Spring Overseas Shipholding Group Inc. Equity Analysis and Valuation. Analysis Team

Transcription

1 Spring 2009 Overseas Shipholding Group Inc. Equity Analysis and Valuation Analysis Team William Newland Kamil Bachleda Jonathan Farrell Michael Randell Kirby Viktorin Steffen Schwartz Page 0

2 Table of Contents Executive Summary... 7 Business and Industry Analysis Company Overview Industry Overview Five Forces Model Rivalry Among Existing Firms Industry Growth Concentration of Competitors Differentiation Switching Costs Economies of Scale Fixed-Variable Costs Excess Capacity Exit Barriers Threat of New Entrants First Mover Advantage Distribution Access and Relationships Scale Economies Legal Barriers Threat of Substitute Products Relative Price and Performance Customers Willingness to Switch Bargaining Power of Customers Switching Costs Differentiation Page 1

3 Importance of Product for Costs and Quality Number of Buyers Volume Per Buyer Bargaining Power of Suppliers Switching Costs Differentiation Importance for Costs and Quality Number and Volume of Suppliers Key Success Factors Cost Leadership Economies of Scale and Scope Efficient Production Lower Input Costs Little Research and Development Differentiation Superior Product Quality Superior Product Variety Competitive Advantage Analysis Economies of Scale and Scope Lower Input Costs Superior Product Quality Superior Product Variety Accounting Analysis Key Accounting Policies Operating Leases Goodwill Page 2

4 Hedging Activities Benefits and Pension Plan Assess Degree of Potential Accounting Flexibility Operating Leases Goodwill Hedging Activities Benefits and Pension Plan Evaluate Actual Accounting Strategy Operating Leases Goodwill Hedging Activities Benefits and Pension Plan Quality of Disclosure: Qualitative Analysis Type 1 Key Accounting Policies Economies of Scale and Scope Efficient Production Lower Input Costs Type 2 Key Accounting Policies Operating Leases Goodwill Hedging Activities Benefits and Pension Plan Quality of Disclosure: Quantitative Analysis Sales Manipulation Diagnostics Expense Manipulation Diagnostics Identify Potential Red Flags Page 3

5 Undo Accounting Distortions Restating Distortions in Financial Statements Financial Analysis, Forecast Financials and Cost of Capital Estimation Financial Analysis Liquidity Ratio Analysis Current Ratio Quick Asset Ratio Accounts Receivable Turnover Days Sales Outstanding Working Capital Turnover Conclusion Profitability Ratio Analysis Gross Profit Margin Operating Expense Ratio Operating Profit Margin Net Profit Margin Asset Turnover Return on Assets Return on Equity Conclusion Firm Growth Rate Ratios Internal Growth Rate Sustainable Growth Rate Conclusion Capital Structure Ratios Debt to Equity Ratio Page 4

6 Times Interest Earned Debt Service Margin Altman s Z Score Conclusion Forecasted Financial Statements Income Statement Sales Forecasting Expense Structure Income Statement Restated Balance Sheet Balance Sheet Restated Statement of Cash Flows Cost of Capital Estimation Cost of Equity Size Adjustment Alternative Cost of Equity Cost of Debt Weighted Average Cost of Capital Valuation Methods Method of Comparables Price/Earnings Trailing Price/Earnings Forecast Price/Book Price/Earnings Growth Price/EBITDA Enterprise Value/EBITDA Page 5

7 Price to Free Cash Flows Dividends/Price Conclusion Intrinsic Valuation Models Discounted Dividends Valuation Discounted Free Cash Flows Valuation Residual Income Valuation Abnormal Earnings Growth Valuation Long-Run Residual Income Valuation Analyst Recommendation Appendices A: Sales and Expense Manipulation Diagnostics B: Restating Financial Statements C: Financial Analysis D: Regressions E: Method of Comparables F: Valuation Models Industry Terms Glossary Sources Cited Page 6

8 Executive Summary Analyst Recommendation: Buy (Slightly Undervalued) As of April 1 st, 2009 OSG NYSE (04/01/2009) $ Week Range $ $ Revenue 1.70 Billion Market Capitalization Million Shares Outstanding 39,590,759 As stated Restated Book Value Per Share $57.79 $64.19 Return on Equity Return on Assets Cost of Capital Estimated R-Squared Beta Size Adj. Ke 3 Month Year Year Year Year Altman Z scores Initial Scores Revised Scores Current Market Share Price (04/01/2009) $24.03 Financial Based Valuations Trailing P/E Forward P/E Price to Book P.E.G Ratio Price to EBITDA EV/EBITDA Price to FCF Dividends to Price As Stated Restated $36.01 $49.71 $49.15 $63.39 $29.91 $33.38 $39.22 $47.52 $26.75 $32.73 $47.67 $8.91 $11.22 ($47.53) $16.87 $16.87 Backdoor Ke Cost of Debt WACC (BT) Published Beta As Stated Restated WACC Upper WACC Lower Intrinsic Valuations As Stated Restated Discounted Dividends $ Free Cash Flows $ Residual Income $27.80 $32.51 Abnormal Earnings Growth $21.76 $25.19 Long Run Residual Income $27.59 $25.59 Page 7

9 Industry Analysis Overseas Shipholding Group is an energy shipping company that takes part in the transportation of crude oil, petroleum products, and liquefied natural gas. OSG is one of the largest tanker companies and is competitive both internationally and in the US Flag markets. OSG s main competitors include Frontline Ltd, Teekay Shipping Corporation, and Tsakos Energy Navigation. To remain competitive in this industry, OSG relies on its diverse fleet of vessels to satisfy customer needs. Below is a table of the five forces that affect the degree of competition within this industry. Competitive Force Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Customers Bargaining Power of Suppliers Degree of Competition High Moderate Low Low High Page 8

10 Since there is not a significant difference between the types of services that each of the companies in this industry perform, the companies must compete on price to attract customers in this highly competitive industry. The rivalry among existing firms is considered high and leading firms in this industry are diversifying the types of services that they offer to offset the risk that is associated with relying only on crude oil transportation and also gain an advantage in other market segments. Transporting petroleum products, liquefied natural gas, and transporting crude oil within the US Flag market are just some of the additional market segments that competitive firms are involved in. One of the ways that companies in this industry grow and diversify is by acquiring smaller companies and their vessels. The treat of new entrants is considered moderate since it would not be considered difficult to enter the industry, but it would be difficult to stay competitive in the long run with the industry leaders who are involved in multiple market segments to offset risk. High competition in this industry also exists because of the high bargaining power of suppliers. The largest shipbuilders decide on which business they would like to accept and building larger vessels can take years to complete. On the other hand, since there are limited alternatives to transport products around the world, the shipping industry has a very low threat of substitute products. The main key success factors in this industry are cost control and differentiation. Reducing costs is possible by having low input costs and maintaining tight cost controls. These are very important in this industry where competing on price is the focus to attract potential customers. Also, differentiation in the energy shipping industry can include having the highest quality vessels with updated technology for reliability and safety. Page 9

11 Accounting Analysis Accounting analysis plays a large role in valuing a company because it determines whether or not the key accounting policies reflect the company s true value. Because accounting numbers are man-made, they are subject to errors and manipulation, which can portray the financial status of a firm inaccurately. When compared to other energy shipping companies in the industry, Overseas Shipholding Group was conservative in their accounting policies and, therefore, was effective in accurately portraying the company. The key success factors for the energy shipping industry were cost leadership, including: operating leases, goodwill, hedging activities, and benefits and pension plans; and differentiation, including a mixture of superior product quality and variety. Operating leases are an important key success factor in the energy shipping industry because vessels have high fixed to variable costs, and managing these fixed assets through operating leases reduces excess capacity. Operating leases also reduce the firm s liabilities, assets, interest expense, and depreciation. Overseas Shipholding Group would be considered moderately aggressive in their reporting of operating leases because the lease periods are about as long as the life of the vessels. We believe that a discount rate for capital leases would be useful in capitalizing existing operating leases. Goodwill is difficult to account for and even harder to measure in terms of business activities. It can, however, be used to make a firm look more favorable in investors eyes. Goodwill is only a small portion of OSG s assets and the company states that it impairs goodwill on a yearly basis as required by SFAS 142. Total assets would be overstated if goodwill is left on the balance sheet and not impaired. Companies that report goodwill on their balance sheets have more accounting flexibility than companies who do not. OSG s goodwill represents only 1.74% of total assets. The company is considered conservative in reporting net income because goodwill is maintained at less than two percent of total assets. Page 10

12 Hedging activities are common in the energy shipping industry because of the unstable nature of the market. OSG participates in hedging activities to reduce future risks that may be encountered. Many companies enter into Forward Freight Agreements to reduce exposure to changes in spot market rates. Interest rate swaps are another hedging activity that allow companies to be unaffected by changing interest rates other firms may be forced to use. Forwards contracts are yet another hedging activity that promises a fixed rate in the future, ignoring any fluctuations in the value of foreign currency. There is a very low degree of flexibility when reporting hedging activities. It is difficult for a firm to use conservative or aggressive accounting strategies in the area of hedging because estimates are similar and guidelines are strictly enforced. Lastly, Benefits and pension plans are recorded on the balance sheet at present value as liabilities. Because the rates on these plans are primarily created by the firm, they are subject to human error. OSG has a high disclosure of information regarding benefit plans when compared with other companies in the industry, which affords OSG a higher value over its competitors. Because OSG is the only company to disclose its growth rates, we conclude that they use a conservative approach in presenting this information. Financial Analysis, Forecasting Financials, and Cost Estimations Financial analysis involves examining a firm s liquidity, profitability, and capital structure through the use of financial ratios. The numbers computed by using these ratios assist analysts in comparing a firm to its competitors over a long period of time. The three types of ratios most used by firms are liquidity, profitability, and capital structure. Liquidity ratios measure a firm s ability to pay off their short term debt obligations. These liquidity ratios are compared to the ratios of other firms to determine the credit risk of the individual company. Overseas Shipholding Group s ratios indicate Page 11

13 that they are the most capable of all the firms to cover their short-term debt obligations. Profitability ratios measure how effective a firm has been at generating revenues to create profit during a given year. Overall, OSG had a mixed profitability performance. The firm s ability to control costs, such as voyage expenses, has allowed it to be an industry leader in gross profit margin measurements. Its operating expense ratio and operating profit margin, however, is consistently below average because of high charter hire expenses. OSG s net profit margin, asset turnover, ROA, and ROE have all been similar to industry averages and show signs of increasing trends, which is favorable for the company. Capital structure ratios are used to determine how a firm raises money to fund its investment and operating activities. The debt to equity ratio is important because it provides insight to the firm s default risk which describes the creditworthiness company. OSG s debt to equity ratio and debt service margin consistently outperforms the rest of the industry. Potential growth rates can be determined using sustainable and internal growth rates after computing the liquidity, profitability, and capital structure ratios. OSG has been performing around the same level as its competitors, and when it comes to potential growth, the firm shows nothing that would give investors a reason to believe it will grow at a greater rate than its competitors in the future. Due to the nature of the energy shipping industry and the size of OSG, it seems that the firm will continue to perform at the industry average in the long run. The cost of capital estimation measures the opportunity cost of an investment and is also necessary in valuing a firm. Cost of capital is made up of the weighted average cost of debt and equity. The cost of equity is the minimum rate of return a firm must offer shareholders for risk compensation. When using the capital asset pricing model (CAPM) the cost of equity equals the beta of the firm times the return of the market minus the risk free rate plus the risk free rate. From our regression analysis, we found our beta to be and stable across the time period; meaning OSG s systematic risk is not changing over time. Using the CAPM equation and filling in the beta, the MRP of 6.8% and the risk free rate of 2.87%, we found the cost of equity to Page 12

14 be 15.77%. We found the cost of debt by multiplying the weighted average of the liabilities by the interest rates assigned to the liability. The weighted average cost of capital (WACC) could then be found using the cost of equity and cost of debt. OSG s size adjusted weighted average cost of capital before taxes is 10.48% and, using the effective tax rate of 35%, is 9.67% after taxes. Because OSG has large amounts of long-term liabilities such as leases and tankers, we believe the range of eight to twelve percent of assets to finance future business is an accurate number. Before we were able to value the current position on this company, it was necessary to forecast future financial statements based on the expectations. We forecasted the income statement by starting off with the expected sales until It was necessary to have forecasted financial statements for both as stated and restated numbers. Since the restated statements capitalized the original operating leases, the financial position would be different. The significant increases in liabilities after restating would provide an alternative view when valuing the firm. These significant liabilities would affect the firm if we consider it as overstated, understated, or fairly valued. After completing the balance sheet, the statement of cash flows was forecasted by using previously obtained ratios to link these statements with either the balance sheet or income statement. We used the CFFO/Operating Income ratio to find CFFO since it proved to be more consistent over time when compared to the CFFO/Net Income and CFFO/Net Sales ratios. Also, the cash flows from investing were forecasted by taking the yearly change in vessels at cost, minus accumulated depreciation. Lastly, we simplified the CFFF by reflecting only the forecasted cash dividends paid to stockholders. Valuation Summary The analysis that has taken place to this point will allow us to complete the final step: accurately valuing the firm. To do this, we use the method of comparables and intrinsic valuation models to compute an estimated price per share on the valuation Page 13

15 date of April 1 st, OSG s market price per share on that date was $ We used a 15% margin of safety so if the model price is below $20.43 we considered the current stock price overvalued and if the model price is above $27.63 we considered the current price undervalued. The method of comparables is a simply way of finding an estimated price per share by using information provided by industry competitors. An industry average is calculated for various ratios, and then working backwards with OSG s information it is possible to find an estimated value for the firm. Based on the P/E trailing, P/E forecasted, P/B, P.E.G, price/ebitda restated, and raw EV/EBITDA ratios, OSG is currently undervalued and based on EV/EBITDA restated, P/FCF and dividends to price ratios, OSG is currently overvalued. There will not be much weight placed on the method of comparables because it is not theory-based and not the best way to accurately value a firm. Intrinsic valuation models offer theory-based assumptions and provide a more accurate valuation of a firm. This accurate representation is due to the current performance of the firm, which is taken into consideration in juncture with industry trends. Sensitivity analyses are used to explain how changes in the cost of equity or growth rate affect the time consistent price per share. Forecasted future values were discounted back to April 1 st, 2009 so that we had a time consistence price that could be compared to the current market price of $ Based on the overall valuations, we feel that the intrinsic models suggest that OSG is currently a slightly undervalued company. Page 14

