High fixed costs and low marginal costs explain why something can cost a lot and be worth nothing…

The world’s worst business is one with high fixed costs, low marginal costs, and lots of competition. In that case the competitive forces will drive prices down to the low marginal costs – and it will be impossible to recover fixed costs.

When the fixed costs are debt financed, bankruptcy often follows. That is precisely why the airlines have been bankrupt many times. The marginal cost of filling the otherwise empty seat is very low – and competition at times drives prices to those very low marginal costs.

John Hempton, Bronte Capital

I wrote yesterday about when the bottom in subsea and offshore supply would come and then came across the quote above. It could clearly have been written about offshore supply or the subsea fleet. The quote explains perfectly why something can cost a lot but not be worth anything, which is a concept I think some distressed investors in offshore struggle with. I think the amount of work offshore will gradually increase but the problem is the supply side of the market. Being an offshore contractor is a good business potentially, as long as you don’t have too many vessels, but it won’t be as good as 2012/2013 for a very long time (if ever).

I think the “recovery” or bottom will have arrived when industrial players are the main purchasers of assets and provide the pricing signal as to intrinsic value driven by the real cash they can generate. Anedoctally I have spoken  to too many alternative finance providers lately who are just trying to be to clever: all of them are hoping to discover a way of finding the metaphorical “cash behind the sofa” that someone else hasn’t thought of, when actually it is pretty simple: there are simply too many vessels relative to the amount of work.

In the subsea space the DSV Swiber Atlantis went to NPCC for c. USD 8m, when in 2013 it had a broker valuation of USD 40m, this is slightly less on a percentage basis than the Amazon going to McDermott for USD 52m when the original build cost was USD 400m (but that included some of the mothballed lay system). So the new market value is potentially a 75% reduction on build cost or 20% of 2013 market value.

The Nor DSVs remain the most interesting asset here: they have not worked in well over 18 months now and will not work in the North Sea, barring a recapitalisation as a North Sea dive contractor, something that would be in the tens of millions in addition to the vessel OpEx, and offer nothing but lower rates for all with absolutely no guarantee of success. The owners are in the worst positon of anyone in the market: trying to be a vessel owning company but unable to behave like one. Move the vessels somewhere else and the owners will have to accept that they are worth well below par because no one out of the North Sea needs such a high spec DSV… The original investors lent USD 110m per vessel and have now ended up with an equity position valued at USD 20-25m based on the comparable transactions above – less the USD 15m (c. USD 7.5 per vessel) that was put in as “super senior” to give them the working capital to remain tied up in Blyth this year (that by there own forecast will be exhausted by December this year). If the vessels sold at the low range that would imply a c. USD 13m net proceeds (11.8% of par)… But the only other option is to fund another year of OpEx with no guarantee it will be different to the last? (And actually its more likely  that there is no change because before any responsible company allowed those vessels to dive now they would insist on some expensive trial dives and likely remedial work).

Some of the distressed debt investors brought into the Nor bonds at ~.30 par which implies they need a sale of at least USD 40.5 million to breakeven before December. Mark this as a bellweather deal. At some point the distressed investors actually need an industrial buyer, they just can’t keep selling the bonds to each other at an ever greater discount?

In offshore supply one of the reasons I think the HugeStadSea merger is a mistake is that an industrial buyer is paying far more for the asets than they would be worth on a liquidated basis. Yet it is very easy to see a Gulfmark or Tidewater emerging from Chapter 11 and buying assets strategically on a liquidated basis and having a more compelling economic and investment case than Solstad Farstad (how long will the Farstad last I wonder? Maybe until the first deeply discounted rights issue?) You don’t even have to be that hypothetical: Fletcher Shipping, with signficant investment from Standard Drilling, is bringing older PSVs back to the North Sea – while 80 vessels are in lay-up in the peak summer months – to operate (hopefully?) at cash break even on vessels purchased for USD 2.5m (plus refit fully delivered c. USD 8m), way above the implied values Solstad has paid. Yes, they are not the same quality tonnage, but if buyers were discrimiating on vessel quality at the moment NAO would be breaking even and the Fletcher vessels would be quiet… and that clearly isn’t the case.

Tidewater, Gulfmark and CGG shareholders all look to get less than 5% of the restructured companies going forward and using that as a comparator again Solstad looks to have given up its exposure to quality tonnage for commodity tonnage very cheaply. Will it really be able to compete against a recapitalised American group of companies such as Seacor, Hornbeck (restructuring imminent) etc? Trico shareholders led the creation of DeepOcean and US investors just seem so willing to back big ideas…

The Fletcher model of assets that are fully equity financed but breaking even on a cash basis is where the market needs to get to. When the market adjusts to the new lower values which reflects the risk highlighted in the opening quotation, and industrial buyers are the ultimate owners, then I think we have reached the market trough.

2 thoughts on “High fixed costs and low marginal costs explain why something can cost a lot and be worth nothing…

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