8/7/08

Why I'd Wait to Buy FRO and OSG

Over the next several years, as emerging economies continue to grow and developed economies (hopefully) get back on track, demand for oil should continue to rise. Frontline, Ltd. (FRO) and Overseas Shipholding Group (OSG) are two of the largest crude tanker operators in the world. Both companies have bright futures, but now may not be the best time to buy their shares.

Reasons to Wait to Buy Frontline

Frontline is highly leveraged to tanker spot rates. While rates have been high recently (factors include China getting ready for Olympics, Iran using some of its tankers for purposes other than oil transport), they are likely to drop next year. FRO, along with its competitors, has been busy investing in new ships. While some of these will replace existing ships, the first half of 2009 is expected to see a large net gain. Tanker oversupply may lead to a fall in spot rates, even if demand for oil remains constant.

While high, the dividend yield is probably below the 19% currently advertised. Frontline has never had a stable dividend. So don't buy the stock expecting $2.75 per quarter. It may be higher next quarter, but as earnings mostly depend on spot rates and asset sales, the dividend will likely decline next year.

The high analyst estimate for 2009 earnings is $6.66 per share. As of the recent close of $55.90, Frontline is trading at 8.39 times the highest 2009 earnings estimate. The stock has had an average P/E of 4.7 over the last five years. If it trades close to its average P/E, the share price will be substantially lower.

In addition to the short term concerns above, investors in FRO always run the risk of share dilution. The generous dividend policy leaves the company with little cash. Acquisitions and unexpected expenses are likely to be financed by issuing new shares or taking on more debt (debt/equity is already over 5.9).

Frontline's fleet list can be found here.

While FRO may not get that low, as John Fredrksen runs a tight ship, I would wait until the stock goes below $40 a share before buying.


OSG May Be a Better Buy Right Now, But It Can Go Lower Too

Overseas Shipholding Group faces similar earnings pressures for 2009. However, the company is less leveraged to the spot rate market. As of June 30, 2008, non-cancelable term charters amounted to $1.6 billion. Locked in future revenues also include $1.8 billion from OSG's natural gas operations.

OSG is trading at a substantial discount to its Net Asset Value (estimated at $110 to $120 per share). Frontline has made buyout overtures, and OSG is receptive. The US Jones Act, which provides, among other things, that foreign investors cannot own more than 20% of a US shipping company, seems to be preventing a deal. Frontline is incorporated in Bermuda. Whether a deal materializes or not, the prospect of one can provide additional downside protection for investors (although it doesn't seem to prevent the stock dropping over 7% in one day).

While there aren't any significant barriers to entry in the crude shipping market, OSG enjoys the protection of the Jones Act from foreign competition. The company expects earnings before taxes and expenses in its US operations to grow by 65% over the next three years. Future projects include shuttling oil from deepwater drilling in the US Gulf. (Interested investors might want to take a look at OSP, OSG's master limited partnership.)

While OSG's dividend yield is not nearly as high as FRO's, it is stable, and may rise in the future (it was recently raised by 40%). OSG has good cash flow, and its debt/equity ratio is 0.66. The company's clean balance sheet will enable it to take advantage of future opportunities.

While the share price looks attractive compared to OSG's estimated NAV, the company may trend lower in 2009. Analyst consensus for 2009 earnings is $7.37 a share. Over the last five years, the company's P/E has been 7.46 on average. As of the recent closing price of $66.33, OSG is trading at 9 times 2009 earnings consensus. Keep in mind that OSG has a knack for failing to meet Street estimates, sometimes to the upside and sometimes to the downside, usually by double digit rates (who's to blame, the company or the analysts?). The low analyst estimate is $2.21 a share. If this turns out to be correct, OSG is trading at nearly 31 times 2009 earnings.

A list of OSG's fleet can be found here. Note that the link is an Excel spreadsheet.

Expect lots of volatility and keep an eye on the tanker rates (here and here are good places to get started). I would look to buy a small speculative position in OSG if it falls below $60, and then see what happens in 2009.

Disclosure: I don't own any of the stocks mentioned in this post, but I used to own OSG.