Golden Ocean Has Found A Way To Navigate The Cyclical Bulk Carrier Business

seekingalpha10-04

GOGL has improved returns since 2014 by focusing on efficiency, cost-effectiveness, and flexibility in fleet management and market positioning.Despite a volatile bottom line due to fluctuating charter...

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Its financial position is average.A Monte Carlo simulation shows that there is a 2.6 to 1 odds that the intrinsic value is greater than the market price. This is a good \"margin of safety.\"   1001slide Investment Thesis Since pivoting to the bulk carrier business in 2014, Golden Ocean Group Limited (NASDAQ:GOGL) has delivered improving returns. This was due to its strategy of emphasizing efficiency, cost-effectiveness, and flexibility based on several key elements – fleet class, fleet age, market positioning, and flexibility. This strategy would enable the company to be profitable over the cycle. A point estimate provided only a 16% margin of safety. But a Monte Carlo simulation results in a 2.6 to 1 odds that the intrinsic value is greater than the market price. I would suggest that this is a better interpretation of the margin of safety. As such this is an investment opportunity. Business background GOGL described itself as “one of the world’s leading dry bulk shipping companies…supply the world with commodities essential to farming, manufacturing, and energy supply.” The company was originally established as a crude oil tanker business. In 2009, it expanded into the dry bulk segment and discontinued the tanker business in 2013 to focus on the dry bulk segment. Since then, the company has grown via acquisitions as well as buying, disposing, and new buildings of vessels. You can see this from the left part of Chart 1. Today, the company operates worldwide within the dry bulk shipping sector. According to the company, charter rates for dry bulk vessels are volatile. As such the “financial results are subject to the cyclicality of the dry bulk shipping industry and any attendant volatility in charter hire.” You can get a sense of the volatility of the charter rates from the right part of Chart 1. Chart 1: Class of ships and Ship statistics (Author) Note to Chart 1: The average age of the ships was estimated based on the fleet information provided in its Annual Report. It represents the difference between the year of publication of the Annual Report and the weighted average age (weighted by DWT) of the fleet. The company’s business strategy seems to centre around the following:  “Operating with the largest sizes of dry bulk carriers (Capesize and Panamax). Refer to the left part of Chart 1. Maintaining a low average fleet age, ensuring low operational costs and a low carbon footprint. Refer to the right part of Chart 1. Balancing between fixed-paying versus spot market. Refer to the right part of Chart 2. Adjusting its market exposure through time charters, voyage charters, bareboat charters, sale and leasebacks, sales and purchases of vessels, and acquisitions.” Refer to the left part of Chart 2.  Chart 2: Charter type (Author) I would summarize its business strategy as emphasizing efficiency, cost-effectiveness, and flexibility based on several key elements – fleet class, fleet age, market positioning, and flexibility. Operating trends From 2014 to 2023, revenue grew at a 31.3% CAGR. This growth was partly due to corporate mergers/acquisitions, as well as the acquisition and disposal of vessels. Refer to the left part of Chart 3. Chart 3: Performance Index and Returns (Author) The increase in revenue in 2021 was mostly due to the increase in the charter rates. The time charter equivalent rate in 2021 was USD 27,582 compared to USD 13,466 in 2020. This was an industry phenomenon as illustrated in the right part of Chart 4. You can see the impact clearly on the gross profit margin as illustrated in the left part of Chart 4. However, the charter rates and gross profit margin have since come down from these highs. Chart 4: Margins and Baltic Dry Index (Author and Trading Economics) While revenue showed “stable” growth, the bottom line was more volatile with a 24.2% CAGR over the past decade. Apart from the changes in the charter rate, another reason for the volatile PAT is because of asset write-downs and loss/gain from the disposal of vessels. Given the volatile PAT, returns were also volatile with several years of negative returns. Refer to the right part of Chart 3. As such over the past 10 years,  ROIC averaged 4% compared to the current WACC of 7%. ROE averaged an average of 3% compared to the current cost of equity of 8%.  With returns less than the respective cost of funds, shareholders’ value was not created. But if you look at the performance over the past few years, you can see that GOGL has delivered record profitability. There are several reasons for this:  It has reached a size where the fixed cost is a smaller portion of the total cost. Fixed cost has reduced from 57% of the total cost in 2014 to 42% in 2023. As will be shown in the next section, the company is more efficient today compared to that in 2014. The higher charter rates in the past few years probably provided some tailwind.  Efficiencies The key point to note is that capital efficiency as measured by gross profitability (gross profits/total assets) and various return metrics shows uptrends. Given that efficiency is an integral part of its business strategy, I wanted to see whether there are broad-based improvements in other measures of operating and capital efficiencies.  