Why restructuring concerns weigh down Frontline's stock (Part 4 of 7)
Cash burn cushion
In most cases, if rates are lower than the breakeven cost, companies such as Navios Maritime Acquisition Corp. (NNA), Teekay Tanker Ltd. (TNK), and DryShips Inc. (DRYS) would be burning cash. For Frontline, this is somewhat cushioned.
As the crude tanker industry’s fundamental weakness took longer than what most had anticipated, which had also negatively impacted the Guggenheim Shipping ETF (SEA), Frontline underwent a restructuring in 2011. As part of the restructuring, it sold some assets, and the associated debt, to Frontline 2012, a related company owned by billionaire John Fredriksen, who also owns Frontline. More importantly, Frontline and Ship Finance International Ltd. (SFL) agreed to modify their previous lease contract.
The new agreement reduced the lease for each vessel by $6,500 per day until the end of 2015. Note, however, that Frontline would still have to distribute any extra earnings it makes to Ship Finance, up to the amount equal to the original lease rate. Ship Finance calls this the “cash sweep.” Essentially, it reduced the rate at which Frontline would start burning cash.
In exchange, Frontline made a prepayment of $106 million to Ship Finance International (SFL), which included a non-refundable $50 prepayment of profit sharing agreement, and $56 million as security for charter payments. Plus, Ship Finance’s share of profit above an originally stated threshold rate increased from 20% to 25%. Investors can view this as transferring some risk from Frontline Ltd. (FRO) to Ship Finance in exchange for lower future returns.
Positive or negative?
The modified contract allowed Frontline a greater chance of survival when the market is down. But when rates are rising, the company’s profitability will be negatively affected by the higher profit sharing agreement it has with Ship Finance International. Keep in mind that starting from 2016, the lease rate will go back to its original level.
Browse this series on Market Realist:
- Part 1 - Investing in Frontline: A pureplay crude tanker company
- Part 2 - Why Frontline predicts higher 2014 tanker rates but a weak Q2
- Part 3 - Why Frontline’s high cash breakeven could mean underperformance
- Personal Investing Ideas & Strategies
- Frontline Ltd