Hello, everyone, and thank you for joining us during the Lytham Partners Fall 2024 investor conference. My name is Roger Weiss, and I'm a Vice President of Lytham Partners. In this Analyst Insights video, we welcome Liam Burke, Managing Director of B. Riley Securities. He provides research coverage of diversified industrials, shipping, and natural resources. Liam is a two-time recipient of the Thomson Reuters Analyst Awards and a longtime Wall Street veteran. All right, Liam, let's talk about what's going on in the shipping industry.
Sure.
Um.
Hopefully, we'll change the perspective or give another perspective on the sector.
Excellent. And maybe we should start out by saying, you know, just kind of conceptually, in past shipping upcycles, we've seen vessel operators who expect rates to stay high respond to higher rate expectations by leveraging up their balance sheets to fund expansion of all their fleets by buying new vessels. Then, as the cycle invariably turns down and the rate environment weakens, these same shippers are left with obviously over-levered enterprises that generate negative cash flows and drive down share prices. How has the shipping sector changed during the current cycle?
Well, the first way to look at it, and you correctly pointed out, that's the carnage that occurred in the last upcycle. This upcycle, I think we're looking at managements with a much, much more disciplined return perspective. And they are looking at a new vessel in terms of what value can be created versus other alternatives on how they can reinvest their capital, either debt reduction, returning cash to shareholders. But I'd like to think that rationality among the owner-operators is the driving force, but there is another overriding factor here, and that's the International Maritime Organization, or IMO. That's the regulatory body above the shipping industry that lays down regulations, and their environmental regulations have stated that they by 2050, they want to be at net carbon zero emissions for the global shipping sector.
Well, they've begun doing it, and they've taken some baby steps, but in order to meet that mandate in 2050, there needs to be a new propulsion or new filtration technology developed, which today doesn't exist. So let's go back to our investment discipline. Let's say I'm a tanker owner-operator that wants to invest in a new large tanker known as a VLCC. They cost roughly $100 million, so I know what my costs are. I know what my five-year special surveys cost, and I can make a range of assumptions based on historical spot rates or time charters as to the cash flows that that asset can generate. Fine. I can make a rational decision based on variables that are fairly known. But let's take the environmental mandate.
For ten years from now, propulsion technologies or filtration technologies decide several possibilities on that original investment could occur. Maybe the technology is at a point where it makes that vessel obsolete in ten years, leaving fifteen years of economic life on the table. Probably not gonna happen, but you have to factor that into your investment decision. More likely than not, there's gonna have to be a modification made on that vessel. How much will it be? Is it 10% of that $100 million? Is it $10-$15 million? Again, possibilities, but very unknown and very difficult to make an investment case on a new build.
What we're seeing now are vessel operators are managing their fleets or renewing their fleets using opportunistically buying secondhand vessels, either adding these vessels to grow their fleet or adding newer vessels and secondhand vessels and selling older ones to manage the fleet this way, but the net effect is we don't have, there's no capacity growth on the global fleet, and the order books have remained muted, where we are not seeing any additional fleet growth until twenty twenty-six or twenty twenty-seven, so now we have an enterprise that's capital expenditures outside of vessel acquisitions or limited special surveys every five years or dry dockings of their vessel, so the cash flows are very strong, so what have these vessel operators done on how they're managing their balance sheet?
They're looking not towards elevated rates forever. They're managing the balance sheet for the downturn. So what's happened here is there's been a tremendous amount of delevering across the board. Most of the companies we follow have debt to trailing twelve-month EBITDA of less than one. We're also seeing three companies that may be net debt zero by the end of 2024, and definitely by the first quarter of 2025. The other benefit is rates are still elevated. Lower debt translates to lower cash cost per vessel, further increasing the operating leverage that these fleets will generate. So we've looked at fleet renewal, we've looked at dry docking, and we've looked at debt reduction, and we still have excess cash. So the companies are looking at it in different ways on how to approach returning cash to shareholders. One is obviously buybacks.
One of these companies looks at what is known as net asset value, or NAV, and they look at the net asset value of their shares, vis-à-vis their fleet. If their shares are trading, which they are, at a discount to that NAV, the company will buy back those shares up until they reach NAV. They're also, at the other end of their fleet, they've got older vessels that can trade, that sells at NAV. So they'd be selling vessels at NAV, taking that cash, plus existing cash flow, and buying in their shares. This quarter alone, they've reduced their share count by 0.5%, one quarter alone. Another way to look at it or way other companies look at it is distributing it through variable dividend.
What happens here is, companies will establish a quarterly dividend that they know they can pay through the cycle and set that as a baseline. Then they'll turn around and say, "Okay, remember, on a quarter-to-quarter basis, our cash flows are variable, and on a set formula, we'll distribute that excess cash based on the quarterly cash flows." And they've done a really nice job of educating investors to say, "Hey, that dividend will change. So if we have a strong quarter, and, for example, $1 a share, don't be surprised if a seasonally slower quarter, that dollar is only maybe $0.75 or $0.50." But on a cumulative basis, you look at the dividend yields of two of these companies that have stated variable dividend programs, and those dividend yields are well north of 10%.
