SFL Corp Ltd. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to the SFL Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. I must advise you the conference is being recorded today. I would now like to hand the conference over to your speaker today, Ole Hjertaker. Please go ahead, sir.

Thank you and welcome all to SFL's second quarter conference call. I will start the call by briefly going through the highlights of the quarter. Following that, our CFO, Aksel Olesen will take us through the financials and the call will be concluded by opening up for questions. Before we begin our presentation, I would like to note that this conference call will contain forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Words such as expects, anticipates, intends, estimates, or similar expressions are intended to identify these forward-looking statements. These statements are based on our current plans and expectations and involve risks and uncertainties that could cause future activities and results of operations to be materially different from those set forth in the forward-looking statements. Important factors that could cause actual results to differ include conditions in the shipping, offshore, and credit markets. For further information, please refer to SFL's reports and filings with the Securities and Exchange Commission. The announced dividend of $0.25 per share represents a dividend yield of around 10.5% based on closing price yesterday and this is our 66th quarter with dividends. Over the years, we have paid more than $27 per share in dividends or $2.3 billion in total and we have a significant fixed-rate charter backlog supporting continued dividend capacity going forward. The total charter revenues of $158 million were in line with the first quarter with more than 90% of this from vessels on long-term charters and less than 10% from vessels employed on short-term charters and in the spot market. All customers are current on the charter payments and we have good cash flow visibility into the current quarter. The EBITDA equivalent cash flow in the quarter was approximately $121 million, and the last 12 months, the EBITDA equivalent cash flow has been approximately $481 million, demonstrating stability. With a very large proportion of long-term charters and the fact that all customers are current with charter payments, the underlying business remained robust and the cash position was more than $150 million after a payment of a bond loan in June. In addition, we had $35 million in marketable securities at quarter end. Our fixed-rate backlog stands at approximately $3.4 billion after recent vessel acquisitions, charter extensions, and vessel sales providing cash flow visibility going forward. We have been cautious in light of the uncertainty caused by the COVID-19 outbreak. But in May, we acquired a new build VLCC with a long-term charter. The net purchase price was $65 million, which is significantly below current broker estimates for VLCC resales effectively providing SFL with a very attractive risk profile. Our chartering counterparty, the Landbridge Group has secured a three-year sub-charter to an oil major providing good cash flow visibility. There are purchase options for the charter during the charter period first time after three years and at the end of the charter, there is a purchase obligation. The net contribution after debt service during the first three years is estimated to be more than $4 million on average with full cash flow effect from this quarter. We have been active extending charters on our existing fleet. And so far this year, we have added $172 million to our charter backlog on existing vessels. $38 million was linked to an extension agreed in the second quarter for seven container vessels extended by another 4.5 years. With a large fleet of assets, there will always be acquisitions and disposals and two of the vessels on charter to the Hunter Group have been repurchased by them. The Hunter deal was designed to give us a very high return on a low-risk profile in exchange for flexibility on Hunter's part. This is a good example of a cost of capital arbitrage where we could utilize our premium access to low-cost funding and at the same time give flexibility that Hunter was willing to pay for. Delivery took place earlier today and net cash to us is $23 million after repayment of the associated financing, and there is one vessel remaining with Hunter in our fleet after that. We have also been active in the financing market over the last few months and have addressed most of the financing maturities this year. Terms have been attractive, and we have seen lower all-in interest costs than ever before despite the general market volatility. We believe part of the reason for this is the consistent performance of SFL over the last 16 years and our ability to source capital from a much wider market than most other maritime companies. During the second quarter, we refinanced four large container vessels at historically low interest costs. We sourced $50 million of non-recourse financing on the new VLCC we acquired, and we repaid the Norwegian kroner denominated bond loan due in June from our cash position. The COVID-19 pandemic has caused massive disruptions in most transportation