Investment Thesis
In July last year, we upgraded Frontline plc (NYSE:FRO) from a Hold stance to that of a Buy stance. At that time, the share price was only $15 and our upgrade was based on our shared optimism with the company's management about the prospects for higher FCF and dividend payments.
In general, our preference is for shipping companies with very little exposure to the spot market. As such, our largest position in this space is in SFL Corporation (SFL).
However, the favorable supply and demand dynamics for VLCCs have spurred interest from us over the last year. More spot exposure does take on more risk, but we do believe it is a good risk/reward match.
During the last year, FRO's share price has increased by nearly 83%.
It has certainly been a good place to be invested over the last year, but is it still going to be a place to be invested in the future?
Frontline’s Q4 of 2023 Financial Results
Profit & Loss
The second half of 2023 was not as good as the first half. FRO earned $430 million in FH 2023, but only $226 million in SH 2023.
The freight market went down 40% in the autumn of last year, as can be seen from the following graph;
Despite the lower freight rate in SH 2023 and what we have seen so far in Q1, it has not discouraged optimism about the future for FRO. After all, investors are buying the future - and not the past.
However, it is concerning that the gap between the share price and the freight market is getting wider.
The higher cost of borrowing money hit FRO last year. The finance cost for FY 2023 was x 3 of 2022. They spent $171 million on finance costs in 2023, compared to just $45 million a year earlier. It was somewhat cushioned by a jump in finance income from $1.5 million to $18 million last year.
Balance Sheet
FRO, which is controlled by John Fredriksen, has grown to become the world's largest player in large crude oil tankers by mergers & acquisitions.
After a merger with Euronav NV (EURN) fell apart, FRO still managed to acquire as many as 24 of their modern VLCC vessels.
The aggregate purchase sum was $2,350 million. This was, in our opinion, a brilliant deal. It is no secret that the order book for new vessels has been and continues to be limited to only a few new vessels.
Even if there would be a surge of new building orders, these vessels would only arrive 3 years later on. FRO got immediate delivery of an additional 24 vessels for $98 million per vessel. Standard new buildings from Korea for delivery in 2027 are today priced at about $130 million, excluding scrubbers. By the time you add in this and some other options, plus the cost of supervision during the building period plus the interest owners have to pay on their staggered payments before delivery, the total cost will be nearly $140 million.
A good deal indeed. But back to the balance sheet.
We know that FRO, or any other company controlled by JF is not afraid to borrow money. Therefore, we want to monitor their debt level.
As of the 31st of December 2023, their gearing ratio was 62%
We have assumed that the $308 million in cash in Q4 last year included the proceeds from the sale of the $13.7 million Euronav shares that they sold. The net proceeds from the sale of the 5 VLCCs of $207 million, plus additional cash of $68 million, were used to pay off the short-term loan of $275 million from Hemen Holding, which is Mr. Fredriksen's private company.
We expect only a minor change to the gearing ratio in Q1 of 2024. Our estimate is that the gearing ratio will increase to 65%.
Our assumption is that the value of the fleet goes up by $2,071 million. That is the $2,350 million purchase price for the 24 vessels, minus an estimated book value of 279 million for the 5 older VLCCs they disposed of.
Other changes to the balance sheet in Q1 of 2024 will surely come. However, the purpose of our estimate is only to see what happened to the gearing ratio after the large acquisition was executed and the vessel's ownership changed hands.
Their gearing ratio is higher than some other similar shipping companies, like DHT Holdings which has a gearing ratio of only 17.8%
But when we look at the gearing ratio, we also have to consider the age profile of their fleet. FRO, with this large new acquisition, is getting a very modern fleet with an average age of only 5.4 years.
Dividend
FRO has been generous with dividends, whenever there is free cash flow to distribute. We believe they will continue to do so.
However, shareholders and prospective investors should realize that these often-large distributions are all dependent upon quarterly earnings, which are largely determined by the spot freight market. Rates that owners can achieve can change dramatically, both ways, in a matter of a few trading days.
In our previous article back in July last year, we estimated that FRO might be paying out a dividend for Q2 of $0.80. This was based on our calculation of cargoes or charters they had booked, plus using estimates of the spot market for the balance of their fleet.
We were lucky, again, as the dividend declared was $0.80 per ordinary share.
Now we will use the same methodology to estimate the earnings and the dividend for Q1 of 2024.
FRO is expected to come out with their Q1 results on the 30th of May.
The methodology used is imperfect. There is an element of luck involved as to when a vessel becomes open and what the spot market is for that position. When doing an estimate, we need to use an average. To complicate matters further, we know that some vessels with modern economical specification can achieve a premium to the average spot rates stated.
Nevertheless, with the doubling in FRO's VLCC fleet size, we estimate that the net EPS for Q1 might come in at about $0.89, which is 68% higher than the $0.53 they delivered in EPS in Q3 of 2023.
Assuming they will stick to their dividend policy of distributing close to earnings per share adjusted for non-recurring items, we could see a dividend of about $0.70 per share.
Risks to Thesis and Conclusion
We will again remind our readers that the supply and demand dynamics for VLCCs are very favorable.
In the first month of 2023, we noticed as many as 14 VLCC new buildings being ordered. That got our attention. The enthusiasm has since abated. During the balance of Q1, another 6 VLCCs were ordered. We have not registered any new orders in Q2.
In terms of demand for crude oil going forward, according to the IEA, the total demand for crude oil in 2023 was 101.7 million barrels/day. Their latest forecast in May this year is for the demand to grow by 1.1 million barrels/day this year, and to remain relatively unchanged in 2025.
Trying to look further out than two years becomes very difficult
However, from 2030 there is a risk that demand for crude oil will be lower.
Recent news from PetroChina indicates that their expectation is for crude oil importation to China to peak by 2030. One reason for this is that the adaptation of EVs is gaining momentum. By that time, as much as 50% of new car sales in China will be electric vehicles.
It is news such as this that perhaps is causing shipowners to take a "wait and see" attitude about investing hundreds of millions of dollars in new crude oil tankers. Such investments need 20 years to amortize. Nobody knows what the demand will be then.
For the next couple of years, we still believe that the freight market will become quite tight, which should result in even higher earnings for tanker owners like FRO.
Therefore, our Buy stance remains for now.
Tudor Invest Holdings
Tudor Investment Holdings Private Limited is a Singapore based investment company. Its investments are in commercial real estate and managing a global portfolio of investments in equities and bonds.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of DHT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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