So we have tighter balance sheets, we have return discipline, and we have cash being returned to shareholders. So it's a very different world than the one that was incorrectly laid out about 10 or 15 years ago, where trees were growing to the sky, and you could buy vessels until your heart's content and lever up because nobody cared.
Right, and until the worm turns. And so-
Again, as I mentioned before, they're managing their balance sheets for that downturn.
That's, that's very interesting to hear. Obviously, besides the environmental and economic inputs, we have seen certainly over the last year, geopolitical issues. When you think about, you know, understanding variables like, you know, the geopolitical risk associated with the attacks in the Red Sea, how do you see the market in the shipping sector for the remainder of this year and into 2025 ?
Really good question. When you think about the Red Sea, the simple answer is that it takes longer. Shipping requires longer distances to deliver commodities and goods. But let's dig down specifically, and let's use the container sector as an example. Going into 2024, there was slight excess capacity in the global container fleet, and it was expected to remain that way through the beginning of 2026. Now, that's not a big deal in the container sector, because typically, it's a steadily growing business, steadily growing in terms of shipping volumes. Over the last 50 years, container shipping volumes have only declined on a year-over-year basis only three times. So it's vis-à-vis dry bulk and tankers, this is a fairly predictable sector.
So if capacity grows a bit, people aren't overly concerned because it doesn't, the order book doesn't get too much out of hand. So with the advent of the Red Sea crisis, where we saw ton mile distances in order to deliver goods increase by about 20%. So that translated to a slightly 10% surplus or overcapacity, to 90% to a 10% deficit. And to translate that into rates, and I'll define that as the cost of sending a container from point A to point B. Those rates jumped from the end of 2023 to this week, almost 300%. So there is a clear distance problem or distance opportunity, bad for us, good for them, and it translates into elevated rates. Now, the way the market is looking at this is temporary.
I mean, we're all hoping this resolution happens sooner rather than later, and I agree with the market. This is temporary. This will resolve itself. However, the benefits of these elevated rates are permanent, and what I mean by that is, the excess cash that has been generated during this period of elevated rates has not gone into additional fleet investments. It's gone right back to the benefit of the shareholder. Accelerated debt amortization obviously benefits the shareholder by transitioning enterprise value from the debt to the equity holder, and again, returning cash to shareholders in programs like buybacks or dividends or both, and those are events that occur and have permanent benefits to the shareholders as we move forward. Right now, just a comment on, we're a year into this now.
There doesn't seem to be any sign of letting up, but I do want to emphasize the way we view it is, it's temporary. On a rate basis, they inevitably will come down, but all that cash has gone to good use during the time of elevated rates.
Got it. That's very helpful. I know we only have limited time, so let me ask one more question, and this regards the biggest, I think, manufacturer out there, China, and whose economy continues to slow down, and how does that influence the shipping sector?
China is a very large influence on shipping. 40% of all dry bulk goods are imported by China. China imports 15% of the world's crude. Right now, we're seeing the Chinese government sort of pulling back from the stimulus to try and maintain these outside GDP growth rates, and we're seeing an admitted slowing in GDP growth, which has translated to flat-to-down steel production. We're looking at less iron ore demand, which is the largest dry bulk. And in the second quarter and early third quarter, crude oil imports were down in China, which is something that nobody's seen in a long time.
So we're looking at that, saying, "Okay, on the surface, this is a problem." But if you look at what the IEA says, the International Energy Agency, they're still predicting, despite what we're seeing in China, that crude consumption is gonna grow year over year, worldwide. If you talk to World Steel Association, despite the fact they anticipate flat-to-down steel production in China, global steel production will grow, albeit slightly, but grow. And then looking at Vale, the largest iron ore producer, they're anticipating production growth in 2024. So what I'm getting at here is that, yes, demand is down, and that's not a good thing when the country... the shipping industry is heavily dependent on this country, but we're seeing redistribution of that demand. I'm not suggesting this transition is going to be smooth.
There's obviously going to be bumps, but we're seeing additional demand pop up where we're looking at macro demand. The other thing in terms of shipping industry is sourcing of key raw materials, like crude. Most of the production growth is coming from non-OPEC+ countries, Latin America, Africa, US. Those are longer ton miles. Iron ore, Africa and Latin America versus Australia, again, longer ton miles. So as long as we have tighter supply, as long as we have incremental growth, I think the decline or the slowing growth of the Chinese economy is very manageable.
So all in all, if I could put it all together, and you'll excuse the pun, you continue to see smooth sailing for the shipping sector. I'm sure you've never heard that line before.
No, I haven't. No, yeah, I do. Keep in mind, on a quarter-to-quarter basis, you'll see volatility. There's always headline risk, so that's something that you have to live with, but I mean, some of the reputation garnered from all the things that you pointed out in the past are well earned, but I think the industry is working very hard for transparency, good corporate governance, and certainly a stewardship of both the fleets and the balance sheet.
Very good. Well, on that note, Liam, thank you again for joining us here at the conference and speaking about your views on the shipping sector, and expectations for, obviously, the rest of this year and into 2025. To all the viewers out there, thank you for watching us, and we appreciate your interest, and hope you enjoy the rest of the Lytham Fall 2024 conference.
Thank you, Roger.
Thank you again.