The Trade Trade – February 08

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For a while now, we’ve been looking for just the right trade to bring to our subscribers. We’ve wanted something better than a simple bet on the big troubles we expect for the economy. Instead, we’ve been searching for something that would pay off nicely if things get ugly right on schedule and that would also work well if this “goldilocks” thing keeps going for a while. We believe we’ve found it on the high seas.

For most of the last century, “transportation” of goods meant trucks and railroads. Today, thanks to rapid globalization and U.S. dependence on cheap products from Asia, it also means ships.

One way to take the pulse of the shipping industry is with the Baltic Dry Index [BDI] , which is an index of the rates being charged for shipping dry bulk commodities on 22 international shipping lanes. From day to day, the index gets bumped around by things such as storms in the Atlantic, port backlogs in Africa and, we’re not kidding, pirate attacks. But over longer stretches, it’s the world economy that drives the BDI. Think the global economy is strengthening? Then go long the BDI, because rates should go up. Think it’s going to tank? Then short the BDI.

It used to be easy to place such a bet, when there was a futures market with contracts tied to the BDI, but no longer. Today, the only way for retail investors to get in the game is through a “spread betting” account in the UK, which is probably more trouble than you want. (Although if you’re interested, you can get more information at www.balticexchange.co.uk). And, of course, even if you’re willing to bear the inconvenience of going that route, you still need to pick the right side to bet on. We prefer something requiring a bit less timing, but understanding what we’ve found requires a little background on the shipping industry.

Ahoy

The shipping industry is highly cyclical. Charter rates, operating profits and ship values are all volatile, with big leverage to fluctuations in the world economy. Other demand factors that make life interesting in the shipping business are regional economic conditions, international trade developments, port congestion, weather, crop yields, armed conflicts, politics, embargoes, strikes and demand for consumer goods, dry bulk commodities and crude oil and oil products – the effects of which can be more important for particular segments of the industry than for others.

Ships get built, serve for a while and then sink or are retired. So changes in the supply of shipping capacity depend mainly on the number of new vessels being delivered and the number of older vessels being scrapped. The scrappage or retirement rate depends, obviously, on the accumulation of wear and tear, but also on safety and environmental regulation by governments and international authorities. Increasingly, regulation is cutting into useful lives of older fleets.

[There are many listed shipping companies, but they’re not all the same. You can find prices for the equities listed below and links to fundamental research here.

There are four sectors to the shipping industry -- tankers, LNG/LPG, dry bulk and containers – and each has an economic life of its own.

Tankers

Tankers handle crude oil and its refined products, such as gasoline, diesel fuel, jet fuel and naphtha. Depending on the product, tankers move it from pipes leading out of oil fields, from storage depots and from refineries. And they deliver it to pipelines, storage depots, refineries, distributors and industrial consumers.

Oil Tanker Demand is Steady

While tankers sometimes visit pipelines to load or unload, they also compete with pipelines. For long hauls, tankers are generally the more cost-effective alternative and are considered less vulnerable to political instability, sabotage and economic blockade and less prone to environmentally embarrassing spills.

Tankers are operated either by independent ship owners or by proprietary owners (such as oil and petrochemical companies and petroleum trading companies) transporting their own cargo. For the most part, ships operated by product owners are chartered from independent ship owners, some under short-term contracts, some on long-term charters. The prices for transporting crude oil and refined petroleum products, which are referred to as tanker charter rates, are set in highly competitive markets in which both independent and product owners participate.

Tankers are the sector that’s been touched most by safety and environmental regulation over the past decade. Tanker owners have learned to take extra care in the maintenance of their vessels, some of which are being regulated into obsolescence. According to International Maritime Organization (IMO) regulation, all single-hull tankers will be retired by 2010.

LNG/LPG Shipping

This sector handles liquid natural gas and liquid petroleum gas. The patterns and characteristics of this segment of the shipping business are much the same as in the tanker sector, but the ships themselves are designed and constructed for handling products that are both volatile and very cold. It is a much smaller market, and the big energy companies own most of the ships. Private companies in this sector listed on U.S. exchanges include: Teekay LNG Partners L.P. (NYSE: TK), Golar LNG Limited (Nasdaq: GLNG) and Stealth Gas (Nasdaq: GASS).

