The Ship Finance Publication of Record
Marine M O N E Y INTERNATIONAL Hamburg
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October 2011
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LONDON
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NEW YORK
OSLO
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PIRAEUS
VOLUME 27, NUMBER 6
Pushing Through
Co n t e n t s October 2011 n
Greek Shipping Has to Grab the Headlines Greek owners have to step it up. — page 2
Publisher Senior Research Analyst ArtDirector/Production Manager
GEORGE WELTMAN
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Ship Leasing Takes Flight in China Rodricks Wong throws light on the important role of leasing in China.
RODRICKS WONG
— page 4
CARI KOELLMER
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KEVIN OATES
Vale’s Shipping Strategy – Creating a Competitive Advantage
U.K. Director
BORIS NACHAMKIN
Arlie Sterling dissects and explains the Valemax.
Greek Director
KEVIN OATES
Events Director Managing Director of MM Asia
Greek Marketing Representative Marketing / Sales Director Marketing Associate & Event Administrator Subscription Director Technical Support President Chairman
LORRAINE PARSONS
MIA JENSEN
— page 8
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The Landscape of Ship Finance in Korea Meeyoung Choi provides an overview.
MICHAEL MCCLEERY
— page 16
ANDREA FARRISON ELISA BYBEE MICHAEL HANSON
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Automated Valuation Models: An Appraisal Chris Rivlin describes the future of ship valuations.
MATT MCCLEERY
— page 22
JAMES R. LAWRENCE
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The Athens Stock Exchange outlines its case.
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Investor Relations – Objectives, Form and Substance Richard Lemanksi explains the ins and outs of the IR function. — page 36
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Opportunities for Shipping in the Greek Public Markets
Investor Relations: Maximizing the Potential of the US Marketplace Nicolas Bornozis provides a practitioner’s view.. — page 38
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The Shipping Corporate Risk Trade-Off Hypothesis Messrs. Merikas, Sigalas and Drobetz put market and financial risk in perspective. — page 40
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Yes, Netflix Exists but I’m Going to Buy a VCR Social Media’s time has come in shipping according to Adam Baylor.
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— page 44 On 30 August 2011, the Suezmax tanker Vladimir Tikhonov, owned by SCF Group passed Cape Dezhnev thereby completing her transit along the Northern Sea Route – the most difficult part of the high-latitude route from Europe to Asia through the Arctic. Cover photo courtesy of SCF Group.
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The Shipping Corporate Risk TradeOff Hypothesis By Andreas G. Merikas, Christos Sigalas and Wolfgang Drobetz he decision making process in maritime financial management consists of three main pillars: investment, financing and operation. Each pillar defines its own subuniverse and constitutes its own market with its own rules. The investment pillar refers to the market for newly built and secondhand vessels, the financing pillar is associated with the markets for debt and equity capital, and the operation pillar is related primarily to the freight market. Nevertheless, all three pillars and their underlying markets have one common denominator, namely “volatility”, which affects – in various ways and through various channels – the level and the variation of the outcome of any shipping corporate decision. Specifically, given that vessel prices can move radically in either direction, the decision of when to invest in a newly built or a secondhand vessel exposes shipping companies to substantial investment risk. Management’s choice to operate a vessel in the spot charter market rather than in the period charter market introduces market risk due to the variation of freight rates as a result of shipping market
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demand and supply shifts. And, finally, the choice between debt and equity financing determines a shipping company’s financial risk, as increased financial leverage reduces the probability that the cash flow generated from operating a vessel will be sufficient to meet the contractual capital repayments and the associated interest expense. For any given investment in a vessel, the combined outcome of financial risk and market risk constitutes corporate risk. Together, their coexistence may lead to financial distress. More specifically, cash flow volatility due to market risk in conjunction with financial risk arising from high interest expense and debt capital repayments will increase the possibility of suspension of payments and thus raise “going concern” issues. Accordingly, two key questions in strategic shipping financial management arise: • What is the relationship between financial risk and market risk in the shipping business practice? • Do a shipping company’s capital structure decisions affect its commercial strategy?
