Scorpio Tankers (STNG) shocked many income investors when the company announced a 92% cut to its dividend this morning.
After all, the company’s management team sounded confident about maintaining Scorpio Tankers’ dividend just a few months ago in November:
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“If you run through our model, the company is fully able to pay its dividend and be in compliance of its loans.” – CEO Robert Bugbee
In the blink of an eye, however, Scorpio Tankers’ dividend yield plunged from 14% on Friday to just 1% at the end of Monday, wiping out substantial income for many yield-hungry investors.
While this type of company is highly inappropriate for conservative investors living off dividends in retirement, it’s worth studying to understand what makes some high yield stocks riskier than others.
Let’s review why Scorpio Tankers cut its dividend, how dividend investors could have known the company’s dividend was in danger ahead of time, and what could happen next for the stock.
Scorpio Tankers Does Not Enjoy a Healthy Business Model
Scorpio Tankers is the world’s largest ECO-spec (i.e. lower fuel cost) product tanker company.
The business has 78 product tankers on the water and an additional nine vessels under construction and due to be delivered in 2017 and 2018.
The company’s ships provide marine transportation of refined crude oil products (e.g. gasoline, diesel, jet fuel) to areas of demand all around the world.
Many ships transporting commodities and various hard goods have fallen on hard times in recent years. However, product tankers were holding up quite well.
The chart below compares the stock price performance of DryShips (DRYS), the blue line, with Scorpio Tankers, the red line, from the start of 2012 through the third quarter of 2015.
You can see that DryShips dropped more than 90%, while Scorpio Tankers nearly doubled. The divergence in performance began in mid-2014.
“A glut of ships, combined with slowing growth in demand for commodities from China, has wreaked havoc on the [dry bulk] industry,” according to the Financial Times.
Why did Scorpio Tankers hold up so much better?
While many container ships were suffering, oil product tankers, such as Scorpio, were benefiting from the rise of U.S. shale oil supply and the plunge in global oil prices.
Lower oil prices made it more economical for companies to produce refined products, driving up transportation demand for product tankers.
The U.S. also emerged as a refined products powerhouse, quickly becoming the world’s largest product exporter.
Demand was outstripping ship supply during this time, helping Scorpio Tankers enjoy a surge in time charter equivalent per day rates (i.e. the average daily revenue performance of a vessel).
Scorpio Tankers’ average rate nearly doubled from $12,898 in 2011 to $23,162 in 2015!
With vessel revenue growing nicely, profits swelled thanks to the operating leverage in Scorpio Tankers’ business model.
Regardless of vessel revenue and transportation activity, the costs Scorpio Tankers incurs to operate its capital-intensive fleet is largely fixed.
As you can see below, the company’s vessel operating cost per day has remained between about $6,500 and $8,200 every year since 2006.
When shipping rates are high and demand is strong, Scorpio Tankers delivers blistering profit growth because so many of its costs are fixed (i.e. they don’t increase when revenue increases, dropping more profits to the bottom-line).
However, the opposite is also true – when vessel revenue drops, the company has a hard time cutting costs to preserve cash flow.
Unfortunately, Scorpio Tankers has extremely little control over the factors influencing vessel revenue and profitability.
Shippers are notorious for overbuilding when times are good, creating a glut of new ships that cause prices to collapse or come on line right when economic conditions are beginning to deteriorate.
Take a look at the chart below, which compares product tanker newbuilding contracts (red bars) with Scorpio Tankers’ time charter equivalent per day (vessel revenue – blue line).
You can see below that a huge wave of newbuilds were under contract in 2006, when rates were very favorable ($33,165).
Then, the financial crisis hit. A glut of new ships entered the market, and demand for their services plummeted – a toxic combination.
Many shippers went bankrupt, and you can see that the shipping rate took until 2011 to bottom out at $12,898 – more than a 60% decline from 2006.
Removing excess capacity from the market is very costly and takes time. Fortunately for product tankers, the boom in shale oil and refined products reignited the demand picture, helping drive freight rates higher.
Refiners in the U.S. exported roughly 2.97 million barrels a day last year, the most since at least 1993, according to data from the U.S. Energy Department.
Scorpio Tankers was especially fortunate. The company built out its ship fleet just as freight rates were beginning their surge from 2012 to 2015.
By now, it should be clear that Scorpio Tankers (and virtually all other shippers) are complete price takers in the commodity markets they compete in.
Demand for their shipping services is out of their control and unpredictable. And anyone with access to financing can build new ships whenever they please, impacting shipping rates for potentially years at a time.
While Scorpio Tankers has some of the newest ships in the industry (its average ship age is less than three years old), it is still extremely sensitive to changes in freight rates.
Due to volatile freight rates, unpredictable demand trends, and the capital-intensive nature of providing shipping services, Scorpio Tankers is not an attractive business to invest in.
