Scorpio Tankers: bet on product tankers cycle

Robust financials, excellent fleet, and macro tailwinds at an attractive price

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In four separate articles, I present reports on energy, mining, shipping, and banking companies. My goal is to introduce my analytical framework for each industry. The analyses were published on Seeking Alfa and Investo.bg (my Bulgarian website) and my LinkedIn profile. In one additional article, I will show a portfolio example.

It is time to introduce Scorpio Tankers, STNG, one of the major product tanker operators. The article was published on Investo.bg (behind a paywall) in January 2024.

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Mines, ships, and banks - my three favorite sectors. They combine the material essence of our economy, extraction, processing, and transporting. Plus, financing makes all those ventures possible.

The existence of each of these industries depends on the existence of the other two. I have written about banks and mines many times. Today, the turn of the second variable in the equation makes the global economy alive, particularly product tankers.

Tankers perhaps have the most interesting history of all the merchant ships. They are associated with the wealth of more than one Greek shipping magnate. The most famous, of course, is Aristotle Onassis. He made his initial capital in Argentina in the tobacco business, but the big money came when he entered the oil shipping business.

Today's report looks at one of the main subtypes of tankers - product carriers. These carry petroleum products from the refinery to end users, while crude oil tankers carry cargo from oil wells to refineries.

The product tanker market is cyclical. As investors in shipping companies, we need to determine with high confidence which stage of the cycle we are in to extract alpha. The following two lists describe the bottom and top characteristics of the shipping cycles.

Market bottom:

·       Day rates around operating costs

·       Secondhand prices close to scrapping prices

·       Almost nonexistent order book

·       Many ships for scrap

·       Banks are reluctant to finance new ships

·       Pessimism towards business

Market Peak:

·       Day rates x3 of operating costs

·       Prices of 5-year-old ships close to those for newbuilds

·       Excessive order book

·       Few ships for scrap

·       Banks generously provide financing

·       Positive sentiment toward the industry

Those characteristics apply to tankers and all ship types. In particular, product tankers depend on refineries' active capacity. The higher the number of refineries built and the fewer old ones shut down, the more oil products are in demand. More and more tankers will be needed to transport them from the refinery to the end customer.

Product tankers market

We live in a multipolar world. The US is not so weak as to hand over the throne of dominant power, nor is it so strong as to remove its competitors. The latter are not so strong as to take the throne, but neither are they so weak as not to challenge US dominance.

This delicate balance between the Great Powers leads to world polarization. It means that new alliances will emerge, and old ones will dissolve. In other words, economic ties in the global economy will change qualitatively and quantitatively.

How does this affect shipping? The answer is given in the chart below:

The chart shows the average duration of the oil trade, measured in tons per mile, i.e., tonne-mile demand. This lengthening is due to the geopolitical fragmentation mentioned earlier. In other words, shipping is not just a function of economics but is highly dependent on geopolitical dynamics. Geopolitics is changing existing logistics routes, thereby extending the duration of trade. This means longer charter contracts and higher fleet utilization.

Demand is driven by growing seaborne exports, increasing voyage distances, and increasing trade activity. The main driver in the long term will be increasing voyage distances. Demand for product tankers depends on current inventories and operating refinery capacity.

Global inventories are at the lower end of the five-year range. Sooner or later, they will reach their average. The lower stocks are for a longer time, the greater the tanker demand. Unused capacity at oil refineries affects the price in the short term. Over the past few months, idle capacity has declined, leading to greater demand for product tankers. I believe combining an aging fleet, record low order book, and extended voyages will lead to long-term day rate growth.

Supply is affected by a record-aging fleet, declining yard capacity, low order volumes, and stringent environmental regulations. The chart below shows that the world's tanker fleet is aging, and no new ships will be delivered soon.

By 2026, one in ten product tankers will be over 20 years old. This is the average age at which ships are scrapped. The largest group of aging ships are medium-range (MR) tankers. Handy tankers are a close second. The average age of the global tanker fleet will continue to increase for the foreseeable future, as shown in the chart below.

The order book is at a record low, creating limited supply in the long term. The following chart shows which ship classes have fewer orders than their fleet size, i.e., order book.

At the bottom are crude oil tankers with 2.8% and offshore supply vessels with 2.5%. Next were bulk carriers at 7.4% and product tankers at 8.7%. A single-digit order book portends a deficit of ships in the respective classes over the next 12-18 months.