Dry Bulk Carriers

Dry bulk carriers handle bulk commodities — the “major bulks,” such as iron ore, coal and grain, which usually ride in the larger vessels and comprise about two-thirds of dry bulk trade, and the “minor bulks,” such as fertilizers, steels, sugars, and cement.

The dry bulk carrier sector is fragmented, with many owners and operators, some proprietary, some independent and some state controlled. Participants range from family-owned, single-ship operations (Dad may be the captain) to large public companies. There is big money in this business; it’s what made Aristotle Onassis famously wealthy; but it is very cyclical.

Container Shipping

Okay, we admit we find this part of the global supply chain especially interesting. Stories of families traveling inside containers for months to get to a better life grab us, so we ask you to indulge us in a bit of a history lesson.

Life Before the Box

Think of the great seafaring peoples — including our friends remembered in the last two issues, the Phoenicians, as well as the Egyptians, Greeks, Romans, Portuguese, Spanish, British and others. In ancient times, sailing the world looking for new treasures, they brought home spices, jewels and materials previously unknown to their countrymen. But it was never easy. Even into the 20th century, the loading and unloading of goods in assorted barrels, sacks and crates was a slow, cumbersome business that required armies of men with forearms bigger than the average guy’s thighs. And the process invited delays, accidents and, in modern times, loss to organized crime and feeding by the political bosses who joint ventured with organized crime to run the stevedore unions. And with so many thousands of tons of piecework to be done, even when everything went smoothly, a vessel might spend more time in port than at sea.

But by the second half of the 20th century, what for many years had been just a fragment of an idea was starting to find the rest of itself.

Boxes similar to modern containers had been used for combined rail and horse-drawn transport in England as early as 1792. And the U.S. government used small, standard-sized containers during the Second World War, to speed up the unloading and distributing of supplies. However, cargo handling was almost as labor intensive at the end of World War II as it had been in the mid-1800s.

Then, in 1955, Malcolm McLean, a trucking entrepreneur from North Carolina, (alas, no relation) bought a bankrupt steamship company with the idea of carrying entire truck trailers with their contents still inside – thereby escaping the slow, costly exercise of unloading and reloading cargo. This gave birth to “intermodalism,” whereby a container proceeds from one mode of transport to another quickly and without any need for handling the contents — a seamless transfer of a (relatively) few, large objects between ships, trucks and trains, instead of a slow, clumsy transfer of many small objects.

It was a logical step that container sizes should be standardized, for better staking and so that ships, freight cars, trucks and cranes could be optimized to handle a single size. In 1961, the International Organization for Standardization defined a short list of standard specs, the most important of which had a 20-foot length. The 20-footer, referred to as a Twenty-foot Equivalent Unit (TEU), quickly emerged as the conventional measure of container traffic and of container ship capacity.

Birth of the Container Ship

On April 26, 1956, Malcolm McLean’s converted Second World War tanker, Ideal X, made its maiden journey from Port Newark to Houston with 58 metal container boxes riding on its reinforced deck. By the time the ship arrived, six days later, the company was already taking orders to ship containerized goods back north.

McLean’s enterprise became known as Sea-Land Services. Its Gateway City, the first ship designed for carrying containers, made its maiden voyage on October 4, 1957, from New Jersey to Miami. It needed only two gangs of dockworkers to load and unload, and they moved the cargo at 264 tons per hour – six times faster than doing things the Phoenician way, which had been the only way just a year and a half earlier.

Container Shipping Goes Global

On April 23, 1966, ten years after the first voyage of a container ship, Sea-Land’s Fairland sailed from Port Elizabeth (South Africa) to Rotterdam with 236 containers — the first international voyage of a container ship.

Rapid Growth

In 1968 alone, 18 container vessels were built, ten with a capacity of 1,000 TEUs, which was large for the time. The next year, 25 ships were built, the largest approaching 2,000 TEU. Today, 20,000 TEU vessels are on the books.

Throughout the 1970s and 1980s, container shipping grew exponentially. In 1973, U.S., European and Asian liners were carrying 4 million TEUs. Ten years later, when containerized shipping had reached the Middle East, India and Africa, volume had grown to 12 million TEUs.

