SFL Corp Ltd. Q1 FY2022 Earnings Call

Thank you, and welcome all to SFL's first 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. Our Chief Operating Officer, Trym Sjølie, will also be present for the Q&A session. 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. Forward-looking statements are not guarantees of future performance. These statements are based on our current plans and expectations and are inherently subject to 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, but are not limited to, conditions in the shipping, offshore and credit markets. You should, therefore, not place undue reliance on these forward-looking statements. Please refer to our filings with the Securities and Exchange Commission for more detailed discussions on our risks and uncertainties, which may have a direct bearing on our operating results and our financial condition. The announced dividend of $0.22 per share is an increase of 10% over last quarter's dividend and represents a dividend yield of around 8.8% based on closing price yesterday. This is our 73rd quarterly dividend and over the years, we have paid more than $28 per share in dividends or nearly $2.5 billion in total. And we have an increasing fixed rate charter backlog supporting continued dividend capacity going forward. The total charter revenues were $166 million in the quarter with the vast majority from vessels on long-term charters and only 20% from vessels employed on short-term charters and in the spot market. The EBITDA equivalent cash flow in the quarter was approximately $119 million. And over the last 12 months, the EBITDA equivalent has been approximately $455 million. The net income came in at around $47 million in the quarter or $0.37 per share. There was also a positive mark-to-market on interest rate swaps and equity investments but only a small portion of the total economic effect of the swaps flows through our profit and loss statement. Most is defined as hedging accounting and the book effect would have been around $10 million higher otherwise. In the quarter, there were around $1 million higher operating costs due to additional crew rotation costs linked to COVID restrictions in some areas and increased airfare and also higher legal expenses in connection with the Seadrill bankruptcy and redelivery of the rigs. We expect this to come down when travel restrictions ease and the rigs are redelivered to us later this year. Our fixed rate backlog has increased significantly and stands at approximately $3.6 billion from owned and managed vessels after recent acquisitions and charters, which provides continued cash flow visibility going forward. The backlog figure excludes revenues from the vessels traded in the short-term market and also excludes future profit share optionality. In March, we announced a $540 million added backlog on our 6 large 14,000 TEU container vessels. The vessels will finish their initial 10-year charters to Evergreen in 2023 and '24, and we have now added another 5 years to Hapag-Lloyd, taking the charter coverage to 2029. Hapag-Lloyd is the world's fifth-largest container line, and the transaction highlights the value and importance of our strong operational platform and our time charter strategy enable us to build strong customer relationships with industry-leading counterparties. In connection with Seadrill's Chapter 11 process, we agreed to take over the charter contract on West Linus with effect when all government approvals are in place. Based on the current charter rate, around $500 million was added to the backlog. But given the market-adjusted charter rate, this could increase if the drilling market strengthens. West Hercules will be redelivered when the current drilling assignment for Equinor in Canada is finalized towards the end of the year. Thereafter, that rig will be managed by Odfjell, a market-leading operator of harsh environment drilling rigs, and we will drop the West prefix on the rig names. The sale of the last 2 VLCCs on charter to Frontline marks the end of an era and demonstrates the transformation SFL has gone through. Initially, Frontline was our only customer and the fleet consisted of nearly 50 crude oil tankers. The 2 remaining vessels were 18 years old and we sold them after the quarter end for approximately $70 million, including a compensation from Frontline. We expect to book a gain of approximately $2 million in connection with the sale. And subsequent to quarter end, we have also delivered the 19-year-old 1,700 TEU container vessel to MSC Alice, which has been on a hire purchase agreement to MSC for the last 5 years. This transaction illustrates the value of having optionality where the final payment was intended to be marginal as the vessel had effectively been paid down over the 5 years, but we negotiated a profit share agreement into the deal at the time. And while we, of course, hope that there would be some value in that option, we didn't expect it to be more than $1 million or $2 million. Assuming 5 years forward to today, the very strong container market currently meant that we ended up with a profit split of nearly $12 million instead. The vessel was debt-free and SFL expects to record a gain of approximately $12 million in the second quarter. Excluding the drilling rigs, the backlog from owned and managed shipping assets was $3.6 billion at the end of the quarter, up from $2.8 billion in the previous quarter. Over the years, we have changed both fleet composition and structure, and we now have 71 maritime assets in our portfolio after these transactions. Over the years, we have gone from a single asset class chartered to one single customer to a diversified fleet and multiple counterparties. And over time, the mix of the assets and charter backlog has varied from 100% tankers to nearly 60% offshore 10 years ago to container vessels now being the largest segment with nearly 60% of the backlog and tankers only at around 10%. Most of the vessels are on long-term charters, and in the quarter, only 12% of hire was from vessels in the spot market. Also, we have nearly 90% of charter revenue from our shipping assets on time charter contracts and only 11% on bareboat or dry lease arrangements. We have also had significant contributions to cash flow from profit share over time, both relating to charter rates and fuel savings. The aggregate profit share was $22 million last 12 months and $4.5 million in the first quarter. We do not have a set mix in the portfolio; the focus is on evaluating deal opportunities across the segments and trying to do the right transactions 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 with a focus on technology and transition over time to more fuel-efficient vessels. SFL owns 2 harsh environment drilling rigs, the West Hercules and West Linus, which have been chartered to subsidiaries of Seadrill since new. We have now been through 2 Chapter 11 rounds in Seadrill. And while we have been paid charter hire during the processes, we have decided to end our chartering relationship with Seadrill. The long-term drilling contract for West Linus with ConocoPhillips will be assigned to us as soon as customary Norwegian regulatory approvals have been obtained, currently expected to be completed in the third quarter. Thereafter, the rig will be managed by Odfjell Technology, a leading supplier of our offshore operations who is already performing extensive drilling services for ConocoPhillips on the fixed installations. The West Linus has been drilling for ConocoPhillips at the Greater Ekofisk Area since it was new in 2014, and its contract runs until the end of 2028 at market index charter rate. It was ordered against the contract and has several features which make it particularly effective at the Ekofisk field on the Norwegian Continental shelf. The Ekofisk field was the first oil discovery in Norway and has produced more than 6 billion barrels of oil equivalent since its startup in 1971. Recently, the production licenses in the Greater Ekofisk Area was extended from 2028 to 2048, and the area's license partners have recently announced new significant investments in future production given the size and proximity to European markets. The harsh environment semisubmersible rig, West Hercules, will remain on charter to Seadrill while it finalizes a drilling contract with Norwegian oil major, Equinor, in Canada. This is expected through the fourth quarter this year, and thereafter, the rig will be redelivered to SFL in Norway. It will then undergo a scheduled 5-year special survey estimated to take around 3 months before the rig is ready to work again. Odfjell Drilling, a market-leading harsh environment drilling rig operator, will perform commercial and operational management of the rig after redelivery from Seadrill. The rig is one of only a handful of rigs fully equipped to drill in the harshest Arctic environment. Market analysts are positive about market prospects after the strong oil price development and the realization that there has been a fundamental underinvestment in the segment for a number of years. We follow the market closely, of course, and will announce future employment in due course. The strength of our counterparties and diversification is key when you assess our portfolio and quality over contracted backlog. The list speaks for itself with market-leading operators like Maersk, MSC, ConocoPhillips, P66 and Volkswagen to name a few. Relatively few of our customers are intermediaries where we have less visibility on the use of the assets and quality of operations. Strategically, this also gives us access to more deal flow opportunities such as the repeat businesses with Maersk, MSC, Evergreen and Trafigura, for example. Our strategy has therefore 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. And with full control over vessel maintenance and performance, including energy efficiency and emission minimizing efforts, we can impact improvements to our vessels through the life of the assets. And not only be passively owning vessels employed on bareboat where the customer may not always have an incentive to make such improvements. In addition, we can retain more of the residual value in the assets when we charter out on a time charter basis. And in the current environment with rising raw material costs and inflation driving replacement costs for vessels, this value is for the benefit of SFL and our stakeholders. For bareboat deals, this mass value is usually retained by the charterers through fixed price purchase options. And with that, I will give the word over to our CFO, Aksel Olesen, who will take us through the financial highlights of the quarter.

