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Problems faced by the shipping industry in raisingcapital in the securities marketsPeter Stokes aa Maritime Consultants Ltd, Rosedale House, Rosedale Road, Richmond, Surrey, TW9 2SZ,UKPublished online: 29 Jul 2006.

To cite this article: Peter Stokes (1996) Problems faced by the shipping industry in raising capital in the securities markets,Maritime Policy & Management: The flagship journal of international shipping and port research, 23:4, 397-405, DOI:10.1080/03088839600000097

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MARIT. POL. MGMT., 1996, VOL. 23, NO. 4, 397-405

Problems faced by the shipping industry in raising capital in the securities markets

PETER STOKES

Maritime Consultants Ltd, Rosedale House, Rosedale Road, Richmond, Surrey TW9 2SZ, UK

This papers examines the reasons for the shipping industry's general failure to exploit the enormous capital raising potential offered by the world's major secur- ity markets. The basic reason put forward is one of joint ignorance and a lack of communication. On the one hand shipping perceives the market as being unsym- pathetic to its requirements. On the other, the Stock market assess it as a minor activity and this is combined with a presumption of industrial instability. An analysis of recent initial public offering of equity options in shipping highlights the inadequacy of companies who have ventured that way. In particular it is pointed out that shipping companies who embark on such a course must not forget that equity is, at one and the same time, the cheapest and the most expen- sive money which they can raise. There is a further underlying problem for the industry, which is that market capital raising necessitates the loss of personal control.

1. Shipping securities and the stock market The shipping industry is frequently heard to complain about the ignorance of the stock market concerning shipping. Somewhat less frequently, the stock market is forced to think about shipping and usually tends to conclude that it is an industry far too risky, unpredictable and unreliable to warrant any further consideration. In theory, all securities markets should be available to shipping companies, just as they are to every other major industry. In practice, however, a European or North American shipping company seeking to raise capital through an issue of equity or debt securities quickly discovers that the options available are pretty limited. More often than not during the past decade or so, the equity IPO ('initial public offering') option has in fact been unavailable altogether for the majority of shipping compa- nies. This paper examines the background to this unfortunate lack of communica- tion and sympathy between the securities markets and the shipping industry, the implications of it, and the potential for an improvement in the situation during the remainder of this decade.

Before commencing this examination, it is probably worth describing what the universe of quoted shipping securities looks like at present. There are over 150 quoted shipping or shipping-related companies worldwide (which admittedly includes shipbuilders, shiprepairers, shipping service companies and offshore supply boat and rig companies as well as shipping companies). Numerically, therefore, there are many more quoted shipping companies already in existence than most people imagine, but it is important to recognize that the vast majority of them are small- capitalization companies of little or no interest to the world's leading investment institutions. Even the larger quoted shipping companies do not in most cases offer the size or liquidity which the big institutions need. Bergesen, for example, is

03084839196 $12.00 0 1996 Taylor & Francis Ltd.

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regarded as a major company in the bulk shipping industry, but its stock market capitalisation of around US$ 1.2 billion is almost inconsequential in relation to the top tier of large-capitalization stocks in the U.S. and Europe. (It will, however, become significantly larger upon completion of its proposed merger with Havtor, which has a market capitalization of around US$ 600 million.)

Therein lies one of the industry's chief problems in relation to the securities markets. An industry cannot attract the attention of the broad range of institutional investors unless it first attracts the attention of a large number of analysts working for the leading stockbroking firms. Analytical coverage of a sector will follow turn- over, which in turn is linked to market capitalization. In most stock markets around the world, shipping represents an infinitesimal part of total market capitalization and turnover, and therefore the sector is neglected by most institutions. The obvious exception is Oslo, where shipping is one of the major sectors of the stock market, but the Oslo stock exchange is a minnow among the world's securities markets. At 31 December 1994, the capitalization of the Oslo stock exchange amounted to NOK 254.8 billion, or approximately US$37.5 billion, of which 13.5% was represented by the shipping sector. By comparison, the market capitalization of the New York stock exchange is between US$4 and 5 trillion, of which marine transportation represents no more than a rounding error.