markets and for offshore assets. As early as January, we implemented a robust emergency management plan, with the goal of ensuring the health and safety of our crew on board the vessels and onshore while maintaining our business operations as efficiently as possible. In addition to our own requirements, all crewing managers are following the guidance issued by the World Health Organization and the International Chamber of Shipping to ensure that the proper protocols are in place on board the vessels. We are hosting regular meetings with all crewing managers in all our sectors to discuss and handle any issues, particularly challenges facing our crew and safe operations as they arise. While we have good and strong protocols in place on board our vessels during the normal ship and port operations, our biggest concern is with crew changes. The logistics challenges of testing and moving people across borders safely without infection are enormous. In many countries and ports, such movements are not even allowed. This means that we have had to postpone crew changes and extend the contracts of many of our seafarers over this period after the outbreak. While they have shown great understanding of the situation, there are many individuals who have suffered due to this and we acknowledge their vital contribution in these challenging times. In addition to crew transfers, we have also experienced some delays at shipyards in connection with dry dockings and scrubber retrofitting of vessels. Of the 85 vessels, currently only three are idle, and we have seen some improvements in the market in several of the segments recently. After all, the vessels more exposed to near-term market developments represent less than 10% of our charter revenues and the 90% fixed-rate revenues are more insulated to short-term market movements caused by FX that we could not predict. Despite the impact of COVID-19 on global trade, all our counterparties are current on charter hire payments with good visibility for the current quarter. But we will, of course, continue to closely monitor developments in our customers' end markets to be able to react quickly to any potential business disruptions. Following the recent charter extensions, our charter backlog now stands at approximately $3.4 billion and of this, more than $420 million has been added in the last 12 months. Over the years, we have changed both fleet composition and structure, and we now have 85 assets in our portfolio with no vessels remaining from the initial fleet in 2004. We have gone from a single asset class, chartered to one single customer, to a diversified fleet in multiple counterparties. Over time, the mix of the charter backlog has varied from 100% tankers to nearly 60% offshore at one stage, to container being the largest segment now with 55% of the backlog. We do not have a set mix in the portfolio; the focus is on evaluating deal opportunities across the segments to try to make the right decisions from a risk-reward perspective. Over time, we believe this will balance itself out, but we try to be careful and conservative in our investments and not just invest because money is burning in our pockets. With the exception of two car carriers that are currently idle in the shipping space, all our other assets are generating cash flow. Some segments like the dry bulk market and containership market have also improved over the last few months. The offshore market, however, remains very challenging. We have three rigs on charter to Seadrill and two of the rigs are harsh environment units working in the North Sea. West Linus is sub-chartered to ConocoPhillips on a very long charter until the end of 2028. West Hercules, a semi-submersible, is sub-chartered to Equinor until next year. In addition, there are some options for Equinor for extended employment. The third rig, West Taurus is idle and laid off in Norway. Seadrill is paying the agreed charter hire on all three rigs and we continue reducing the debt on the rigs as per schedule. This means that we have reduced debt by nearly 30% since Seadrill filed for Chapter 11 in 2017. Seadrill has disclosed that it is currently engaged in discussions with its lenders to provide operational flexibility and additional near-term liquidity. We believe it will be in all stakeholders' interest to have a financially stronger counterparty and we are in a constructive dialogue with Seadrill. I can unfortunately not comment anymore on this right now. But given our fleet composition most of our cash flow comes from shipping assets and unlike most other companies with a financing profile in the maritime world, nearly two-thirds of our cash flow comes from vessels on time charter and only one-third from bareboat chartered assets. Our strategy has been to maintain a strong technical and commercial operating platform in cooperation with our sister companies in the Seatankers Group. This gives us the ability to offer a wider range of services to our customers from structured financing to full-service time charters. But more importantly, we also believe it gives us unique access to deal flow in our core segments. And with that, I will give the word over to our CFO, Mr. Olesen, who will take us through the financial highlights for the quarter.

