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Author: Hohum777 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 22312  
Subject: FRO 2010 update Date: 2/24/2011 11:02 PM
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Last year I posted on my favorite tanker biggie, Frontline (FRO), and it was the original idea in a series of posts on different tanker ideas. Fascinating company, provides lots of data about what is occurring in the tanker sector. The other tanker biggies, Teekay (TK) and Overseas Shipping Group (OSG), individually have more vessels in their fleets than FRO. However, their fleets span across a greater mix- shuttle tankers, LNG tankers, FPSOs, FSOs, product tankers (for TK), or ATBs, product tankers, LNG tankers, lightering vessels, US Flag tankers (for OSG). FRO is basically 90% crude oil tankers & 10% Dry bulk.

Let me start with a couple of definitions
VLCC- Very Large Crude Carrier (vessel category carries up to 2 Million bbls)
Suezmax - tanker vessel category carries up to 1 Million barrels
DH - Double Hull
SH - Single Hull
OBO - Oil-Bulk-Ore
newbuild - state of vessel from order placement to delivery date

SH vessels have limited geographical space to operate from 2011 and beyond.

FRO operates in the crude oil tanker and Dry bulk business. The company fleet at the end of 2010 consisted of:
44 DH VLCCs (-1 vessel in Q1 2011)
5 SH VLCCs (-2 vessels in Q1 2011)
21 DH Suezmaxes
8 OBO vessels (strictly trading Dry bulk cargo)
2 newbuild Suezmaxes & 5 newbuild VLCCs (Usually newbuilds aren't counted in the fleet until the
vessels deliver)
78 operating vessels + 7 newbuilds

But FRO is a tanker biggie, and these are complicated entities, so it is helpful to break them
down further. Same categories as last year
A. Vessels belonging to Ship Finance Limited (SFL)
B. Vessels chartered-in or managed by FRO
C. Vessels belonging to FRO subsidiary, ITCL
D. Vessels owned by FRO

Of the fleet mentioned earlier,
A. SFL owns 17 DH VLCCs, 5 SH VLCCs, 6 DH Suezmaxes, 8 OBO vessels, or 36 of 78 operating vessels

The sale of Front Vista took effect in 2010, but I had already removed it from the SFL fleet last year. So the vessel count has not changed. What did change was the deployment of
vessels- a pair of SH vessels moved to storage activity. During the 2nd half of 2010, a DH VLCC got
fixed on a time-charter ($40K/day for 3 years + options)

B. Multiple interactions with vessels managed, or chartered-in here
- There are 3 VLCCs owned by Saga Tankers (vessels are commercially managed)
- There's 4 VLCCs owned by Knightsbridge (VLCCF), and
- There are a six-pack of 3 VLCCs & 3 Suezmaxes financed by the Germans,
- Front Chief, Front Commander and Front Crown are three VLCCs which FRO could have acquired in late 2009. The three vessels got converted into one year charter-in deals for 2010
- A charter-in VLCC, Desh Ujaala

The NAT Suezmax vessels left FRO's fleet after Q2. As mentioned in the VLCCF write-up, John Fredriksen entities now own VLCCF shares (a 10%-ish stake).
In Nov 2010, FRO announced charter extensions on Front Chief, Front Commander and Front Crown for another year, all of 2011, at lower charter-in rates

C. There's a subsidiary, ITCL, which owns 6 VLCCs & 3 Suezmaxes
All vessels were chartered to two oil majors BP and Chevron, for most of 2010, on bareboat charters. In Dec 2010, one VLCC chartered to Chevron had its charter terminate. In Jan 2011, same outcome
for a VLCC chartered to BP. The three Suezmax vessels have bareboat charters good through 2015.

D. FRO owned vessels include
9 DH Suezmaxes
5 VLCC newbuilds
2 Suezmax newbuilds

FRO took delivery of 4 new Suezmaxes and 2 new VLCCs in 2010. In Apr 2010, FRO had a bond offering. The company used some of the proceeds to acquire two 2009-built VLCCs. One of the 2009-built VLCCs got placed on a 5-year time charter in Nov 2010.

I want to talk about profit-share for a few minutes. SFL mentions $500M of profit-share over the last seven years. If one looks at the SFL earnings slides, profit-share the last two years has been $33M (2009) and $30.5M (2010). SFL "inherited" 47 vessels from FRO in 2004, which was a good year for profit-share - $115M. The number of vessels is down to 36 (2010), or 34 (after Q1 2011). 2008 represented the second best year for profit-share for SFL, but that is also the year SFL transitioned to the UDW vessels. Can I use the "jump the shark" analogy here for SFL's profit-share?