2. Public equity offerings The first problem facing a shipping company wishing to make a public equity offer- ing therefore consists in simply getting the attention of a sufficient number of insti- tutions. The core institutions on both sides of the Atlantic which are immediately approached whenever a shipping IPO is launched probably represents no more than a couple of dozen names. The bunching of shipping IPOs, which typically occurs whenever a resurgence of investor interest in the sector is detected, quickly results in the same institutions being bombarded with a succession of similar deals. It does not take long for their appetite to become jaded, therefore, even before their patience has been exhausted by the performance of the newly issued shares in the aftermarket.

This prompts consideration of what is probably the greatest problem faced by shipping companies seeking to raise equity in the public markets: the pricing of new issues. In the early 1980s, when there was still a fairly actively traded shipping sector on the London stock market, it was taken for granted that the valuation of quoted shipping companies (at least bulk shipping companies) was essentially a matter of working out market-adjusted net asset values. A stock was attractively priced if the stock market capitalization represented a large enough discount, say 20% or 30%, to the adjusted NAV (Net Asset Value). Essentially, not much has changed since then, except that the shipping sector of the London stock exchange has virtually disap- peared and that shipping analysts and investors now direct their attention to the Oslo and Stockholm markets. By the same token, a shipping company looking to issue new shares takes the view that its proper objective should be to price the shares as near to adjusted NAV as possible. Some have even sought to sell their shares at a premium to adjusted NAV, but they have usually been forced to admit defeat.

The problem with all this resides in the relationship between secondhand ship prices (or, to be more exact, shipbrokers' estimates of fleet market values), and the operating earnings and operating cash flow generated by the companies concerned. The ship sale and purchase market is in theory a mechanism for arriving at the net present value of the future anticipated earnings of vessels. In practice, it is a bazaar,

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where the combination of excess liquidity and over-optimism sends ship prices to unsustainable highs and where the opposite combination of a liquidity squeeze and abject pessimism causes prices to plunge to unreasonable lows. It is certainly not a reliable basis on which to assess the investment value of a shipping company, except in the circumstances of a liquidation or a takeover bid.

Investors who subscribe for shares in shipping IPOs generally discover the truth of this pretty quickly. As mentioned previously, shipping IPOs tend to come in flurries at times when shipping companies and their financial advisers discover that new issues can, for a time at least, be sold at around adjusted NAV per share. It goes without saying that these are always times when the optimists are in the ascendant. The reality is that shipping IPOs priced at adjusted NAV can only be expected to hold their price in the aftermarket if there is an immediate subsequent upsurge in freight rates and ship prices. Sad to relate, this hardly ever happens, and the consequence is that most shipping IPOs put on a dismal display in the after- market.

Examples of this behaviour pattern are readily to be found if one looks back at the sequence of new shipping issues in the Oslo market in the second half of 1993. These issues really marked the emergence of Oslo as the listing venue of preference for new shipping share offerings in the European market. While it is true that the majority of companies in question were of Norwegian origin, even if domiciled for tax purposes outside Norway, the IPOs were often led by London merchant banks which nevertheless opted for listings in Oslo rather than London. It is all the more unfortunate, therefore, that the subsequent performance of most of the newly listed stocks has been so poor.

The most strikingly negative case has been that of Smedvig Tankships, which came to the market in July 1993 at a price of US$ 10.00 per share but subsequently traded below US$ 8.00 pretty consistently. Smedvig incurred a net loss of US$ 8.3 million on operating income of US$ 11.8 million for the final seven months of 1993 and a net loss of US$ 18.8 million on operating income of US$31.6 million for 1994. Even operating cash flow was negative in 1993 and only barely positive for 1994. First Olsen Tankers was also brought to the market at US$ 10.00 a share a little later in 1993 and has recently been trading at around US$ 7.00. In 1994, First Olsen incurred a net loss of US$ 6.1 million on net freight income of US$ 36.3 million, but generated operating cash flow of US$ 8.3 million. Bona Shipholding which completed its IPO right at the end of 1993 at a price of US$ 9.00 per share, has managed to defend the issue price with reasonable success over the past year, with the shares being quoted recently at around US$ 10.20. Bona made a marginal net profit of US$ 0.9 million on timecharter equivalent income of US$ 73.7 million in 1994, and operating cash flow was comfortably positive at US$ 22.2 million.