Thank you, Mr. Hjertaker. On this slide, I've shown a pro forma illustration of cash flows for the first quarter. Please note that this is on a guideline to assess the company's performance and is not in accordance with U.S. GAAP and also net of extraordinary and noncash items. The company generated gross charter hire of approximately $166 million in the first quarter, including $4.5 million of profit share with approximately 85% of the revenue coming from a fixed charter rate backlog, which currently stands at $3.6 billion, providing us with strong visibility on cash flow going forward. In the first quarter, the liner fleet generated gross charter hire of approximately $88 million, including approximately $4.4 million in profit share contribution related to fuel savings on some of our large container vessels. Following the company's recent acquisitions and charter extensions, vessels liner fleet backlog increased approximately $2.5 billion with an average remaining charter term of approximately 5 years or 7.7 years if weighted by charter hire. A small container vessel, which has been on a hire purchase arrangement during the last 5 years, was delivered to the buyer subsequent to quarter end against a total purchase price of $13 million. SFL expects to record a gain of approximately $12 million in the second quarter; the vessel was debt-free. In the first quarter, SFL had a fleet of 16 crude oil, product and chemical tankers, with the majority employed on long-term charters. Our tanker fleet generated approximately $30 million in gross charter hire during the quarter compared to $17.5 million in the previous quarter as additional Trafigura vessels joined the fleet. The net charter hire from the company's 2 Suezmax tankers employed in a short-term market was approximately $2.3 million compared to $3.1 million in the previous quarter. Subsequent to quarter end, SFL sold the 2004 built VLCCs to Front Frost and Front Energy, and simultaneously agreed to terminate the vessels charter arrangements with a subsidiary of Frontline. The sale price was approximately $70 million, including compensation from Frontline for the early termination of the charters. SFL expects to record a gain of approximately $2 million in the second quarter as a result of the sale. During the quarter, the company had a fleet of 15 dry bulk vessels of which 10 vessels were employed on long-term charters and the other 5 are trading in the short-term market. The dry bulk fleet generated approximately $26 million gross charter hire in the first quarter, including approximately $100,000 in profit share contribution from our Capesize vessels on charter to Golden Ocean. The 5 vessels trading in the spot and short-term market generated approximately $8 million in net charter hire compared to approximately $8.6 million in the previous quarter. SFL owns 2 drilling rigs, which have been charted out to subsidiaries of Seadrill on bareboat terms. In the first quarter, the company received charter hire of approximately $21 million from the rigs, including approximately $7 million in lump sum payments relating to termination of the West Linus charter. This summarizes an adjusted EBITDA of approximately $119 million for the first quarter compared to $121 million in the fourth quarter. We then move on to the profit and loss statement as reported on the U.S. GAAP. As we have described in previous earnings calls, our accounting statements differ from those of a traditional shipping company. As our business strategy focuses on long-term charter contracts, part of our activities are classified as capital leasing. As a result, a portion of our charter revenues are excluded from U.S. GAAP operating revenues and instead booked as revenues classified as repayment of investment in financing leases and vessel loans, results in associates and long-term investments and interest income from associates. For the first quarter, we report total operating revenue according to U.S. GAAP of approximately $152 million, which is less than approximately $166 million of charter hire actually received for reasons just mentioned. During the quarter, the company recorded profit share income of approximately $100,000 from our 8 Capesize dry bulk vessels, and an addition of approximately $4.4 million from fuel-saving arrangements on some of our large container assets. The operating expenses of our fleet are up compared to the previous quarter due to a combination of new vessels entering our fleet and expenses related to COVID-19 related logistical challenges. In addition, we also saw an increase in depreciation due to new additions to our fleet during the quarter. Furthermore, the company recorded a $7.3 million gain related to positive mark-to-market effects related to interest rate swaps and a $2.5 million gain related to positive mark-to-market effects related to equity investments. So overall, and according to U.S. GAAP, the company reported a net profit of approximately $47 million or $0.37 per share. Moving on to the balance sheet. At quarter end, SFL had approximately $149 million of cash and cash equivalents. And with the sale of 2 vessels subsequent to quarter end, our cash position increased by an additional approximately $48 million. Furthermore, the company had marketable securities of approximately $24 million based on market prices at the end of the quarter. Following the sale of a small container sold subsequent to quarter end, the company had 4 debt-free vessels with a combined charter free value of approximately $73.5 million based on average broker appraisals. The approximately $247 million of remaining CapEx on 4 car carriers under construction is expected to be financed by senior debt facilities similar to SFL's other assets with long-term charters. So based on the Q1 numbers, the company has a book equity ratio of approximately 28%. Then to summarize, the board has declared a cash dividend of $0.22 per share for the quarter, an increase of approximately 10% compared to the previous quarter. This represents a dividend yield of approximately 8.8% based on the closing share price yesterday. This is the 73rd consecutive quarterly dividend. And since the inception of the company in 2004, more than $28 per share or $2.5 billion in aggregate has been returned to shareholders through dividends. Last year, SFL successfully committed more than $1 billion towards accretive investment. And so far, in 2022, we added more than $1 billion to the backlog which now stands at $3.6 billion, providing strong visibility on future cash flow, debt service and continued distribution capacity. With a strong balance sheet and approximately $200 million in cash, SFL is very well positioned to execute on new accretive investments. In addition, we have seen a strong recovery in the offshore drilling market since the beginning of the year. And our 2 harsh environment drilling rigs are well positioned to benefit from the increased activity level in the sector. One rig is employed on a long-term market adjusted charter rate, while the other rig is available for new contracts in 2023.

