Shipping’s graveyard is littered with the carcasses of companies that found themselves with too much debt at a time when market cycles turned against them. Restructurings, bankruptcies, and liquidations have been some of the inevitable results. But what about the notion of having too little debt?
Odd as that may seem, the issue came to the fore at a recent Marine Money financial conference in relation to dry bulk owner Genco Shipping & Trading’s eventual goal to achieve zero debt as a public company. The goal is aligned with the owner’s new high-payout dividend policy, with an intention to continue rewarding shareholders no matter what rates the dry bulk market might bring. Under the model, Genco hopes to shed the traditional method of valuing shipping companies according to net asset value and instead shift to a share priced off dividend yield and cash flow. It’s a feat that’s never been tried before by a dry bulk shipowner. The hitch came when a zero-debt goal was criticized as a “lazy” approach to management by Flex LNG chief executive Oystein Kalleklev, who was sharing a panel with Genco CEO John Wobensmith.
Kalleklev later told TradeWinds on the sidelines that he couldn’t fathom relying solely on the cost of equity – which can range to 12% or more – when he could easily get loans at a rate of 2% to 3%. So sharp elbows aside, who’s right on the issue? Streetwise found that there is some disagreement. For example, one veteran finance man with experience on the shipowning side argued that Genco has this one right. “Basically, I think it’s a good idea,” he said. “It’s just challenging for an existing company to manage to get to that level.” While he agreed that equity can appear more costly at a price of between 8% and 12%, “the problem is that the value of equity at times goes negative and the equity generally doesn’t survive that” when debt is too high. This typically happens in the trough cycles to which shipping is especially susceptible, the ship finance expert said.
Shipowners may also issue extremely expensive “rescue equity” at such times, heavily diluting exiting shareholders. Another problem is that pricing models say the value of debt over equity is attributable to tax deductions from paying interest costs. “But shipping companies don’t pay taxes,” he noted. A final factor is that the cost of equity becomes cheaper as debt becomes lower, the finance expert said. “The public market experience is that if you can get to zero debt, the equity market likes that and will give you a better valuation,” he said.
Still, an equity analyst struck a position that leans more toward Kalleklev’s position. “At some point, you can be under-levered,” he said. “We are seeing more dry bulk and container ship companies with debt down to 20% to 35% after taking advantage of strong markets and that’s a very good thing. “But I’d agree that you don’t need to get to zero. I’d rather see a company with 20% debt using cash to buy back shares when they’re undervalued.” The analyst cited inflation as another concern. “If you think that interest rates are heading up, why would you not lock in some loans now at 2% to 3% above Libor while debt is cheap?” he said. Genco may need to settle the matter, but the journey could take a while. The shipowner is targeting zero “net debt” by the end of 2023, with hopes to shed the rest – if it can – sometime after that.