating.

We also can’t ignore the fact that billionaire investor John Fredriksen (#72 on the Forbes richest list) has a vested interest in protecting his investments in both Frontline and Ship Finance.

Happily, for SFL shareowners, his 34 million share Ship Finance stake is worth more than four times his Frontline (26 million shares) holdings.

It is important to note that the Frontline relationship accounts for roughly 25% to 30% of SFL's fixed charter payments, while no new business has been transacted with Frontline for more than six years and there is $2 million in cash pledged to Ship Finance by Frontline on each of the vessels.

Also, a restructuring of the contracts does not mean a cancellation of the charters (and even in that scenario, the ships could be re-chartered).

In addition, SFL management would most likely demand a time extension and an increased profitability split in re-negotiating decreased rates, thus some of the potential negative impact to SFL's financial health would be muted.

Finally, it is worth mentioning that while last quarter's results came in light relative to investor expectations, the company still earned $0.35 per share (excluding one time charges, the results would have been $0.40) and paid a dividend (which was announced after the Frontline news broke) that when annualized has the shares currently yielding 16.3%.

Furthermore, analyst expectations are for SFL to earn more than $1.50 per share over the next 12 months.

Certainly, weakness in the global economy could further pressure shipping rates, but putting my money where my long-term optimistic mouth is, we're adding to our position in  SFL in our portfolio.

Learn more about this financial newsletter at John Buckingham's The Prudent Speculator.