Bona's superior performance in the aftermarket may be attributed to a number of factors, but not the least important is the fact that the company was forced to reduce its IPO price from US$ 10.00 to US$9.00 just before the launch. Bona was third in line after Smedvig Tankships and First Olsen in coming to the market in 1993, and by the time of the Bona road shows the institutions were getting jaded and rather worried about the collapsing share prices of the other two companies. The Bona board was effectively presented with a take-it-or-leave-it situation after a major U.S. hedge fund agreed to take a substantial chunk of the issue, but only at US$ 9.00 rather than US$ 10.00. The board reluctantly decided to take it, but subsequent events have shown that US$9.00 was the right price.

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Table 1. Rate of return comparison for Smedvig Tankships, First Olsen Tankers and Bona Shipholding (%).

Return on capital Smedvig Tankships First Olsen Tankers Bona Shipholding Return on equity Smedvig Tankships First Olsen Tankers Bona Shipholding Cash flow: total capital Smedvig Tankships First Olsen Tankers Bona Shipholding

Source: The companies published accounts as analysed by Castalia Advisers Ltd. t Smedvig Tankships' returns for 1993 are based on only seven months' trading $ First Olsen Tankers produced no meaningful figures for 1993.

The exceptionally poor performance of Smedvig Tankships since its IPO did not go unpunished, and the case should serve as a cautionary tale to shipping executives and promoters who think that, once they have the investors7 money in their pockets, their problems are over. Bona, helped by its highly liquid balance sheet and a super- ior market reputation, was able in 1995 to acquire control of Smedvig Tankships through a stock market raid in which roughly two-thirds of Smedvig's shares were tendered by its shareholders in one day at a price 20% below the original IPO price.

If shipping company IPOs are to break out of this cycle of bunching followed by extended periods of investor disillusionment, it will be necessary to move towards a more realistic approach to pricing. This is turn pre-supposes that the shipping industry starts to put up more serious candidates for stock market attention, com- panies with a track record which can be assessed on the basis of achieved returns on capital, operating cash flow quality and debt coverage ratios as well as adjusted NAV in order to build up an overall valuation. It is worth stressing just how poor the record of even the leading companies in this industry has been in terms of return on capital. In the five years from 1990 to 1994, for example, the highest annual return on capital achieved by American President Companies was only 9.1%. During the same period, Bergesen achieved double-figure returns on capital in only two years, and in 1992, 1993 and 1994 it recorded figures of 1.8%, 3% and 2.2% respectively. The highest annual return on capital reported by Overseas Shipholding Group in this period was a mere 6.7%. These returns should be seen against a probable cost of capital for first- and second-tier shipping companies of between 10% and 13 %, based on a notional cost of equity of between 15% and 20%. In other words, most shipping companies in most years have not been covering their cost of capital, which implies that their equity has failed to grow at a rate sufficient to satisfy financial investors and has in some cases remained static or declined.

Shipping companies embarking on IPOs tend to forget that equity is at the same time the cheapest and the most expensive money which they can raise. It is the cheapest, because most shipping companies pay no dividend, or only a modest

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one, and most investors accept that the capital intensive nature of the shipping industry requires the reinvestment of the bulk of attributable earnings on fleet repla- cement and expansion. In cash flow terms, therefore, the cost of equity is negligible. In terms of the return which providers of capital require, however, equity is, of course, by far the most expensive form of funding available to shipping companies. At present, most shipping companies of any substance can borrow from banks at 1 % over LIBOR or less. Subordinated debt might cost 10-12% per annum. But the return which equity investors will typically be seeking from shipping shares, which they perceive to be among the most volatile and unpredictable of securities, is in the range of 15-20% per annum.

3. Improved marketing awareness The aborted IPO in New York in 1994 of Viking Star Shipping Inc. (subsequently renamed Teekay Shipping Corporation) indicated that the shipping industry and its financial advisers were at last groping towards a more mature approach to raising capital in a major securities market. At the same time, it still displayed many of the features which weaken the credibility of shipping company IPOs, although these were probably not the main reason for the withdrawal of the offering. On the plus side, Viking Star was a substantial company which would have had a market capi- talization after the offering of around US$ 900 million. It had a track record based on high fleet productivity, a significant share of its chosen market and an unusually high quality of operating cash flow for a crude tanker company. On the negative side, investors were reportedly dissatisfied with the arrangement whereby the fleet was managed by a private affiliate, and had reservations about certain aspects of the proposed executive remuneration package, specifically the size of the options pack- age proposed as well as the exercise price and period. The fact remains that this was a deal which it was possible to evaluate through intelligent analysis rather than the sort of wishful thinking which is required in order to look favourably on most shipping IPOs.