In order to answer these two questions, we define the “commercial strategy” of a shipping company as the choice to operate its vessels either in the period charter market or in the spot charter market. Whereas a shipping company secures fixed period employment for its vessels to smooth out swings in the freight market in the former case; it aims to capitalize on the upward spikes of the freight market in the latter instance. Therefore, one simple way to manage freight market risks in the shipping industry is to charter out vessels at a fixed rate over medium to long-term periods. The choice of a specific capital structure implicitly determines the company’s financial risk, and conventional financial management theory suggests that a heavy debt load increases financial risk (and vice versa) but also leverages returns for the non-risk averse. The shipping company’s commercial strategy further adds to its overall corporate risk. Therefore, the prudent financial decision maker in a shipping company should determine the capital structure of the company in conjunction with
its commercial strategy. All things being equal, we expect that highly leveraged shipping companies should operate their vessels on a fixed employment basis and hence in the period charter market in order to limit their market risks. In contrast, low leveraged shipping firms exhibit low levels of financial risk, allowing them to chase the upswings of the market and take on more market risk by operating their vessels in the spot charter market. Recapping these propositions, we claim that a “Shipping Corporate Risk Trade-off Hypothesis” (SCRTH) is in place, suggesting that: • A heavy indebted or levered shipping company that faces high financial risk, in order to mitigate its overall corporate risk, will assume low market risk by operating its vessels on the period charter market. • A spot market oriented shipping company that faces high market risk, in order to mitigate its overall corporate risk, will assume low financial risk by keeping its capital structure debt free. If the SCRTH is valid, there are several far reaching implications for efficient corporate risk
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management in shipping companies. A few examples for implications of the SCRTH, which prudent managers of shipping firms should consider are: 1) there is an inverse relationship between market risk that drives a shipping company’s commercial strategy and financial risk that shapes its capital structure; 2) the commercial strategy of a shipping company should not be viewed independently from its capital structure; 3) the coexistence of excessive financial risk and market risk exposes a shipping company to unjustifiable corporate risk; 4) the realization of unjustifi-
able corporate risk may lead to a financial distress situation where the “going concern” issue is imminent. If the two elements of corporate risk which are analyzed in the SCRTH – financial risk and market risk – are unrelated in the real world of maritime financial management, our proposition remains an academic issue without practical implications. In contrast, if the SCRTH contains some validity, we expect to observe a negative relationship between financial risk and market risk in the empirical analysis. In order to get preliminary empirical support for the SCRTH, we performed a correlation analysis using the population of US dry bulk listed companies.
There were 14 dry bulk companies listed on US stock exchanges during the year 2010. From this population of listed dry bulk companies, 13 companies were selected because they met the criterion of generating the majority of their revenues from deep sea transportation services. We used two simple variables in our analysis. The variable used to measure market risk, is the charter coverage ratio for the years 2011, 2012 and 2013, which is calculated based on the earliest delivery date of vessels as reported in the companies’ earnings release for the third quarter of 2010. Specifically, charter coverage is calculated as the ratio of the days in a period during which the vessels in a fleet are under fixed period
employment and the number of days in the same period during which the vessels have been owned. The variable used to measure financial risk, is the debt to equity ratio, a commonly accepted financial measure of leverage. The debt to equity ratio is calculated based on the companies’ balance sheet figures of debt and equity, as reported in the earnings releases also for the third quarter of 2010. Table 1 summarizes the data that is used in our empirical analysis. The list with the selected thirteen US dry bulk listed companies is shown in column (1). The financial risk variable is presented in column (2); it is positively coded because a shipping company’s
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Table 1: Dry bulk companies
financial risk increases with a higher debt to equity ratio. The market risk variable is provided for the years 2011, 2012 and 2013 in the remaining columns (3)-(5); it is negatively coded because a shipping company’s market risk decreases with a higher charter coverage ratio.