I wanted to discuss fleet management and the possibility of additional asset sales. I think there was a purchase option exercised on a smaller feeder or intermediate container ship. As we consider the next few quarters, can we explore the potential for other vessels that might also have such options, especially given the current strength in the overall market? It seems likely that many of those options could be exercised if they exist.

Yes, we have some older, smaller midsize containerships. One was just chartered for another three years with Maersk at a relatively high rate, reflecting the current market. We have one more that will be available for chartering again in a few months, with no options related to either of those two assets. We also have a couple of older 4,100 TEU vessels and 5,800 TEU vessels that have been on long-term charter to MSC, structured effectively as hire purchase type deals, so we don't have market exposure there. I would be very surprised if those options were not exercised, but that was also the design back then. For assets where we have more capital at risk, primarily the larger container ships from 9,000 TEU and above, all built from 2013 onwards, those vessels are equipped with new generation electronically controlled engines and designed post-financial crisis, making them suitable for long-term viability in the market. We have the first of those coming up for rechartering potentially in 2024, and there are extension options at similar levels. Based on market trends and replacement costs for assets, we believe there is a high probability that those charters will be exercised, allowing us to extend those contracts through well into 2025 and some even as far as 2028. Overall, we have very long charter coverage on our significant larger container ships, especially now that we have secured six 14,000 TEU vessels starting from 2023 and fixed through to 2029.

Okay. Great. I'm not very familiar with the car carrier sector, but the contract with Volkswagen seems promising. As we consider that opportunity, we observe strength in the global container market. In terms of the car carrier sector, are there ongoing opportunities for investment? I'm not well-versed in this area, but it appears to be a solid sector for your company. There are only a few vessels involved, so is there potential for further capital deployment, or were the projects you've undertaken mainly unique, one-off contracts?

It's Trym Sjølie here. The car carrier market is very interesting for us. It's a market where SFL has an advantage. Typically, operators have a long-term view and engage in extensive fleet planning. Currently, there is significant opportunity for fleet renewal due to new emissions regulations that render many ships obsolete. These vessels either need to be replaced or must drastically reduce their speed in some cases. The fleet consists of approximately 700 vessels, and a substantial number of them—at least a couple of hundred—will need to be built in the next five to seven years just to replace the existing fleet. We find this scenario quite appealing. The challenge lies in identifying the right vessels, securing the right new building slots, and finding suitable counterparties, but we believe we have a solid position.

It's good to hear that. As I mentioned, I'm not as familiar with the car carriers, so any insights on that would be really helpful. I also wanted to discuss the offshore rigs. Clearly, the West Linus is in a long-term contract and is well-positioned. However, I am curious about the West Hercules. It seems to me that asset prices for that type of rig are strengthening. Is the company exploring opportunities to monetize that, or are we primarily focused on leveraging our rig relationships to secure a contract for that rig? Once it's contracted, could we then consider the possibility of monetizing that asset?

Yes, that's a good question. Our focus with that rig is to recontract it. We have engaged Odfjell Drilling, which is a leader in operations in harsh environments. The rig is one of the few capable of operating in Arctic conditions during winter, which is quite unique. We are currently observing a market dynamic where many players and companies recognize the long-term underinvestment in this segment. There is an energy squeeze, particularly in Europe, which has been highly dependent on natural gas from Russia and is now seeking alternative sources. The North Sea is conveniently close, with many pipelines available, but significant drilling is necessary to start production. That’s just one aspect. We are also seeing a strong focus on deepwater regions like Brazil and West Africa, where this rig would be fully compatible. While we might not utilize its winterized features in those areas, it would still perform effectively in typical harsh environments. Therefore, I believe this rig offers considerable flexibility. I don't think this is the right time to sell it, as our priority is to generate cash flow, secure a contract, and build backlog on this unit. We are encouraged by the robust oil prices and the successful negotiations we finalized with Seadrill in February, after which oil prices rose by over 50%. The market has indeed transformed significantly in recent months.

Congratulations on a lot of positive developments here. I just had a question related to the Linus. On the $500 million in revenue backlog that you talked about, how sensitive is that to the market index rate? And can you kind of talk around that?