Thank you, Mr. Hjertaker. On this slide, we have shown a pro forma illustration of cash flow for the second quarter. Please note that this is only a guideline to assess the company's performance and is not in accordance with U.S. GAAP, and also net of extraordinary and non-cash items. The company generated gross charter hire of approximately $158 million in the second quarter with more than 90% of the revenue coming from our fixed charter rate backlog, which currently stands at $3.4 billion providing us with strong visibility on the cash flow going forward. The liner fleet generated gross charter hire of approximately $80 million. And of this amount, approximately 97% was derived from our vessels on long-term charters. At the end of the quarter, SFL's liner fleet backlog was approximately $1.8 billion with an average remaining charter term of approximately five years or approximately eight years if weighted by charter revenue. Approximately 84% of the liner backlog is with the world's largest liner operators, Maersk Line and MSC. During the quarter, SFL extended the charters for seven 4,100 TEU container vessels with MSC until the third quarter of 2025. The extension added approximately $38 million to SFL's fixed charter rate backlog. Our tanker fleet generated approximately $27 million in gross charter hire including $4.5 million in profit-split contribution from our two VLCCs on charter to Frontline. The two VLCCs earned approximately $72,000 on average per trading day in the second quarter. During the quarter the vessels commenced new time charters on which the vessels will trade until the fourth quarter at similar rates ensuring stability on quarterly profits with contributions also for the next two quarters. As for Suezmax tankers, revenue was down for the quarter as one of the vessels underwent special survey scrubber retrofit installations during the quarter. Furthermore, the company acquired the 2020-built scrubber-fitted VLCC Landbridge Wisdom in combination with a 7-year bareboat charter to the Landbridge Group. The vessel was delivered in May and has been sub-chartered for three years to an oil major on a time charter basis. The acquisition cost of $65 million was financed by a $50 million non-recourse debt facility. The transaction will have a full earnings effect in the third quarter. On August 18, 2020, the company redelivered two VLCCs to the Hunter Group after the declaration of purchase options. The transaction increases SFL's cash balance by approximately $23 million. During the second quarter, our dry bulk fleet generated approximately $26 million. Of this amount, approximately 84% was derived from our vessels on long-term charters, and approximately 16% was derived from vessels on short-term charters. There was no profit-split contribution from our Capesize vessels on charter to Golden Ocean during the quarter, as the COVID-19 pandemic negatively impacted dry bulk demand by creating logistical issues, including port closures and quarantine restrictions. The soft travel market also impacted the revenue on our 10 vessels trading in the short-term market. At the end of the second quarter, SFL owned three drilling rigs. All of our drilling rigs are on long-term bareboat charters to fully guarantee the affiliates and generated approximately $25 million in charter hire. The harsh environment jack-up rig West Linus is sub-chartered to ConocoPhillips until the end of 2028. While the harsh environment semisubmersible rig West Hercules is employed on consecutive shorter-term subcontracts to Equinor in the North Sea. The semisubmersible rig West Taurus is currently in layup in Norway. This summarizes to an adjusted EBITDA of approximately $121 million for the second quarter or $1.11 per share, which is in line with the previous quarter. We then move on to the profit and loss statement as reported on U.S. GAAP. As we have described in previous earnings calls, our accounting statements are different from those of a traditional shipping company. As our business strategy focuses on long-term charter contracts, a large part of our activities are classified as capital leasing. As a result, a significant portion of our charter revenues are excluded from U.S. GAAP operating revenues and instead booked as revenues classified as repayment of investment in finance leases and vessel loans results in associates and long-term investments and interest income from associates. So for the second quarter, we report total operating revenues according to U.S. GAAP of approximately $118.5 million, which is a smaller number than the $158 million of charter hire actually received for reasons just mentioned. Furthermore, the company recorded non-recurring and/or non-cash items including negative mark-to-market effects related to interest hedging, currency swaps, and equity investments of $7.3 million, prepayment of interest under swaps of $4.5 million, amortization of deferred charges of $2.6 million, and credit loss provisions of $1.4 million. Adjusted for these items, the company's net income would have been $27.8 million. Overall and according to U.S. GAAP, the company reported a net profit of $11.8 million or $0.11 per share. Moving on to the balance sheet. In terms of liquidity, the company continues to have a solid cash position with approximately $152 million in cash and cash equivalents, excluding approximately $50 million held in fully owned non-consolidated subsidiaries. In addition, the company also had $8 million in restricted cash related to equity securities. At quarter end, the company had marketable securities of approximately $19 million net and adjusted for purchase obligations on securities. This includes 1.4 million shares in Frontline Limited and financial investments in secured bonds and other securities. During the second quarter, SFL sold approximately 2 million shares in Frontline, explaining the drop in the book value of marketable securities on the previous quarter. Approximately $300 million of short-term debt is related to senior bank financing on vessels for SFL, secured by charter extensions until 2024 and 2025 at attractive terms. This includes three 8,700 TEU container vessels on charter to Maersk and seven 4,100 TEU vessels on charter to MSC. The balance of approximately $100 million is related to ordinary scheduled loan amortization and a $16 million purchase obligation on the Frontline shares. At quarter end, SFL had five debt-free vessels with a combined charter fair value of approximately $30 million, based on average broker appraisals. Based on Q2 2020 figures, the company had a book equity ratio of approximately 25%. Then to summarize, the Board has declared a cash dividend of $0.25 for the quarter, which represents a dividend yield of approximately 10.5% based on the closing share price yesterday. This is the 66th consecutive quarterly dividend. Since the inception of the company in 2004, more than $27 per share or $2.3 billion in aggregate has been returned to shareholders through dividends. While we continue to collect revenue from a $3.4 billion fixed charter rate backlog, we also have upside from profit-split arrangements from our VLCCs in addition to profit-split arrangements related to fuel savings on some of our large container vessels. Despite a relatively volatile market in 2020, we have already added approximately $230 million to our fixed charter rate backlog and we continue to explore new business opportunities. While risk premiums on energy and shipping investments have increased with the recent volatility in financial markets, SFL has, at the same time, with new fleet financing at all-time low cost of debt, continued to expand its group of lending banks. SFL's business model has continuously been tested throughout its 16 years of existence and has previously been highly successful in navigating periods of volatility. And with that, I give the word back to the operator who will open the line for questions.