Even if shipping companies order new tankers today, they cannot be built within a few years. And the reason is the shipyards' lack of capacity to build bigger ships. The following chart shows the reduced shipbuilding capacity worldwide:

Following the shipyard capacity peak from 2005-2008, mainly driven by China, consolidation and market reallocation followed. 30% of shipyards take 90% of global orders for new ships. The backlog to capacity is lower than the peak in 2007; however, orders significantly exceed present shipyard capacity. Currently, yards can deliver one ship for every three orders. At the same time, the principal orders are for containerships and LPG and LNG carriers. With others for tankers, the order has not yet come.

Supply is still limited: the tanker fleet is aging, orders for new ships are at record lows, and shipyards have limited capacity. On the other hand, day rates are about twice the operating costs, driven by rising demand.

Prices for five-year-old tankers are 30% below new. At the cycle's peak, five-year-old tankers often trade at higher prices than brand-new ships. The reason is timing—a new ship will be ready for service in at least 24 months, whereas an old one is ready now. In the first scenario, we would wait two years until the ship starts generating cash flow, while in the second, the ship begins earning immediately.

There is also no extreme sentiment around the industry. The Economist has not published a cover recommending investment in tankers.

In my view, we are not at the bottom of a cycle but in the first half of the cycle expansion phase. Plus, we have a catalyst: geopolitics. The limited traffic through the Red Sea mainly affects product tankers and container ships. The former bring oil products from the Middle East and Asia to Europe and Chinese cargo to Europe.

Maersk resumed passage through the Red Sea, only to find that the crisis was not over. Their ship was again attacked with a ballistic missile on 30 December. Yesterday, the company announced a diversion of all its ships on the route, excluding the Red Sea.

There are still companies that have not canceled passage through the region. Ships will pass in convoy, meaning a significantly lower passage speed, resulting in fewer ships passing daily. That's the case if the Yemeni rebel attacks stop. I don't think that will happen any time soon, and having military convoys will only change their strategy, not their objectives.

The diplomatic crisis between Ethiopia and Somalia, which has led to the signing of a partnership agreement with Somaliland, adds more fuel to the fire.

Ethiopia recognizes Somaliland's sovereignty, which has meant conflict with Somalia. Ethiopia's ultimate goal is to access Somaliland's ports. If the diplomatic crisis between Somalia and Ethiopia escalates into a military conflict, security in the region will remain in doubt for a long time.

In 2024, I think tankers will be one of the most exciting investments due to fundamental factors determining the shortage of ships. The Red Sea crisis and the Panama Canal drought are the catalysts that will accelerate the processes that have started.

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Scorpio Tankers

Scorpio Tankers (STNG) is one of the world's largest owners and operators of product tankers. The company owns 111 vessels, 87 of which are equipped with scrubbers.

The latter are becoming increasingly important to the world's merchant fleet. Their role is to reduce sulfur emissions from ship exhaust. Ships that have scrubbers installed are chartered at higher daily rates. While the initial capital investment to install them is high, it pays for itself in 18-24 months. Of its competitors, Scorpio has the highest percentage of vessels with scrubbers. Hafnia, Scorpio's direct competitor in fleet size and quality, has a significantly smaller percentage of such vessels.

The average age of Scorpio's fleet is 7.8 years, and Hafnia's fleet is 8.1 years. STNG has 14 Handy ships, 59 medium-range (MR) ships, and 39 long-range (LR1) ships. STNG's fleet has the lowest average age among its competitors:

The STNG ships of each class are much younger than the world average, as shown in the graph to the right. Given the aging world fleet, record low order book and lack of capacity, STNG leads its competitors. While they have to queue up to order new ships, STNG is under no pressure to order, let alone wait for them to be built.

MR tankers cover sailings in the Americas with major ports in Brazil, Colombia, Venezuela, and Houston in the US. With discoveries in Guyana, Brazil, and Colombia, South America has become a significant player in the oil business.

The lifting of sanctions against Venezuela will further increase demand for tankers in the region. So far, the conflict with Guyana has not escalated, and sanctions have remained lifted. I assume that if Venezuela takes more severe action, sanctions will be reimposed, which means its oil is out of the equation. However, this will not change the supply/demand balance for tankers. In South America, Brazil is the big player. Some of Scorpio's tankers are chartered by Petrobras or by Petrobras customers.

Scorpio's management possesses the three necessary characteristics to get me to pay attention to their company: the executives have an average of over ten years of history with the company, have experience in the industry, and last but not least, own shares of the company.

Robbert Bugbee has been Chairman of the Board since 2009 and owns 1.3% of the company. Emanuel Lauro has been CEO of the company since 2010 and owns 1.8% of the shares. Cameron K. Mackey has been CFO since 2013 and owns 1.35% of the company.