Operating efficiencies. Refer to the left part of Chart 5. While there were improving trends for ROA, inventory turnover, and operating expense ratio, the operating profit margin declined. Capital efficiencies. Refer to the right part of Chart 5. Except for the current ratio which showed a declining trend, there were improvements in the other 3 metrics.  Chart 5: Efficiencies (Author) I would interpret the results as follows: Volatility in the charter rates and demand negatively impact profit margins, even with improved efficiencies. Chart 4 shows the volatile gross profit margin and Baltic Dry Index. Note the declining Selling, General, and Administration (SGA) margin supporting the company’s cost control capability. As for the declining current ratio, this was because the company has taken on more short-term debt impacting its current ratio negatively. While the company was able to control internal expenses, there is a limit to what it can do to the volatile charter rates. Peer comparison I compared GOGL's performance with 4 global dry bulk shipping companies as listed in Table 1. The peers were companies with slightly larger revenue than that of GOGL in 2014. Over the past decade, GOGL had the highest revenue growth rate so by 2023, it ranked in the middle in terms of revenue. Table 1: Peer revenue (Author) I looked at the trends of 4 metrics to get a sense of how well GOGL performed compared to its peers – return on capital, EBIT margin, Free Cash Flow margin, and EPS. Refer to Charts 6 and 7.  GOGL started the decade with a low return on capital but ended up with one of the better ones. Its EBIT margin was about average at the start but became one of the better ones over the past few years. I would consider GOGL’s levered free cash flow margin as average. But it had improving EPS.  Relative to the panel, I would consider GOGL’s performance as average. Given its low cost and efficiency strategy, it is not surprising that GOGL stood out in EBIT margin and Free Cash Flow margin over the past few years. Chart 6: Peer return on capital and EBIT margin (Author from TIKR.com) Chart 7: Peer levered Free cash flow margin and EPS (Author from TIKR.com) Financial position I would assess GOGL's financial position as average. While it has positive points, they were offset by the negative ones. Its positive points included the following:  Over the past 10 years, it generated positive cash flow from operations for 8 out of the 10 years. During the past 10 years, it generated about USD 1.9 billion in cash flow from operations compared to a total PAT of USD 0.8 billion. This is a good cash conversion ratio. Over the past 10 years, it incurred a 26% Reinvestment rate (Reinvestment/NOPAT). This meant that a good part of the NOPAT could be returned to shareholders. It has a good capital allocation track record as can be seen from Table 2. It was able to cover its CAPEX with the cash flow from operation.    Table 2: Sources and Uses of Funds 2014 to 2023. (Author) Its negative points included the following:  It has a 43% debt-capital ratio as of the end of Jun 2024. According to Damodaran Jan 2024 datasets, the transportation sector had a debt-capital ratio of 25%. As of the end of Jun 2024, it had USD 99 million in cash and short-term investments. This was only about 3% of its total assets  You can see that its cash flow from operations was sufficient to cover CAPEX. It could have easily reduced its debt further (but at the expense of dividends). That is why I am not too worried about its financial position. Valuation My analysis has shown that the company delivered improving returns over the past decade. I posit that this is due to its business strategy of emphasizing efficiency, cost-effectiveness, and flexibility based on several key elements – fleet class, fleet age, spot vs fixed-paying rates, and charter types. I expect this strategy to continue. I thus valued the company based on the following long-term picture. The company had reached a \"mature\" stage given the stable fleet size over the past few years.  Growth would be at the long-term GDP rate of 4%. I assumed the past 3 years' revenue to represent the base demand.  This is a cyclical company with changes to the demand for freight and freight rates. As such it is more appropriate to look at the performance over the cycle. In this context,  I used the average 2014 to 2024 operating efficiencies and capital efficiencies as the base efficiencies. From a conservative perspective I will assume that there will not be any operating efficiency or capital efficiency improvements.  The cyclical nature of the sector is such that asset write-downs and/or asset gain from the disposal of vessels is part and parcel of the business. In this context, I took the past 10 years' average net write-downs as part of the costs. On such a basis I estimated GOGL’s intrinsic value to be USD 15.32 compared to its market price (1 Oct 2023) of USD 13.16 per share. There is only a 16% margin of safety. This 16% is the conventional view of the margin of safety obtained by comparing the point estimate of the intrinsic value with the market price. I would like to suggest an alternative view of the margin of safety based on the possible range of intrinsic values obtained from a Monte Carlo simulation. Chart 8 shows the results of such a Monte Carlo simulation. 72% of the intrinsic values are greater than the market price. This is equivalent to a 2.6 to 1 odds that the intrinsic values are greater than the market price. I would consider this a good margin of safety and as such view GOGL as an investment opportunity.   Chart 8: Monte Carlo simulation (Author) Sanity checks To see whether the assumptions used in my valuation are grounded in reality, I compared the results of my valuation model with the historical performance of GOGL and its peers. Refer to Chart 9 where I have overlayed the base value of the 4 metrics (red dotted lines) onto the historical performance of GOGL and its peers. You will agree that I have not been aggressive with my assumptions.   