Thank you. Your first question today is from the line of Greg Lewis from BTIG. Please go ahead.

Hi, Greg.

Hello, good afternoon, everyone. Ole, I'm interested in your thoughts on the challenges capital is facing in your traditional investment area. I have two questions regarding that. First, could this lead you to explore opportunities outside of your usual conventional shipping focus? That's my first question.

Thank you for your insight. You’re right in noting that we are not limited to any specific segment. Our focus has been on the maritime industry for several years because we have observed significant deal flow there, and we might even get access to opportunities before others due to our connection with Mr. Fredriksen, which helps us identify long-term employment opportunities. This ongoing information flow has been beneficial for generating business. However, we are not exclusively tied to maritime. We can explore other infrastructure sectors as well. Our primary objective is to maintain a structure that ensures we have deal flow to deliver predictable long-term dividends to our shareholders while managing an appropriate risk profile. So far, our ventures have largely remained within the maritime sector. One reason for this might be that if we venture into new areas where we lack information leverage, we risk overpaying, acquiring deals that others have rejected, or accepting returns that are too low to justify entry. Ultimately, it comes down to identifying the right deals, which we can also pursue outside the typical shipping domain.

Okay. Great. To rephrase that question, given the lack of capital interest in the maritime space that has emerged over the past 12 to 18 months, have you noticed any increases in the potential returns of the transactions you are considering? Or are we in an environment where there is less capital available, but still enough to keep returns relatively stable?

Yes. It's a good point and observation. I think the way we see it is that capital in shipping is priced more correctly. And there's also the traditional lenders are retracting from the market. So basically there’s less capital available, and there’s, in general, especially to quality. For SFL's part, we again have access to a larger pool of banks. We have access to capital at a lower cost of capital. We're able to find transactions where we can take advantage of the capital cost arbitrage at attractive risk-reward metrics. A good example of that is the recent Landbridge transaction. We acquired a brand new scrubber-fitted VLCC at $65 million on a variable basis. The client, Landbridge Group has a three-year charter with BP shipping on a time charter basis attached to it. We believe that's a very attractive risk-reward in terms of the capital we're able to deploy and the return we're able to achieve. I think that's a trend that will continue going forward.

Okay. Thank you very much.

Thank you.

The next question is from the line of Randy Giveans from Jefferies. Please go ahead.

Hi gentlemen. How’s it going?

Hi, just good.

I guess first just looking at the balance sheet. Obviously, it's in great shape. Plenty of cash, substantial free cash already booked for the subsequent quarters. So I guess with that two questions on it. Can you provide some more details on the rationale for issuing the 13 million or so shares to the ATM? And secondly, are there certain leverage ratios you're looking to get to in the near term, or how do you kind of view your balance sheet at these levels?

