Posted on May 25, 2016
EBITDA – The Misleading Truth
I sailed the seven seas in many vessels be they Container, Tankers or Dry Cargo one of my first voyages as a cadet in 1970 was in the 21 year old vessel pictured. (As a reward to those that read through I will give the name at the end of this diatribe) OSV’s are however are a different beast as neither technology nor the requirement for intense reliability will allow that they survive so long.
OSV companies live in a world where the amount of investment will usually exceed the full visibility of returns, primarily due to our long term depreciation models which almost always extends beyond the duration of the initial contract. I know of no operators who have succeeded in a full and 100% birth to grave investment within our industry.
Prior to our current woes, if offered a profitable long term contract of say 5 to 10 years, how many of us would have built a vessel worrying about the rest of the 15 to 20 year depreciation period? This despite the vessel being redundant at end of contract and still having a book value of 10s of millions of US$.
Even today a 10 year old vessel is regarded as old and a 15 year old as past its sell by date. The problem is today that with falling vessel values we cannot sell without taking significant impairments which then reduces profitability and thus our ability to finance, which in turn stumps growth. So we restructure to borrow more to pay off debt or we have to supply additional security to reissue Bonds. Or worse, we sell our more viable assets to bring in working capital, or even more critical, to pay interest. This will become all the more prevalent as new cheaper vessels from stretched shipyards enter the arena.
Of course, not all OSV operators will be driven to dip so low. But these are desperate times for some.
So why is this happening for some? I believe it’s the overwhelming desire to portray EBITDA as the key benchmark to business performance which, agreed, can be a guide peer to peer in exactly the same industry. But depreciation is a real cost – as many are finding today – and will do so at year end valuations, to their detriment.
Warren Buffet said:-
“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. When Wall Streeters tout EBITDA as a valuation guide, button your wallet”.
Buffet was referring to a 10 year model here. The OSV industry has generally adopted a 25 or even 30 year model. The OSV dilemma is compounded by the fact that the vast majority of IOCs insist a vessel is less than 20 years old at end of contract.
Investment will either come through bilateral financing of 7 years, or bond issues of between 3 to 5 years. Who therefore is really taking the risk? Surely it’s the operator, as most investors will have cashed in, before the long term depreciation model becomes an issue, and impairments follow?
Who really benefits from the risk that operators are taking?
That’s a bit complicated so to put into plain language. First, the investors give operators the cash to buy high value assets, in the knowledge that the long term depreciation model increases short term profitability and thereby enhances the security of their returns. Secondly and a bit more controversially, is it not the end clients, the IOC’s who benefit from a more competitive market of lower rates? This has actually stacked up well in the past, primarily due to the stability in vessel values.
Let’s look at an example:- In 2004 you could buy a Norwegian built UT755L for US$14 to US$15m. Prior to this crisis, 10 years later in early 2014 we could sell the same vessel for at least US$15m. Hence as the NBV at that time will be US$9m where even with the write off of Dry Dock accruals there is enough in the coffers to make this scenario work. However vessel demand grew so much that in 2006, the cost of the same UT755L would be US$25 to US$27m, making the NBV remaining after 10 year’s US$15m, and a whole different sell.
Vessel prices have dropped 25% in the past 6 months, and my opinion is that this will have the greatest effect on the industry. We can lay ships up, we can cut costs in numerous ways but if there is little sight of future earnings, auditors will have no choice but to adjust valuations in annual accounts with the resulting impairments.
In conclusion I would argue that its clients who benefit most from a more competitive market hence lower rates; seconded by stakeholders who invest in high value assets in the knowledge that the long depreciation model increases profitability and thus enhances the security of their returns. A distant third comes the operator. So who are the mugs?
The exceptions perhaps are the companies which have successfully listed where investor dividends depends on the company’s overall performance and is not subject to amortisation or coupon.
The WOES of OIL Prices – The Misleading Truth
Not only have we had a sustained drop in the price of oil, after a period of some six months we also have not witnessed the expected rise and in reality prices have double dipped and actually dropped further.
This in itself is unprecedented, with analysts predicting this could go on for another 2 years. Never in the history of OSV’s have we been challenged by this degree of low utilisation, and rates for such a prolonged period of time.