The 1984 Shipping Act aided the rapid growth. It cut government intervention in the industry and freed shipping companies to exploit all the potential efficiencies of containerization. Inevitably, when the government got out of the way, shipping rates dropped, and some of the high-cost players went bust and left more room for the healthy companies.

Soon these decks will be empty.

The present-day industry is truly global and touches nearly everything. If it’s coming out of China or elsewhere in the Orient, or if it’s going into Wal-Mart or one of its competitors, it has probably taken a ride in a 20-foot container.

Containerized shipping continues to expand. Over the last five years, the volume of loaded containers moved has grown nearly 10% per year. The 2007 estimate is that global loaded container trade exceeded 141 million TEUs. That’s a lot of boxes.

But will the industry’s growth last? Therein lies our trading idea.

The Play

Well, there are several. The simplest is to just go long one of the best shippers. We like the tanker segment the best because capacity is tight — demand for oil deliveries is increasing while environmental regulation is pushing old ships out of service faster than shipyards can replace them. Shipbuilders have a long backorder list and are wallowing in fat city, which bodes well for a tanker company with a new fleet already in service.

Arlington Tankers (NYSE:ATB)

This is a company we like a lot, and we believe it has a margin of safety large enough to invite an outright long position. Right now we believe ABT is a good buy at $20.50.

Arlington is all tankers. It’s a young fleet of eight double-hulled vessels, of which two are V-MAX tankers, two are Panamax tankers and four are product tankers. Together, the vessels enable the company to transport a wide range of products – crude oil, fuel oil, and clean products such as gasoline, diesel and jet fuel to the Americas, West Africa and Europe. Perhaps most importantly, all the tankers meet all the environmental requirements scheduled to take hold between now and 2012. Few tanker companies have an entire fleet that is compliant.

The company has entered into daily charter contracts and charter contracts for periods from 3 to 5 years for other companies to use its vessels. Of their projected revenue for the next three years, over 70% is locked in on long-term contracts. Ship management service for the fleet is outsourced on a five-year contract, which locks in ATB’s operating costs for several years to come.

ATB is close to being a floating Real Estate Investment Trust (REIT). The basic model is simple. Income from tanker leasing exceeds the cost of debt finance plus the company’s overhead and operating costs.

Like a REIT, ATB acquires expensive assets using some equity and a larger measure of debt. As with commercial real estate, long-term finance is available, but more commonly on variable rate terms. ATB has, however, hedged its interest rate risk through a series of rate swaps with Royal Bank of Scotland. This hedging may cost the company some profitability if interest rates fall, but it protects against getting hurt when rates are rising.

And like the most generous REITs, Arlington distributes most of its cash from operations as dividends. Currently the company is yielding over 10%.

Here are some of the basic statistics we think offer a compelling valuation story with a high margin of safety even if demand for tanker capacity weakens.

The 2007 reduction in profit margin came primarily from the cost of hedging interest rate risk.

Noteworthy is the debt-to-equity ratio. While Arlington is more heavily levered than the industry, their fleet is newer than the industry average, which takes some of the scare out of the leverage. It’s not surprising, and in fact it is encouraging, that such a new fleet can return a net profit over 16%.

The Flat Screen Bubble: Soon Empty Containers Will Clog Ports

Arlington is in the best sector of the shipping industry if our likely scenario (economic trouble, but primarily in the U.S. and Western Europe) plays out. Demand for energy may not continue to grow as it has if there is a global slowdown, but it is unlikely to decrease much unless we hit the Greater Depression. If that does happen, there will be time to get out. Until then, we suggest you tuck these shares in a retirement account where the dividends are not taxed. (Arlington is incorporated in Bermuda, so there’s no withholding on the dividends.)

The Trade

Going long Arlington will work out well if the global economy continues to grow or even goes sideways. However, if the economy really falls off the cliff, the company will get hurt. But there’s an efficient way to hedge against that risk: short Seaspan Corporation (NYSE: SSW) and Star Bulk Carriers (Nasdaq: SBLK).