Yes. First of all, we have issued a relatively small number of shares in relation to our total share count, which is quite marginal. Part of this was associated with a dividend reinvestment plan. However, there are challenges. The key focus for us is ensuring that we invest capital in a way that adds value per share. For example, with our VLCC deal, the return on our invested equity significantly exceeds the yield from the shares we issued. We evaluate transactions and finance deals at the asset level. We have capital available which we can access from the bond market, convertible market, or the equity market, allowing us to utilize that as effective equity in these deals. There is nothing particularly concerning about this; our goal is to maintain a sustainable business that allows for long-term investment. We will engage with various markets to enhance value per share.

Got it. Okay. And then I guess next question. In the presentation here you took out the slide on kind of the offshore market and the drilling rigs. So I guess around that, what is the kind of status of those? It seems like that really is accounting for most of the risk and uncertainty around SFL around the dividend, what have you. So for those Seadrill conversations, is there a timeline maybe around these talks? And is the most likely scenario a possible charter reduction and extension, or what are your thoughts on that?

Yes, the reason why we didn't put it in this quarter is simply that there hasn't really been any change since last quarter. Things are pretty much as they were then. The only difference is that we've had another three months of cash flow and pay down debt associated to those assets. We guarantee around 50% of the outstanding loans relating to Seadrill assets. Unfortunately, I cannot really comment much on the Seadrill situation apart from that we think it's positive to have a stronger counterparty. We think it does make sense in the current environment to trim balance sheet activity levels. What we are, of course, happy to see is that in an otherwise challenging offshore market, two of our rigs are working. One is on a very long-term charter to ConocoPhillips. So at least, we have two of the relatively active rigs in the harsh environment space today, but I cannot guide you on the timeline for Seadrill. I'm sure they will comment on that when they report, I believe in a week or so.

Right. Well, then I guess last quick question for the tanker market. You returned two of the Hunter vessels. I'm assuming the third soon. You brought in one on the 2020 side. Is that more of a strategic play of just making sure you have that tanker presence, or again was it just a sector-agnostic kind of capital arbitrage play, or are you really looking to grow the tanker exposure here?

The last deal was primarily a capital cost arbitrage opportunity. We found a chance to enter the market with an attractive risk profile and believe we can secure efficient financing to achieve a solid return on our investment. We have a strong understanding of the tanker market and are open to investing in it under the right circumstances. However, we haven't encountered many long-term chartering opportunities with end users, which we are actively exploring. While we've considered various options, we can't discuss specifics on what we've not pursued. We are actively engaged in the market and are capable of handling both capital cost arbitrage opportunities and providing comprehensive time charter solutions, similar to our arrangement with Phillips 66, where we operate LR2 product tankers under seven-year time charters.

Terrific. Great. Well, that's it for me. Thanks again. Hope all is well.

Thanks a lot.

The next question is from the line of Liam Burke from B. Riley. Please go ahead.

Yes. Thank you. Good afternoon.

Good afternoon.

You mentioned how COVID has disrupted the market. However, in the container space, rates and capacity are tightening, rates are increasing, and things seem to be stabilizing. How does that affect your deal flow? Are things becoming clearer, or do you have more confidence in pursuing deals?

Yes. Thanks. It's an interesting observation what we have seen recently. The way I look at it is that, because the liner operators have a recent experience from the financial crisis in 2008-2009 and the effect of that, I think they've taken a very different approach to the market disruptions this time. Back then, my impression was that the focus was on utilization of the assets, it was also more fragmented business in the first place, but their focus was on utilization. The operators started cutting rates to ensure that they were filling the vessels. The effect of that was that the demand side dropped inevitably. So the effect was that you had lower volume and you had lower revenues as well because of your cost-cutting measures. This time around what the liner companies have done instead is that they've been holding back volume, i.e., they’ve been blanking sailings, and by doing that there have been tremendous cost savings in the operations. The fuel cost has been very positive for the liner operators because that's really dropped a lot since pre-COVID-19. If you then adjust for other negative effects, it's actually a positive. For instance, the one alliance group reported a massive improvement in profits in the first quarter as a result of this. We've also seen, as I'm sure you also follow closely, that the Asia to U.S. East Coast pricing is at record high levels. What we're seeing now is that the liner companies, as they see that the revenues hold up, they seem to be filling in with more volume to ensure that there is sufficient capacity for the market. This is, of course, very positive for us. It demonstrates that our customers are taking steps to protect their business and shows resilience to market disruptive effects like this that nobody could anticipate just a few months ago. So yes, it sort of helps our decision-making and putting more money also into the liner space.