16 Business and Industry Analysis Company Overview Since Overseas Shipholding Group s (OSG) founding in 1948, they have become one of the world s leading bulk shipping companies engaged primarily in the ocean transportation of crude oil and petroleum products. (OSG 10-K) They currently transport both liquid and dry bulk cargoes to both an international market as well as within the borders of the United States. Most shipping companies are moving abroad to cut costs and avoid U.S. regulations, but since OSG is committed to maintaining a prominent presence in the U.S. shipping industry, they are the only major tanker company with a significant U.S. Flag and International Flag fleet. (OSG.com) Overseas Shipholding Group is headquartered in New York, New York with 10 other offices located both nationally and internationally. They also have nearly 4,000 employees who are based both onshore and offshore. Since November of 2006, OSG has acquired three well-established shipping and lightering companies including Maritrans Inc., Stelmar Shipping Ltd., and Heidmar Lightering. This shows that OSG is beginning to grow and advance within their industry. Since OSG has a greatly diversified fleet of vessels, it is difficult to place an exact competitor against them for shipping in general. The closest competitors at this point in time would be Frontline Ltd., Tsakos Ltd., and Teekay Shipping Corporation. In order to transport their products, Overseas Shipholding Group relies on an extremely diversified fleet of vessels. At the present time, they own and operate a fleet of 112 vessels of varying sizes and types, which makes them the second largest publicly traded oil tanker company in the world. Operating that many vessels also allows them to compete in several different markets of energy transportation. Of the total 112 vessels currently in operation, 93 are used specifically in the international market and the remaining 19 operate in the U.S. market. In order to stay as competitive as possible, OSG focuses on four market segments instead of just one. Since their vessels Page 15

17 are active in the crude oil, refined petroleum products, U.S. flag, and gas markets, they can stay competitive even if one of the markets is in a downturn. Industry Overview Overseas Shipping competes in the energy transportation industry, specifically, international flag product and crude carriers and U.S. Flag lightering. The industry is characterized by economies of scale in moving large amounts of crude oil from the Middle East, North Africa, The North Sea as well as other originates, to the large industrialized economies of Europe, Asia and the United States. The business involves arbitrage trades of moving excess diesel, a byproduct of crude oil refining, to Europe and returning with excess gasoline. In addition, according to the Maritime Marine Act of 1920 (The Jones Act), any military or precious cargo must be transported on a vessel constructed, owned by a United States corporation and operated by at least 75% American citizens. This business is referred to the U.S. Flag ship business and involves lightering (unloading cargo at a neutral destination and reloading to a U.S. Flag vessel) operations to bring cargo to United States in accordance with the aforementioned act. Ever since 1886, oil and gas has been transported on large carriers to industrialized economies. Recent reductions in inventories by oil majors have prompted increased demand for energy transport services. Middle Eastern oil producers are located far from the largest consumers, necessitating long voyages, and thus, more carriers. In addition to transporting oil and gas to refineries, a myriad of consumer products are fashioned from petroleum products, most notably, plastic products. These consumer products require the transportation of oil for use as a raw material, as well as the subsequent exporting activity that utilizes the product carrier market. Energy shipping firms connect with customers through the spot market for various transport distances as well as time charter arrangements. Time charters allow the customer to use a vessel for a specified period of time for a specified price. The spot market matches owners of vessels with customers on a short-term, per-day basis. Overall, the energy shipping industry is an undercurrent to economic growth, through Page 16

18 the needs of transportation, product, heating and other uses, and should be expected to grow with the world economy. Five Forces Model Analysis of a particular firm would be useful for a prospective investor. In order to effectively value and analyze a firm, a quantitative analysis approach is needed to consider the industry as a whole. Michael E. Porter s Five Forces Model allows a framework for such analysis. The model involves five key components which allow the analyst to consider the industry s overall profitability. The first three relate directly to competition among actual and potential firms. By analyzing the rivalry among existing firms, threat of new entrants and threat of substitute products, the measure of competition can be obtained. The last two components of the five forces determine the industries bargaining power of either suppliers or customers. When all five components are considered, the firm s competitive force, and thus, its profitability are valued. The following table summarizes the degree of competition for each competitive force. Competitive Force Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Customers Bargaining Power of Suppliers Degree of Competition High Moderate Low Low High Rivalry Among Existing Firms When evaluating a business within an industry of rivals, it is vital to consider the degree of competition within that industry. In an industry that is highly competitive, pricing is the differentiating force that sets apart its competitors. In other industries, Page 17

19 companies compete through other product features such as innovation or brand-image. In order to determine the aspect that will set apart the firms image, consideration should be given to industry growth, concentration of competitors, differentiation, switching costs, economies of scale, fixed-variable costs, excess capacity and exit barriers. Industry Growth Rate The growth rate in an industry is important to comprehend because of the nature of an expanding firm. If the industry is growing at an increasing rate, businesses do not need to compete on market share. But in some industries, as in the energy shipping industry, the primary ways a firm can expand is by attempting to take market share away from the competition or acquire (buy out) competitors. One way to analyze market growth is to look at the sales figures of an industry. Industry Sales (in thousands) Company Overseas $297,283 $454,120 $810,835 $1,000,303 $1,047,403 $1,129,305 Shipholding Frontline Ltd. $551,595 $1,161,383 $1,855,666 $1,495,975 $1,558,369 $1,299,927 Teekay Corp. $783,327 $1,576,095 $2,219,238 $1,954,618 $2,013,306 $2,406,622 Tsakos Ltd. $130,004 $241,365 $318,278 $295,623 $427,624 $500,617 Total $1,764,211 $3,432,963 $5,204,017 $4,746,519 $5,046,702 $5,336,471 Page 18

20 $6,000,000 Industry Sales Measured In Thousands of Dollars $5,000,000 $4,000,000 $3,000,000 $2,000,000 Industry $1,000,000 $ Percentage Change in Sales Company Overseas Shipholding % 52.76% 78.55% 23.37% 4.71% 7.82% Frontline Ltd % % 59.78% % 4.17% % Teekay Corp % % 40.81% % 3.00% 19.54% Tsakos Ltd. 3.98% 85.66% 31.87% -7.12% 44.65% 17.07% Total % 94.59% 51.59% -8.79% 6.32% 5.74% % Industry Sales Growth % 80.00% 60.00% 40.00% Series % 0.00% 20.00% % Page 19

21 The above graph indicates that the industry experienced high growth in the early 2000 s, but has since experienced a decreasing growth trend. In the 2007 fiscal year, the industry only experienced a 6.24% increase in sales compared to the 2003 fiscal year when it experienced a 79.26% increase. Sales in the industry have stayed at a steady growth, but significant increases in sales between 2002 and 2004 surpass these newer growth patterns in comparison. Because of the relative decrease in the market sales in the past two fiscal years, pricing wars might become more common in the future. Concentration of Competitors According to Palepu and Healy s Business Analysis and Valuation, the number of firms in an industry and their relative sizes determine the degree of competition in an industry. If the firms have relatively equal market share, then they will try to follow pricing patterns of the other companies in the industry. Also, if the industry is fragmented, then price competition will become rigorous due to multiple companies competing for better share of the market. If the industry has one dominant firm, then that business sets prices for the whole market and the rest tend to follow. Market Share Percentage of Total Industry Sales Company Overseas 13% 16% 21% 21% 21% Shipholding Frontline Ltd. 34% 36% 32% 31% 24% Teekay Corp. 46% 43% 41% 40% 45% Tsakos Ltd. 7% 6% 6% 8% 9% Total $3,432,963 $5,204,017 $4,746,519 $5,046,702 $5,336,471 Page 20

22 2007 Market Share Overseas Shipholding Frontline Ltd. Teekay Corp. Tsakos Ltd. 10% 21% 45% 24% According to the 2007 market share graph, Teekay Corporation is the dominant firm in this industry. These findings give evidence that there is unequal dominance in this industry. The energy shipping industry has been around since the early 19 th century which hinders the introduction of large public firms to the industry, but does not render it impossible. Furthermore the Herfindahl-Hirschman Index, which is a commonly accepted measure of market concentration on a scale of zero to 10,000, only measures to This indicates a low concentration of firms for an industry of this size on a global scale. This provides further evidence that, upon entry into the industry, it is unlikely the new firm would obtain a large share of the market. Level of Differentiation Differentiation is the company s ability to enhance or change a product or service to set itself apart from the competition. If the product or service offered by the competing firms is similar, there exists a low degree of differentiation. Thus, the customer chooses the firm on the basis of competitive pricing. The level of differentiation among competing firms could be determined by several factors. One such factor in the energy shipping industry could be shipping locations. It would stand to reason that a potential customer would more readily utilize the services of a particular company if that company had shipping locations close to the customer. In Page 21

23 this industry, most firms participate in a global market minimizing the importance of differentiation among shipping locations. Another differentiation factor is the use of commercial pools (i.e. partnerships between firms) to network equipment use across global locations. However, because many firms in this industry participate in commercial pools, this aspect would not be a significant determinant of differentiation among competing firms. Because of a similar service product line, the energy shipping industry is mainly competitive through its pricing strategy. Switching Costs Switching costs determine a firm s commitment to specialization within an industry. Low switching costs indicate that a firm can use its production capital or services for another business activity. Alternatively, high switching costs demonstrate that companies use customized assets that could not be used in an industry with differing business activities. Because the energy shipping industry has highly customized production assets (tankers), they have high switching costs. Energy shipping tankers are highly customized because they must meet certain regulations, such as double thick hulls. The only low switching cost conversion would be to use the tankers as offshore floating storage. Shipping companies presently engage in this activity when low demand drives petroleum shipping rates up, the decline in demand already has pushed millions of barrels of oil into storage terminals and onto tankers offshore (WSJ-Oil Price Falls, Inventories Rise). These companies already understand the risks involved with floating storage. When floating storage is only used during times of low demand, profits are lost to the high rates and low activity of ships. Tanker rates have skyrocketed in the past couple of months, making oil storage more expensive and wiping out some of the potential profits to be made with floating storage (WSJ-Oil Prices). Since these profits are lost during times of low demand, firms would only engage in storage of oil products when high demand stimulates rates low enough to realize a profit. This provides evidence that this industry has high switching costs, but only at times of high demand for their services. Page 22

24 Economies of Scale The chart below highlights the total assets of the major shipping firms. The information was provided by the 10-k s of each company. Total Assets (in thousands) Company OSG $2,034,842 $2,000,686 $2,680,798 $3,348,680 $4,230,669 $4,158,917 Frontline $3,034,743 $4,463,535 $4,338,760 $4,454,817 $4,589,937 $3,762,091 Teekay $2,723,506 $3,588,044 $5,503,740 $5,294,100 $7,733,476 $10,060,153 Tsakos $694,545 $825,507 $937,938 $1,089,174 $1,969,875 $2,362,776 Total $8,487,636 $10,877,772 $13,461,236 $14,186,771 $18,523,957 $20,343,973 According to Palepu and Healey, size is an important factor for firms in the industry. Logistics, relationships with customers, and fleet size are where the economies of scale lie within the shipping industry. The shipping industry s market concentration is high. A select number of companies dominate the market, operating with large fleets and using commercial pools to gain more market share which make it harder for the smaller firms to compete on that level. Fixed-Variable Costs If the ratio of fixed to variable costs is high, firms have the incentive to reduce prices to utilize installed capacity (Palepu & Healy). Most firms will try to increase demand to reduce fixed costs. In the shipping industry, the fixed costs of the firm are high because of things like maintenance, dry-docking fees, and operating leases. The variable costs of the shipping industry include voyage expenses and tariffs. These variable costs are not very high, especially when compared to the extremely high fixed costs. Although the ratio of fixed costs to variable costs is high, the fixed costs can be managed through charters and commercial pools. Page 23

25 Excess Capacity Palepu and Healey state: If capacity in an industry is larger than customer demand, there is a strong incentive for firms to cut prices to fill capacity. Percentage Change in Sales Company Overseas Shipholding % 52.76% 78.55% 23.37% 4.71% 7.82% Frontline Ltd % % 59.78% % 4.17% % Teekay Corp % % 40.81% % 3.00% 19.54% Tsakos Ltd. 3.98% 85.66% 31.87% -7.12% 44.65% 17.07% Standard Deviation The chart above indicates that the industry experiences volatility in sales because it is dependent on demand of petroleum products which influences spot and charter rates. The shipping industry has high potential for meeting excess capacity because of the potential to have too many tankers and not enough oil to ship if demand for oil decreases. OSG is the only company that discloses any form of excess capacity. This is measured by revenues compared to owned boats, and revenues compared to chartered boats. The excess capacity is seen through the total amount of boats (with newbuilds) compared to total shipping revenues. This excess capacity is displayed in the table below. Page 24

26 Revenue Days per Boat Revenue Days per Boat Relation of Vessels to Revenue Days Excess Capacity Number of Boats Revenue Days Revenue Days Per Boat , , , , , , , As seen in the graph above, the percent of revenue days per boat increases from 2007 to This is due to the fact that OSG decreases its number of operating vessels from 2007 to This percentage can determine the excess capacity for Page 25