Absolutely. That was essentially based on the market index rate at the time. We currently have a bareboat rate with Seadrill during the transition period, where Odfjell is applying for a Document of Compliance relevant to the Norwegian continental shelf. Looking ahead at the market rate development, it appears positive, and this is further supported by recent fixtures of the same type designs from Maersk drilling to Aker BP on five-year agreements. As the market index rate is expected to increase going into 2023 and 2024, it will, of course, positively impact the backlog number.

Okay. That's fair. Then on the Hercules going into special survey, how long do you expect that will take? Will that commence during the first quarter of next year? And how long do you think it will take before I guess it's secured on a new charter after that?

Regarding the timing of redelivery from Seadrill, it's currently estimated to be at the end of the fourth quarter, though the exact date is still to be confirmed. We are preparing with Odfjell Drilling for the Special Periodic Survey, which we anticipate will take about 90 days. We are also marketing the rig for various employment opportunities, but the exact start date is still not confirmed. Over the last couple of months, we've seen a significant increase in tender activity in both harsh environments and potential worldwide operations. Our focus, given that we have a top-tier exploration rig for harsh environments, is to keep the rig in Norway, with a possibility of moving to Canada or the U.K. sector.

The current deployment in Canada just began drilling a couple of days ago, so we won't have results until the first well in that offshore Canada program is completed. We aren't certain how much time it will take to finish the remaining work. Consequently, we need to wait for that information before we can provide specific timing for when the rig will be redelivered to Norway and when the SPS process can commence. However, we expect this to be around the end of the year. This situation also impacts the contract discussions we are having for employment opportunities after the rig's redelivery and the SPS process.

Okay. I guess my follow-up question to that would be the travel time from Canada to Norway, and then if it's redeployed back into Canada, what the travel time would be.

I think that somewhat depends on the weather. I think that could be 2.5, 3 weeks, give or take, kind of in normal circumstances, but the rig will be at least on the base case now being we're kind of finalizing operations in October. At that time, kind of the weather in the North Atlantic can be a bit choppy. So I mean it all depends, I think it's approximately estimated 3 weeks kind of transfer back to Norway.

Yes. Ole, I have 2 questions for you this morning, 1 is philosophical and 1 is directional. And on the philosophical question, in certain segments, such as dry bulk, could we potentially be entering a super cycle given the lack of new building, the restructuring of trade routes such as coal coming from Australia to Rotterdam, et cetera, et cetera? And the second question is, looking forward, what areas do you think are the most interesting to allocate capital in the future?

Thank you for joining the call. I find the dry segment particularly intriguing, as well as the tanker market. Both sectors are currently experiencing historically low order books, the likes of which we haven't seen in the last couple of decades. We typically see that the shipping market is greatly impacted by owners overbuilding vessels when the market appears favorable, leading to an oversupply once those vessels are completed, which in turn drives the market down. A notable instance of this was the dry bulk market following the 2014 ordering surge, where, despite high demand growth, excessive vessel orders meant it took years to balance the market again. As you mentioned, shipyards are essentially full; if you're looking to order a series of vessels, you won't receive them until late 2025 or into 2026. Hence, in both the dry bulk and tanker markets, significant lead times are required for new vessel orders, contributing to potential market opportunities due to limited supply. Additionally, the new CII regulations coming into effect in 2023 might further constrict ton mile capacity as owners of less energy-efficient vessels may be forced to reduce their power consumption to comply, ultimately removing transportation capacity from the existing fleet. This effect will also be noticeable in the tanker sector, but less so than in dry bulk. Regarding car carriers, this segment may face a heightened impact due to their relatively low cargo capacity compared to vessel size. Overall, these segments present fascinating market dynamics. Moreover, if inflation risks are a concern, owning vessels serves as a hedge since they are tangible assets, and inflation would likely enhance their value. In response to your second question about investment opportunities, we see potential in all these segments. While we cannot disclose specific areas of focus, we are exploring numerous opportunities across various sectors. However, we exercise caution in our investments, recognizing the need for vigilance in volatile markets. Our strategy involves chartering vessels to leading industry players, which we believe should lower portfolio risk and enhance the likelihood of strong long-term returns. I hope this addresses your questions. Thank you. Then I would like to thank everyone for participating in this conference call and also thank the SFL teams on board the vessels and on shore for their continued efforts in delivering value for our stakeholders. If you do 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 web page, www.sflcorp.com. Thank you.

This concludes today's conference call. Thank you for participating. You may now disconnect.