As I mentioned in the introduction, the shipping business is distinctly cyclical. On average, cycles are 5-7 years long. Managers have sufficient experience in Scorpio, going through one complete cycle. In other words, they've seen both scenarios – when day rates were high, their ships were money machines, and daily earnings were lower than daily OPEX.

Balance sheet report

STNG has reduced its debt over the past two years. The company reported $364.9 million in cash and $1.77 billion in total debt in the previous financial report. The table below shows the evolution of the company's balance sheet.

As of December 31, 2021, STNG's gross debt reduced from $3.164 billion to $1.830 billion in the third quarter of 2023. The top left graph shows the debt repayment schedule. In November, the company made debt payments of $281 million. The remainder is lease buy-backs ($264.7 million) and scheduled principal payments ($45 million).

Due to its quality fleet, STNG's CAPEX has remained low over the past year. 78% of the company's ships have scrubbers, and the rest are categorized as ECO.

Interest expense was $49 million in the third quarter of 2023, and EBITDA was $193 million. The company's liquidity metrics have been stable in recent quarters. The capital structure has improved significantly through regular debt repayments. Currently, total debt represents 41.9% of the company's equity.

Compared to other companies in the industry, STNG has more liabilities relative to equity. At the same time, the capital raised has been used appropriately to build the best fleet in the industry, considering its age and the presence of scrubbers. STNG's competitors have yet to invest in fleet renewal and installing scrubbers, which means more capital expenditure.

Profitability

In the most recent quarter, STNG realized a 30.2% ROE and 11.9% ROTC. The gross margin increased from 37.44% in 2021 to 75.3% in 3Q23. Rising day rates are a significant contributor to this. The following table shows vital parameters reporting.

Scorpio performs excellently on all parameters. Particularly impressive is the net income per employee of $28.7 million. They significantly exceed the industry average of $1.2 million and the five-year company average of $4.39 million. Long-term efficient employees mean higher profit margins and return on invested capital.

STNG outperforms its competitors in the product tankers segment with excellent margins, 75.8% gross profit margin, and 48.2% FCF margin. This is due to the higher day rates at which STNG's ships are chartered due to the availability of scrubbers. At the same time, higher leverage negatively impacted ROE and ROTC.

Unlike its competitors, STNG's strength is not dividends but share buybacks. For the past year, the buyback yield was 18%, while the dividend yield was 2.3%. Share buybacks have their advantages over dividend distributions. The most significant benefit is that managers and shareholders look in the same direction. Buying your own stock at a large discount shows that management has long-term priorities to generate value for all shareholders.

Underperforming and undermotivated management teams often use dividend distribution as a marketing ploy. In this way, they attract shareholders seeking short-term results through cash flow. Of course, dividends have their place in investing. They are one of many tools to generate value. As such, they work in certain situations, for certain companies, and with certain market participants.

STNG's buyback policy is a sensible solution, considering the stage of the tanker cycle. The reason is this: by buying back shares, the company reduces the total number of shares on the market. Metaphorically speaking, the 20-slice pizza becomes 15. Thus, with a constant number of shareholders, each has more value. When the company has growth potential, this value will multiply inversely proportionally to the number of shares outstanding.

A hidden bonus of a share buyback is that it is directly reflected in the company's capital value, whereas a dividend is a cash flow. As such, it is taxable. The company's increasing value is not taxable until we close our position.

The company increased its quarterly dividend from $0.25 to $0.35 per share. Since July, STNG has repurchased 1.9 million shares for $90.7 million. The total repurchase value for 2023 is $489 million, or 10.0 million shares.

Valuation

There are several methods of valuing a shipping company's business. The most appropriate is Net Asset Value. It is calculated by adding the current assets to the value of the company's tangible assets, i.e., its fleet replacement cost, and subtracting its liabilities.

There are several methods for determining the value of a fleet:

·       Scrap value is the most appropriate valuation method at the bottom of the cycle. However, I believe we are past the bottom, so this approach is out of the question.

·       Replacement Value: The price for five-year-old ships with the same characteristics determines the value.

·       Residual Value after ten years - the value of the fleet is calculated using annual inflation, annual depreciation, and the cost of the ship as new.

The latter two methods are most appropriate for determining the value of a firm's fleet when we are far from the cycle ends. To estimate STNG, I will use replacement value relative to the price for five-year tankers. I do not use prices for new ships because they will be available in at least two years, whereas five-year-old tankers are already available, i.e., ready to generate revenue.