27 OSG, this is because the excess capacity of revenue days shifts from 156 vessels to only 154 vessels. This does not seem significant in the grand scheme, but this does considerably increase revenue days per boat. The energy shipping industry will cut the cost of shipping if there is an excess capacity of tankers. When excess capacity is high, consumers enjoy a reduction in shipping rates and when excess capacity is low, consumers experience increases in shipping rates. Excess capacity in the shipping industry is volatile, as is the demand for the oil that it carries. Exit Barriers In the energy shipping industry, exit barriers are not high. These company s assets are fixed in their tankers, which are in high demand within the market. A company could easily exit the industry just by selling its fleet. These used tankers are also selling for the same price as new ones. There is not any strict regulation on exiting the shipping industry. Conclusion Rivalry among existing firms is a critical component of evaluating an industry s level of competition. The energy shipping industry has a competitive environment because the industry experiences entry barriers, but they are not completely prohibitive. Furthermore, firms experience difficulty differentiating. Because the concentration of competitors, economies of scale, and fixed to variable costs are all high and industry growth, differentiation, switching costs, exit barriers and excess capacity are low, the energy shipping industry can be considered price competitive when considering the rivalry amongst existing shipping firms. Threat of New Entrants In a particular industry, firms should not only focus on rivalry from existing firms but also from new businesses. High levels of profitability within an industry will attract new entrants. New entrants will ultimately increase the level of competition and affect Page 26

28 future profitability for the existing firms. Firms already in an industry benefit if barriers make is difficult for outside businesses to come in and take part of the market share. This threat depends on four factors: first mover advantage, distribution access and relationships, economies of scale, and legal barriers. First Mover Advantage In certain industries, existing firms have an advantage over possible new entrants due to the first mover advantage. First movers are able to set trends in an industry and move ahead of the competition while everyone else tries to catch up. This advantage usually takes place in industries where customers that change companies incur high switching costs. In the energy shipping industry, there is not a significant first mover advantage because it is easy for customers to switch to a different company for their shipping needs. Customers mostly look at price and the specific type of vessels they need when shipping crude oil, oil products, and liquefied natural gas. Existing firms have gained a reputation with certain customers, but these firms would not have much of an advantage if a new firm entered the industry with much lower shipping rates or new bigger vessels. Overall, the relatively low effects of the first mover advantage increase the threat of new entrants in this industry. Access to Channels of Distribution and Relationships Channels of distribution are an important part of every firm s process to get the final product out to the customers. Firms currently in the industry have the advantage of having access to channels of distribution and forming relationships with not only customers but also with each other. Certain firms have commercial pool agreements with each other to operate more efficiently and be more cost effective. Under a pooling arrangement, different vessel owners pool their vessels, which are managed by a pool manager, to improve utilization and reduce expenses (TK 10-K). These commercial pools also allow businesses to provide better service to their customers. Although not all firms operate under commercial pools, they allow existing firms to be more productive and utilize the benefits from their relationships. These factors make it more difficult for Page 27

29 new entrants to enter this industry and have an immediate effect. There are no specific barriers to prevent new entrants to start commercial pools but forming relationships within this industry takes time. While access to channels of distribution and forming industry relationships puts new firms at a slight disadvantage, they do not significantly lower the threat of new entrants. Economies of Scale Operational efficiency improves if there are large economics of scale. This is another factor that new firms look at to see what they need to do to become competitive. In the energy shipping industry, there are large economies of scale with firms that have large total assets. Specifically, firms invest in vessels by buying, leasing, or building them. In this industry, it is also common for larger firms to acquire smaller businesses. When a business is acquired, so are all of the vessels and other assets that were owned by that business. This is one reason it would be difficult for a new entrant to compete in this industry. Another reason that new entrants would have a difficult time in this industry would be because the most successful firms are diversifying the types of vessels they have to protect themselves from spot markets. Historically, spot markets have been known to have higher rates of return than other more stable business sectors. Spot markets have varying rates that can be very risky for firms in the industry that solely rely on them. Existing firms go into different sectors of the industry to minimize this risk. For a new entrant to fully compete with an existing firm, they would need to strongly invest in fixed capital. A new entrant can easily enter this industry and focus on one sector, but for long term success and the ability to compete with industry leaders, diversity is very important. For this reason, economics of scale are one of the factors that decrease the treat of new entrants in the energy shipping industry. Page 28

30 Legal Barriers It is important for new firms to understand the legal barriers that exist when entering an existing industry. The energy shipping industry has laws and regulations that are getting tougher and constantly changing. New firms have to abide by the laws in areas in which their vessels operate. This would include local, state, national, and international regulations. Vessels are also subject to scheduled and unscheduled inspections by government and private organizations that make sure safety and environmental standards are being followed (OSG 10-K). Also, the areas in which a new company s vessels will operate will determine the required licenses and permits that will need to be acquired. Firms that fail to meet certain requirements in this industry risk the possibility of severe fines. Although there are several legal requirements that new firms need to follow, there are also regulations that every firm in this industry, new or existing, must comply with. For this reason, legal barriers are not a major factor in the threat of new entrants. Conclusion In the energy shipping industry, the threat of new entrants is moderate. The biggest barrier that new firms have when entering this industry is obtaining the high levels of capital that are required to remain competitive with industry leaders. A company would have to invest in property, plant, and equipment, specifically shipping vessels because of the large economies of scale. Although new entrants would start off in this industry at a disadvantage because of the first mover advantage and access to distribution channels, these are major factors that new entrant would be able to overcome. Also the laws and regulations that new entrants would need to follow are the same as existing firms, so there is not an advantage for either side on the legal barrier issue. Overall, if a new entrant can enter the industry with a large diverse fleet of vessels and start forming relationship with potential customers by offering lower shipping rates, they could become a threat to existing firms. Page 29

31 Threat of Substitute Products The function that a company performs is the primary factor to consider when evaluating the threat of substitute products. Since not all companies produce the same product, it is important to analyze the function that each company or product performs in order to determine whether or not they can be considered a substitute of one another. When you consider the shipping of crude oil and petroleum products overseas, there will not be much variation between companies in the functions they provide. Therefore, there are a few other key factors to consider when determining substitute products. The threat of substitutes depends on the relative price and performance of the competing products or services and on customers willingness to substitute (Palepu & Haley). Relative Price and Performance Two products can be considered substitutes if they perform the same function for a very similar price. When two different products perform the same function for the same price, it makes the customers focus more on the price then the product itself. This makes a competitive price scheme very important to industries with low product differentiation. The energy shipping industry would fall into the low product differentiation category, so it is important for their prices to stay competitive. Companies that ship crude oil and other types of energy products provide similar functions. When a potential buyer is looking for energy shippers, they simply need a vessel that can store and transport their shipment to its final destination. Since most companies in the energy shipping industry can satisfy the needs of potential customers, the price is the differentiating factor. In order for companies to gain a competitive price advantage, to gain increased revenue, internal costs must be kept at a minimum. If the shipping company maintains low production costs, it will be able to, in turn, charge a lower fee to the customer and eventually gain more business. Page 30

32 It is pivotal for the success of companies in an industry such as this to perform at a level that is satisfying to their customers. The performance of a company in an industry with low service differentiation is what could potentially set them apart from the rest of their competitors. If specific companies continually satisfy their customers with their performance they could keep those customers for an extended amount of time, even if their prices vary. Customers Willingness to Switch When firms are competing in an industry with low product or service differentiation, buyers are attracted to firms that offer lower prices. This holds true for the energy shipping industry, for which customer s switching costs are low. With the possibility of a high customer switching rate, an energy shipping company must differentiate itself from the competition in ways other than pricing. Gaining customer loyalty by providing shipping benefits or rebates are a few ways to earn a competitive edge. Conclusion In order for a company to stay competitive in an industry with low product or service differentiation, focus must be given on competitive pricing and improving internal and external performance. If pricing and performance are favorable, customer s willingness to switch may not be a threat. Firms must keep internal costs low so that they can afford to give their customers a lower price. It is also important for a company to continually provide its customers with satisfying performance to gain a loyal customer base. Since the threat of substitute products in this type of industry is low, a company must find alternatives to pricing in order to set itself apart from the competition. Bargaining Power of Customers Petroleum is shipped all over the world on a daily basis creating a large demand for oil tankers to transport the petroleum from one country to another. In a commodity Page 31

33 industry like energy shipping, it is important for companies to try and differentiate their service as much as possible. Companies strive to keep shipping costs at a minimum, creating price competition within the industry. This price competition gives the customer control over the industry, allowing them to shop around for the best company based primarily on price. Switching Costs Services in the industry are very similar which cause switching costs in the industry to be low. There are many competitors in the industry, which creates price competitions. The customer has the opportunity to compare the prices of each company and choose the company that has the best price. However, because in the industry customers ship such large amounts of petroleum, some customers might consider paying slightly more for a more reliable or familiar company. Differentiation In any industry, it is important to differentiate products or services as much as possible. Services in this industry are very similar, but many companies try to distinguish their slight differentiations from other companies that they believe make them a better choice. Some companies advertise the young age of their fleet and others might advertise the size of their ships. In this industry differentiation can help to win over a customer and gain their business for many years. Importance of Product for Costs and Quality In petroleum shipping price competition is highly important. The industry works hard to compete on prices because the shipping industry is very homogeneous and prices are elastic. Many customers are drawn to the lowest possible price because they are shipping a large amount of petroleum. It is important for companies to keep their prices in the same range because any company with a price too high will lose business. When prices are comparable, companies will remain with the same company. Other Page 32

34 customers will switch according to the lowest price. Product cost is an important component in competing for customers. Number of Buyers The energy shipping industry services a high volume of customers. Most of these customers are made up of major oil and gas companies, as well as, refiners and traders (osg.com). Customers include large companies such as, BP, ExxonMobil, ChevronTexaco, Valero, and ConocoPhillips (osg.com). Although there are many large clients, a substantial amount of small firms play a part in the entire industry. Since there are a large number of patrons that ship oil and petroleum products, the shipping firms retain the bargaining power over the customers. Volume Per Buyer Within the energy shipping industry, the amount customers need to ship varies. Since the shipping volumes vary, the industry incorporates many different kinds of vessels to meet specific customer needs. These vessels volumes range from 500,000 to three million barrels of oil. When demand drops and rates are up, customers decide to ship less. This causes companies to employ the use of their smaller capacity vessels such as their 500,000 barrel Suezmax carriers. Volume per buyer in the shipping industry is volatile since firms can meet the varying needs of the customers. This keeps the bargaining power of customers low in the energy shipping industry. Conclusion In the energy shipping industry, low switching costs allow customers to move with ease from one shipping firm to another. Such movement is determined by the shipping firm s differentiation, which is essentially age of the fleet and sizes of the ships. The competition generated by such differentiation renders the service cost and product quality important. Additionally, numerous buyers give bargaining power to the shipping firm. This balance of competition and demand makes the energy shipping industry a catalyst to low bargaining power of customers. Page 33

35 Bargaining Power of Suppliers The profitability of the sea transportation industry depends on a myriad of factors like spot rates, charter rates and new ship build costs. In order to understand the power suppliers have in this relationship, we will need to understand who provides the inputs in which we add value. The relative power of these suppliers will affect the profit margins of our business and theirs. When our industry is experiencing rapid sales growth, as it did in 2006, suppliers want to increase their margins as well. Alternatively, when our industry is contracting, as it did in 2001, neither suppliers nor users want to reduce their operating margins. Both parties relative success in this dynamic relationship will be the topic of the following discussion. The sea transportation industry has few suppliers. Primarily, the suppliers are shipbuilders, diesel used to propel the voyage, as well as the crew members on the ship itself. Understandably, the most significant supplier in this relationship is the shipbuilder because of their large contribution to our overall costs. For this analysis, we will ignore the costs of diesel and personnel, because of their miniscule contribution to our costs structure. Switching Costs In the context of supplier relationships, switching costs refer to the propensity for the company to switch suppliers. If a supplier makes a critical component used in the company s product, and a limited number of alternative suppliers exist, the supplier has significant power through the companies unwillingness to switch suppliers. The sea transportation industry s primary suppliers are the ship builders. Ship builders are large, numerous and primarily Asian domiciled companies. Shipping companies have very little customer loyalty as to who builds their tankers because of the build-to-order and lengthy build time nature of the industry. Therefore, many shipping companies have a number of ships made from multiple shipyards. The Page 34

36 following chart reflects the diversity in shipyards supplying the vessels for the frontline fleet. Frontline Vessels by Shipyard Hitachi Hyundai Samsung Daewoo Jinhaiwan SWS Other Differentiation Suppliers have more power over their customers if their products are of a differentiated nature. The degree to which the inputs for the company are a commodity or homogeneous nature influences the suppliers bargaining power over the company. Alternatively, if the product the supplier sells is highly unique and proprietary, the supplier has more power to dictate pricing over the company because of the lack of relative substitutes. The following section will discuss the degree in which shipbuilders build differentiated products and the price premiums warranted for these specialized tankers. In particular, we will examine the recent trends in ship design and how the industry is responding to these new products. Sea transport companies differentiate themselves by how modern and technologically advanced their fleet is as well as their age. It is imperative to understand the advantages these modern fleets bring to the shipping company in order to measure the recoverability and longevity of their assets. Additionally, as ship builders can be more selective in the ships they build, it is important to determine if these high Page 35

37 value added tankers really warrant the premium charged and the advantages are truly unique to that shipbuilder. Ship builders tend to make standardized products with few differences in the way their products operate. For instance, liquid national gas carriers are seen in the industry as being a higher-value added product, and thus warrant a price-premium. Similarly, floating, production, storage and offloading vessels have emerged in recent years as an all-in-one tanker with natural gas liquefaction and refining capabilities onboard. However, these are unique examples in respect to the industry as a whole. The vast majorities of tankers are highly similar and are differentiated on dead weight tons alone. An example of this is the emergence of ULCCs (ultra large crude carriers) which are tankers over 400,000 DWTs, and V-pluses, which are 50% larger than traditional VLCCs (200,000+DWT). Due to the industries primary focus on cost, innovation in tanker technology slants toward making larger ships that can take advantage of economies of scale. Daewoo Shipbuilding and Marine Engineering claims their proprietary pre-swirl stator, which better directs water to the propeller, decreases fuel consumption by 5~6%. Similarly, their Computational Fluid Dynamics hull designs reduce the effect of waves on the stability of the tankers, thus decreasing fuel consumption and increasing operating efficiency. Hyundai heavy industries pride itself on its engine technology that is expected to lower maintenance costs over the life of the tanker. Overall, the significant differences in tankers are their capacity, with Daewoo Shipbuilding leading the shift to ULCCs. Importance for Cost and Quality In any industry, the nature of the input for cost and quality determines how powerful a supplier can be to the company as a whole. If it is not important for the input to be of relatively high quality, cost competition is sure to occur and the bargaining power of the supplier is diminished. Alternatively, if the input is needed to be of relatively high quality, a supplier can leverage more power in the relationship. This Page 36

