Flex LNG Ltd. Q1 FY2022 Earnings Call

Thank you, and welcome everybody to today's Flex LNG webcast. I'm Oystein Kalleklev, CEO of Flex LNG Management. And I will once again be joined by our CFO, Knut Traaholt, who will talk you through the numbers a bit later in the presentation. As always, we will conclude with a Q&A session. Before we start the presentation, I will remind you of the disclaimer as we will provide some forward-looking statements, use some non-GAAP measures, and there are limitations to the completeness of detail we can provide in this webcast. So we recommend that you also review our earnings report. So okay, let's kick off with the highlights and a short summary of them. It's fair to say that while the first quarter has been a fantastic period for cargo owners given the global energy shortage with elevated LNG prices worldwide, it has not been as good for shipowners with ships in the spot market. The spot freight market has been challenging due to the rather rapid shift in trade pattern. The shift in trade pattern started in late 2021, well ahead of the war in Ukraine and occurred as European buyers started to mop up the spot cargoes to ensure they got supply given the low gas inventory levels. The pull to Europe instead of Asia resulted in a sharp increase in sailing distances and thus freeing up more ships in the market. With significantly lower activity in the spot market, this adversely affected the earnings on the three indexed ships, as well as approximately 1.5 ships, which we have traded in the spot or short-term TC market during the first quarter. In any case, despite a challenging spot market, we were able to deliver revenues of $74.6 million in line with our guidance presented in February. Revenues were just about $40 million lower than in Q4 last year, but it's fair to say that Q4 was exceptionally good given the all-time high spot rates. About half of the decrease in revenues was due to lower earnings on the three ships on variable hire contracts, while the remaining half was due to spot exposure in Q1 for the 1.5 ships mentioned. Despite the softer market, net income came in at a cool $55.8 million or $1.05 per share. A big chunk of the earnings was admittedly related to our portfolio of interest rate derivatives prior to the interest rates going on a bull run due to Fed tightening. We secured the majority of our debt against higher interest rates through interest rate swaps, and Knut will give some more details about our hedging strategy a bit later in the presentation. Adjusted for the big gains on interest rate swaps, earnings per share came in at $0.45 per share. As we guided in our February presentation, and I am repeating today, we do expect to deliver sequential quarterly improvements in our revenues, which will beef up our cash flow. We have a strong backlog with 98% contract coverage for the next three quarters. So our earnings variability is related to the three ships with variable higher rates. Being exposed to the spot market is, however, affected now given the recovery in spot rates. The dividend for the quarter is $0.75 per share, which gives our shareholders an attractive yield of about 12%. Lastly, as I will explain, we are also well-positioned with three ships coming fully open over the next 22 months. And with strong term market interest, we are upbeat about the prospects of recontracting these ships. Turning to page 4 and our fleet status. As you can see from the slide, we are more or less fully covered for the year. The only possible open position is Flex Amber, which could possibly redeliver at the end of October unless the charter utilizes their last one-year extension option. Term charter coverage for Q2 to Q4 is just 98% as explained. During Q1, we had a couple of ships coming off shorter-term time charters and commencing longer-term charters. In January and February, Flex Courageous and Flex Resolute were delivered from shorter-term contracts and following redelivery, the two ships commenced time charters with a super major. The period for the new time charters is a minimum of three years with two plus two optional years, bringing the period to seven years in total for each ship. Due to the structure of the time charter for these ships and contracts, we do expect that the charter will eventually declare the full seven-year period. In February, Flex Freedom was redelivered from a short-term 10-month time charter. After redelivery, she was delivered in direct continuation to a super major for a period of five years where the charter has the option to extend the period to also seven years in total. In February, we also got Flex Aurora redelivered from a 17-month time charter, and we fixed her on a short-term flexible time charter of five to seven months, also with a super major, and this duration matched exactly with the delivery window for the Cheniere contract commencing in Q3. Flex Volunteer, which performed impressively in the spot market last year, especially in the fourth quarter, had a very weak first quarter as there were very few spot requirements at the start of the year, resulting in significant waiting time for the ship during this quarter. We were, however, able to eventually fix the ship for our short spot voyage and thereafter agree with Cheniere for early delivery of the ship to them about two months ahead of the original schedule in Q3. Hence, Flex Volunteer thus became the fourth ship to Cheniere with a duration of about 3.7 years, rather than the original 3.5 years. As Cheniere has also utilized the option to add our fifth ship, Flex Aurora will thus be the fifth ship going to Cheniere during Q3 with a minimum period of 3.5 years. Flex Rainbow is the first ship that will be fully open in January 2023. In our view, this is a fantastic position, as there are very few modern large ships available prior to 2025. As I will also touch upon later, the term market is very strong, as charters are willing to pay to secure fuel-efficient tonnage given the elevated LNG prices and the introduction of EEXI and the European emission trading scheme for shipping next year. Lastly, we have three ships on variable hire contracts, as mentioned, these being Flex Artemis on a minimum five-year variable hire contract with Cheniere, as well as Flex Amber and Flex Enterprise. The charters of Flex Amber and Flex Enterprise have one additional extension option each. So if the charter were to utilize these extension options, which we think is very likely, the ships will come open during Q4 2023 and Q1 2024. As mentioned regarding Flex Rainbow, we think this provides us with very attractive marketing windows for these ships. As I've already covered our contract portfolio extensively on the previous slide, I just want to highlight the development in the charter coverage over the next couple of years. Most of the backlog is now fixed higher, but we also maintain a very high backlog on the three ships, which gives us exposure to the spot market, which usually reduces the earnings as we approach the winter season. We also do have some ships coming open in this period as mentioned, and we look at this more often as an opportunity than a challenge given the very strong term market. Slide six is our revenue guidance for the year, and the numbers are the same as we presented in February, with the only difference being that the Q1 numbers are now actual rather than our guidance. As you can see, we delivered according to the guidance provided. And we are now also guiding about $80 million of revenues in Q2, right in the middle of previous guidance of between $75 and $85 million. As mentioned, Q1 revenues are on the weak side due to our soft spot market. However, the spot market has bounced back, so we expect to generate higher revenues going forward. We have also covered the gap periods for both Flex Volunteer and Flex Aurora, and we are therefore expecting gradually improved revenues in the next couple of quarters. In aggregate, this means we still expect revenues for the year to be broadly in line with what we delivered in 2021, despite a bit of a slow start. Turning to slide 7 dividends, given our previous communication, it should not come as a big surprise that we are sticking to our dividend of $0.75 per share. As we have highlighted in the past, we prefer having a stable dividend level rather than adjusting up and down every quarter. This means that we sometimes pay out more and sometimes less than earnings, but over the longer term, this nets out, and we aim to pay out our full earnings over the cycle, as we have also been doing in the past, as you can see from this slide. Additionally, given our forward backlog, we also expect less volatility in earnings than what we have seen in the past. As we covered in detail in previous webcasts, we apply a balanced scorecard to assess the appropriate dividend level. For Q1, the earnings only received a yellow light, but with a large backlog, strong outlook, and very sound financial position, we expect all the lights to turn green again shortly. So with that, Knut will now go through the financials, before I return with our market update.