To compound the bad news, this week no one could miss the doom and gloom reports of the Chinese economy, one of the largest users of energy and entering a significant decline, which inevitably will mean less demand for Oil and Gas. What quantity are the OIL stocks in China? Does anyone know? I doubt it. Hence we are with yet another variable in an already fractured market.
It’s true, there are many events that could change the cycle. Some say Saudi Arabia and the US may come to an agreement on Fracking and OPEC reduces production: but I would question are OPEC as influential as they were in the 90’s?
Others believe that war, Insurgence or another major world event could again change the cycle. But at this stage it would have to be cataclysmic, to have any immediate effect.
Finally Iran coming on line, as soon as maybe 1 to 2 years, must have an effect. Presumably with sustained low returns we will see a further decline in IOC’s enthusiasm for expenditure and future development that may take years to see viable returns.
So, why are we surprised? Why do CEO’s lay all the blame on the volatility of the market? Even if all of these events were not predictable one, two or even three years ago are we not duty bound to protect our stakeholders through due diligence and reduction of risk? Why did so many companies seek out investment capital, using EBITDA growth as the lure, and employ questionable financial instruments to fund growth aspirations? Of course, the answer is obvious, isn’t it?
Blaming the tough markets and the so called unpredictability of the geo-political and macro –economic environment is a limp excuse for lack of strategic planning and fiscal integrity.
TAKING ACTION – POSSIBLE SOLUTIONS
First, let me deal with some short term solutions, before moving on to longer term options.
2.1 Short-term solutions
1.Laying-up vessels
2.Cost Reductions
3.Asset Divestment
4.Sustainable Partnerships
Laying up Vessels – A short term measure
Stating the obvious will not solve the problem. But elements of a solution can be seen with those operators that are presently performing best, in an otherwise bad world? Strangely it is those that had the initiative to go the conventional way and lay vessels up thus immediately reducing their OPEX, who are performing better.
I will not name, but will say that most of these guys are still in the black. Yes they may not be making a great deal of profit; but neither do they have to dip into reserves to top up their working capital.
Others believe that moving vessels geographically is the answer. Wait a minute guys: it’s a Global Industry problem! The best you can hope for is to steal the work from a competitor at a lower rate, compound the problem and incur mobilisation costs at the same time. Additional availability will only encourage clients not to fix longer term, until there is a significant upturn in Oil Prices and then they will inevitably want to fix long at low prices.
Whilst the conventional lay-up method has worked in the past, and is apparently doing so to date, it is not sustainable, due to the fact that the average vessel age has reduced considerably. This results in more expensive assets being laid up. In most cases, these vessels will still be liable to amortisation, and certainly depreciation. In addition this “trough” is expected to last significantly longer than the 1 year to 18 months of the past. So the lay-up method cannot reasonably be prolonged.
Cost Reductions:- There are various methods here and I will not insult my colleagues by dwelling on the obvious of down manning, inventories, procurement etc. However what I will say is that the companies who have built “families” around their organisations will be better placed to reduce manning costs and keep the talent and experience in place. I see many initiatives in this regard but one of my favourites is the ability of some operators to gain WILLING approval of their employees to take wage cuts by one means or another.
1. Asset Divestment.
Another obvious one but if the vessel is losing money and will do so for years to come get rid of it now. This is of course more difficult now than it would have been 12 months ago however whilst you may lose money on the sale consider and take into account how much you will lose say over the next two years of inactivity in amortisation and opex. .
2. Sustainable Partnerships
Cabotage is upon us, use it to your benefit. Partner investment may not be the key to success but it certainly is one of the tumblers. Be prepared to share the gain and expect partners to share the pain.
Longer Term Solutions
Now, to the more challenging longer term solutions.
Accept the new Reality
We have to accept that we are now in the day of lower oil prices and reduced capital investments by IOC’s and that Hope is not a Strategy
Personally I believe the OSV Industry (as with the whole Oil and Gas Industry), has no choice but to adapt to lower Oil prices.
There will inevitably be casualties, as some will be the victims of their historical greed and hunger for growth. Those who do not adapt (and quickly), will fall by the wayside. Those who do will create more sustainable businesses for their shareholders and be well positioned to take advantage of the future opportunities that will surely arise.
The alternative is last out switch off the lights and leave the keys for the banks.
Build Strategically
Although many OSV operators are cutting back their orders for new builds, we are still left with a glut in new build vessels. The reality is that ship builders will cut back, but cannot afford to stop building completely. They will of course reduce margins and offer comparable quality resulting in newer but less expensive vessels that will inevitably be introduced to an already competitive market.
