Distressed Debt Analysis: OSG - A lot of Questions.

The "topic du jour" in many distressed circles is Overseas Shipping Group ("OSG"). I wrote about shipping a little over a year ago when I discussed value traps. Since that time, the shipping industry (specifically tanker market) has gotten considerably worst. Which brings us to OSG.

Before I begin this post, I would like to make a fairly significant disclaimer. Frankly, I do not know if OSG will file even file for bankruptcy. We will know soon though the fate of the company as its unsecured $1.5b revolving credit facility matures in February of 2013 and will be replaced by a $900M "forward start" facility with "more restrictive" covenants. Given the price of the bonds, the IO value is substantial and the longer the bonds stay the current the better the investment.

With that said, at this juncture, using public information, the OSG bonds are uninvestable with any reasonable margin of safety. The bank debt could be compelling but at lower prices and with a few things going your way (and technicals not ripping your face off).

The second caveat I have is that I am probably one of the more bullish people on tanker market in the long term. The supply / demand equation reeks of overcapacity in the market and with the U.S. producing an enormous about of crude domestically, one would think that the prospects for tankers will not be robust. While these are legitimate concerns, I believe that as the influx of new ships as a percentage of existing fleets decreases combined with global economic growth, tanker rates across the board will move up to reasonable levels versus today's rates where ships may be losing money on a week to week basis depending on bunker prices.

I am looking at OSG in a number of ways. From talking to a number of buy siders a general consensus has emerged:

1. A diligent investor can get comfortable with the asset value of OSG
2. It is incredibly difficult to forecast with any certain the claims pool at various boxes in the corporate structure

From here the asset side of the balance sheet is being built up through a sum of parts analysis:

1. What EBITDA and what multiple to apply to US flag business? Comps include KEX, MATX, HRZL
2. What is the market value of the unencumbered fleet?
3. What is the equtiy value of the FPSO JVs?
4. How much cash will be on the balance sheet the day the company files? Probably more important, where does that cash sit and what entity drew down on the revolver?

Given the leverage through the bonds, very small assumption changes can dramatically alter recoveries hence my comment above about the bonds being uninvestable. There is ~$510M notional value of bonds outstanding trading at a blended price of the high 20s. For rounding purposes, let's say 30% or ~$150M of market value of bonds. The US flag business is doing $100-125M of EBITDA. If you assume 1x turn less for the U.S. flag, you could wipe out nearly your entire bond recovery if it hinged on the multiple. For the bulls in you, if you assume 1x more turns for U.S. flag you just doubled your investment.

As noted above the problem with valuing OSG's capital structure is that the claims pool in various boxes is uncertain. The tax issue (foreign earnings being taxable in the U.S) that has notoriously put OSG in the cross hairs of many distressed investors drives this uncertainty. Some investors and research shops believe the ultimate liability will be low at ~$100M. Others I have talked to the number as high at $700M. Some funds have gone out and engaged tax specialists to better drill down on the liability. And as noted above, small changes in recovery tremendously moves ultimate returns of the bonds and hence this issue contributes to the difficulty in investing in OSG bonds.

The actual among of the tax liability is just one of the questions revolving around the tax liability:

• I have assumed the tax claim will be administrative in nature. But is there way based on where that claim is located (ultimate holdco) for it to get adverse treatment relative to the bank facilities?
• What interest rate will the IRS charge on tax in arrears?
• Will OSG try to negotiate with the IRS to lower the actual amount of put together a schedule whereas it will be drain on cash flow in the emergence years?

The next question many distressed investors are struggling with are the amount and location of charter rejection claims. OSG is party to a number of uneconomic arrangements where they are paying significantly more for vessels than current spot rates (or the current market for long term charters). OSG should and will reject these arrangements in bankruptcy and hence (like a typical rejection of executoruy contracts) create a claim in bankruptcy for their counterparties. Nuanced aspects of maritime law come into play here (does a rejection constitute a maritime lien and hence higher priority provisions may accrue?). I have plugged a number of $250M for rejection claims here and I believe they will definitely be senior to the bonds and at best (for the bank debt), pari with the unsecured revolver. But where were those charters executed? Are they closer to the assets and hence receive better status? 

Luckily with two extremely large unknowns, the capital structure of OSG is fairly simple. The bonds are issued at the holding company without any subsidiary guarantees. The unsecured revolver is structurally senior to the bonds as two intermediate holding companies (OSG Bulk Ships, Inc. and OSG International, Inc.) are also borrowers. There are two senior secured team loans backed by 15 ships that probably, at worst, simply be rolled. 

Some other aspects of the OSG case make it particularly interesting to me. The CEO of the company used to run a maritime restructuring firm. He knows the drill. And as all economic players do, he probably will act in his best interests which means siding with whichever party gives him the best management incentive plan. I foresee a valuation fight here (akin to Six Flags) where different creditor groups emerge and try to "team up" with management here to become the fulcrum.

Finally, the bifurcation of different "types" of holders in the unsecured credit facilities is simply fascinating. Is there a scenario where hedge funds step up to do a rights offering combined with a take-back facility to placate unsecured European lenders that do not want to hold equity, cram down the bonds, and emerge owning most of the de-levered company (with 10% to management) right before the cycle is about to turn? 

I think if you are buying this bank debt in the 60s, you will come out happy. Its still trading in the low 80s apparently driven by European banks unwilling to sell at prices below 80. At prices in the 70s, it becomes a bit more difficult to get comfortable with a 20+% just given the process risk. I am not sure if it will get there but a filing may force some weaker lenders hands.

If you want to discuss OSG shoot me an email as I've spent way too much time on it and as I do more and more questions emerge. Shipping bankruptcies have been interesting to follow this year (ONAVQ's hilarity comes to mind) and I am sure OSG, if they do file, will be a fascinating case to analyze.