Perhaps profit-share has "jumped the shark" for FRO also. But before one writes it off completely, let us consider a few things. When FRO moved those 47 vessels over to SFL, do you know how many vessels FRO had remaining? Answer: Two VLCCs.
I realize cash is fungible, so it might be tricky separating cash from operations vs cash from profit-share. However, if SFL had $440M of profit-share during its first five years, then FRO had $440M*4 = $1760M in profit-share. Some of that flowed down as dividends, but a chunk went into their newbuild program, of which, 8 vessels (4 VLCCs and 4 Suezmax) delivered in 2009 & 2010. And there's more newbuild vessels on the way too. I would suggest that, at least some chunk of the newbuild down-payments came from profit-share.

Based on the vessel age and vessel reductions, it seems reasonable to expect profit-share to continue declining. BTW, the SH reductions in 2011 have no impact, as the charter agreements decided on no profit-share for a SH tanker vessel after its 2010 aniversary date. Now, profit-share can still serve as a gauge or a signal. Not a 100% indicator, but FRO had a higher dividend in Q1 & Q2 vs Q3 & Q4

Last year, the main thesis was "FRO used to be a monster dividend machine" and I went about hunting for cash from the company's vessels operations. FRO reported year-end results on 2/22. The Q4 dividend was 10c/sh. For the full year, the dividend was 75c-75c-25c-10c, or $1.85/sh. What happened? I mean, things started out well- 75c in Q1. Another 75c in Q2, but things came undone in Q3 and Q4. What caused this? Let's use the same grouping as last year to assist
I. The SFL vessels
II. The ITCL subsidiary
III. Other vessels
IV. Intangibles

I. When I reviewed SFL last week, I generated some revenue type numbers by vessel category. I'm using a subset of that data--
For 2010, one can get the SFLrev from here
(slide 6 provides Q1 & Q2)

and here
(slide 9 provides Q3 & Q4)

Category Q1 Q2 Q3 Q4 Total
VLCC 53.4 49.7 46.0 42.4 191.5
Suezmax 12.9 14.2 14.3 14.3 55.7
Dry Bulk 15.6 15.6 15.7 17.2 62.1
Profitshare 11.3 11.4 5.8 2.0 30.5

I now need to tweak some of the numbers because
- The VLCC numbers include one vessels chartered to a third party (TMT) (only Sept 2010)
- The two newest Suezmaxes are not chartered to FRO
- Dry bulk includes contribution from a Panamax vessel and a Supramax
- There's one more vessel that can contribute to profit-share (the jack-up rig). The numbers indicate all the profit-share is from vessels managed by FRO

Fixed chtr hire Q1 Q2 Q3 Q4
VLCC 51.1 47.4 43.7 42.4 184.6
Suezmax 11.2 11.2 11.2 11.2 44.8
Dry bulk 14.0 14.0 14.0 14.0 56.0
Pshare 11.3 11.4 5.8 2.0 30.5

The profit-share split is 20-80, so FRO's share is $30.5M*4 = $122M, slightly less than last year's figures.

II. The ITCL subsidiary.
One can call this "tanker biggie + 2 Oil majors". There's 6 VLCCs and 3 Suezmaxes chartered out to either BP or Chevron on bare-boat charters. This entity was fun to explore last year, and the conclusion was, not too much excess cash from ITCL. Since the bareboat charters stayed much the same as 2009, I will suggest that we won't find excess cash here again. This might change in 2011.

III. Other vessels
Excluding the SFL and ITCL vessels, we're left with 78 - 36 - 9 = 33 vessels.
By vessel type, it is 21 DH VLCCs and 12 Suezmaxes
Like last year, let me focus on the VLCCs but exclude the 5 commercially managed VLCCs. Here were my observations on Q1 2010--
The VLCCs have had much healthier Spot rates Jan thru Mar. Break-even on the VLCCs is about $30k daily. If those vessels managed $40k-$50k daily in Q1,
there's $10k-$20k*14*87 (I don't like using 90 days for the Q) = $12.18M-$24.36M.

Assume we were trying Q2 with 16 VLCCs
$10K - $20K * 16 * 87 (same reason as last year for 87 days) = $13.92M - $27.84M

Note my caution last year,
No, no, I won't extrapolate that number to a full year, Spot rates are way too unpredictable for that.
That range just represents the type of cash flow available in a decent quarter for a set of 12-15 VLCC vessels.

