On January 18, Diana Shipping (DSX) is spinning off most of its 55% stake in the company’s privately held subsidiary Diana Containerships (DCIX) to shareholders of record from January 3. DCIX will be listed on Nasdaq and begin trading at that date.
Spin-offs often make good value investments due to institutional neglect and small size, and this one should be no exception. As an added bonus, Diana Containerships has a few other details that will encourage individuals and institutional investors to sell without looking.
The first positive omen is the distribution ratio, a paltry 1 for 30.7. Only the largest DSX shareholders are going to be left with a meaningful number of shares after the distribution takes place; everyone else is going to be left with a pittance. Tiny distributions create non-economic selling and ought to drive the price down to intriguing levels for value-oriented investors.
The second positive omen – a money-losing first year – ought to drive prices down even farther. I’ve whipped up a quick pro forma income statement for fourth quarter based on the operating info from the most recent report (third quarter and operating info can be found here) to get an idea of what the overall 2010 numbers will look like.
Q4 Income Statement
Gross Profit 1,940
Operating Profit (242)
Net Income (497)
When you add that to the operating results from the first nine months, that comes out to a full year loss of roughly $2.5M. That’s strike two for DCIX.
The third positive omen is the size of the company itself. Diana Containerships, with book value of only $85M, will definitely be a small cap company. This ought to stimulate additional waves of selling from funds that prefer or require mid- or large-cap investments.
Finally, the company has several contractual arrangements with DSX that might make investors uncomfortable. After the spin-off, DCIX will owe DSX over $1M per year in management and brokering fees, which gives the appearance of unfair dealing. That’s strike…four?
So, it’s pretty reasonable to expect that people will be selling and that the stock can likely be had for bargain prices shortly after the distribution. The next question: is it actually worth owning?
The answer is “yes” for the prices it will likely be trading around. Although the initial financials are going to look ugly, they should improve with time. Asset-wise, the company’s value is readily identifiable and the initial selling could leave the company selling at a discount to its liquidation value. Insider signs are mixed, however, and require the margin of safety that a spin-off provides.
The first year’s operating results are hampered by the fact that the company effectively didn’t commence operations until the end of June when its first ship arrived. Even worse, that ship’s first charter (84 days) was for only $8400/per day, roughly half of what it is currently earning per day. Since the ship is now chartered at a much higher rate, it’s reasonable to expect that losses will be reduced by those two factors alone. Additional non-operating factors also exaggerate the extent of the company’s losses. DCIX keeps its cash balance in euros, which led to a foreign exchange loss in the fourth quarter that I estimate at around $480,000. That accounted for almost all of the net loss in Q4 and with either currency hedges or a more favorable environment for the euro (well, uh…maybe just the hedges) the company could protect against future losses. Eliminating losses from currency fluctuations brings DCIX near the breakeven point on Q4. That isn’t true for the third quarter, but only because the average daily rate earned in Q3 was weighed down by that first $8400/day charter and the later start for the second ship. Had the ships been chartered out at their current rates, the company would have earned around $800k pre-tax in the third quarter (though again, much of that would be due to currency fluctuations, albeit in the opposite direction). With either cost reductions or a new charter for the Sagitta, which currently earns $4,000/day less than its sister ship Centaurus, DCIX should be able to turn a profit. A better charter is more likely, since DCIX is already paying a below-average rate for daily ship operating expenses (about $900/day less, as you can see from data provided in the prospectus). Also, average charter prices are continuing to rise. Even as of July 2010, the average rate was greater than the Sagitta’s current daily rate and still moving upwards. By the time Sagitta’s charter expires in March-June (the precise end date depends upon the redelivery time chosen by the charterer) average rates should be even higher, resulting in in substantially higher rates for that ship and probably putting the company in the black for FY2011.
The company’s assets provide much clearer value. Assets consists almost entirely of two items: cash and the two ships. Both can be valued easily, which is a plus for investors looking for safety through asset value. Cash is $12M, plus $93M for the vessels. Judging by the secondhand vessel prices listed in the prospectus, the two ships would fetch about $25M a piece if they were sold off. That adds up to a liquidation value of $42M (net of all debt), which is a handy benchmark for investors. With about 6M shares outstanding, there is $7 liquidation value per share. If the initial waves of selling drive prices below that level, DCIX becomes a solid value even without its impending return to productivity. As an added bonus secondhand prices are tied to average charter rates – moving in the same direction but lagging a few months behind – so if charter rates continue to rise, then resale values ought to follow. There’s also a semi-active secondary market to facilitate sales. For the truly pessimistic, scrap value comes out to be $200/ton and, backtracking from depreciation, the total lightweight tonnage (the ships’ physical weight) is 75,800 tons, meaning total scrap value for the ships is $15.16M and overall scrap-liquidation value is $27M, with $7M left after debt. For reference:
Book Value (essentially tangible book) = $85M, or about $14.16/share
Liquidation Value = $42M, or $7/share
Scrap-liquidation Value = $7M, or $1.17/share
Since shipping rates (and the profitability of this company/industry) tend to follow the volume of trade up and down, the proper buy-in point will probably reflect investors’ level pessimism about the economy and desire for safety.
The last item to check is a faithful indicator of which way those “in the know” expect things to play out: insider actions and incentives. The upside is that Diana Shipping is retaining an 11% stake in DCIX. If Diana Shipping thought this thing was genuine garbage – or if they intended to bleed it dry with pointless fees – there’s no reason to hold on to hold on to a fifth of their DCIX stock. Diana Shipping therefore has at least some interest in seeing DCIX succeed (and in recouping the $50M that it invested in Diana Containerships to get it going). This is especially true since DSX’s executives also hold all the major offices in DCIX. If anyone would know the problems on either side, they would.
The issue of DCIX’s management and brokering agreements is a little more complicated. Short version: DCIX is under contract to pay Diana Enterprises, a related business owned by Symeon Palios, the CEO of DCIX and DSX, $1M per year in fixed fees (jumping to $1.3M after the public offering), plus 1% commission and $15K/month on the charters. This makes folks nervous – or will when they read it – and with good reason.
The charter commissions and fees seem relatively normal for the industry, where commissions can range up to 5%, but the fees paid to Diana Enterprises seem a bit extravagant – not to mention blatantly self-serving – regardless of the prospectus’ assurances that such fees are consistent with industry standards (is anything on a prospectus ever inconsistent with industry standards?). It’s an unsettling setup, but there are a few minor bright spots. Mr. Palios seems to have a similar system set up with Diana Shipping, which at least appears to be run competently and profitably. It’s also good to see that the management contract is for only one year. It renews automatically each year, but it looks like the renewal can be cancelled without penalty by either management or a shareholder vote. Since management only controls about 4% of the company’s stock after all incentive awards, shareholders could theoretically toss it out when it comes up for renewal in June even if management was opposed (realistically, shareholders are probably too lazy…). Management also does have the aforementioned 4% share to keep it pseudo-honest. It’s not a strong guarantee, but it’s better than nothing.
All in all, the mixed interests of insiders are the biggest red flag for DCIX, but the improving earnings situation and readily quantifiable assets combined with (presumably) bargain prices following the distribution present a good value opportunity.
Spin-off Announcement: http://www.secinfo.com/ds2zp.r6U1.htm
Latest Earnings: http://www.secinfo.com/ds2zp.r6Hu.d.htm