SFL DUE DILIGENCE

A CASE FOR THE RETURN TO NORMALCY IN Q1 2021 AND Q2 2021

Published by /u/slipperymagoo

Disclaimer

I am not an investment advisor or finance professional, nor have I ever held experience in a related position.

I hold positions in stock and/or instruments related to SFL.

Everything I say could be wrong. I am an idiot, so do your own research.

Company Background

SFL is a shipping company incorporated in Bermuda that makes money by leasing out and chartering large marine cargo vessels and offshore rigs.

SFL is unique in that they specialize in long-term fixed-rate time charters (>1 year), while most shipping companies operate in the short-term and spot markets, where prices change daily.

Because of their commitment to long-term charters, SFL is relatively unaffected by market conditions or short-term changes in shipping rates. Roughly 90% of their revenues are derived from long-term charters, leading to stable and predictable cashflows. Their backlog sits at $2.3B, with an average weighted charter period of over 5 years.

SFL currently leases oir operates a fleet of 84 vessels:

Some of these vessels are not on long-term contracts and operate in the short-term/spot markets:

The Thesis

In Q1 2020, SFL experienced a precipitous decline in share price from $14.50 to a low of $7.50, and then finally bottomed out in Q4 at $6.00. Today SFL trades at roughly $7.50/share.

It is my belief that the threats to SFL were misunderstood, as they achieved the highest revenues and operating cashflows in years, despite the effects of the pandemic on global trade. As the economy recovers and supply chains resume production, it is likely that SFL will return to a much higher valuation as shipping rates in container and dry-bulk sectors climb to decade highs. These changes have already occurred in the first quarter of the year and the expansion in earnings to be reported for Q1 and Q2 of 2021 is not properly reflected in the share price.

Why SFL is down:

A decline in asset value for 8 vessels during the 2020 calendar year left SFL with a large non-cash loss.

  1. In Q1 of 2020, SFL realized a non-cash impairment charge against 7 of their handysize dry-bulk carriers, in which the carriers were depreciated more quickly than expected. While covid-19 may have had an impact, a charge would likely have occurred regardless, as prices for handysize dry-bulk carriers had been depressed for several years. SFL was not able to locate favorable leases following the expiration of the previous leases, and expected to liquidate the ships at lower-than-expected prices.
  2. In Q4 of 2020, SFL customer SeaDrill declared bankruptcy and defaulted on leases for 3 offshore oil rigs. Two of the rigs continue to operate profitably on subcharters to oil majors. The cashflow for those rigs has been temporarily delayed, but the full amount owed is held in pledged accounts and will be distributed following the SeaDrill bankruptcy. The third rig has been in layup for 5 years and will be returned to SFL in late Q2 or early Q3. Given that the market for offshore rigs is poor, SFL opted to realize a non-cash impairment charge that lowered the book value of the vessel to scrap value; a total loss of around $187 million.
  3. In anticipation of general market turbulence and the SeaDrill default, SFL began cutting its dividend in Q1 of 2020, lowering it from $0.35/quarter in 2019 to $0.25 in Q1 and Q2 2020, and then again to $0.15 for Q3, Q4 of 2020. The price of SFL tracks the dividend and usually trades at around 10-12 times annual yield.

Opportunities for SFL to rise:

  1. Strong Dry Bulk Market

    Year-to-date, dry-bulk rates have skyrocketed, with handysize and supramax spot rates nearly doubling from the start of January to March, and capesize spot rates increasing by more than 50%. The pandemic lead to mass cancellations of ship orders, leaving a shortage of bulk carriers as supply-chains are reestablished, and it is expected to take years to correct this imbalance. Most of SFL's exposure to the short-term market exists in the dry-bulk space and they will likely realize unexpected and outsized profits:

    1. SFL may reverse the previous impairment charge on their 7 handysize bulkers, and the ships may be chartered out again on long-term leases at much higher rates, or liquidated for a substantial profit.
    2. In addition to the 7 handysize vessels, SFL also operates 3 supramax vessels in the short-term/spot markets.
    3. SFL has a profit-sharing agreement with Golden Ocean, to whom they lease out 8 capesize carriers. Golden Ocean primarily charters in the spot market, and SFL receives 33% of profits from these vessels above a certain threshold.

