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:

 

“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.

 

Scorpio Tankers STNG Dividend Cut

Source: Scorpio Tankers Investor Presentation

 

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.

 

Scorpio Tankers STNG Dividend Cut

Source: Google Finance

 

“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.

 

Scorpio Tankers STNG Dividend Cut

Source: Simply Safe Dividends, Scorpio Tankers Annual Reports

 

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.

 

Scorpio Tankers STNG Dividend Cut

Source: Simply Safe Dividends, Scorpio Tankers Annual Reports

 

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.

 

Scorpio Tankers STNG Dividend Cut

Source: Simply Safe Dividends, Scorpio Tankers Annual Reports

 

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.

 

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