Taking a stab at floating steel: Cool Company $CLCO

Probably Not a Value Trap

"If I die, I have to go before Crom, and he will ask me, 'What is the riddle of steel?' If I don't know it, he will cast me out of Valhalla and laugh at me" - Conan the Barbarian

Welcome back to the “Probably Not a Value Trap” series where I discuss businesses with a 10%+ dividend yield which I believe probably won’t get cut and why, but don’t come after me on Twitter if they do.

A popular sector for small cap value investors is shipping, some analysts call it floating steel, others talk about embedded energy.  This is as cyclical as cyclical gets, a combination between heavy industry and transportation.  It’s also as degenerate as it gets, with management who make me think that piracy never really ended, they just became shipping CEOs instead.  In this space you always have to be on the watchout for complex ownership structures and self-dealing.  

For a generalist, shipping is an attractive addition to a portfolio because the supply is visible, there are research firms who compile what is being built in every shipyard in the world.  This gives us a very clear understanding about the supply of new ships coming online.  On the demand side of the equation, the global economy grows, and things are usually boring, until somebody shuts down the Suez canal and the demand for ton miles goes through the roof.  Since the Houthis have already done this, it might be a bad time to jump into shipping, as earnings and prices are temporarily elevated until peace breaks out in the middle east.  I don’t have an opinion about how long it will take for peace to break out in the middle east, but buying most shipping companies today is probably at the wrong part of the cycle. 

Given that the entire shipping sector is elevated today, and could come crashing down on peace with the Houthis, there are two choices, stay away for now, or try to get clever and hope it doesn’t come back to bite me.

The order book of newbuild ships is dominated by two sectors, container cargo ships and LNG carriers.  The supply chain crisis during Covid led to dramatically increased demand for container cargo ships, which caused those companies to over earn substantially.  Did they take that money and return capital to shareholders?  No, of course not, it wouldn’t be shipping if shareholders weren’t abused!  The container cargo companies took that cash and punted on newbuilds, even newbuilds for alternative fuel types.  Rather than pay a special dividend, they paid to build ships that will run on ammonia, despite the fact that there are no ammonia storage tanks, production capacity, transportation network, etc.  Up until the Houthis blocked the Red Sea, it was the consensus that container cargo ships would take a decade to work off the glut from the current order book of container ship buildout.  

LNG carriers have a similarly large order book, but the demand here is more structural than cyclical.  LNG is what is replacing coal in the west, and at low prices there is plenty of demand in the east as well.  If the buildout of export terminals and import terminals is on a similar pace as the shipyard orderbook, then the LNG carrier rates don’t necessarily have to crash.  And the consensus among investors who look at the order book is to stay away from LNG carriers, but the LNG shipping companies themselves argue that only 18 out of over 200 newbuilds coming online by 2026 don’t have fixed contracts and are susceptible to spot prices. Spot rates are set at the margin, so any increase could lower day rates, but the forward contracting of the fleet buildout is impressive.

I found an LNG carrier company that might not be a value trap.  The Cool Company (CLCO) is a recent joint venture between the largest private shipping company in the world, Eastern Pacific Shipping and Golar LNG (GLNG).  GLNG sold their stake, and Eastern Pacific did a private placement, bringing Eastern Pacific’s ownership of CLCO up to 58%, and it is not clear what their plans are in the future, sell, buy, or hold.  The status as a recent public equity makes me somewhat optimistic as I believe this is part of the reason why Jackson Financial (JXN) had a depressed stock price for so long while the underlying business was so good.  If 60% of funds are quantitative, and their multivariate regressions drop observations with missing data, then it could take a couple of years for there to be enough trailing twelve month observations for quantitative strategies to bring the price more in line with peers.  In the best case scenario, a recent spinoff has too little data to be bid up by the algorithms, but still has decades of experience in the industry while they were private, or a subsidiary of a conglomerate.

CLCO is currently sitting at a price to tangible book of 0.85 compared to Dorian LPG (LPG) at 1.66, Golar LNG (GLNG) at 1.73, and FLEX LNG (FLNG) at 1.68.  CLCO’s price to sales is 1.82 compared to 2.87, 12.38, and 3.86 respectively.  Apples to apples, CLCO seems to be about half the price of their peers, which means that even if LNG carriers are being somewhat overbuilt, it could still be a reasonably good investment anyway.

The dividend of $1.64 is a 13.78% yield at the current price of $12.15. CLCO spent $88 million out of their operating cash flow of $180 million to fund this dividend.  Their 13.78% yield is 2x covered by operating cashflow.  The rest of the operating cash flow went toward building out those new LNG carriers of course.

