The new trading game… and the deal of the downturn…

It is my belief that no man ever understands quite his own artful dodges to escape from the grim shadow of self-knowledge. The question is not how to get cured, but how to live.

Joseph Conrad

 

La fatal pietra sovra me si chiuse. / “The fatal stone now closes over me”)

Morir! Si pura e bella / “To die! So pure and lovely!”)

Aida

Solstad Farstad announced it’s 4th extension to its Solship/ Deep Sea Supply problem last week. The Q1 2018 results also noted that they had breached the covenants for the Farstad  entity as well and were therefore seeking a waiver for this part of the Group. Solstad state they expect the Farstad part to fall into compliance in the 2nd half of 2018, this is significant because if this doesn’t happen then two of the three legs of the merger have effectively broken and the entire industrial logic for this merger will have fallen apart less than a year after closing. That this has occured so rapidly after the merger is a large credibility blow to all those involved putting the deal together.  All the major stakeholders, except for the Deep Sea Supply shareholders, bet all on a market recovery that had no basis in reality, and now, unsurprisingly, it hasn’t happened they are bereft of ideas. It is no wonder the Chairman has been recently replaced.

I think Solstad are actually aware of the scale of the problem now, the new Chairman who not only has a strong financial background but as Chairman of the Norwegian National Opera and Ballet surely apprecites drama and tragedy, seems to be playing for serioius time? The Q1 2018 report is significantly more downbeat than the annual report released only a few weeks earlier and the financial risks section highlights how serious the problems are.

It is very hard to underplay what a mess this is from an industrial perspective, with a Group holding company responsible for two insolvent trading companies (of three trading entities) and yet the scale of all three put together was the core rationale of the deal? In a bizarre twist of logic Solstad claim the merger cost synergy targets remain in place despite the fact they must be close to simply handing back the Deep Sea/ Solship 3 fleet to the banks and yet remain liable for the running costs of the company, despite it being a massive economic drag on the group? Surely if they do this they need to explain what synergy number cannot now be achieved? This is just one example that highlights in reality getting out of this deal will be far harder than it was to get into. What will the new Solstad look like? The banks will be seeking to get out as soon as possible from all but the aquaculture business, and the relationship to Hemen/ Fredriksen just another complication from an industrial perspective the company doesn’t need.

Not to put too finer point on it but the Q1 2018 results for Solstad Farstad really made clear that the company is insolvent, by that I mean in the accounting sense where the ability of the asset base to generate enough economic value to pay their liabilities is clearly compromised. Solstad don’t have a liquidity problem immediately but they will soon having gone back NOK 400m in Q1… unless they have a stonking Q2, and there is no reason to believe they will. An upcoming (round 2) restructuring appears imminent because its financing costs are killing it. The comparison with the efficiency of the American Chapter 11 system which has allowed  Tidewater, Gulfmark, Harvey etc. to emerge and take market share is such a contrast to the European system it merely adds another nail in the coffin here.

Like Siem Offshore, and so many other offshore vessel companies, Solstad can pay for everything up to finance costs, and then it falls into a pit of actual cash outflow. Welcome to the new normal. Eventually, in an industry with depreciating assets that need replacing, this model doesn’t work.

One amazing financial revelation of the Q1 2018 results is the fact that Solstad depreciate vessels over 20 years to 50% of original cost! If anyone thinks a 20 year old AHTS is worth 50% of the new build price they either know nothing about the industry or enjoy a healthy portion of magic mushrooms. These values are apparently adjusted by broker values but this policy must massively overstate the book equity in the company relative to current market values. The policy itself seems a remnant of a bygone era when a demand boom meant assets depreciated less slowly than book value implied. The only thing making those creditor claims look economically realistic appears to be a policy that has consistently over valued the asset base above its long-term economic value.

As an argument for how some audit firms are too close to their clients Solstad Farstad makes a strong case given the EY statements regarding the financial positon of the Group. On the 18.04.18 Solstad Farstad published their 2017, and inaugural, accounts for the combined entity which EY accepted as fairly representing the positon at year end 2017. A mere 2 weeks later, literally just before the Easter holidays, the first deferral of the Solship 3 “investment” was made, something that would have been blatantly obvious to all concerned closing the accounts, and this allowed all the long term debt to be recorded as just that. In effect, as became clear at the Q1 2018 accounts, coming only a few weeks after the Solship deferral and was clearly obvious in Q4 2017, Solstad Farstad had a massive problem and a covenant breach,  therefore a major portion (NOK 11bn) needed to be reclassified as short-term as the lenders could theoretically call this in immediately. This looks stage managed in the extreme. One would think this was such a significant post balance sheet date event that it must be reported…

This is just another sympton of how out of control the whole situation is. What is clearly happening in the background here is that Solstdad Farstad needs to hand back the entire Deep Sea Supply to the banks, something everyone in the industry knows, but the banks don’t want it. It also means all this talk of a recovery in large AHTS is hokum. A few good weeks over summer doesn’t make an asset economic over 52 weeks. Without this mirage of scale of the merger is a busted flush and someone then needs to go back to the market and explain that the stated industrial strategy and planned synergies as outlined in the original merger document, less than one full financial year before this became apparent, are totally unrealistic and have in fact threatened the very existence of the entity. Without new equity, which would require a substantial writedown in bank debts, Solstad will simply limp along as a zombie company with the banks extracting what they can over time and the equity remaining worthless at best. It will be like a bank in run off with the asset base eventually eroding away to nothing.