This surplus is further compounded by the continued build activity of the Chinese yards, who will continue the policy of employment through production. If construction continues at current rates in a few years the market will be flooded with ships at even lower prices, which in turn may drive down Charter Rates even further.
The primary solution here is to address future fleet planning. Holding onto to and losing money by offering old assets to clients is not sustainable and will only exacerbate the problem both short and long term. The problem with this scenario is that the average age of the world fleet is lower than it’s ever been and most of us depreciate over 25 years hence we enter the same argument once more on the evils of EBITDA.
Bottom line is we need to asset strip ourselves before the financiers do it for us.
Invest in New Technologies wisely
In the past 10 years the industry has also gone through, what I can only describe as an open cheque book mentality to safety, with quality being tagged on.
Of course, such investment is good: but it became all the more prevalent in our increased requirements for safer options such as DP 2 where we witnessed the requirement becoming mandatory but the cost predominantly became an add on to service and lay at the operators door.
For many years there was a worldwide shortage of experienced officers with DP 2 qualifications. Agreed many operators trained existing personnel but just as many merely paid that few dollars more for the guys who were already trained resulting in many cases Masters on a per day basis, earning more than the OPS Manager.
A worse outcome was the higher turnover of personnel, which in itself raises more safety concerns and costs, in continually having to employ and familiarise new personnel.
Low cost operations does not need to compromise on safety. There is plenty of evidence in the airline industry that professionally managed low cost airlines do not, and many have better safety records than the market leading commercial airlines.
Operators need to build relationships with IOC’s and other clients which are based on real partnerships in which decisions about vessels specifications are based on longer term sustainable commercial and functional realities.
Build real Partnerships with Client
I have always been a proponent of the importance of deep-rooted client relationships; much more than simply sporadic calls or visits by the Commercial team. But the relationship needs to be aligned at all levels between organisations: from the ship’s crew and the guys loading the ship, through Technical and Operational contacts, up to Chief Executive. When I was MD in Nigeria during the 1998 crisis my most valued commercial input came from the Port Engineer Peter McLaughlin (I am sure Peter will not mind me naming him). Whilst at the “coal face” in Onne If Peter even had a whiff of a vessel requirement to Texaco, Chevron, Total, Exxon Mobil etc, he was straight round to their site office and on the phone to me.
Five years’ of personal experience of this approach in Azerbaijan I feel, facilitated the growth of my previous company from 50% of available business to over 90%.
Closer liaison with clients is imperative, they have firepower; be it in procurement, logistics, finance etc., Why not work together to one another’s mutual benefit. What can we do in return? Fuel efficiency? Maintenance in service?
We could align logistics and here are just a few examples of value creating questions that immediately spring to mind, there are of course many more but that I will gladly share but too many for this article.
Do clients really need 24 hour DP operations?
How often are vessels alongside a rig for 24 hours?
Can we optimise fuel consumption?
Can we advise on logistics or route planning.
Can we do the same as was in the past in Peterhead and share vessel’s.
Push aside the thought that end client are out to make savings at any cost, I ask do they really want to live today and die tomorrow because that’s what will happen if we do not make the industry sustainable. They need us as much as we need them, we may be the bottom of the food chain but we are an integral part of it.
Operators need to promote a win-win strategy with clients in which transparency is the norm, and short-termist commercial practices become a thing of the past.
There will inevitably be differing ideas, innovative initiatives and varied opinions for every OSV company in dealing with their own issues. But one thing that is agreed universally, is that if business continues as usual, many may no longer be the owners of their own destiny.
Challenge the Financial Model
Perhaps the most difficult change we will need to make in this industry is to challenge the financial models we use to build an OSV business. Aggressive growth based on shallow foundations without a concern for longer term return on capital is simply no longer sustainable. Similarly, aggressive tendering practices by IOC’s driving down day rates while demanding continually renewed fleets will force many OSV operators to the wall, thus lowering the pool of potential competitors and will continue the misalignment of supply and demand.
OSV Operators need to adopt sustainable business practices, which are under-pinned by focus on the cost of capital and true long term shareholder value creation.
IOC’s need to adopt tendering strategies in which supplier sustainability is of paramount importance and manifest in their development and production planning