At a market capitalization of $655 million, with operating cash flow of $180 million, the company is priced in such a way as it could return itself to shareholders in 3.65 years.  Now that is more than enough time for the glut of new LNG carriers to come online and crash the price, so am I a Judas sheep leading a flock into a slaughterhouse?  What if I told you that CLCO had a mostly contracted fleet with an average backlog duration of 4.9 years including option extensions and 3.1 years not including option extensions?  CLCO just signed a 14 year contract to import LNG for GAIL, India’s leading natural gas company.  Fixing a 10%+ return for 14 years is a guaranteed 3x of their investment on that LNG carrier.  And CLCO is at a price to operating cashflow of 3.65.  

Even if there is a glut of LNG carriers, and even if the day rates of those carriers crashes, management doesn’t need to sign many more contracts over the next 12 months before CLCO is completely derisked.  If they could sign a few more 2025 and 2026 leases in the next 12 months, then CLCO can pay for itself, and we can reevaluate the situation in 2027 and see how much the enterprise is worth then.  Commodity prices are currently depressed, but the summer is particularly hot in Asia right now driving up LNG demand.  Similar to my previous writeup on Vermillion Energy (VET), there have been two warm winters in a row, and eventually that trend will stop.

I do believe a small dividend cut will be coming, as management has a stated dividend payout policy of a variable dividend of 100% of free cash flow, and has been just slightly above this number.  The dividend appears to be 159% covered by net income, but not when you take into account that some of the net income is caused by mark to market adjustments on their derivative hedges.  I don’t expect management to pay out depreciation as dividends, they obviously want to keep growing their fleet, and nobody hates a growing dividend.  But I do take it as a positive that they are trying to book contracts for their newbuilds to more than cover the cost.  Even with a small dividend cut, it is likely to stay above a 10% yield given the current purchase price.  Out of their 11 ships, only one is susceptible to current day rates under a floating charter, and the remaining 10 are on fixed contracts.  Going forward to 2025, there are two to three ships in need of contracts, and by 2026, there are four.  The 3.1 year backlog is an average, which is affected significantly by the 14 year GAIL contract.  A failure of day rates to increase this summer would be an additional threat to the dividend in the medium term as it would affect contracts for that 30%-40% of the fleet.

Taking CLCO as a component in a larger portfolio, it makes an excellent companion to Black Stone Minerals (BSM) and Alliance Resource Partners (ARLP) as the volume of LNG shipped is inversely related to US natural gas prices, which are a substitute for coal.  If LNG prices stay low, BSM and ARLP will suffer, but CLCO will do well.  If the Permian depletion doomers are correct and domestic US natural gas prices are high, BSM and ARLP should make money hand over fist while CLCO suffers.  Due to the fixed contracts in CLCO and BSM, it is entirely possible that they both enjoy a happy moderate world where everyone makes money.

The big threat to CLCO aside from low day rates for LNG carriers, either caused by high US natural gas prices or a glut in new ship builds, would be from management.  Usually investing in a junior shipping company would be asking to be abused.  In this instance, however, the 58% ownership by Eastern Pacific Shipping is probably a pretty good guarantor that the CEO won’t be up to any hanky panky.  It does bring about its own unique threat, which is that if the share price were to be low enough, I don’t think there is anything to stop Eastern Pacific from buying the whole thing.  And, with a possible impending although small dividend cut, the price could fall.  In some instances, even with a large, deep-pocketed shareholder, there is a reason to stay public, such as access to the debt markets or intention to do acquisitions.  I do not believe any of those reasons are here to prevent Eastern Pacific from acquiring CoolCo.  The divestment of GLNG from CLCO removes any obstacle, to my knowledge, of being acquired.

The presence of Eastern Pacific, however, is touted by management to be an asset in contract negotiations both between banks, clients, and shipyards.  It is possible that GAIL wouldn't have signed a 14 year contract with just any junior shipping company if that company didn’t have a big older brother.  CLCO also has fixed rate debt, or floating but 90% hedged, with an average cost of 5.7%, which is definitely superior to a lot of my other portfolio companies, and might be influenced by the presence of Eastern Pacific as well.  I am not focusing much on their two newbuild ships coming online in the second half of this year for this analysis, as it isn’t necessary when something is this deep value.  

In summary, there is this $655 million market cap company with $2 billion in assets and $1.2 billion in liabilities with a 5.7% fixed cost of debt, and a $1.9 billion revenue backlog, or over $1+ billion free cash flow backlog, of contracts on their assets yielding a high teens return on equity, and you can buy that equity at a discount while inflation eats away at your leverage.  Management has committed to paying out 100% of free cash flow in dividends, and the biggest risk is the largest shareholder buying up the whole thing.  Day rates on ships are cyclical, and natural gas prices are cyclical, so size your position accordingly.  I am almost never smart or lucky enough to be writing about this at the bottom, but I wouldn’t wait for a price drop to start building a small position.