Chart 9: Comparing base valuation metrics with GOGL and peers (Author) The other sanity checks are shown in Table 3. I would consider the company as cheap if the Acquirer’s Multiple is less than 6. This is also not a fantastic investment from the 4% Free Cash Flow yield perspective.   Table 3: Comparative valuation (Author) Notes to Table 3: a) EV / (average 3 years Op profit + Depreciation). b) Past 10 years average Free cash flow/market price. Finally, in Chart 10, I compared the historical performance with the projected ones used in the valuation model. The projected values do not look unreasonable.   Chart 10: Comparing valuation with historical performance (Author) Note to Op Profit Profile. I broke down the operating profits into fixed costs and variable costs.  Fixed cost = SGA, Depreciation & Amortization and Others. Variable cost = Cost of Sales – Depreciation & Amortization. Contribution = Revenue – Variable Cost. Contribution margin = Contribution/Revenue.  Valuation model My valuation is based on the single-stage Free Cash Flow to the Firm model, as shown in Table 4. Free Cash Flow to the Firm (FCFF) = EBIT(1-t) X (1- Reinvestment rate). Value of Firm = FCFF X (1 + g) / (WACC – g). Value of Equity = Value of Firm + Cash – Total Debt – Minority Interests. EBIT = Revenue X contribution margin – Fixed cost. The contribution margin and fixed cost are based on modelling the business, as shown in the left part of Chart 9. The operating efficiency is represented by the contribution margin. The capital efficiencies are represented by the capital turnover (Revenue/TCE) and Reinvestment margin (Reinvestment/Revenue). Table 4: Estimating the intrinsic value (Author) Most of the items in Table 4 are self-explanatory, except for the following: Item c. This is based on the past 3 years' fixed cost plus the past 10 years' average net write-downs. Item n. WACC. This was based on the first page Google search for “Golden Ocean WACC” as shown in Table 5. Item q. I compared the total capital employed (TCE) required by the model with the actual TCE. There is a shortage, implying that there is not enough total capital. This impacts the non-operating assets.   Table 5: Estimating the WACC (Various) Risks and limitations There are 2 key issues in my valuation:  Tax rate. Point estimates.  Historically, the company had very low effective tax rates that averaged less than 1%. I am not a tax expert, but I gather that this is because the company operates in several jurisdictions which offer favour tax rates and/or tax incentives for shipping companies. I am not sure whether this could continue in perpetuity. If I use a nominal 24% tax rate instead of the 0.3% as per the model, the intrinsic value drops by half. Secondly, I used point estimates in my valuation. To provide further insights into the range of possible values, I carried out a Monte Carlo simulation where I varied the following key parameters based on triangular distributions.  Revenue and contribution margin ranged from + 10% and - 10% of the base values. Capital turnover and Reinvestment margin ranged from + 10% and – 5% of the base values. This is to reflect that there is a better chance of efficiency improvement than decline. WACC ranged from 6.9% to 7.8% as per the range shown in Table 5.  The result of the Monte Carlo simulation was shown earlier in Chart 8.  28% of the values are less than the market price. I consider this a good sign. This meant that 72% of the intrinsic values are greater than the intrinsic values. This is equivalent to a 2.6 to 1 odds that the intrinsic values are greater than the market price. There is a 5% chance that the intrinsic value could be USD 21 or higher.  Conclusion I would consider GOGL as fundamentally sound:  It is a prominent player in the dry bulk shipping sector, emphasizing efficiency and flexibility in operations. Its focus on larger vessel sizes and maintains a low average fleet age position. The company delivered improving returns over the past decade. This has been fueled by strategic acquisitions and effective fleet management. Its financial position looks ok given its strong cash conversion ratio. Compared to its peers, it delivered one of the better performances over the past few years.  But it is not all plain sailing:  The company's profitability has been volatile due to fluctuating charter rates and asset write-downs. But while it did not create shareholder value over the past decade, the picture would be different if you look at the past few years’ performance. There is some risk on whether the historically low effective tax rate could continue in perpetuity. This will impact the valuation.  The key concern was the lack of a 30% margin of safety from the point estimates perspective. A conservative investor might view GOGL as a moderately risky investment and wait for the price to drop further. However, the Monte Carlo valuation shows that there is a 2.6 to 1 odds that the intrinsic values will be greater than the market price. I consider this a good margin of safety, and as such see GOGL as an investment opportunity.  Editor's Note: This article was submitted as part of Seeking Alpha's Best Value Idea investment competition, which runs through October 14. With cash prizes, this competition -- open to all analysts -- is one you don't want to miss. If you are interested in becoming an analyst and taking part in the competition, click here to find out more and submit your article today!","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2472938236"}