38 section will analyze how important the ships are for cost and quality, and thus, how much power the suppliers have in this situation. The fixed assets of vessels represent a significant portion of the cost structure to the shipping company. Depreciation and vessel expenses are the primary expense to a shipping company and understanding the importance of vessel price and quality is essential to creating a perspective of shipping companies and the relationship they have with their suppliers. Vessel cost and quality are critical in the consideration of expense management and used ship sales revenue. Ship costs have much less to do with the costs of their inputs, like labor and steel, than they do with expected future freight rates. Considering how singular the supply chain is to a shipping company, it is very important for a shipping company to understand the market for ships and freight rates, and therefore manage their fleet through time-charters and sale and lease backs. In order to examine the relative importance of ships to the overall cost structure, we will look at how ship costs affect the income statements of Frontline, Overseas Shipping and Teekay. For this analysis, we will use vessel expenses, which include all maintenance and dry-docking expenses, to measure ship quality. Additionally, we will look at depreciation, amortization and time-charter expenses to measure initial ship purchase price relative to total expenses. Page 37

39 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% OSG Teekay Frontline Remaining Expenses Vessel Expenses Charter Expenses Depreciation As the figure indicates, depreciation and charter expenses represent a significant portion of the cost structure, ranging from 30-48% of total expenses. This represents the amortization of the purchase price of the vessels along with rent on vessels owned by another independent operator, or sale-and-leaseback transactions. Vessel expenses are included to show maintenance, repair and subsequent dry-docking fees associated with the vessels themselves. In aggregate, these expenses represent 52-78% of total expenses, placing high importance on ship quality and cost in the industry s key success factors. Number and Volume of Suppliers The number of suppliers in an industry affects the availability of inputs used for value creation. For whatever reason, if a limited number of suppliers exist, firms must manage relationships in order to guarantee continuous supply of raw materials, in this case, shipping vessels. Similarly, the volume per supplier influences the relative power of suppliers over buyers in the industry. If the market share of the various suppliers is highly fragmented, purchasers are more dependent on a handful of suppliers and must manage these relationships with sustainability in mind. Alternatively, if the market is flush with firms willing to supply an input and market share is reasonably distributed, Page 38

40 purchasers have much more bargaining power by being able to auction their upstream needs. The shipbuilding industry has numerous suppliers, but market share is highly fragmented as well. The largest shipbuilders have the luxury of discerning what business they would like to accept, that is, the high value added, high margin vessels. Samsung Heavy Industries shipbuilding slogan is emblematic of this approach: Generating high profits by selectively receiving orders for high technology and high value added ships. Backlog for new builds is between 2-3 years across the industry and build-time is around one year. This constant flow of business allows the suppliers to manage their capacity and be selective as to which vessels they would like to build. Although a comprehensive list of shipbuilders would be too elaborate to include here(over 150), the fragmentation of the industry can be conveyed by showing the market share of the tanker industry of the main shipyards. Korean shipbuilders have emerged as the pre-eminent force in the industry with Hyundai Heavy Industries accounting for 15% of the market, followed by Samsung with 11% and Daewoo with 13%. These shipbuilders have become so influential that they demand payment in Korean won, instead of the U.S. Dollar, which was common practice until recently. Conclusion A crucial element in valuing the sea transportation industry is determining the relative bargaining power of the suppliers in the industry. We have discussed how Korean shipbuilders are commanding more market share and more influence, concentrating the supply of new vessels. Additionally, we have showed how important initial purchase price of a vessel is to any shipping company, representing 30-48% of total expenses, adding in vessel upkeep, and total vessel expenses range from 52-78% of total expenses. It has been shown that product differentiation is focused primarily on the size of the ship and its operating efficiency, but by no means, the prevailing Page 39

41 characteristic of the needs of purchasers. Switching costs remain very low with very little customer loyalty, as represented by the diversity of shipyards supplying shipping company s vessels. In this environment, we can expect increases in shipping rates to directly correlate with purchase price of new and used crude carriers, necessitating intelligent and strategic procurement of the more important fixed asset a shipping company has, the vessel. Conclusion The energy shipping industry has been analyzed quantitatively by using Porter s Five Forces Model. This analysis revealed high level of rivalry among existing firms within the industry. Analysis also revealed a moderate threat of first-time entrants to the industry. The threat of substitute products, (or services as in this specific industry) is determined to be low. Bargaining power of customers is low, where the bargaining power of suppliers is high. By analyzing the rivalry among existing firms, threat of new entrants and threat of substitute products, the measure of competition can be obtained. The last two components of the five forces determine the industries bargaining power of either suppliers or customers. When all five components are considered, the industry as a whole has the potential of fostering highly profitable firms. Key Success Factors Within an industry, firms must decide on one of two strategies that create value. The two most common competitive strategies include cost leadership and differentiation. Successful companies choose one of these strategies to gain an advantage against industry competitors. Essentially, firms that focus on cost leadership supply same product or service at a lower cost and the ones that focus on differentiation supply a unique product or service at a cost lower than the price premium customers will pay (Palepu & Healy Figure 2-2). The key success factors that Page 40

42 create value within the energy shipping industry include the economies of scale and scope, efficient production, lower input costs, and superior product quality and variety. Cost Leadership Economies of Scale and Scope Economies of scale and scope refer to the ability of a firm to reduce their variable (per-unit) costs through heavy investments in capital, often leading to a higher portion of fixed costs in their expense structure. The energy shipping industry is emblematic of this approach in that larger, more flexible vessels are necessary for a firm in the industry to be successful. Most crude oil is transported in very large crude carriers (VLCCs) that weigh over 200,000 DWT. Such vessels can transport two million barrels of oil in their hulls and usually have depreciable lives of 25 years. In addition to large investments in physical assets, successful energy shipping companies have multiple types of vessels enabling increased flexibility, utilizing economies of scope. These vessels can travel the Panama Canal, as well as the Suez Canal. These ships are referred to as Panamax and Suezmax tankers, respectively. These high investments in physical assets and low industry differentiation lead to the problems of excess capacity, putting downward pressure on spot rates. This volatile business environment places heightened importance on energy shipping companies to diversify their fleet to effectively hedge against these volatile rates. Efficient Production Efficient production occurs when a firm uses its available assets to produce the maximum number of goods and services. In the energy shipping industry, percent utilization can be used to measure this efficiency. Firms obtain a competitive advantage if they can utilize their current fleet of vessels more efficiently than their rivals. Ninety percent utilization of the world's tanker fleet is considered full use by the industry Page 41

43 (Houston Chronicle: World's tanker fleet is 'close to 100 percent utilization). When firms operate at ninety percent utilization, they can offer optimum shipping rates for their customers. The remaining percentage accounts for vessel maintenance. Above 90 percent utilization, the shipping rates drastically increase for the customers. Lower Input Costs Input costs are cost of direct material, direct labor, and other overhead items devoted to the production of a good or service (allbusiness.com). Reducing input costs is a key success factor in any industry. The energy shipping industry is highly competitive and firms that achieve lower input costs can have a strong competitive advantage. Voyage expenses such as fuel, canal tolls, port charges, and tariffs are major input costs that the overseas shipping industry strives to reduce. Additionally, the costs of the vessels significantly impact a firm s cost structure. The energy shipping industry is service-based and thus firms cannot reduce input costs through vertical integration by producing their own inputs (vessels, bunker fuel, etc.). Firms must think of more creative ways to lower their input costs. Most companies manage these costs by participating in commercial pools and charters that increase asset utilization through coordination of resources. Little Research and Development Research and Development, or R&D, is the investigative activities that a business chooses to conduct with the intention of making a discovery that can either lead to the development of new products or procedures, or to improvement of existing products or procedures (Investopedia.com). The energy shipping industry is a service industry in which firms do not typically invest in research and development. Therefore, this is not a cost incurred by an energy shipping firm. It would be very costly for a firm to start building their own vessels, and it is common industry practice to buy or lease the vessels they use for shipping. R&D would be much more likely to be seen in the companies that build the vessels and then sell to firms in this industry. Page 42

44 Differentiation Superior Product Quality In the energy shipping industry, superior product quality is essential to maintaining a competitive edge. Many of the companies in the industry supply different characteristics dealing with their products quality. Some companies base their superior quality on the fact that their ships are new and state-of-the-art. Others rely on their innovations, such as, safe tank venting, inert gas systems, crude oil washing, sophisticated engine room control systems and satellite navigation. The most significant innovation in recent years has been the double hull design, which became mandatory from the early 1990 s (osg.com). Many major companies offer at least one of these features in order to create a competitive advantage, in terms of quality, over other companies in the industry. Superior Product Variety Companies within this industry must search for ways to provide their customers with superior product variety in order to stay competitive. Since the basic functions of each company do not significantly differ from one another, it is essential for companies to offer a variety of products that set them apart from their competitors. For example, since a large portion of the industry has begun to participate in the shipping of crude oil internationally, some companies have started offering their customers other services such as the shipment of liquefied natural gas. This allows a small portion of the industry to gain a competitive advantage through an area in which other companies are not participating. Providing superior product variety in the energy shipping industry will allow a company to stay competitive and successful. Conclusion In the energy shipping industry, firms focus on various strategies that create value and allow themselves to be competitive with rivals. Cost leadership is the main strategy that these firms use to have competitive prices for customers. Companies that Page 43

45 have lower input costs, utilize tight cost control systems, and refrain to focus predominantly on research and development have been able to succeed. Industry leaders apply differentiation strategies to stay ahead of a changing industry with an increased focus on superior product quality and variety. With cost being very similar, firms that are able to also differentiate have an edge over those that do not. Competitive Advantage Analysis Companies within the energy shipping industry compete against one another using mostly cost leadership strategies. Since there is a relatively low amount of product differentiation in this industry, companies try and distinguish themselves from one another based on supplying their service at a lower price. Although cost leadership is the strategy used to gain a competitive advantage in the energy shipping industry, some companies use a few differentiation strategies to further set themselves apart. Overseas Shipholding Group is one company within the industry that operates using both the cost leadership and some differentiation strategies. OSG applies economies of scale and scope, lower input costs, and tight cost control systems as cost leadership strategies, and the use superior product quality and superior product variety as differentiation strategies to gain a competitive advantage in their industry. Economies of Scale and Scope Overseas Ship holding Company excels in maintaining a diversified fleet of vessels that take advantage of the dynamics of global trade. In particular, their Aframax, Panamax and Suezmax vessels enable Overseas Shipping Company to ship through the Panama Canal and the Suez Canal. In addition to allowing passageway through various canals, the large size of the company s Very Large Crude Carriers (VLCC), enable overseas shipping to participate in the spot and charter markets moving oil from the Middle East, North Sea and North Africa to North America, Western Europe and Asian industrialized economies. Overseas Shipping also operates two of the four V- Page 44

46 Plus VLCCs in existence. These ships can transport 3.2 million barrels of oil, opposed to 2 million barrels for a standard size VLCC, and achieve much greater economies of scale through their reduced bunker (fuel) costs, decreased labor usage per barrel, and decreased toll and port fees per barrel transported. Aframax Suezmax Panamax VLCC Handysize Other As the above graph indicates, Overseas Shipping achieves increased asset utilization through the flexibility of their fleet. This enables the company to dry dock or time charter vessels that aren t being used at full capacity and to combine their large fleet with others in the industry through commercial pools. Through the aforementioned strategies, Overseas Shipping is able hedge against the volatile spot market for energy transportation by diversifying their fleet in order to take advantage of economies of scale and scope. Lower Input Costs The energy shipping industry is service-based, therefore; firms cannot simply use vertical integration or outsourcing to lower their input costs. They must be more creative. According to Overseas Shipholding Group s 10-k, financial flexibility is a big part of their business strategy. The Company believes its strong balance sheet, high credit rating and high level of unencumbered assets give it access to both the unsecured bank markets and the public debt markets, allowing it to borrow primarily on an unsecured basis. This, in turn, reduces its financing costs and cash flow breakeven Page 45

47 levels. This financial flexibility permits the Company to pursue attractive business opportunities (OSG 10-k). Because OSG excels financially with a high credit rating, it is able to lower input costs by financing business at a lower interest rate. Low financing rates save the company money which results in lower cost to the customer. According to Wikinvest.com, OSG s cash to market cap ratio was 28% at the end of the third quarter in OSG s growth and diversification has led to big gains in revenue over the past four years (wikinvest.com) Overseas Shipholding Group sometimes pays with their large amounts of cash-on-hand to avoid interest expenses that could drastically increase their input costs. In a serviced-based industry such as energy shipping, OSG has found creative ways to reduce their input costs through efficient financing. Superior Product Quality Overseas Shipholding Group holds a competitive advantage over other companies when it comes to its vessels ages and their double hulls. The company s VLCC (which includes its two V-Plus vessels) has an average age of seven years. The Aframax vessel has an average age of 9.2 years and the average age of the world fleet is 8.9 years. The Panamax has an average age of 4.3 years, while the world fleet average is 9.1 years. The handysize product carriers have an average age of 6.2 years, and the average world fleet is 9.4 years. Besides the Aframax every other type of vessel is considerably younger and more up to date then the average age of the world fleet. When customers consider the quality of the vessels that will be used to ship their energy, they want to be assured that the vessels are reliable and up to date (OSG 10- k). Another factor that gives OSG a competitive advantage over other companies in the energy shipping industry is the double hull enclosed in each of their vessels. The newer ships that contain double hulls have a large advantage over older fleets that have only single hulls. A double hull is a ship hull design and construction method where the bottom and sides of the ship have two complete layers of watertight hull surface: one outer layer forming the normal hull of the ship, and a second inner hull Page 46