Solstad (and it will be just Solstad going forward) is probably only viable as a Norwegian area (re: Equinor sponsored) PSV and AHTS operator, with an option on some Brazilian tonnage. The CSV operation is still potenitally considerably overvalued: it is an aging fleet that will never realise book value because no bank will lend against assets that old and and without long term contracts going forward. The Australian/Asian operations need to go immediately and the laid up Brazilian assets (i.e. the majority of the Brazilian fleet) need to go as well. Siem Offshore appear to be pulling out of Australia and Solstad cannot be far behind them on any rational basis. The aquaculture business will surely revert to Hemen/Seatankers/Fredriksen or be sold.

Quite why Solstad is therefore publishing two week extensions when this problem will take months to sort out is anyone’s guess. But a whole pile more deferrals are coming unless some rabbit is pulled from a hat. The Q2 results are likely to lead only to the creditors starting to get real about the scale of the problem.

To be clear this isn’t only a Solstad issue, although the merger was clearly a folly on an epic scale: in the the same week Bourbon Offshore announced that they were suspending debt repayments (again). Miclyn Express Offshore, Pacific Radiance and EMAS (again) cannot find sustainable financial positions. Siem Offshore recently reached agreement to defer payments on debt

It defies the laws of economics and common sense to believe that any one firm can outperform any others in this market in a meaningful financial sense when they all offer assets that are identical in function and form to their (identical) customer base. Siem Offshore now isn’t paying it’s lenders back in full until 2022 and lowered (again) payments by 30%. It will simply reduce day rates to get utilisation and it shows the banks know they have no leverage here. Deferring all borrowers across the industry indefinitely however will ensure they never get paid paper claims. Eventually winners will have to be picked and it will clearly be those burning the least cash.

I have followed the Solstdad situation more closely than any other simply because a) from an industrial and financial perspective it was clearly such a bad idea; and, b) their public prognostications have been so divergent from any actual data points in the market, and so far removed from realism, it makes a fascinating sociological experiment. Those of you who have read The March of Folly will know what I mean.

The funny thing about all the banks delaying the bullet payments outstanding (to Siem Offshore, MMA, Pacific Radiance, Solstad, ad infinitum) is that each bank knows in truth their own bank would never lend on the other side of the deal. The Siem deal recognises this. The banks in these deals are locked into the boats and companies they have backed because the bullet payment will never be made unless they sell it at a huge discount to a distress debt investor. The banks are stuck in these deals but they are not getting into any more, but in this self-perpetuating cycle it also locks in low asset prices and day rates. Breaking this self-reinforcing circle will only occur when the mythical demand fairy appears.

All offshore supply companies, and by that I mean OSV operators who do not engage in engineering and execution, are price takers in the current market: there is no ability to add value, they are in effect trading firms wholly depedendent on the market price and demand levels for a commodity asset, with no ability to take anything other than what they are offered. This isn’t what the original funders signed up for, isn’t the skill set of the majority of management, and is significantly more risky given the risk/reward basis that rational investors should be comfortable with. Eventually funders will realise this and new equity will stop flowing into the industry under the promise that all you have to do is burn cash and wait. Pacific Radiance and EMAS are two good examples where clearly due diligence has revealed the downside of this strategy.

Anyone investing in this market should realise they are betting against the greatest shipping trader of the age: John Fredriksen. When the chips are counted from this downturm the greatest deal in offshore will not be an acquisition at the bottom of the market it will almost certainly be a divestment: and it will be the story of how JF managed to put only $20m in to rid himself of a bankrupt entity, with some really low market tonnage, that surely his major bankers would have demanded substantially more support for had it not been folded into Solstad? Now Deep Sea Supply is inextricably tied to Solstad and it is a management and funding issue of this company not a Seatankers/Hemen problem.

If you are buying AHTS’s and PSV’s you need to ask yourself what you know that JF doesn’t? And what your industrial angle is that is better than Seatankers?

Anyone who tells you scale and consolidation will save all needs only to look at how many high-end AHTS Solstdad Farstad have, and after a year of operation all it brought them was a covenant breach. Scale without pricing power is meaningless, the costs of the vessel operations are so high relative to the onshore costs that saving a few dollars a day on SG&A costs is just a rounding error. A new industry narrative is required for the lender to be kept happy but each becomes more tenuous than the last.

Not all offshore supply firms are going to survive, but quite understandably the banks want the failures to be someone elses. There is nothing written in stone that Solstad Farstad will survive. Every Solstad report talks of a willingness to participate in consolidation but the equity has no value and anyone taking it over would want the banks to write-off the billions of NOK. Given the post-merger performance of the Group it isn’t a serious proposition that anyone would take their shares in a consolidation play either. My money would be on a take-private deal where the Solstad backers hope to use it as a consolidation vehicle, but everyone is doing this at the moment and eventually some firms need to drop out and take a hit before this works for someone. But if you think some of the public firms valuations are high I bet some of the private fund accounting going on is even more aggressive…

For the industry to recover a few big firms, and their associated asset bases, are going to have to go and some losses way beyond those taken to date are going to have to realised by banks and increasingly equity investors. Even the most outrageous demand forecasts for next year don’t offer the sort of demand boom required to fundamentally alter vessel profitability. Unless this relationship below reverses the global OSV fleet has substantially less value than some recent deals presume:

McKInsey BH Q1 2018.png

Source: McKinsey.

Working out when  profits come again is highlighted by the Siem Offshore results which pointed out that owners are laying vessels up and bringing them out when day rates recover. Scrapping simply hasn’t happened at the levels that some were forecasting. Something has to give and at the moment it’s day rates and utilisation. For as long as the high-capital values of vessels relative to marginal day-rates make this worthwhile, or companies like Standard Drilling buy cheap and sell cheap, then this is just a straight trading game. The scale of any recovery in offshore work required to make the whole fleet even economically breakeven so far into the distance it is definitely a chimera.