    Relative to Q4 2020 cashflows, I estimate that the 7 handysize vessels will generate an additional $2.2MM in Q1 2021 and $4MM/quarter moving forward. I estimate that the 3 supramax vessels will generate an additional $1.3MM in Q1 2021 and $2.6MM/quarter moving forward. The profit share from Golden Ocean will likely generate an additional $0.9MM in Q1 2021 and $2.4MM/quarter moving forward. In total, this is a $4.4MM increase for Q1 (~$0.04 per share), and $9MM increase (~0.08 per share) should the rates hold throughout Q2.

  2. Successful Liquidation of Subsidiary

    In 2018, SFL spun off several oil-related assets into a separate company, ADS Crude Carriers. The goal of this company was to charter the ships profitably in the short term and eventually liquidate the holdings. That liquidation completed in Q4 2020 and SFL will receive $9.6MM in cash in Q1 2021 that may influence the dividend payout positively.

  3. Completion of SeaDrill Restructuring

    When SeaDrill defaulted on their oil rig leases, cashflow was temporarily halted for SFL. The two parties quickly reached an agreement in which Seadrill agreed to pay 75% of the charter hire on two of the three rigs, with the remaining 25% being held in accounts pledged to SFL until after the restructuring is completed. Following the restructuring, SFL will receive a very large cash payment from these accounts, which have been accumulating $4.5MM/quarter starting in Q4 and currently stand at around $11MM. Based on SeaDrill's 2018 bankruptcy and current proposals, it is likely that restructuring will conclude in the summer.

  4. West Taurus Oil Rig Potential

    In anticipation of the SeaDrill lease default, SFL cut the dividend in order to aggressively pay off the loans on their 3rd offshore oil rig, West Taurus, which has been held in layup by SeaDrill for roughly 5 years. SFL closed out 100% of the loans in Q4 2020 and depreciated the rig to an estimated scrap value of around $5.5MM. Prior to default, the rig provided revenues of ~$8MM/quarter, with a net income of roughly $0.02/share after loan payments. While it is likely that the rig is scrapped, I believe it is also possible that the rig could be sold at above scrap or leased again and it would generate a substantial amount of income because of the lack of debt-service. If oil prices stay strong and the rig is rechartered, it is possible that the rig could have its impairment charge reversed.

  5. Potential Increase in Corporate Taxes

    Because of the nature of their business and incorporation in Bermuda, SFL is provided an exemption from the IRS and does not pay any corporate tax. Unlike most partnerships, earnings are also not counted as normal income for shareholders; dividend tax only. In the event of a corporate tax increase, SFL is likely to appreciate relative to the rest of the market as their earnings are entirely unaffected.

  6. Appreciation of Container Feeders

    SFL operates two container-feeder ships in the short-term market, and rates have exploded due to high demand for container ships and excessive port congestion. I believe these two ships will generate an additional $0.5MM in Q1 2021 and 1-2MM/quarter moving forward. Both ships appear to have recently entered into short-term time charters and details exact details on cashflow are unknown at this time.

Conclusion/TLDR

Due to recent dramatic increases in dry bulk and container shipping rates and a large quantity of deferred cash payments incoming, it is my belief that SFL will increase their quarterly earnings (and therefore dividend) from $0.15 in Q4 2020 (excluding rig-related items) to $0.20 for Q1 2021, and it may reach as high as $0.25. Should this not occur in Q1 2021, I think it is very likely that it occurs in Q2 2021. When the dividend is increased, the share price is likely to rise above $10.

Sources