Thank you, Oystein, and let's turn to slide eight and the financial highlights. We delivered revenues just shy of $75 million and within the revenue guidance of $72.5 million to $80 million. This translates into a time charter equivalent of $63,000 per day. The quarter-on-quarter lower revenues are due to the weaker spot market in the first quarter, impacting our three vessels on variable hire contracts and the performance of Flex Volunteer and Flex Aurora, as explained by Oystein. The background for the softer market will be covered in more detail later in the presentation. The operating expenses were $14.4 million or $12,300 per day in OpEx. For Q1, we have made a one-off accounting adjustment relating to previous periods, and this is explained in more detail in the earnings report. The adjustment had a positive effect of $2.9 million on the operating expenses. Except for this adjustment, the operating expenses were higher quarter-on-quarter due to a higher number of crew rotations and handovers in Q1 versus Q4. Crew rotations for the vessels traded in the Pacific are more costly due to the continued severe COVID restrictions and quarantine requirements. In addition, ordering of spares, supplies, and associated services for the full year were expensed in the first quarter; thus, this should result in lower operating expenses for the rest of the year. Our main change this quarter is the gain on derivatives of $31.9 million, which relates to our interest rate derivative portfolio. As a result of increased long-term interest rates, this portfolio has continued to develop positively for us. I will come back and cover more on our interest hedging and derivative portfolio later in the presentation. In conclusion, net income for the quarter was $56 million, and adjusting for the gain on derivatives, the adjusted net income was $24 million. This results in earnings per share of $1.05 or adjusted earnings per share of $0.45. On the next slide for the balance sheet, for the quarter, there are no material changes on the balance sheet. The total assets is about $2.6 billion, consisting of our fleet of 13 state-of-the-art LNG vessels with an average age of 2.5 years and a book value of $2.3 billion, in addition to a cash balance of a solid $175 million. As covered on the next slide, the cash balance will further grow with the completions of the balance sheet optimization program scheduled for Q2. On the liability side, the vessels are financed by a diversified mix of leases, ECA financing, and traditional bank debt, with the first maturity due in 2025. We updated our balance sheet optimization program in the fourth-quarter earnings presentation in February. And today, we announced that a six-year $375 million bank facility was signed in April and utilized to refinance the Flex Ranger and the Flex Rainbow in April. The aggregate $320 million financing for the two 10-year leases for Flex Constellation and Flex Courageous was also signed in April and is scheduled to be concluded tomorrow. This leaves us with $905 million in book equity and a robust equity ratio of 36%. On the next slide, we see the cash flow for the quarter, and our cash balance at the end of the quarter ended up at $175 million. This is $27 million lower than last quarter, primarily driven by lower cash flow from operations, as explained earlier. Also, note that we pay higher amortizations in Q1 compared to Q4 due to the semiannual repayments under the $629 million ECA facility. This quarter, we did not have any proceeds from financing. Thus, after the net of $40 million in dividends, the cash balance came in at a solid $175 million. As shown in the graph, the cash balance will grow substantially in Q2, as we finalize the last phase of the balance sheet optimization program. $111 million will be freed up following the conclusion of the Ranger, Rainbow, Constellation, and Courageous financing. In Q3, we will refinance the existing lease for the Flex Endeavor, with her being the third vessel under the $375 million bank facility. As the bank tap amount for this vessel is slightly lower than the existing lease, the net effect is negative $12 million, resulting in net cash of $100 million being released under the balance sheet optimization program, which should be concluded materially tomorrow. The growing cash balance further adds to our already clean and robust balance sheet. So turning to the next slide, and more on our interest hedging. With the increase in interest rates, we thought it would be good to also provide some insight into our interest rate hedging portfolio. Over the last couple of years, we have built up a derivative portfolio with an aggregate notional amount of $876 million of plain vanilla interest rate swaps. This hedges the floating interest rate risk under our debt financing. With the assuring long-term interest rates and the new financing added to our debt funding, we utilized a big drop in long-term interest rates during the first week of March and secured interest rate swaps of $200 million, with tenors up to 10 years at an average rate of about 1.7%. In Q1, the derivative portfolio gained about $32 million, and we also informed that in April, it gained an additional $16 million due to the rising interest rates. In addition to the interest rate swap portfolio, the interest rate risk is further hedged through our fixed-rate leases, in particular for Flex Endeavour, Flex Enterprise, and Flex Volunteer. Despite that the lease of Endeavor is scheduled to be refinanced in Q3, the two remaining leases provide us with about $290 million of balance sheet hedge due to fixed-rate leases. There is no mark-to-market of the interest on the P&L for these leases. However, the 10-year $160 million for Flex Volunteer, which was done in December last year, carrying all-in interest of 4%, provides a very good hedge against rising interest rates. Our hedge ratio, including the fixed-rate leases, thus gives us a hedge ratio of 70% over the next years, with an average duration of 4.6 years and an average fixed interest of 1.25% compared to about 3% for a similar period today. Our hedge portfolio gives us good coverage for the expected high-interest environment in the period ahead. So in conclusion, we are quite pleased to see that our conservative interest rate hedging policy helps pay us off and contributes to maintaining the cash flow visibility from our time charter backlog. And with that, I hand it back to you, Oystein.