Great. And I know this is a small part of your business and talking on the bulker side. You do have a larger than average percentage in the spot market. Can you generate acceptable returns in the spot market in the bulker space? And I know it's not conducive to the longer-term charters the way you would possibly see with a VLCC or in the entire container space, but how do you address the spot market on the bulker side?

It's a very good question. What is a reasonable rate in that space? All the bulker vessels we have, which were previously ordered, were on longer-term charters. Some have come off charter and been redelivered after their charter periods. Typically, we don’t re-charter them immediately. If we believe the market is low, we prefer to trade the vessels instead, hoping to secure longer-term charters as the market recovers rather than accepting whatever the market offers at that moment. We have a relatively small number of vessels in this case, but in terms of overall volume, it’s quite minor. Currently, we have been trading them in the market. The market was soft, particularly in the second quarter. However, we are noticing improvements with smaller bulkers, and according to market observations from Clarksons, Handysizes are now priced at around $9,000 per day. That's a reasonable rate. We can work with that. But if it drops to $2,000 or $3,000 per day, as we've experienced at times, that's not sustainable. We also need to consider whether we can secure new longer-term employment for these assets or how to manage them, a topic we discuss every day.

Great. Thank you very much.

Thank you.

Thank you. The next question is from the line of Chris Wetherbee from Citi. Please go ahead.

Good afternoon guys. This is James on for Chris. I wanted to follow-up on that prior question around containers. You highlighted the fact that the improvement in profitability is driven from supply discipline. I wanted to actually make sure that you also were seeing some strength in deal flow in containers despite that. As a secondary question to that one, does that mean that we might see a particular focus in the capital that you deployed back on containers similar to the way it was prior to COVID-19?

I don't think that's the case. We are examining all sectors and segments simultaneously. Prior to the COVID-19 disruption, we had many container ships in our fleet, so we paid close attention to that area and how our customers are adapting to the difficult circumstances. It provides us with reassurance to see that they have handled the situation much better than many expected a few months ago when things were at their worst. The situation is still ongoing, and we should anticipate continued uncertainty. However, it is encouraging to observe disciplined end users, like liner companies, who are maintaining a robust business and responding quickly to challenges. We have noted some transactions in this area, although new building orders have slowed down significantly. Overall, the new building order book is low across most sectors, including tankers and dry bulk. This scarcity of assets could positively influence market dynamics, potentially leading to enhanced earnings over time. We will continue to exercise discipline in ordering and financing, which we hope will yield good returns for market participants.

Got it. Given the current backdrop you’re monitoring, can you comment on the credit risk within your portfolio? You mentioned that it seems relatively stable on the liner side. Are you noticing any areas of credit risk outside of offshore, whether in bulk or tankers, that you think should be highlighted, or are you generally comfortable with what you are observing?

I would say, if you look at where we are active, I would say, of course offshore is challenged, as Aksel commented on earlier. There has been a massive disruption in oil exploration and production activity, both onshore and offshore. So that's of course been focused on a lot in the media, generally. The oil price collapse did not help there. If you look at our other sub-sectors, we have two car carriers that are idle right now. One came off charter in mid-May. The second came off a charter just two weeks ago or so. Generally, what we are seeing is more activity on the chartering side, in that segment as well. We've seen idle fleet drop from more than 250 vessels some weeks ago to roughly half of that. That doesn't mean that the market is in good balance yet, but there is a significant change in dynamics there, where at least the market activity is going in the right direction. We only have two of these, so it doesn't have a big impact on our business. Of course, we would be happy to see them back trading, earning a good return on capital.

Okay. Thank you.

Thank you.

Thank you. I would like to thank everyone for participating in our second quarter conference call. Also, I would like to thank the SFL team both on board the vessels and onshore for their efforts in a very challenging time and commitment to continue building our business. If you have any follow-up questions, there are contact details in the press release or you can get in touch with us through the contact pages on our webpage.

Thank you.

That does conclude the conference for today. Thank you for participating. And you may now disconnect.