It was all the more disappointing, therefore, that the IPO fell apart amid a chorus of 'I told you so' from Oslo and London. A valiant attempt was made by the managers of the issue to wean the shipping industry and the investment community away from NAV considerations and towards operating cash flow as the primary basis for valuing this company. In so doing, however, they failed to come clean about the fact that the shares were being offered at a premium to adjusted NAV, and this allowed the backwoodsmen from Oslo and London to cry 'foul' and under- mine the credibility of the whole exercise. It should be pointed out that even the maximum target IPO price of US$ 19.00 per share represented a multiple of only 5.4 times Viking Star's average annual operating cash flow per share for 1991-94, despite the fact that this price represented a significant premium over adjusted NAV per share. The Oslo issues in 1993 were all priced at much higher multiples of operating cash flow, but looked cheaper in relation to adjusted NAV. One of the lessons to be drawn from these anomalies is that there is a much greater divergence between individual tanker and dry bulk companies in terms of cash flow returns on capital than even shipping companies themselves generally realize. In the circurn- stances, it is hardly surprising that the investment community shows little ability to differentiate intelligently between different tanker or dry bulk stocks.

It was a positive development, therefore, when Viking StarITeekay made a second attempt at an IPO in 1995, scaling down the size of the offering and reducing the

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Table 2. Teekay Shipping Corporation: Rates of return (%).

1992t 19937 1994$ 19956

Return on capital 10.9 0 5.9 5.4 Return on equity 19.3 12.7 7 1.5 Cash flow: total capital 17.7 10.8 11.5 11.6

Source: The company's published accounts as analysed by Castalia Advisers Ltd t Year ending 30 April. $ Eleven months; year ending 31 March. $ Year ending 31 March.

price, as well as merging the vessel ownership and management operations into one entity, named Teekay Shipping Corporation.

Teekay came to the market with a track record of superior cash flow returns on capital for a tanker company, as table 2 shows very clearly. The slump in return on capital in 1993 was a result of foreign exchange losses, largely unrealized, on yen newbuilding commitments, and the yen exposure was subsequently covered. Teekay had come close to serious problems in the early 1990s because of its high gearing and uncovered yen exposure, but the commercial strength of the company was never in question. Unlike most tanker companies, it was able to argue that it had significant market share in its particular sector and that its assets consistently produced a better cash flow return than those of most of its competitors. Indeed, if we take the company's average annual operating cash flow for the five financial years preceding the IPO and adjust for the additional shares issued and the use of proceeds to reduce debt service, the IPO price of US$21.50 per share represented a cash flow multiple of only around 4.5 times. Probably no other tanker IPO has offered such strong cash flow support for the price.

The result has been a consistently robust share price performance in the after- market, with the shares trading at US$ 23.00 or better. It is worth noting that analysts obsessed with NAV estimates continue to regard Teekay as over-priced, totally failing to differentiate between Teekay's assets, which consistently produce a satisfactory cash flow return, and those of many other tanker companies, which do not.

4. Choice of stock market If we assume that there are other shipping groups of substance from various sectors of the industry which would like to go public when favourable conditions return, the question arises as to which stock market they should choose. This was a matter of intense debate within the board of Bona Shipholding prior to the launch of that company's IPO in 1993, and the situation has not really changed since then. Bona had the choice of attempting a New York IPO, which had some relevance given the trading pattern of its fleet, or a European offering with a primary listing in either London or Oslo. Eventually the Board plumped for a European marketing cam- paign and an Oslo listing.

New York has far and away the greatest potential as a stock market for shipping IPOs, if only because of the size of the market and the diversity of the investment community. The larger investors in the United States are prepared to make single investments in relatively esoteric IPOs on a much larger scale than anything seen in

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Europe. They also have more open minds, which more than makes up for the fact that most of them know very little if anything about shipping.