48 which is somewhat further into the ship, perhaps a few feet, which forms a redundant barrier to seawater in case the outer hull is damaged and leaks (Wikipedia.com). It would stand to reason companies would enjoy having this perk in their shipping vessels because of the added protection it allows for their valuable energy shipment. Superior Product Variety Overseas Shipholding Group is on the leading edge of superior product variety within the energy shipping industry. Since the energy shipping industry has a low product differentiation, OSG has reached out and obtained one of the most diversified fleets in the industry to allow them to compete in several different ways. In order to distinguish themselves from the industry as a whole, they have developed four distinct products to offer their customers. By offering their customers significantly more products than their competitors, it helps them to gain a competitive advantage. Although OSG s main form of revenue is still crude oil shipment, their continually diversifying their sources of revenue more efficiently than their competitors. Much more diversified than many of their top competitors. Page 47

49 The most noteworthy aspect of OSG s company that allows them to gain a competitive advantage in their industry is their participation in U.S. based shipping. Although it is a small portion of their overall revenue, in the specific U.S. based market, they hold an extremely high percentage of the market share. Two of their top competitors, Frontline Ltd. and Tsakos Energy Navigation, do not even offer this product to their customers. As you can see from the graph, where OSG is growing the most is in their revenues from their international product fleet. Even though three of OSG s top four competitors also offer this service to their customers, OSG is expanding their share of that market more than other firms. The last aspect of OSG s product variety is the shipment of liquefied natural gas. This makes up the smallest portion of their overall revenue but, again, OSG is one of the top suppliers of this service relative to the industry as a whole. One of OSG s top competitors does not offer this service while another top competitor has only one ship to supply this service. Conclusion In conclusion, Overseas Shipping primarily adheres to a cost leadership strategy but finds ways to differentiate itself through several elements of the differentiation strategy. Overseas Shipping positions itself in the market as a diverse shipper and broker through its extensive product variety. The flexibility of their specialized fleet to traverse various canals and waterways, as well as their economies of scale in brokerage, logistics and sheer vessel size, enable Overseas Shipping to reap abnormal returns relative to the industry. It is through the aforementioned strategies that Overseas Shipping is able to manage the shipping cycle through time charter arrangements, diverse shipping destinations, scale/scope of their vessels and diversity of the customers they service. The higher predictability (smoothing) of the company s earnings infers a lower than average cost of capital which further enhances their abilities to manage downturns(rate backwardation) as well as expand in up markets(rate contagion). Page 48

50 Accounting Analysis The purpose of accounting analysis is to evaluate the degree to which a firm s accounting captures its underlying business reality (Palepu & Healy). Many companies use accounting to portray an inaccurate view of the financial state of their business. Therefore, a thorough accounting analysis is key to any financial evaluation. The six steps required to perform a successful accounting analysis are: 1. Identifying the key accounting policies that directly relate to the firm s key success factors. By focusing on these related accounting policies, financial analysts have a basis to measure the company s critical components as well as its risks. 2. Assessing flexibility in choosing accounting policies and estimates. The policy choices managers use have a sizeable impact on the reported performance of a company and are, therefore, important to assess. 3. Evaluating the strategy managers use to maximize the benefits of the flexibility in accounting policies. Managers who have accounting flexibility have the ability to hide poor performance so analysts must pay attention to this. 4. Evaluating a firm s choice in disclosure of accounting information and whether the company used the disclosure to its benefit. Analysts must ask whether the company s choice of disclosure is helping or hurting the perception of the company. 5. Identifying potential red flags that highlight questionable accounting. Analysts examine problematic items within the financial statements and gather more information about them. 6. Undoing accounting distortions that are misleading. To prevent people from mistakenly valuing the company based on misleading strategies and accounting policies, analysts must undo misleading distortions. Page 49

51 Key Accounting Policies In accounting analysis the analyst should identify and evaluate the policies and the estimates the firm uses to measure its critical factors and risks (Palepu & Healy). As previously discussed, the key success factors in an industry play a major role in determining what a company should do to be successful. Economies of scale and scope, efficient production, and lower input costs are all type 1 key success factors pertaining to Overseas Shipholding Group. Accounting policies also contribute to a company s success. Overseas Shipholding Group s type 2 key success factors were cost leadership and differentiation. The cost leadership success factors included economies of scale and scope, and lower input costs. Also, the differentiation success factors were a mixture of superior product quality and variety. When OSG executes its key success factors well, it is likely to be successful and profitable, but skewed accounting can lead to an inaccurate valuation. Managers who are willing to distort accounting numbers will most likely distort important policies to significantly improve their company s financial outlook. The smallest distortion in OSG s accounting could potentially mislead their customers. The job of an analyst, then, is to review a company s accounting policies, which tell whether or not a company is achieving their key success factors. Operating Leases In acquiring long-term fixed assets, firms have choices in the structure of their payments and how these cash flows are reflected on the financial statements. A firm can purchase the asset outright with cash generated from retained earnings or from external financing sources. Alternatively, the firm can effectively rent the asset through operating leases, or rent-to-own the asset through a capital lease. In the event the company chooses to lease the asset, the type of lease (operating/capital) determines whether or not future lease payments are incorporated in the liabilities section of the balance sheet as well as the subsequent asset of the owned portion of the asset, less accumulated depreciation. Additionally, the firm will have to recognize Page 50

52 the interest expense associated with carrying value of the liability in the event a capital lease is chosen. Although capital and operating leases are close substitutes, each contractual arrangement reflects different business realities and the appropriate lease type should be chosen to reflect the operating life as well as the duration of future lease payments. Operating leases are appropriate when the usage of a capital is short term, relative to the life of the asset, and there exists no ownership rights to the asset. The usage of an operating lease implies the lessee has no stake in capital gains, or losses, of the asset because the firm lacks ownership rights to take advantage of such gains (or suffer the associated losses). Operating leases reflect a short-term relationship of future lease obligations and suggest to the investor that the firm could effectively back-out of their usage of that asset and cease lease payments. Capital leases are recorded on the balance sheet as a liability (present value of all future lease payments) as well as the accompanying leased asset (fair value of the asset or the equivalent present value of future payments, less accumulated depreciation) at lease signing. This is the significant distinction between the two types of leases in that future lease payments are recognized as a liability and ownership rights of asset are effectively transferred to the end-user under a capital lease. The usage of a capital lease communicates to the user of financial statements that the duration of future payments better mirrors the useful life of the asset as well as ownership of that asset and its capital gains or losses. Principally, a capital lease is appropriate when the firm owns the asset at-risk and will continue to use the asset for the majority of its useful life. In the energy shipping industry, managing fixed assets, namely vessels, and their potential for excess capacity (high fixed to variable costs) is a key success factor of the industry. Accounting for these fixed assets is important in understanding the future profitability of the company and its ability to earn abnormal returns on assets. Accurately reflecting fixed future payments for vessels is important for several reasons. Page 51

53 First, vessel prices are highly correlated with vessel spot rates and fluctuate greatly. Reflecting the ownership component of the vessel is very important in communicating the economic consequences of business activities because the firm will eventually have to record a gain or loss on the sale of that asset (or adjust its depreciation methods to write the asset off over time). Secondly, reflecting the binding aspect of future lease payments, often lasting for longer than 15 years, is useful in determining the potential for future excess capacity and the accompanying price-competitive environment. Simply, how will the firm weather the storm of prolonged backwardation in spot rates when they have to pay fixed operating expenses Goodwill Goodwill is an intangible asset that arises when a firm pays an excess price for a certain acquisition. Goodwill gaps the difference between the market value and the book value of an acquired asset. In the energy shipping industry, this premium a company pays is due to external selling factors such as long-term customer relationships or charter-in contracts acquired. This makes goodwill difficult to account for and even harder to measure in terms of business activities. Though it is difficult to account for, goodwill can be used to give a firm a more favorable standing with regard to its financial statements. Goodwill can also be used to determine why the firm overpaid for a certain asset. According to SFAS 142, goodwill has to be written down immediately upon being deemed overvalued. This means that goodwill cannot be amortized. Furthermore, SFAS 142 states that goodwill needs to be assessed for impairment annually. OSG states that it impairs goodwill on a yearly basis as required by SFAS 142. Yearly impairment is used unless an extreme situation requires the need to impair it more frequently. Impairment to market value is necessary when the carrying value is greater than fair value. Companies may leave goodwill on their balance sheet indefinitely only as long as the goodwill remains valuable. If goodwill is Page 52

54 left on the balance sheet and not impaired, then total assets will continue to be overstated. Assets = Liabilities + Equity Revenues - Expenses = Net Income O N O N U O N=No Effect O=Overstated U=Understated As evidenced by the above table, managers can change the financial position of the firm by overstating goodwill, not presenting it as impaired, when it should be. Within the energy shipping industry, firms will acquire other shipping companies in order to expand their own. Goodwill is recorded as an asset when firms buy these new subsidiaries. The goodwill of Overseas Shipholding Group and its close competitors is reported in the table below. Goodwill (in thousands) Company Overseas Shipholding ,293 72,463 Frontline Ltd Teekay Corp. 89, , , , , ,590 Tsakos Ltd OSG and Teekay Corporation are the only two companies that have reported any goodwill over the past six years. As seen above, goodwill has drastically increased over the last few years. Though goodwill has increased over the past two years, it is only a small portion of OSG s total assets. OSG s Property, Plant and Equipment for 2007 amount to $4,158,917,000, therefore, goodwill is only 1.74% of total PP&E for this year. Page 53

55 Goodwill as Percent of Plant, Property and Equipment Company Overseas Shipholding % 2.46% Teekay Corporation 4.62% 5.39% 5.17% 5.26% 5.02% 6.35% The above table discloses the comparison of goodwill to plant, property, and equipment. According to the table, goodwill is only a small portion of PP&E for both Teekay and OSG. Over the last two years, OSG s goodwill only represents an average 2.5% of PP&E. However, Teekay s goodwill represents an average 5.3% of its PP&E over the past six years. These numbers provide evidence that the premium paid on acquired subsidiaries only represent a small portion of their PP&E. Goodwill as Percent of Operating Income Company Overseas Shipholding % 34.91% Teekay Corporation 74.73% 44.63% 26.84% 27.05% 63.23% % For these close competitors, goodwill represents a large portion of operating income as evidenced by the table above. Though OSG s goodwill is a large portion of its operating income, it is not as significant as Teekay s reported goodwill. We believe that OSG needs to impair more goodwill in order to accurately depict the portion of operating income. To determine if goodwill compared to operating income is accurate and significant, an amortization of goodwill compared to operating income must be calculated. The following table depicts an amortization of 2007 goodwill over a fiveyear period at twenty percent per year. Page 54

56 Goodwill Amortized at 20% (in thousands) Company Overseas Shipholding 14,492 14,492 14,493 14,493 14,493 Teekay Corporation 86,918 86,918 86,918 86,918 86,918 Once this forecast is determined, the assumed amortized goodwill percentage of operating income per year must be derived. The following table depicts these percentages. Amortized Goodwill as a Percent of Operating Income Company Overseas Shipholding 6.44% 2.85% 3.05% 3.81% 6.69% Teekay Corporation 29.67% 10.58% 13.76% 20.6% 21.84% If OSG were to amortize its goodwill over a period of five years at twenty percent, it would significantly decrease the goodwill portion of operating income. Teekay s goodwill portion of operating income would still be at a high level. This leads us to reason that OSG is impairing its own goodwill at appropriate times. This method of amortizing goodwill, as shown above, could drastically change the financial position of a firm in this industry. Managers of the firm could use this or other described methods to hide the true value of goodwill. This leads to the assessment of determining the flexibility of goodwill relative to the accounting structure. Page 55

57 Hedging Activities In industries that rely heavily on cost control procedures, as in the energy shipping industry, certain differentiation activities may be used to reduce company costs. Within the energy shipping industry, there are several factors that could lead to an unstable market. Fluctuations in interest rates, foreign currency exchange rates, and energy costs are some major factors that, if not handled properly by a firm, could lead to unstable costs. In order to minimize and help control future costs in the energy shipping industry, most companies choose to participate in an activity known as hedging. Hedging is a strategy designed to minimize exposure to such business risks as a sharp contraction in demand for one's inventory, while still allowing the business to profit from producing and maintaining that inventory (wikipedia.com). The main purpose of hedging is to reduce risk in an unstable market. The energy shipping industry can be greatly affected by fluctuations in shipping rates. A high majority of revenues earned by firms within the energy shipping industry are from contracts in the spot market. The spot market or cash market is a commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective (wikipedia.com). Since such a high proportion of revenues come from the spot market in the energy shipping industry (as evidenced by the graphs below) it is important for firms within the industry to attempt as much control of the market rates as possible. Page 56

58 As Percent of Total Revenue Frontline Time Charter Spot Market Overseas Shipholding Group 29% Time Charter Spot Market 71% 62% 38% One way that firms attempt to maintain a stable rate within the industry is by entering into Forward Freight Agreements. These agreements are an economic instrument that reduces a firm s exposure to changes in the spot market rates earned by some of its vessels in the normal course of its shipping business (OSG 10-K). Firms within the energy shipping industry are also at risk to changing interest rates. OSG and its top competitors implement a hedging activity known as interest rate swaps to aid in minimizing this risk. Since the interest rates are constantly fluctuating within this industry, firms employ interest rate swaps to ensure that a currently floating rate will remain fixed when implemented. This is an important cost control feature for firms because it allows them to maintain a steady rate in the future and remain unaffected by changing interest rates other firms in the industry may be forced to use. Since a large majority of business is conducted overseas within the energy shipping industry, the foreign currency exchange rate is a major component that, if not controlled, could have a damaging effect on a firm. Since some major firms in this industry are paid in foreign currency, it is important they seek to keep these rates in check. In order to do this, some firms will enter into forwards contracts that promise a rate to be paid in the future even if it has fluctuated since the signing of the contract. Page 57