Each of these factors ultimately caused the company to cut its dividend.
Scorpio Tankers’ Dividend Safety Score
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a company’s dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at a company’s most important metrics such as payout ratios, debt levels, free cash flow generation, industry cyclicality, profitability trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
The chart below plots each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis. You can see that almost all companies cutting their dividends scored below 40 for Dividend Safety at the time of their announcements, and companies with lower Dividend Safety Scores generally experienced larger dividend cuts.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been (including analysis of every dividend cut in the chart above), and how to use them for your portfolio. You can review this analysis and learn more about Dividend Safety Scores by clicking here.
Scorpio Tankers’ Dividend Safety Score at the time of its dividend cut announcement was 6, indicating that the company’s dividend was at risk of a major cut.
The company primarily ran into trouble because of its high debt load, cyclical earnings, capital-intensive business model, and unsustainable payout ratio.
It costs a lot to build and maintain product tankers. More specifically, the average cost of a newbuild for Scorpio Tankers ranges from $30 million to $60 million. For a company with a market cap below $700 million, those are not insignificant sums of money.
To finance these large expenditures, shippers take on a lot of debt. In fact, as of February 10, 2017, Scorpio Tankers held just $91.5 million in cash compared to $353 million in short-term debt and $1.53 billion in long-term debt.
Further compromising the company’s flexibility, Scorpio Tankers has nine new building vessel orders, requiring substantial installment payments every quarter:
Scorpio Tankers took on a meaningful amount of debt in recent years to fund the expansion of its fleet, leaving the company with less flexibility in the event that profits contracted.
This is an important point because a company’s dividend will only be paid after a business can comfortably meet its debt obligations.
As luck would have it, sales and profits began to nosedive shortly after Scorpio Tankers’ massive growth spending peaked.
Freight rates plunged from $21,057 per day in the fourth quarter of 2015 to just $12,465 in the fourth quarter of 2016, a drop of more than 40%.
The average daily rate last quarter was actually lower than the average during 2011, when freight rates finally bottomed following the financial crisis!
The drop in rates was caused by “persistently high refined product inventories along with a lack of arbitrage opportunities,” according to the company. As a result, there was less demand for global product tankers.
Given the high amount of fixed costs in Scorpio Tankers’ business model that we previously discussed, the company’s operating income collapsed 75% in 2016 on a 31% sales decline. Scorpio Tankers failed to generate a profit last quarter as well.
The business did generate $51.7 million in free cash flow during 2016, excluding proceeds from disposing of vessels. However, this amount fell meaningfully short of the $86.9 million of dividends the company paid during the year, resulting in an unsustainable payout ratio.
To keep paying the dividend, the company would need to come up with over $35 million in cash to plug the hole unless market conditions rapidly improve.
When combined with Scorpio Tankers’ high financial leverage and installment payments for the newbuilds under construction, slashing the dividend was a prudent move to free up cash flow and protect an already-fragile balance sheet.
Scorpio Tankers remains extremely dependent on credit markets to survive (i.e. it must continuously find lenders to refinance its debt), and the company certainly needs freight rates to head higher if it wants to earn a return on its substantial growth investments in its fleet.
With so many risks inherent in Scorpio Tankers’ business model, the company’s extremely weak Dividend Safety Score and massive dividend cut shouldn’t have been a surprise. These speculative stocks are not for the faint-hearted!
Here’s what management said on the call today:
“Once the rate environment has improved during the first quarter of 2017, the fundamental drivers for the product tanker markets have remained largely unchanged. And although, we remain optimistic for the product tanker market medium-term outlook, the Company has taken the decision to scale down its dividend and pay a quarterly dividend of $0.01 per share for the current quarter.”
Cutting the dividend positioned the company better to ride out the market’s current weakness and have more dry powder to reinvest for (hopefully) better times within the next few years.
Closing Thoughts On Scorpio Tankers’ Dividend Cut
Dividend stocks with extremely high yields are often too good to be true, and Scorpio Tankers was no exception. While some investors might have expected a dividend cut this quarter, the magnitude of the reduction took many by surprise.
However, any company with as many fundamental risks as Scorpio Tankers should trigger some concerns – even if the dividend were to have remained safe for the time being.
The company failed four of our five tips to find safer dividend stocks, mainly driven by its high financial leverage, unattractive industry dynamics, and high operating leverage. Each of these issues can result in permanent capital losses for investors.
Scorpio Tankers remains a speculative stock with high upside potential, but also real risk of going to zero because of its heavy debt load and lack of control over the industry’s fundamentals.
While freight rates remain near recessionary lows and might not have much downside from here, there are many uncontrollable and unknowable factors that could continue plaguing the industry’s profitability.
Scorpio Tankers was never a stock for safe, dependable retirement income. Conservative dividend investors should continue avoiding this trap and the many others that score poorly for Dividend Safety.