A Mortgage On Floating Collateral That Yields 13%

Navios Acquisition Bonds Attractively Valued

Source: www.USMM.org

In a world of 10 year treasuries yielding under 2% there are still solid yield opportunities from time to time that should be bought.  Navios Acquisition (NNA) 8.625% bonds due 2017 and available for 83 cents on the dollar offer an attractive risk adjusted return currently yielding 13% to maturity and offering the possibility of a capital gain to go with the 10% cash-on-cash yield.

In some prior posts (including http://lifeinvestmentseverything.blogspot.com/2012/01/dumpster-diving-in-junk-bond-market.html and http://lifeinvestmentseverything.blogspot.com/2012/01/dumpster-diving-in-junk-bond-market_11.html) I detailed how I evaluate individual bonds for purchase in an effort to find attract junk bonds worth buying.   One of the regular searches I do for junk bonds is to search everything maturing within 10 years regardless of rating and sort by yield to maturity (highest to lowest).  When NNA 8.625% first mortgage bonds due November 2017 (CUSIP 63938mab2) showed up high on the list, I knew I had found a bond worth further digging.  These bonds are issued by publicly traded Navios Acquisition (ticker NNA), an owner of crude and refined products tankers formed in 2010 by sponsor and majority owner Navios Maritime (ticker NM).  NNA is an early stage company which has a number of ships still being built, so its consolidated balance sheet looks somewhat worse than it really is (ships not yet on the water are costing borrowed money to build, but are not yet generating income).  The tanker industry has been under stress and many companies have either seen their bonds fall significantly in value (as is the case with OSG), been forced to recapitalize (FRO), or even gone bankrupt (General Maritime).  This all starts to sound like a very scary thing to lend money to unless you take the time to dig deeper.

So how do we evaluate these bonds?  Despite the apparent risks attendant to a growth stage company’s bonds, NNA’s paper is secured by a first mortgage on a fleet of Very Large Crude Carriers (VLCCs) which are all chartered out long term at attractive rates.  The company’s website is http://www.navios-acquisition.com/  There is a great deal of detail available about both the bonds and the collateral in the prospectus for the bonds available here: http://www.sec.gov/Archives/edgar/data/1437260/000095012311069684/y05050fv4.htm  Some additional basic details about these bonds are that there are $505MM in face amount outstanding; the bonds are guaranteed by NNA; the bonds are callable starting in 2013 at 104.3 cents on the dollar; and the covenant package includes reasonably strong limitations on NNA’s ability to pay dividends, borrow additional money, transfer value to third parties, and buy back stock.  These bonds are fairly liquid for a junk issue and both retail and institutional sized lots are bought and sold on most trading days.

As with all credit decisions, there are three key considerations in determining whether a borrower is likely to be able to make good on the loan (or bond, in this case):

-          Collateral

-          Cashflow

-          Character

As these bonds benefit from a first priority mortgage on a fleet of ships, we will begin with an evaluation of collateral.  The collateral includes the following VLCCs, which are used exclusively to transport crude oil from where it is pumped out of the ground to where it is refined:

Ship	Vintage	Age	Est Value ($MM, charter free)
Shinyo Splendor	1993	19	21
Shinyo Navigator	1996	16	25
C Dream	2000	12	29
Shinyo Ocean	2001	11	29
Shinyo Kannika	2001	11	29
Shinyo Saowalak	2010	2	90
Shinyo Kieran	2011	1	95
Total			318

You will notice that the above table includes an estimate of the current market value of each ship assuming it was up for sale today without an attached charter.  These values are based on shipbroker reports (I like WeberSeas’ reports) which are available to members (free registration) on the Capital Link Shipping site: http://shipping.capitallink.com/  Please note that these are only estimates and that they do move around considerably: what is worth a dollar today might be worth 75 cents or $1.25 in three months’ time.  That said, shipbroker estimates offer a reasonable ballpark estimate for the current charter-free value of the collateral.  At current ship values, the fleet appears to be worth about 63% of the face amount of the bonds.  Scary, huh?  But these ships are not charter-free and in fact have long term charters that have the ships rented out at rates well above market for periods of time ranging from 2 to 14 years.  Estimating charter values is a tricky proposition, but with 3 year charters on similar ships (optimistically) around $24,000 per day the NNA VLCC average charter of slightly more than $40,000 per day over the next roughly 6 years (average charter length) is worth a great deal of money.  Simply multiplying (40,000 – 24,000) X 365 X 6 gives us undiscounted charter value equal to about $35 million per ship.  Simplistically adding this rough value per charter to the estimated charter-free fleet market value suggests that the value of the ships with their charters is about 111% of par value.  So a worst case valuation suggests that the bondholders would get 63% of par in liquidation, while the value of the ships and the charters appears to be in excess of par value.  With the bonds trading at 83 cents on the dollar, it looks like the downside is 20 points, or a little under 25% of the current price of the bonds.