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Given these empirical data, we are now able to verify the validity of the SCRTH by computing correlations between our proxy variables for financial risk and market risk. Specifically, if we find a negative correlation between financial risk and market risk, then the proposition of the SCRTH has some validity in explaining the suggested shipping management “behavior”. Figure 1 reports that the estimated correlation coefficient between financial risk and market risk is −0.39, −0.66 and −0.76 for the
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three years 2011, 2012 and 2013 respectively. These negative correlations provide strong support for the SCRTH. The outcome of our analysis indicates that a) there is a negative relationship between market risk and financial risk, and b) this relationship seems to become even stronger with the passage of time. While both findings confirm that shipping companies consider financial and market risk simultaneously, the latter observation is particularly interesting against the background of the SCRTH. The increasing correlation between financial risk, as measured by the positive coding of the debt to equity ratio, and market risk, as measured by the negative coding of coverage ratio for the years 2011, 2012 and 2013, suggests that not only a shipping company’s market risk decreases with a
higher charter coverage ratio but also that market risk decreases with an increasing charter coverage ratio. Overall, our empirical analysis strongly suggests that the financial decision makers of listed shipping companies hedge their overall corporate risk profile by trading off financial risk and market risk, and they choose their companies’ capital structure and commercial strategy not as independent but as dependent variables. Given that the corporate risk of a shipping company is the combined outcome of market risk and financial risk, the economic rationale behind the SCRTH rests on two driving forces. On the one hand, the cyclicality of macroeconomic conditions and its consequences on global seaborne trade increase freight rate volatility and cash flow
uncertainty, and hence substantial market risk is an inevitable challenge shipping companies have to cope with. On the other hand, the capital intensiveness of shipping requires capital accumulation, which most likely leads to the debt market, which is responsible for the high levels of leverage we generally observe. A highly levered capital structure increases installments and interest payments as well as the cash flow break-even point. Accordingly, financial risk is the other main issue shipping companies have to deal with. Market risk and financial risk add up, and when combined can adversely affect any shipping company in the sense that the reali-zation of tail risks becomes likely and financial flexibility becomes impaired. In order to better illustrate this
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Figure 1: Correlation between financing risk and market risk variables
*Not statistical significant argument, it is best to present an example from recent history. In the early 2000s, charter rates were constantly increasing amid a global trading boom arising from the higher demand for raw materials from emerging economies. China, by itself, was able to sustain the increases in charter rates. Vessel values were also soaring, sky rocketing to alltime high levels in 2008. At the same time, the proportion of debt to equity had been increasing steadily. The debt to equity ratio even reached and in some cases exceeded 80% prior to the credit crunch and the subsequent economic meltdown. Most shipping companies had undertaken both high market risk and high financial risk, betting on the perpetual increase of freight rates and vessel prices and using disproportional debt in their capital
structures in order to deliver higher Returns on Equity (ROE). The outcome of this trend is well known: many distressed shipping companies were struggling to keep afloat and exerted high pressure on their banks’ balance sheets as their loans turned into bad debt. By now, many shipping companies have intuitively realized that high market risk and high financial risk should not be paired. Many of them are trying to hedge against financial risk by reducing exposure to freight rate fluctuations by securing period charter agreements with visible cash flows for their vessels. At the same time, there are also companies – most notably the case of Baltic Trading – which undertakes high market risk by employing its vessels in the spot market,
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while at the same time implicitly hedging against this type of risk by specifically eliminating most of their financial risk by choosing a very conservative debt to equity ratio. To sum up, our note introduces in a simplified way the concept of the shipping corporate risk trade-off hypothesis , which can be used for efficient corporate risk management in a shipping company. Our preliminary empirical results confirm the notion that prudent shipping managers can influence the level of their corporate risks by properly trading market risk for financial risk (and vice versa). The commercial strategy of a shipping firm, interpreted as the choice between spot and period charter employment of vessels, is not independent from its capital structure. This func-
tional relationship between capital structure and commercial strategy suggests that efficient strategic financial management has a strong impact on the success or failure of a shipping company. The authors can be contacted at the following: Andreas G. Merikas, Professor of Maritime Financial Management The University of Piraeus
[email protected], www.mfmlab.org Christos Sigalas, Analyst Seanergy Maritime Holdings Corp
[email protected].
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Wolfgang Drobetz, Professor of Corporate and Ship Finance University of Hamburg
[email protected]
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