In Europe, London ought logically to be the principal stock market for shipping issues, but the shipping sector on the London stock exchange died out in the 1980s with the exception of P&O, and there are no signs as yet of a resurrection. The London institutions which have an interest in shipping, including the London offices of the big American funds, regard Oslo, and to a lesser extent Stockholm, as the shipping sector of the London market. Of the other European stock markets, Amsterdam and Copenhagen have shipping sectors worthy of the name, but it is hard to imagine any non-indigenous shipping company trying to raise capital in either of those markets. Athens has seen a few IPOs by domestic ferry companies, but it is a tiny and somewhat inefficient market, and it will be many years before major international shipping companies look to it as a capital-raising centre.

Oslo, therefore, appears to have become the primary stock market for European shipping, almost by default. Whatever admiration one may have for the Norwegian shipping industry and for the way in which the shipping sector of the Oslo stock exchange has broadened and developed in recent years, this is not a situation with which the shipping industry at large can be entirely satisfied. Why? Because Oslo is and will remain a small stock market subject to persistent illiquidity and because any industry for which a stock market such as Oslo can be the principal market is probably condemned to marginal status as far as the major investment institutions are concerned. This is why the focus of attention for the more substantial shipping companies seeking to go public should be New York rather than Europe.

The United States offers not just more potential for equity raising than Europe, but also much greater scope for making corporate debt issues. As is well known, the vast majority of the shipping industry comes into the sub-investment grade category as defined by the major credit rating agencies. For sub-investment grade companies, whether publicly quoted or privately controlled, the task of raising capital through placing notes or bonds in the European market is extremely difficult, since European bond investors are primarily interested in investment grade issues. In the United States, on the other hand, the institutional appetite for high-yield paper is enormous, and U.S. investment banks such as Citicorp Securities, Morgan Stanley and Goldman Sachs were able to identify a substantial level of demand for shipping issues during the course of 1993. Beginning with the placement of US$ 175 million of 9.625% first mortgage notes for Viking Star Shipping (now Teekay), we then saw in quick succession OM1 Corp.'s US$ 170 million senior note issue at 10.25%, Eletson Holdings' US$ 140 million issue of 9.25% first mortgage notes, and Overseas Shipholding Group's US$ 100 million 8% note issue (the only investment grade issue among them). More recently, Gearbulk Holding was able to place US$ 175 million of senior notes in this market at a yield of 11.25%.

All of these placements involved ten-year paper, and in 1993, with U.S. short-term interest rates still at their trough and the traditional bank financing market a lot less competitive than it has since become, the opportunity to obtain fixed rate long-term financing on bullet or only partially amortising repayment terms was very attractive to a number of shipping companies. Even now, it can be argued that the terms available are not penally expensive, although sub-investment grade borrowers must assume that they are going to be able to generate returns on capital signifi- cantly higher than the average for the shipping industry over the past decade if they are to cover their cost of capital comfortably. Gearbulk, as an example, had to

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accept an 11.25% coupon at the end of 1994 based on a rating of BB, whereas a year and a half earlier International Shipholding Corporation, rated BB-, was able to issue ten-year senior notes at 9.0%. U.S. interest rates were falling throughout most of 1993, with the ten-year Treasury Bond rate declining to a low of around 5.5%, but the bond market collapse of 1994 sharply reversed this trend, and the ten-year Treasury Bond rate peaked towards the end of that year at around 8%.

At present, it must be admitted that the attractions of issuing high-yield paper are considerably less obvious than they were in 1993, given that corporate shipping groups are able to raise loans very cheaply in the banking market. Bona Shipholding's US$ 200 million revolving credit facility in 1994 was arranged at only 75 basis points over LIBOR, while Bergesen's US$ 500 million bank financing was negotiated at a mere 30 basis points over LIBOR. In other words, these com- panies are currently paying around 6 .044% for their money, compared with the 11.25% being paid by Gearbulk. It is fair to say, however, that, if Gearbulk were launching its note issue today, when Treasury Bond rates are once again at histori- cally low levels, it would probably be priced at around 10%.

5. Debt financing options Current interest cost is not the only factor to be considered in assessing debt finan- cing options, however. Flexibility, predictability of future interest costs, the relative restrictiveness of covenants and the amortization schedule are all important consid- erations which might weigh in favour of issuing debt in the U.S. high-yield market. Another benefit of doing so is the fact that it provides access to the U.S. institutional market, which can act as a way of familiarizing investors with the issuer company prior to an eventual public equity offering. This has already proved to be the case with Teekay, and both Eletson and Gearbulk are privately controlled corporations which, having been able to tap into the U.S. high-yield market, may in due course wish to launch an IPO in New York.