Believe it or not, my observation was quite appropriate. Well okay, things were good for two good quarters. Q1 and Q2 had great Spot rates, but those rates crumbled when 30+ VLCCs were released from contango storage during Q3. The profit-share numbers provide some indication of this. The nice dividends in Q1 & Q2 were courtesy of nice profit-share and healthy Spot rates in Q1 and Q2. Spot rates declined in Q3 and Q4, and have still not recovered in Q1 2011.

IV. Intangibles
I had a different idea for intangibles last year- the Jinhaiwan newbuilds & Front Vista. The Jinhaiwan newbuilds turned into an intangible, but in a different way than I conjured. My scenario had a couple of the vessels in a Sale-and-leaseback scenario. What FRO management pulled off was quite stunning. The short version.
- A few years ago, FRO placed a 4 + 2 VLCC order @ $135M/vessel at Jinhaiwan shipyard. The 4 + 2 order means 4 firm orders and an option for 2 more vessels.
- FRO puts a 20% downpayment, or $27M deposit for each vessel
- In May 2009, FRO cancel the option vessels, but don't lose the down-payment (early enough in the process)
- Things get worse in 2009 and look bad in early 2010. FRO likely underwater on 2 newbuilds, $54M at risk, with only 2 vessels built.
- Sept 2010, incredible negotiating move!!!- FRO keep the two "at-risk" vessels, add another VLCC, negotiate the price down to $105M/vessel for all 5 vessels, and move the delivery schedule out by a few months. Damn impressive!
- First vessel delivers in Q1 2012. So this intangible becomes a work-in-progress.

- Front Vista is a VLCC sold on installments, so it is an asset that produces cash in the background.

- The intangible asset that was monetized in Q3 was Navig8. This was a FRO investment in early 2008. Navig8 owns vessels in the product tanker space, and I think the investment ended up breakeven-ish @ $19M. Q3 dividend was 25c/sh, about 78M shares outstanding, that's near enough to this investment, or if one wants to use Q3 profit-share ($5.8M*4 = $23.2M). As I mentioned earlier, cash is fungible. What is nice is FRO has these small stashes :)

To summarize
Q1 & Q2 had healthy Spot rates which produced nice revenue and profit-share to support a great dividend. Spot rates started declining in Q3, which impacted revenue and profit-share. This put pressure on the dividend. The lower rates continued into Q4.

I have talked about tanker companies that pay a "variable dividend". Given the dividend payout in 2010, and earlier years too, FRO probably fits the mold. However, I think the company would try to phrase it in a different way.

A 10c dividend is not a nice way to end the year. So what's next?
Well, Spot rates were not great the first 5 weeks of 2011, but have started moving up slightly. FRO made a couple of moves Dec 2010 - Jan 2011.
1. FRO signed a Sale-and-leaseback deal on a 2006-built VLCC (Front Shanghai). The company signed a purchase agreement for a pair of vessels in 2004 @ $80M each. After 4+ years of use, FRO is selling this one for $91M - yup, an appreciated capital asset!!
The 2-year leaseback reduces the gain some, but a gain on a 5 year old vessel is still a plus.
2. FRO had an OSG stake, has had it since 2008. FRO sold its position and took a loss on this investment. But it frees up $40M+
3. Two of the ITCL VLCCs have terminated charters. For one VLCC, Antares Voyager, the bondholders have allowed ITCL a few options, including selling the vessel. There's a minimum price, but FRO have not divulged the amount. The second VLCC had a charter terminate in Jan 2011, but ITCL has not received permission to explore options for the former British Pioneer
4. FRO makes $5-6M on the termination of two SH charters.

The ITCL vessels still have the bond debt, and the amount of net proceeds is unknown. Let me leave it off-the-table. That still leaves about $65M for FRO to use. Some of it might back-fill a
small dividend payment. Whatever the amount left, I wouldn't bet against these Norwegians. I think the Jinhaiwan newbuild renegotiation was one great example of executing. The Front Shanghai sale another. But probably the most appropriate example is ITCL --

On July 1, 2003, Frontline purchased a call option for $10.0 million to acquire all of the shares of Independent Tankers Corporation, Cayman Island or ITC from Hemen Holding Ltd., or Hemen for a total consideration of $4.0 million plus 4% interest per year. Hemen is indirectly controlled by trusts established by John Fredriksen for the benefit of his immediate family.

I did well with my FRO stakes in 2010, but only hold a token position currently. I will wait for a better price to build a stake again.

Q4 presentation:

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