59 Benefits and Pension Plan Defined benefit pension plans and medical benefits are a firm s future financial obligations promised to workers. These obligations are recorded at present value as liabilities of the future installments owed. The future installments are calculated by using discount rates created by the firm s management and outside actuaries. Too high of a determined rate would understate liabilities, whereas too low of a rate would overstate the liabilities. Since these numbers are primarily created by the firm, with outside guidance, they can be subject to human error. These long-term liabilities could greatly affect the financial position of a company through its financial statements. The substantiality and validity of these pension plans can be derived from the company s 10-K or equivalent annual report. In comparison to Teekay Corp., Frontline Ltd. and Tsakos Ltd., Overseas Shipholding is the only company that discloses information about discount rates, growth rates for estimating future benefit costs, estimated asset growth used to pay for benefit obligation liabilities, and the proportion of benefit plans relative to long-term debt. This determines that OSG highly discloses information regarding benefit plans relative to their competitors in the energy shipping industry. OSG s 10-K indicates that it sponsors a noncontributory defined benefit pension plan covering substantially all of their domestic shore-based employees hired prior to January of The 10-K also discloses that retirement benefits were based on years of service and compensation earned during the last years of employment. OSG also provides certain postretirement health care and life insurance benefits to qualifying domestic retirees and their eligible dependents. Qualifying employees, according to OSG s 10-K, are ones hired before 2005, who retire and have met minimum age and service requirements under a formula related to total years of service (not disclosed). The postretirement health care plan is contributory, whereas the life insurance plan is noncontributory. The substantiality of these benefits on OSG s balance sheet is miniscule compared to total long-term debts. In 2007, OSG reported total long-term debt as Page 58

60 1.506 billion when they only reported total benefit obligations (postretirement pensions and other postretirement benefits) at million (OSG 10-K). This proves that, compared to the rest of their long-term debt, their long-term obligations to employees only comprise a small amount of liabilities. Further disclosure is provided by OSG because they report the rates at which to discount the future obligations in order to determine their present values. OSG s discount rates from 2002 to 2007 are shown in the table below: Defined Benefit Pension Plan Discount Rates OSG Discount Rate 7.4% 6.7% 6.2% 5.75% 5.25% 5.20% According to the U.S. Department of Labor, the average inflation in 2007 was 2.85%. This inflation rate has been at a decrease over the past few years. Since the discount rate used by OSG from 2002 to 2007 decreased, these are seen as reasonable rates compared to the inflation. OSG discounts their post retirement plans at a higher rate than inflation because any return on an investment would receive this much interest at a minimum without risk premium. OSG also uses a slightly declining discount rate for other medical and post retirement benefits. These rates from 2002 to 2007 are shown in the table below: Other Medical and Post Retirement Benefits OSG Discount Rate 7.4% 6.7% 6.2% 6.4% 6.4% 6.2% Page 59

61 These rates are considered reasonable since they decrease with a relative decreasing inflation rate. The obligation discount rates are disclosed, but the method by which they are determined is not. Assets are needed to pay for future, long-term obligations, such as pensions and medical benefits. To determine how much a company needs in order to pay off these liabilities, a formula is used to grow assets at a rate that is expected to be received in the future. OSG defines the method for calculating these rates in its 10-K by saying the expected long-term rate of return on plan assets is based on the current and expected asset allocations. Additionally, the long-term rate of return is based on historical returns, investment strategy, inflation expectations and other economic factors. The expected long-term rate of return is then applied to the market value of plan assets. Since many factors determine these rates, they are not an exact measure of what the company will receive in the future. From 2003 to 2008 the expected return on the plan assets that were used to pay pensions were set at rates shown in the table below: Rate of Return on Assets used to pay Pensions OSG Discount Rate 8.75% 8.75% 8.75% 6.75% 6.75% 6.75% These rates also follow the decreasing trend in inflation rates over the past several years. In 2007 OSG determined that they needed million to cover pension benefits and 3.74 million to cover other postretirement benefits. The fair value of the pension assets at the end of 2007 was million, which left million unfunded plans at the end of that year. Furthermore, OSG had other unfunded benefits of 3.74 million at the end of But, again, since these pension and other Page 60

62 postretirement benefits are such a small portion of long-term debt, the amount left unfunded is almost an inconsequential amount. Assess Degree of Potential Accounting Flexibility Not all firms have equal flexibility in choosing their accounting policies and estimates. Some firms accounting choice is severely constrained by accounting standards and conventions (Palepu & Healy). The strictness of accounting policies varies from industry to industry. Some businesses accounting policies are highly government-regulated while others are only partially regulated depending on their nature. In certain more regulated industries, activities that are considered important are sometimes required to be expensed while other industries can freely decide how to report their business activities. When managers have constrained amounts of flexibility in choosing accounting policies and estimates concerning their key success factors, accounting data will not be helpful in trying to understand the firm s financial status. However, if managers have substantial amounts of flexibility when considering accounting policies and estimates; their accounting numbers could potentially be informative and reliable, as long as the managers have not used this flexibility to manipulate data. When managers have a lot of flexibility in choosing accounting policies, they should be monitored closely to determine whether or not they are presenting inflated profitability or anything else that would mislead their customers. It is important to determine, not only the level of flexibility but also the significance associated with the business activity in order to make educated decisions based on the company s accounting figures. Analysts must interpret flexible accounting policies differently than regulated ones. Because all firms have some flexibility regarding policies such as depreciation, inventory accounting, and pensions, most of the analysts focus should be placed on the flexibility of accounting numbers. Page 61

63 Operating Leases There exist several criterion mandated by the Financial Accounting Standards Board that differentiate the appropriate use of operating and capital leases. Although the intent of such standards is to accurately characterize the lease, it is often the case that leases are structured with a designation in mind. We will examine the potential flexibility a firm has in classifying a lease as operating or capital and the subsequent effects this flexibility has on the firm s financial statements. Operating leases can be more advantageous to a public firm because they reduce the firms liabilities, the accompanying asset, interest expense and depreciation recorded on the balance and income statement. In addition, the conversion of an operating lease to a capital lease tends to push earnings further back in the current term and in future years through the higher discounting of cash flows in the short term. This discounting effect occurs because interest expense is higher toward the beginning of a loan amortization, while depreciation remains constant (strait-line) or is higher in the near term (accelerated method). Therefore, there exist criterion that mandate the use of capital leases as opposed to the use of operating leases. The criterion are as follows: 1. If the leased life exceeds 75% of the life of the asset. 2. If there is a transfer of ownership at the end of the lease term. 3. If there is an option to buy the asset at a bargain price at the end of the lease term. 4. If the present value of future lease payments, discounted at the appropriate discount rate, exceeds 90% of the fair market value of the asset. The constraints dictated above give users of financial statements a framework to examine managers decisions to characterize the lease as operating or capital as well as to shed light on further contractual covenants. The use of qualitative designations in the Page 62

64 criterion allows significant flexibility in the structuring of leases. Additionally, shareholders, debt-holders and the SEC are the only users with legal standing and enforcement powers to challenge this designation. Goodwill When analyzing accounting strategies, it is necessary to take into account the degree of flexibility that firms have on measuring and changing goodwill. GAAP changed from allowing companies to amortize their assets to ultimately having them impair it, or write it off, to the fair market value of the asset. This change occurred to keep assets from being inflated. Goodwill is difficult to measure when trying to find the fair market value, adding to the potential flexibility. In the energy shipping industry, it is not common to have any goodwill stated on financial statements. Therefore, companies that report goodwill, such as Overseas Shipholding Group, have more flexibility than companies that do not. The reason goodwill has appeared on OSG s books in recent years is because of various acquisitions, such as, the 2007 acquisition of Hiedmar Lightering. Increased flexibility allows firms to manipulate its accounting and makes it more difficult to value. Hedging Activities Flexibility regarding how a firm can account for hedging activities could create drastic changes in accounting numbers depending on the degree of flexibility allowed. With regards to hedging activities, there are specific codes set up to provide firms with detailed instructions on how to account for the exact activities that they have participated in. The guidelines given by the FASB to account for hedging activities are located in FAS 133. FAS 133 states that all derivatives and hedging activities must be recorded at fair value as an asset or liability (fincad.com). Page 63

65 The firm s rational in applying the hedge accounting method must be clearly identified in order to decide how to account for the activity. There are two primary types of hedging activity relationships that affect how the specific activity will be accounted for by the firm. The first is a fair-value hedge. A fair-value hedge is used primarily by a firm in order to reduce the future risk that they may encounter. This type of hedge is related to changes in the fair value of the recognized or unrecognized asset or liability to which the hedge is linked. In order to account for a fair-value hedge, the firm must report any gains or losses from the hedged item in the current period net income. Since the amount of increase or decrease in the fair value of the hedged asset is based on judgment rather than fact, there is a chance for bias. The second hedging activity relationship is a cash-flow hedge. A cash-flow hedge is a hedge of the exposure to variability in cash flows of a recognized asset or liability or a highly probable forecasted transaction, attributable to a specified risk (camagazine.com). The gains or losses reported from this type of hedge are recognized on the income statement under other comprehensive income. There is minimal room for bias in this area since the numbers are calculated by actual gains and losses. The FASB standards for reporting hedge activities make it clear that there is a very low degree of flexibility in this area. The slight degree of flexibility comes from the biases that could arise in the calculations of fair market values. Since there is such a low degree of flexibility, it would be difficult for firms to influence their books to promote healthier hedging activities than what actually is accounted. Benefits and Pension Plan Since pension and other postretirement plans are affected by arbitrary discount and growth rates, they can be subject to human error. The flexibility of these rates, can allow the firm to use larger than appropriate numbers in order to make the Page 64

66 liabilities look smaller. Since these rates are flexible, a firm may use them to affect its financial stability and standings in a manner that make them look more favorable to potential investors. OSG discloses most of the information used for these rates, whereas its competitors do not disclose any. OSG does not, however, provide the expected rates to determine return on plan assets used to cover other postretirement benefits. OSG does mention in its 10-K that the assumed health care cost trend rate for measuring the benefit obligation included in other postretirement benefits is an increase of 10% for 2008, with the rate of increase declining steadily thereafter by 1% per annum to an ultimate trend rate of 5% per annum in This specifies that these rates are estimated by the company s management with opinions from outside actuaries. Since these rates are estimated, issues of flexibility would arise for a firm. For OSG though, the 1% increase/decrease effect on total of service and interest cost components in 2007 is only a difference of $62,000. Also, the 1% increase/decrease effect on postretirement benefit obligation at the end of 2007 is a difference of $583,000. The increase/decrease of rates determined by the firm are, again, insignificant compared to the entire long-term debt. Because of this, it may be assessed that there is a high allowance of flexibility on discount and growth rates. Even though OSG has a lenient amount of flexibility in determining rates, management could still allow growth rates that are lower than needed. This would make the firm s estimates of future liabilities appear lower. Because these future liabilities would be lower, the firm s expenses would be understated and therefore make the company appear more profitable. The following over/under analysis depicts such an environment. Assets = Liabilities + Equity Revenues - Expenses = Net Income N U O N U O N=No Effect O=Overstated U=Understated Page 65

67 This analysis shows the effect of rates on the accounting statements, and how it can allow the company to appear more valuable. These subjective discount and growth rates render flexibility on the accounting cycle at the discretion of the company. Evaluate Actual Accounting Strategy When managers have accounting flexibility, they can use it either to communicate their firm s economic situation or to hide true performance (Palepu & Healy). Flexibility plays a major role in a firm s accounting strategy. In order to determine a company s accounting strategy, an analyst must compare its accounting policies and the level and quality of disclosure to those of others within the industry. It can be difficult to recognize the different ways in which companies distort their accounting numbers, but evaluating trends over time is a common way to detect any skewed numbers. Exceptional increases or decreases in sales, income, or revenues without corresponding economic or management changes are a good indicator of accounting distortion. Analysts must also decide whether a company uses conservative or aggressive accounting policies by considering market and book value. Understated market values can lead to big gains for customers in the future while overstated book values, which can overestimate the value of a company, could prompt less trading. Operating Leases A comprehensive equity analysis involves looking beyond the presented information in annual reports and supplementary data. In order to ascertain the validity of the information, it is necessary to determine the accounting strategy implemented by the firms reporting units. Specifically, evaluating estimates, determining degrees of aggressiveness or conservatism in discretionary items and assessing the relative level of disaggregation in business segments are some of the processes this analysis will utilize to gain a more informed perspective of business operations. Page 66

68 Regarding the accounting strategy for leases (capital and operating), Overseas Shipholding Group would be considered moderately aggressive in their reporting. The extensive use of operating leases for vessels, which have operating lives similar to the lease periods, is a strong signal of aggressive accounting policies. Additionally, OSG does not provide a discount rate for their capital leases for the purposes of capitalizing existing operating leases on restated financials. Due to the high similarity in vessels being leased, a discount rate for capital leases would be highly useful in capitalizing the existing operating leases. To better convey the relative mix of operating and capital leases, the following graph shows the proportion of operating and capital leases payments in future lease obligations. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Future Lease Obligations 3% 3% 3% 2% 0% 97% 97% 97% 98% 100% Capital Leases Operating Leases Although more conservatism in the designation of leases as either operating or capital would be beneficial, the voluntary disclosures detailing operating days, revenue days and assets the lease encompasses are provided. Revenue and operating days are useful in computing a depreciation rate associated with capitalizing the existing operating leases as well as determining how the operating lease payments are segmented into office space or vessel expenses. Relative to the industry as a whole, OSG is very transparent in the performance of their various subsidiaries. Present in the annual reports are details of revenue, operating vessels, expenses and business Page 67