Thank you, Knut. I mentioned the fight against inflation with higher interest rates. As Knut has explained, we are well protected against these rates through our derivatives and fixed-rate leases. Regarding inflation, remember that our asset base consists of modern LNG carriers. With rising raw material prices, yard capacity issues, and increasing wage costs, it should not be surprising that the cost of building a modern LNG carrier has significantly increased. We purchased 11 LNG carriers at the bottom of the new building cycle in 2017 and 2018, which we have now received. Similar vessels are currently quoted at $225 million and newbuilding costs have been reported closer to $230 million. Additionally, you would need to account for newbuilding supervision costs and bulk costs. These prices reflect deliveries in 2026, as most of the 2025 slots are now filled. If you make this investment, you will have no income for the next four years, and to replicate our fleet, you would need to spend around $3 billion. After deducting our net debt of approximately $1.4 billion, the equity requirement amounts to nearly $1.6 billion, which will yield nothing over the next four years. We are not only well hedged against rising interest rates, but our assets also offer our investors solid inflation protection. Now, turning to the market, our February presentation showed the significant growth of US LNG exports, with a 23 million tonne increase in 2021, accounting for 120% of global market growth that year. This growth has persisted into the first quarter with a 4.4 million tonne increase, representing a growth rate of slightly over 20%. Despite the war in Ukraine, Russia has continued to find buyers for its LNG cargoes, increasing its exports by 1 million tonnes. US and EU sanctions do not apply to LNG exports from Russia, and European nations still heavily depend on Russian pipeline gas. However, several European countries are rapidly boosting their LNG import capacity to reduce their reliance on Russian pipeline gas, which will create additional long-term LNG demand. This trend is positive for the LNG shipping market, even with more cargoes heading to Europe, as LNG export capacity must also be expanded to accommodate the unexpected growth in the LNG market.