The company has:

·       14 Handy size tankers - $22 million for a five-year-old ship

·       59 Mid-range tankers - $42 million for a five-year-old vessel

·       39 Long Range 1 tanker - $65 million for a five-year-old vessel

The total replacement cost of the STNG fleet is $5.321 billion.

Current company assets: $585 million

Total company liabilities: $1.864 billion

Net Asset Value = $4.04 billion.

Market cap = $3.06 billion.

Net Asset Value per share = $82.4

Market price per share = $62.52

The following table compares the current EV/Sales, Price to FCF, and Price to Book value against the five-year averages and sector medians.

STNG trades at 3.06 Price/FCF, 4.53 EV/Sales, and 1.27 price to book. All three metrics are below company and sector averages. The final stage of evaluation is to compare it against other companies in the industry - Torm, Hafnia, and Ardmore.

STNG has the highest Price to FCF, lowest Price to Book, and average EV/Sales compared to its peers. STNG has not only the largest but also the highest-quality fleet in the industry. That being said, STNG's stock price has the potential to outperform that of its competitors significantly. In summary, the company is undervalued relative to its net asset value, five-year averages, and industry averages.

When to buy: technical analysis and catalysts

Rising day rates have made the tanker business attractive again. STNG prices have risen strongly since the 2020 low.

The price successfully broke a significant price level in the $60-$62 area. The presence of catalyst events (the Red Sea crisis) significantly increases the chances of the price continuing the bull trend. The current price allows entry with a strong asymmetry in our favor—a close stop below the previous month's low price and as a take-profit company intrinsic value.

Risk

The shipping business is extremely cyclical and capital-intensive. STNG maintains a superior fleet and does not leverage too much, greatly reducing the company’s liquidity risk.

Market risk is always present, but unlike many companies, shipping stocks have a low correlation to broad equity indices. This is an advantage because the price of shipping company stocks is not primarily a function of the price of the S&P 500 and Dow Jones Industrials. A case in point is 2022, when tanker company stocks realized over a 10% percentage return, while the S&P 500 fell 20%.

Tankers are among the few businesses that love geopolitical risk. Recent months illustrate this. Even before the attacks by Houthis in early December, tanker company stocks were performing well. I believe tensions will not be easing soon, which means limited traffic through the Red Sea. I mentioned in the introduction that product tankers are one of the most affected alongside container ships.

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Scorpio Tankers summary

Where to invest?

·       Macro—The Chinese government announced fiscal stimulus for the economy and 60% higher import quotas for crude oil imports. Rising crude oil imports mean rising production of petroleum products, i.e., increased demand for product tankers for transportation. The crisis in the Red Sea most affects product tankers and container ships.

·       Sector—The supply and demand for tankers are imbalanced in favor of the former. On the supply side, we have a record low Order book, reduced yard capacity, and a progressively aging fleet. Demand is driven by restored refinery capacity globally and extended routes due to the Red Sea crisis and the Panama Canal drought.

·       Company - Scorpio has the youngest fleet among the competition. At the same time, it has the highest percentage of ships equipped with scrubbers. The company has excellent financial parameters - liquidity, solvency, and efficiency. The managers have skin in the game and long industry/company experience. 

Why invest in Scorpio Tankers?

·       Balance sheet - the company has an excellent balance sheet, providing sufficient liquidity and stability.

·       Efficiency—The company realizes superior profit margins and return on capital. Scorpio Tankers' values are above the industry average and the historical average.

·       Managers - The company's management is experienced in the industry and owns company shares.

How much do I pay for Scorpio Tankers business?

·       Business valuation—Based on the replacement value for STNG, I get a net asset value of $82.4 at the current market price of $62.52 per share.

·       Benchmark - Compared to its peers, STNG has the highest Price to FCF, lowest Price to Book, and average EV/Sales. STNG trades at 3.06 Price/FCF, 4.53 EV/Sales, and 1.27 price to book. All three metrics are below company and sector averages.

When to buy?

·       Technical analysis: The price broke an important resistance, providing an excellent entry opportunity with asymmetry in our favor.

·       The presence of a catalyst event—the Red Sea crisis—significantly increases the credibility of the timing, lowering the chance of getting it wrong.

How much to buy?

·       Kelly's formula - risk/reward 2.0; 12-18 months; portfolio share 8-10%; position risk 2-3%.

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Everything described in this report has been created for educational purposes only. It does not constitute advice, recommendation, or counsel for investing in securities.

The opinions expressed in such publications are those of the author and are subject to change without notice. You are advised to do your own research and discuss your investments with financial advisers to understand whether any investment suits your needs and goals.