69 descriptions of the various entities under the OSG parent company. This information is useful in determining future cash flows, liabilities and service diversification which aid hedging efforts across all shipping needs and routes. Goodwill The amount of goodwill that Overseas Shipholding Group impairs will cause a change in total assets which, in turn, will affect their expenses. Overseas Shipholding and Teekay are the only competitors in the energy shipping industry that record goodwill on their balance sheets. Although OSG s goodwill only represents 1.74% of its total assets, reporting it would still overstate the company s earnings because their expenses will decrease. The amount of goodwill that OSG is disclosing each year seems accurate, considering the nature of the energy shipping industry. The company is maintaining goodwill at less than two percent of total assets, which means OSG is considered conservative when reporting net income. Hedging Activities Overseas Shipholding Group participates in hedging activities in order to reduce future risks that the firm may encounter. In order to account for these activities, they are required to follow strict guidelines stated in FAS 133. This statement instructs firms that take part in hedging activities to calculate the fair value of its assets or liabilities and record them on the balance sheet. Changes in the fair value of the assets or liabilities are then computed and recorded in either net income or other comprehensive income, as discussed in the previous section of hedging activities. Since OSG and its competitors use market prices to determine fair value and all firms are required to follow the restrictions given in FAS 133, the items reported on their financial statements will resemble one another in the hedging area. It is difficult for a firm to implement Page 68

70 conservative or aggressive accounting strategies in this area since estimates are relatively similar and guidelines are strictly followed. Benefits and Pension Plan Disclosure of information about pension and retirement benefits can be used to determine the value of a firm. OSG is the only company out of its close competitors that actually discloses information related to its pension and postretirement benefit plans. This high level of disclosure affords OSG a higher value over its competitors. Since OSG discloses almost all information related to discount rates, growth rates, assets used to pay future retirement liabilities and actual cost of future retirement debts, this effectively gives more value to its financial statements. This value is assessed through disclosure because it allows outside investors and entities to determine the validity of the liabilities reported. Even though these liabilities are a small portion of overall debt, disclosing information related to postretirement benefits sanctions this analysis. Furthermore, with regard to evaluating the accounting strategy, managers, with well-informed opinions of outside actuaries, are allowed to determine if the discount and growth rates used will be on a conservative or aggressive basis. Since OSG is the only firm to disclose this information, we conclude that they use a conservative approach for determining this information. The conservatism is portrayed through the decline in growth and discount rates over the last six years. This is relative to the fact that interest rates have decreased over the past several years as well. These rates can also be determined as conservative since they do not effect the financial statements substantially. Lastly, these rates can be determined as conservative on a national basis since the S&P 500 companies had a combined pension deficit of $376 billion at the end of 2008, according to Bank of America. Many companies with defined-benefit plans had more than half their assets in equities at the end of If all that was in the U.S., Page 69

71 they still lost 40% last year (WSJ Pension Deficit Disorder). This provides that actual rates were falling nation-wide, not just within a particular industry. Quality of Disclosure: Qualitative Analysis While accounting rules require a certain amount of minimum disclosure, managers have considerable choice in the matter (Palepu & Healy). Analysts must evaluate everything from the letter to shareholders to the footnotes in order to decide whether a company is using such seemingly insignificant things to make their company look better. Evaluating quality of disclosure is less about looking at accounting policies and more about reviewing the other ways managers can misrepresent information concerning their companies. Analysts consider the Management Discussion and Analysis section of the report, footnotes, letter to shareholders, and the manner in which management deals with adverse situations. These elements offer subtle clues to the approach a company takes when considering the subject of disclosure. Type 1 Key Accounting Policies It is essential to consider how the quality of supplementary disclosure reflects upon the key success factors identified in an industry. For the energy shipping industry, we identified economies of scale and scope, efficient production, and lower input as our key success factors. In the following subsection we will examine how the quality of disclosure of operating and capital leases reflects upon the aforementioned key success factors. Economies of Scale and Scope Overseas Shipping Group discloses, quite extensively, the relative ownership of their leased vessels as well as the expiry of such leases. Additionally, OSG discloses Page 70

72 such items like revenue days, operating days, average TCE rates in an effort to allow the investor to examine their operating efficiency and profitability. Many firms in the industry do not go as far as OSG does in disclosing the nature of the operating leases. Specifically, what types of boats are leased, the expiry date, and the remaining revenue days associated with the leased vessels overtime (aggregate contractual obligations). These items are inherently related to economies of scale and scope as well as lower input costs. Users of OSG s financial statements can compare the type of vessels acquired, their future lease obligations and the date of expiry to current lease payments found on the current year s income statement. This would enable the investor to determine how much OSG is paying to lease vessels and increase total revenue days. Although OSG voluntarily discloses more information about their leased vessels than do, for example Teekay, a less convoluted structure to the way they compute revenue days as well as further explanation of the computation would be beneficial in determining the ability to achieve lower input costs. Revenue days are weighted by ownership, but not by vessel type. For example, a revenue day for an Aframax carries the same weight as does a revenue day for a VLCC. This presents distortions in calculating how efficiently OSG is obtaining its vessels. Efficient Production The key success factor of efficient production can be best related to the energy shipping industry in terms of vessels operating in commercial pools. Commercial pools aggregate vessels of similar size and use and coordinate the logistics to ensure efficient use of all the vessels as a whole. Independent operators commit their vessels to these pools and pay management/administrative fees in return for a higher return on their operating fleet. Although OSG details which vessels are operating in commercial pools, they leave the majority of the disclosure up to the commercial pools themselves. The pools don t report how much they charge for management fees, nor does OSG present Page 71

73 what kind of revenue these ships can generate if they were employed independently. Additionally, OSG doesn t discuss how many revenue days are derived from commercial pools. This disclosure would aid the calculation of revenue per revenue day. As discussed earlier, revenue days are calculated indiscriminate to the type of vessel being operated. Discussion of relative revenue days and the management/administrative fees would aid investors in determining the competitive advantage afforded through participation in commercial pools. Lower Input Costs Obtaining lower input costs is a key success factor in an industry characterized by cost leadership. In the context of the energy shipping industry, lower input costs best relates to the acquisition of the operating fleet. As discussed earlier, OSG employs operating leases for 53(fy2008) of its vessels, necessitating the calculation of the costs of these operating leases relative to the vessels obtained. OSG doesn t disclose the price per year of an operating lease on a single vessel, but instead, chooses to only disclose the total amount paid for operating leases in that year. Additionally, OSG discloses the revenue days and expiry of all vessels allowing the investor to determine this is information in a dubious manner. As presented, there is no method to determine if the current years lease expenses are related to future vessels, additional current vessels or a sale-and-leaseback transaction. Therefore, it is very difficult to forecast future lease obligations beyond the minimum lease payments provided, but more so, it is difficult to determine if OSG is benefiting from the use of operating leases. Additional detail is needed to determine if the choice of operating leases opposed to capital leases or outright purchases is beneficial in participating in the spot market while rates are high and limiting their capacity when rates are low. Their disclosure of expiry dates relates to the latter, but actual costs of operating lease contracts related to the specific vessels employed and their participation in spot and charter out markets would be very relevant and useful. Page 72

74 Type 2 Key Accounting Policies Operating Leases Previously we evaluated the degree of conservatism or aggressiveness in reporting financial statements. In regard to operating and capital leases, significant amount details are needed to calculate the restated depreciation expenses for the life of the asset, interest expense and discount rates. For this analysis, examining the quality of disclosure relating to operating and capital leases clarifies the nature of future contractual obligations. Overseas shipping group employs a significant amount of operating leases relative to their capital leases. Since 2003, the company has increased their number of chartered in vessels from 7.1 (ownership weighted) to 53 in The company provides revenue days as well as operating days relative to the future operating lease obligations. Operating days simply reflect the sum of the future calendar days the ship is expected to be operational. Revenue days represent operating days minus time in dry docking, repair and layup, weighted to reflect ownership. In addition, OSG discloses the expiry dates of operating leases (charter-ins) on every vessel they operate, as well as percentage ownership of the vessels under capital leases. Opposed to their competitors, OSG discloses information related to their new build program, their subsidiaries fleet and the date certain vessels will be banned for the lack of double hull construction or special coating for environmental purposes. Although we applaud OSG for their levels of supplementary disclosure, there are several items in which we would like more clarification. First, operating lease obligations rise year over year (since 2003), however their minimum net lease obligations don t reflect the future expansion of their fleet. Additionally, the degree to which the company is expected to charter-out future vessels impacts their exposure to overcapacity if shipping rates decline to unprofitable levels. Most significantly, the lack of disclosure relating to the nature of the sale-and-leaseback transactions is of high concern. Commonly, operating leases on vessels involve provisions to extend the life of Page 73

75 the contract at a specified rate, or simply an option to purchase the vessel outright. This limitation inhibits the transparency of the available information like operating days and expiry dates of operating lease contracts to determine the intent of the company. Simply, the current payments and supplementary disclosures may conceal the company s strategy to extend, cancel or charter out future vessels under operating leases. In conclusion, OSGs quality of disclosure could be considered mixed, moderate or slightly better than the majority of energy shipping terms. The firm goes beyond what similar companies disclose, however, their voluntary disclosure raises new concerns on the details of contractual obligations. Goodwill On an absolute basis, the quality of disclosing goodwill in Overseas Shipholding s financial statements is fair. Furthermore, OSG s disclosure of goodwill is above average when compared to its close competitors. Teekay is OSG s only competitor that acknowledges goodwill. This determines that OSG and Teekay are the only firms that acquire subsidiaries at a premium cost. The information provided by OSG is considered to add transparency to the financial statements. This transparency is derived from the company s reporting of goodwill, which effectively aids in the analysis of the company. Compared to the rest of the industry, an investor would look highly on reported rather than unreported goodwill. The investor would see that the company is making an attempt to expand by acquiring new subsidiaries within the past two years. This evidence supports our determination that OSG is fair with regard to disclosure of goodwill. Hedging Activities As stated in Hedging Activities section under the Key Accounting Policies, firms within the energy shipping industry can be greatly affected by fluctuating rates. The Page 74

76 firms engage in extended contracts that could be affected by changing rates and therefore cause a firm to lose money. They also engage in shipping overseas which can cause transactions to be heavily influenced by foreign exchange rates. The hedging activities executed by firms reduce risk and give an advantage in a cost leadership industry. The information disclosed in Overseas Shipholding Group s 10-K regarding its hedging activities is adequate. OSG discloses exactly what types of items are hedged and the reasons why it is thought to be necessary to do so. Under their Risk Management section, the company provides a clear answer to what activities require hedging. Initially the firm indicates its engagement in interest rate swaps which are an agreement to exchange various combinations of fixed and variable interest rates based on agreed upon notional amounts. After they discuss interest rate swaps, they disclose information on implementation of Forward Freight Agreements. OSG states that by using these agreements, it manages the financial risk associated with fluctuating market conditions. OSG declared that in 2007 their FFA agreements had a fair value of nearly $6,500,000. OSG recorded this amount as a liability. The last hedging activity disclosed in OSG s 10-K is related to foreign exchange rates. In order to avoid any fluctuations in these rates, OSG uses a functional currency of U.S. dollars and says that its revenues and costs are accounted for in this currency. Overseas Shipholding Goup has all of its hedging activities accounted for in its 10-K. Although some of the fair values determined for assets and liabilities can be affected by biases as discussed earlier, OSG does not leave much in question. The description and rationale of activities performed is clearly outlined. When comparing OSG s 10-K to that of top competitors, it becomes clear that this is the standard amount of disclosure for firms in the energy shipping industry. Benefits and Pension Plan The qualitative disclosure on postretirement benefits for OSG is high relative to other companies in the energy shipping industry. Close competitors to OSG do not Page 75

77 disclose any information about postretirement benefits or pension plans. OSG discloses almost every facet regarding the determination of postretirement costs to the firm. The transparency of these accounting numbers is better than OSG s close competitors and is, therefore, considered fairly transparent. Since OSG does not provide the equation for determining growth rates of postretirement benefits, its analysis of future costs for medical plans and other benefits is somewhat indeterminate. Overall the transparency of the financial statements with regard to postretirement benefits is reasonable. Quality of Disclosure: Quantitative Analysis Quantitative analysis is imperative when evaluating and understanding a company s financial statements. Analysts use many different ratios to obtain real world numbers from a company s accounting statements. These ratios are used to analyze accounting quality and disclosure within the industry. Ratios are useful in exposing possible distortions and, thus, lead to a more accurate view of the company. These ratios by themselves, however, are not the final answer in analyzing the valuation of a company. When used in conjunction with one another, ratios can depict certain trends not previously apparent. Sales Manipulation Diagnostics The sales manipulation diagnostics are used to analyze the financial data of a firm and to determine if there are any abnormalities that might be caused by distortions in the way firms report revenue related accounting numbers. Firms may want to manipulate its sales numbers to either understate or overstate its net income for a given year. Essentially, we will be assessing the credibility of the sales reported. Data from the last seven years will be used to calculate ratios for Overseas Shipholding Group and three other competitors in the energy shipping industry. In the end, we will determine if there are any potential red flags that show up from possible manipulation Page 76

78 of financial information or improper discloser. Since there is no unearned revenue, inventory, or warranty liability in this industry, we will look closer at revenues and how it compares to cash from sales and accounts receivable. The tables that were used to create the following graphs can be found in Appendix A. Net Sales/Cash from Sales The net sales over cash from sales ratio is used to view the revenues that a firm is earning and the amount the company is currently making from transactions as opposed to receiving payment at a later date. The net sales to cash from sales ratio essentially reveals if a firm s sales are supported by the amount of cash collected. This ratio should be close to 1:1 and stay consistent over time. A firm with an increase in sales should experience an increase in the cash collected from total sales. There could be a potential red flag if a there is high variability in this ratio because it might mean that a firm is recognizing too much or not enough sale during a given period. Net Sales/Cash from Sales (raw) OSG Frontline Teekay Tsakos Net Sales/ Cash from Sales (change) OSG Frontline Teekay Tsakos Page 77