Gentlemen, and thank you for this comprehensive presentation. Strength in gas pricing has exacerbated the difference in realized rates between modern XDF or MEGI engines relative to TFDEs and especially to steamers. Could you provide some commentary on where do you see the current spread in performance given prevailing market conditions?

Yes. Thank you for the question. And I guess you are working with J Mintzmyer, who is also in Value Investor's Edge. I think we touched upon it. We have a graph here on the spot market, showing the rate for modern tonnage quoted slightly above 80,000 in the spot market, with around a $30,000 spread to older vessels. The spread is due to lower fuel consumption and higher cargo capacity with modern ships. Today, with high prices, the fuel spread has increased further. Under a time charter, fuel is a cost for the charter's account as part of the cargo is used as fuel. And additional time charter offers a chance for more market exposure, which we are happy with given the current outlook.

We have two questions from the web. Can you comment on the decreasing OpEx? Before COVID-19, they used to be around 15,000 per day and now they are much lower?

We have previously indicated that our operating expenses are at $13,000 per day, and we have been managing to stay slightly below that level even before COVID. However, last year, during the challenges posed by COVID, our operating expenses were a bit higher, around $13,300. Generally, we are still aiming for our operating expenses to remain at about $13,000. In the first quarter, they were slightly elevated due to challenges with crew rotations involving Russian and Ukrainian personnel, as well as stricter COVID testing and quarantine requirements in China. The impacts of COVID have continued for over two years, and we must deal with these challenges daily. Overall, we expect our operating expenses to hover around $13,000.

Then we have a question on China and reopening and how that might increase current income expectation for Flex. I assume that would refer to rate levels and revenues?

Yes. China doesn't need to purchase any spot cargoes this year. They have secured numerous new LNG offtake agreements, many of which are tied to oil prices. Additionally, they have made several agreements in the US based on Henry Hub gas prices. This means China can obtain LNG at a relatively low cost and meet all their requirements. We've also noticed some Chinese buyers attempting to sell cargoes to European and Latin American buyers, indicating they are not heavily reliant on spot purchases. If China returns to full capacity after addressing COVID quarantines, they might follow the same economic stimulation path as the US and Europe, which could lead to increased demand. When demand rises, more energy will be needed. Once China fully reopens, I expect a significant surge in their activity, prompting them to seek more spot cargoes that could potentially increase ton mileage and spot rates. Currently, three of our ships are linked to the spot market while the remainder is on fixed-rate charters, so the immediate impact is limited, but since China is the largest LNG importer, we hope they can resolve their COVID-related challenges and return to normalcy like Europe and the US, resulting in increased LNG demand, which has risen substantially over the last decade.

That concludes the questions on the web.

I think there's one question here; it's the same question. It's what are we going to do with all the cash? And I think that was the headline of the Pareto research note this morning. I can tell you one thing; we're not going to do stupid things with the cash. Right now, we're just going to finish the balance sheet optimization program, get this other $99 million on the account, and we'll use the revolver to optimize our cash management while not paying too much interest to the banks. We will continue to return dividends to our shareholders. And we might still look for opportunities to grow the company, but we won't do foolish acquisitions just because we have excess cash; rather, we will pay dividends than overpaying for assets. So, I think that's it. Okay. Thank you, everybody, for joining today, and we will be back in August then with the second-quarter presentation. Have a good day.

Thank you. Dear participants, we will now begin the question-and-answer session. We have the first question coming from Climent Molins from Value Investor's Edge. Please ask your question.