Seaspan

Headquartered in Athens and operating primarily out of Hong Kong, Seaspan leases container ships to established shipping companies. Its lessees need extra vessels from time to time when their own ships are being repaired or when there is extra demand for shipping services. Seaspan’s largest client is none other than China Shipping Container Lines, the behemoth that keeps Wal-Mart’s shelves stocked.

The idea behind this short is simple. If indeed the global economy falls off the cliff, then the container shippers will get crushed. SSW in particular will be hurt because its clients will naturally turn in leased vessels before idling their own fleets. And SSW is a long-haul shipper, so if the U.S. economy tanks but the Asian economy doesn’t, SSW still will suffer far more than the shipping industry in general.

Star Bulk Carriers

On December 2, 2007, Nobu Su, the CEO of Taiwan Maritime Transport, complained that dry bulk charter rates were “insane” and “unsustainable.” Su recently resigned as co-chairman of Star Bulk Carriers and is now the head of a privately owned company with 130 ships in the dry bulk market.Recently floated on the Nasdaq, SBLK is headquartered in Athens and has a fleet of nine bulk carriers that transport iron ore, coal, grain, steel, cement and fertilizer.

The base metals and other bulk cargo are bound to correct

They recently announced the coming purchase of a tenth ship. The company’s average ship age is eleven years.Unlike Arlington, Star doesn’t pay out all of its free cash flow in dividends. It hasn’t yet paid a dividend but plans to this quarter. However, the company’s policy is to spend a large chunk of its earnings to acquire more ships. Also, it doesn’t hedge its interest rate risk, so, as a young company, it is highly leveraged on older ships, and it could conceivably run into trouble meeting its debts if shipping demand slows and interest rates rise.If indeed the economy slows globally, this undercapitalized company with less than three hundred thousand dollars in the bank will be caught expanding while the market is contracting. Again in relative terms, the demand for the carriage of bulk cargo, especially base metals, will wane well before the demand for energy transport.

Likely Scenarios — How the Trade May Play Out

Scenario 1: The U.S. economy and Western Europe are in a recession, but Asian growth continues, albeit at a slower pace. In this scenario, ATB will continue to perform well and will likely be able to keep its dividend. SSW will suffer, and its stock will decline, as the fall-off in imports by the U.S. and Western Europe eliminate the need for Chinese shippers to lease extra capacity. SBLK will also likely suffer as Asian growth slows. This is the best-case scenario, as we would make money on both our long position and our shorts.

Scenario 2: We are wrong and there is no crisis. The U.S. slowdown is “short and shallow,” as many CNBCers are predicting. ABT will continue to prosper and profit. However, so will SSW and SBLK. If we don’t recognize it in time, we could lose more on our shorts than we make on our long position. For this reason, we recommend you limit your losses on your shorts by covering if either Seaspan or Star Bulk goes up by 10%.

Scenario 3: There is a complete global meltdown triggered by a full-scale financial and monetary crisis. The Greater Depression has arrived. All our stocks decline, but SSW and SBLK fall faster and further than ABT, giving you a net profit. However, to maximize the effectiveness of this trade, we recommend a stop-loss on your long ABT position at 15% below your entry price.

Zoom Out

All in all, our macro assessment is that the world’s paper assets are due for a further correction. The U.S. and Western Europe will stagnate or decline relative to the rest of the world. Emerging market paper has been ridiculously overpriced, the work of excess credit and of financial players chasing returns and ignoring risk. This has begun to shake out, but the shaking is far from over.

Our gloomy outlook for the U.S. and Western Europe doesn’t mean we are negative on the world economy. Many emerging markets are fundamentally strong, supported by economies that will continue to grow even after financial markets correct.

Of course, the economy may give our macro-assessment a big horse laugh. But even so, the hedge we are recommending is protected from any big loss and positioned to give you a handsome profit.

Editors Note: When we penned this in early 2008, we did not know when the collapse was going to happen, only that it was bound to happen.  As it turned out our subscribers who followed our advice received a 500%+ profit in less than 8 months.  Admittedly, not all of our recommendations work out this well but our portfolio was up 12% in 2008 and is up over 40% since inception in 2007.  All while the broader markets have lost more than 40%. If you want to read more of our recommendations Subscribe Now and Try Without Borders with our money back guarantee.