Moreover, the U.S. debt securities market is able to accommodate not just cor- porate issues, but also asset-backed issues. There has been very little in the way of genuine securitization of shipping assets and cash flows to date, but 1994 saw one such transaction when the First International Group and its lead managers, Donaldson Lufkin and Jenrette, were able to place a multi-tranche issue of US$ 235 million of first preferred mortgage notes in the U.S. market on behalf of First International Petroleum Transport Corporation, backed by the income stream from bareboat charters to Shell International Petroleum for six new products tankers. This was a remarkable deal in many ways, and eyebrows were raised at the invest- ment grade rating accorded to the longer dated portion of the notes, the repayment of which is exposed to the risk of Shell exercising its option to cancel the charters after seven years. Nevertheless, it was an important example of how a high-quality shipping income stream and the residual value of the vessels concerned could be combined to support a substantial issue of debt securities.

In 1995 a different type of oil company-backed securitization was completed when Nordic American Tanker Shipping, a special purpose Bermuda subsidiary of the Norwegian publicly quoted shipping company Nordic American Shipping, raised an initial US$58.7 million gross through a public offering of warrants lead managed by Lazard Freres. The warrants are effectively partly-paid shares, and they fall due to be exercised in September 1997, requiring the payment by investors of a further US$ 120 million. The purpose of NATS was to assume legal ownership of three Suezmax

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tanker newbuildings to be bareboat chartered to BP Shipping Ltd. for seven years, with options in the charterer's favour for a further seven one-year extensions. BP Shipping assumes responsibility for newbuilding supervision costs, the risk of late delivery, and OPA (Oil Pollution Act 1990) liability risks. The warrant subscription proceeds are being used to pay the newbuilding down payments, while the proceeds of exercise (for which the standby guarantor is Rabobank) will be used to meet the delivery payments. BP Shipping has undertaken to pay a minimum bareboat rate for seven years of US$ 13,50O/day per vessel (equivalent to a timecharter rate of US$ 22,00O/day), and NATS will receive additional charterhire equivalent to any surplus of prevailing spot charter rates over the minimum.

6. Future shipping securitization How many more deals of this type may be viable is open to question, and it may be that the future of securitization for the shipping industry will lie in a different direction. After all, the First International debt deal and the NATS equity deal are really no more than pass-throughs of Shell's and BP's credit ratings via the mechanism of the bareboat charters. Securitization, as it is more normally under- stood, involves the packaging of assets and receivables, each of which individually may be of sub-investment grade quality, in such a way that the totality is able to support multi-tranche issues of securities including a substantial top slice of invest- ment grade paper. In shipping terms, this would translate, for example, into a diverse portfolio of modem vessels fixed on medium- to long-term bareboat charter to operators with a first-class technical record but probably a less than first-class credit rating. The rating of the various tranches of debt supported by such a portfolio would then depend on the level and quality of the combined income stream, the diversification of risk through the variety of ship types and lessees and an assessment of probable minimum residual values upon expiry of the bareboat charters. It may be hard to believe that a ship portfolio of this type could be used to support a competi- tively priced multi-tranche issue of securities, but essentially this is no different to the formula which has already been successfully applied to the aircraft lease sector in the ALPS (Aircraft Lease Portfolio Securitization) deals. There is no fundamental rea- son why it cannot be replicated in shipping.

The shipping industry has barely begun to exploit the capital-raising potential offered by the major world securities markets. This applies not just to issues of corporate equity and bonds and asset-backed securities, but also to the whole area of derivative securities designed to hedge freight market and other exposures. The potential is enormous, but it will remain no more than potential unless the shipping industry accelerates the process of corporate restructuring which we have seen slowly developing since the mid-1980s. This process is not an unmixed blessing and it spells ultimate extinction or marginalization for many of the smaller tramp operators who have made a good living out of shipping in the past. But success, defined as profit- able growth, in the shipping industry will increasingly come to depend on the ability of companies to access capital from a wide range of sources, including the major securities markets. With the majority of the industry still struggling to make mental adjustment to loss of personal control, it is clear that we still have a long way to go.

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