Cashflow is relatively easy to estimate for this fleet because the ships have long term charters at a fixed daily rate and because NNA pays a fixed daily cash expense rate for each ship of $11,644.  Subtracting the expenses from the daily rate of each ship gives us a cashflow number as detailed below:

Ship	Day rate ($)	Expenses ($)	EBITDA ($MM)
Shinyo Splendor	38,019	11,644	9.4
Shinyo Navigator	42,705	11,644	11.1
C Dream	29,625	11,644	6.4
Shinyo Ocean	38,400	11,644	9.6
Shinyo Kannika	38,025	11,644	9.4
Shinyo Saowalak	48,153	11,644	13.1
Shinyo Kieran	48,153	11,644	13.1
Total	40,440		72.2

The fleet as currently chartered produces about $72 million annually in cashflow.  Interest expense of 8.625% times $505 million outstanding is about $43 million annually, resulting in free cashflow of $29 million annually.  This exercise suggests that the VLCC fleet will not have difficulty paying interest on the bonds through maturity and in fact the fleet will produce upwards of $100 million in cashflow over what is required to service the bonds through their maturity date.  Where is this extra cash going?  NNA is using the cashflow to build out its fleet of refined products tankers, which are in the process of being leased out at rates that offer secure cashflow and participation in any upside in product tanker rental rates.  NNA pays a small dividend to shareholders, but is otherwise required to keep the excess cashflow within the company as either cash, increased equity via debt paydown, or invested in additional ships.

Finally, we get to the toughest part of evaluating pretty much every security, namely the character of the people managing the company.  Unfortunately, many junk-rated companies have management teams who are foolish, excessively greedy, extremely aggressive, or unwilling to be transparent and accountable.  In the case of NNA, I believe that management is only venially guilty of one of these sins, namely aggressiveness.  NNA is part of a family of public shipping companies which also includes NMM (an MLP that owns dry bulk ships) and NM (the flagship holding company in the group which owns over 50% of NNA).  Given its limited history, we can evaluate NNA by looking at the other group companies which share the same management team.  Management adroitly piloted NM through the disastrous dry bulk market which accompanied the recent recession, picking up ships at distressed prices along the way.  In a period when obtaining additional financing was difficult at best, NM’s management was able to finance its bargain purchases at attractive terms.  When the junk bond market reopened to new issuance, management quickly took advantage of the opportunity to refinance NM’s debt at more appealing terms and conditions (and provided a call premium to NM’s original bond holders).  Finally, Ms. Frangou (Chairman and CEO of all three public companies in the group) personally owns in excess of 20% of NM and 4% of NNA.  It is rare to see a CEO own that large a stake in a public company.

Taking all of this together, I think these bonds are very attractive at current prices of 83 cents on the dollar (13% YTM).  Downside appears to be in the area of 63 cents on the dollar barring further declines in ship values, while the investor gets a cash-on-cash yield of slightly over 10% (8.625/83).  Maximum upside potential is the call price of 104.3 cents on the dollar plus coupons between time of purchase and when the bonds are called.  Also worth noting is that while these bonds have risen from the low to mid 70s recently, the trend appears to have shifted upward in investor sentiment on these bonds and other tanker industry securities (OSG’s bonds have risen substantially in recent weeks and those are both unsecured and rated a couple notches lower than NNA’s bonds).

Of course, every purchase demands an exit strategy and these bonds are no different.  As with any bond, the easiest exit is to simply wait until the bonds mature or are called.  In the interim, I would look to sell the bonds if they reached the call price of 104.3 or if the global economy dramatically worsened from the current sluggish pace of growth.

Since this is a junk bond, it is worth outlining some of the major risks of this security and determining whether you the investor are willing to accept those risks.  The two most obvious risks would directly impact the collateral and cashflow characteristics of the bonds.  First, charter-free values of the ships could fall significantly further.  If that were to happen, the worst case downside might be considerably higher than my estimate above.  Second, the charterers could default on the long term charters of the fleet.  If this were to happen and NNA were unable to pursue legal remedies against the charterers, cashflow generated by the fleet would decline significantly as the daily rental rates earned by the ships would decline to the current market levels of around $25,000 per day, per ship.  Other risks include general market risk (spreads on junk might spike), the insolvency of NM (50+% owner of NNA and provider of administrative and technical services to NNA), the death of Ms. Frangou, and the risk that something might happen to the ships that is not covered by insurance.  Finally, as these bonds grind toward maturity, some of the charters will expire and a couple of the ships will be old enough to scrap.  As a result, the ability of NNA to refinance or pay off these bonds will rest in part on future tanker market conditions and the success of the company’s efforts to build out the rest of its fleet.

As always, do your own due diligence, don’t buy anything you don’t understand or are uncomfortable with, and be careful.  We are talking about individual junk bonds, not super safe treasuries here.  Make sure you can afford to take risk with any money you invest in this or any other junk bond.

Disclosure: I am long NNA and NM bonds and equity (my money is in the same location as my mouth).