79 Since 2005, OSG has had consistent net sales to cash from sales ratio close to 1:1. This suggests that the revenues that OSG reports in its 10-K are supported by the cash collected. The firms in this industry increase and decrease together from year to year which means there is structural movement in the energy shipping industry. The change graph also does not suggest any red flags or manipulation of sales. OSG has maintained a consistent positive change from year to year. There is no concern when the value of a change graph is greater than zero. Net Sales/Accounts Receivable The net sales over accounts receivable ratio is used to access if the revenues that a firm is earning support the amounts that a firm reports that it expects to receive at a later date from those sales. There should be a positive correlation in these graphs. If the revenues of a firm increase, it is expected that the accounts receivable would also increase. A firm that has abnormal net sales to accounts receivable ratio for a given year would raise a concern that they may be overstating sales for the purpose of overstating net income. Cases such as this would result in a potential red flag Net Sales/ Accounts Recievable (Raw) OSG Frontline Teekay Tsakos Page 78

80 (20.00) (40.00) (60.00) (80.00) Net Sales/ Accounts Receivable (change) OSG Frontline Teekay According to the raw and change form graphs above, OSGs sales are supported by the account receivable. Although lower than the rest of the energy shipping industry, the ratio has remained stable over the last seven year. After analyzing the change form graph, the same is true except for a positive increase between 2007 and A positive value is a good sign and is expected, so OSG does not raise any red flags for this section of the diagnostic test. Conclusion Overall, no potential red flags were found when assessing the credibility of the revenues that OSG reports. These diagnostics do not raise concerns that OSG manipulates its sales for the purpose of increasing or decreasing net income during a given year. Page 79

81 Sales Manipulation Diagnostics OSG Sales/Cash from Sales (raw) Sales/Cash from Sales (change) Sales/Account Receivables (raw) Sales/Account Receivables (change) Sales/Inventory N/A N/A N/A N/A N/A N/A N/A Sales/Unearned Revenue N/A N/A N/A N/A N/A N/A N/A Frontline Sales/Cash from Sales (raw) N/A Sales/Cash from Sales (change) N/A Sales/Account Receivables (raw) N/A Sales/Account Receivables (change) N/A Sales/Inventory N/A N/A N/A N/A N/A N/A N/A Sales/Unearned Revenue N/A N/A N/A N/A N/A N/A N/A Teekay Sales/Cash from Sales (raw) N/A Sales/Cash from Sales (change) N/A Sales/Account Receivables (raw) N/A Sales/Account Receivables (change) N/A Sales/Inventory N/A N/A N/A N/A N/A N/A N/A Sales/Unearned Revenue N/A N/A N/A N/A N/A N/A N/A Tsakos Sales/Cash from Sales (raw) N/A Sales/Cash from Sales (change) N/A Sales/Account Receivables (raw) N/A Sales/Account Receivables (change) N/A Sales/Inventory N/A N/A N/A N/A N/A N/A N/A Sales/Unearned Revenue N/A N/A N/A N/A N/A N/A N/A Page 80

82 Expense Manipulation Diagnostics The expense manipulation diagnostics are used to see if there are any distortions in the accounting information provided that companies might have manipulated to either seem more profitable now or in the future. For example, a firm could understate interest expenses for the purpose of overstating net income during a given year. The purpose of this would be to seem more profitable in the following year or to decrease the current tax burden. Information will be used from Overseas Shipholding Group s past seven financial statements to see how their ratios compare with other firms in the energy shipping industry. If any irregularities are found, we will determine if they are potential red flags. The tables that were used to create the following graphs can be found in Appendix A. Asset Turnover Asset turnover is defined as sales of the current year divided by the assets of the previous year. This measure is useful in identifying outlying years when an abnormal amount of sales are generated by a given amount of assets, or vice versa. Additionally, the metric helps identify a firm s capital requirements to support future growth in sales. Simply put, a certain amount of capital must be put at risk to generate the next year s sales. Asset Turnover OSG Frontline Teekay Tsakos Page 81

83 2.00 (2.00) (4.00) (6.00) (8.00) Asset Turnover (change) OSG Frontline Teekay Tsakos Business firms that have inconsistent revenues, or variable pricing, tend to have very inconsistent asset turnovers. Conversely, firms that have stable pricing tend to have much more stable asset turnover ratios because there is a direct relationship between increasing capacity and increasing sales. For the energy shipping industry, asset turnovers are highly variable because rates for energy shipping services are highly variable to say the least. It s not uncommon to have a five-fold increase or decrease in shipping rates in a single year. Therefore, examining asset turnover without consideration to shipping rates is misleading in understanding the relationship to adding capacity, and receiving proportional higher total revenues. In order to negate the industry wide effects of changing rates, it is relevant to examine the yearly change in asset turnover across an industry. If a firm is experiencing the opposite change as their peers, several things may be occurring. First, the firm may be operating in a fundamentally different environment and thus subject to different shipping rates (product vs. oil/u.s. Flag vs. International). Secondly, a firm may be recording assets that are not yet cash flow-producing, like taking delivery of a ship that hasn t been deployed yet. Thirdly, a firm may be changing their fundamental business model and engaging in a non-related industry. Finally, the firm may be inaccurately characterizing their expenses and recording higher or lower sales with the same amount of assets. Page 82

84 CFFO/OI CFFO/OI (raw) OSG Frontline Teekay Tsakos CFFO/OI (change) OSG Frontline Teekay Tsakos The CFFO/OI ratio is another ratio used to test for potential expense manipulation by analyzing if the cash flows from operations are supported by the operating income. There is no concern if a firm s ratio remains consistent over a long period of time, in this case seven years. The raw graph above, which includes OSG and its competitors, illustrates that there has not been very much variation in CFFO/OI in this industry. Since there are no major changes over the years, it can be concluded that OSG s cash flows from operations support the operating income that is stated on its income statements. In the change form of the expense diagnostics, a value that is less than zero would be a reason for concern. OSG remained positive for the entire seven years after looking at the change form graph. Page 83

85 CFFO/NOA The CFFO/NOA ratio is another ratio used to test for potential expense manipulation by analyzing if the cash flows from operations are supported by the net operating assets. Net operating assets include property, plant, and equipment minus the accumulated depreciation. In the energy shipping industry, net operating assets would mostly account for all the vessels that the firms use for transportation CFFO/NOA (raw) OSG Frontline Teekay Tsakos CFFO/NOA (change) OSG Frontline Teekay Tsakos The raw form graph indicates that are significant structural movements in this industry. In most cases, if a firm has considerable increases in this ratio followed by decreases it would indicate a potential red flag and possible manipulation of expenses. Since every company in this industry follows this trend, there are no reasons for concern when analyzing OSG. There is a potential for a red flag when looking at the Page 84

86 change form graph. Since 2006, the change form CFFO/NOA falls below zero and into the negatives which suggests that there is a concern that expense manipulation could have occurred. Total accruals/change in sales (0.50) (1.00) Total Accurals/Δsales OSG Frontline Teekay Tsakos The total accruals to change in sales ratio is the final diagnostic ratio used find the purpose of finding any expense manipulations on the financial statements. Basically, this ratio is used to see if a firm s total accruals are supported by the change in sales. Accruals can be simply calculated by taking cash flows from operations of a given year and subtracting the operating income of the same year. There are significant structural movements when analyzing this ratio for the industry as a whole. The variation in this ratio between 2005 and 2007 would in most cases signal a potential red flag but since the competitors of OSG also follow this trend no manipulation will be assumed. Conclusion When assessing the credibility of the expenses that OSG reports, a few potential red flags were found from analyzing the graphs and information. The change form graphs for asset turnover and CFFO/NOA fell below zero which raised concern for potential manipulation of its expenses. This could have occurred for the purpose of increasing or decreasing net income during a given year. Overall, there was more concern that OSG possibility manipulated its expenses when compared to its revenue. Page 85

87 Expense Manipulation Diagnostics OSG Asset Turnover Asset Turnover (change) CFFO/OI (Raw) CFFO/OI (Change) CFFO/NOA (Raw) CFFO/NOA (Change) Total Accruals/ Sales Frontline Asset Turnover N/A Asset Turnover (change) N/A CFFO/OI (Raw) N/A CFFO/OI (Change) N/A CFFO/NOA (Raw) N/A CFFO/NOA (Change) N/A Total Accruals/ Sales N/A Teekay Asset Turnover N/A Asset Turnover (change) N/A CFFO/OI (Raw) N/A CFFO/OI (Change) N/A CFFO/NOA (Raw) N/A CFFO/NOA (Change) N/A Total Accruals/ Sales N/A Tsakos Asset Turnover N/A Asset Turnover (change) N/A CFFO/OI (Raw) N/A CFFO/OI (Change) N/A CFFO/NOA (Raw) N/A CFFO/NOA (Change) N/A Total Accruals/ Sales N/A Page 86

88 Potential Red Flags Red Flags suggest that the analyst should examine certain items more closely or gather more information on them (Palepu & Healy). When reviewing a company s accounting quality, analysts should consider some common red flags such as unexplained changes in accounting that could be used to inaccurately portray a company s financial success, and an increasing gap between reported income and cash flow from operating activities, which would normally have a steady relationship. Although these red flags are a great guideline for an initial evaluation, they each have many interpretations and should not be used as an end point. Operating leases are considered a red flag for Overseas Shipholding Group. Operating leases are like renting ships, with an average life of 20 years and make the company seem less capital-intense. Therefore, implementing operating leases allows the company to conceal the actual amount of liabilities reported. Because the present value of operating leases grossly exceeded 10% of the long term debt, the income statement and balance sheet over the previous six years had to be entirely restated. Undo Accounting Distortions If the accounting analysis suggests that the firm s reported numbers are misleading, analysts should attempt to restate the reported numbers to reduce distortion (Palepu & Healy). Because analysts must rely on outside information, they will never be able to fully undo every distortion. The cash flow statement and financial statement footnotes, however, provide important information such as performance based on accrual and cash accounting that can assist in accurately re-valuing a company. The following tables represent OSG s Statement of Income from Operations and Balance Sheet respectively (OSG 10-K). Page 87

89 OSG Income Statement (Raw) Dollars in thousands at December Revenues Voyage charter revenues 53,429 83, , , ,777 Time and bareboat charter revenues 116, , , , ,629 Pool Revenues 640, , , , ,291 Total Revenues 810,835 1,000,303 1,047,403 1,129,305 1,704,697 Voyage Expenses (COGS) (21,254) (38,641) (54,586) (90,094) (159,312) Gross Profit 789, , ,817 1,039,211 1,545,385 Ship Operating Expenses: Vessel expenses 108, , , , ,553 Time and bareboat charter hire expenses 65, , , , ,808 Depreciation and Amortization 100, , , , ,163 General and Administrative 51,993 79,667 99, , ,063 Goodwill Impairment Charges 62,874 Loss/(Gain) on Sale of Vessels (39,007) (7,134) 59,738 Total Ship Operating Expenses 325, , , ,639 1,200,199 Income from Vessel Operations 463, , , , ,186 Equity in Income of Joint Ventures 45,599 43,807 22,474 8,876 12,292 Operating Income 509, , , , ,478 Other Income/(Expense) 45,781 77,367 52,107 75,434 (28,847) Net Earnings Before Interest and Taxes 555, , , , ,631 Interest Expense 74,146 89,489 (68,652) (74,696) (57,449) Change in Accounting Principle and Minority Interest 384, , ,182 Provision/(Credit) for Federal Income Taxes 79,778 (1,110) 8,187 (4,827) 34,004 Minority Interest (1,049) 12,479 Net Income 401, , , , ,665 Cash Dividends Paid (27,532) (27,615) (36,576) (38,038) (44,856) Addition to Retained Earnings 373, , , , ,809 Page 88

90 OSG Income Statement (Restated) Dollars in thousands at December Revenues Voyage charter revenues 53,429 83, , , ,777 Time and bareboat charter revenues 116, , , , ,629 Pool Revenues 640, , , , ,291 Total Revenues 810,835 1,000,303 1,047,403 1,129,305 1,704,697 Voyage Expenses (COGS) (21,254) (38,641) (54,586) (90,094) (159,312) Gross Profit 789, , ,817 1,039,211 1,545,385 Ship Operating Expenses: Vessel expenses 108, , , , ,553 Operating leases payments newly capitalized 24,537 48, , , ,914 Depreciation and Amortization 100, , , , ,163 General and Administrative 51,993 79,667 99, , ,063 Goodwill Impairment Charges 62,874 Loss/(Gain) on Sale of Vessels (39,007) (7,134) 59,738 Total Ship Operating Expenses 284, , , ,006 1,084,305 Income from Vessel Operations 504, , , , ,080 Equity in Income of Joint Ventures 45,599 43,807 22,474 8,876 12,292 Operating Income 550, , , , ,372 Other Income/(Expense) 45,781 77,367 52,107 75,434 (28,847) Net Earnings Before Interest and Taxes 596, , , , ,525 Interest Expense 74,146 89,489 68,652 74,696 57,449 Change in Accounting Principle and Minority Interest 522, , , , ,076 Provision/(Credit) for Federal Income Taxes 79,778 (1,110) (8,187) 4,827 (34,004) Minority Interest (1,049) 12,479 Net Income 442, , , , ,559 Cash Dividends paid (27,532) (27,615) (36,576) (38,038) (44,856) Addition to Retained Earnings 414, , , , ,703 Page 89

91 OSG Balance Sheet (Raw) Dollars in thousands at December Assets Cash and cash equivalents 479, , , , ,609 Voyage receivables 144, , , , ,500 Other receivables 12,815 22,202 71,723 84,627 64,773 Inventories 1,132 1,855 7,002 9,195 6,627 Prepaid expenses 8,252 14,908 23,995 28,105 43,780 Total Current Assets 645, , , , ,289 Capital Construction Fund 268, , , ,174 48,681 Vessels (At Cost) 1,422,239 2,288,481 2,501,846 2,691,005 2,683,147 Vessels under Capital Leases 24,382 36,267 30,750 24,399 1,101 Deferred Drydock expenditures 19,805 50,774 81,619 79,837 Vessel Held for Sale 9,744 53,975 Investments in Joint Ventures 227, , , ,905 98,620 Other Assets 82,701 53,457 53,762 87, ,237 Goodwill 64,293 72,463 9,589 Intangible Assets 92, , ,585 Total Non-Current Assets 2,035,181 2,963,793 3,385,148 3,354,164 3,211,772 Total Assets 2,680,798 3,348,680 4,230,669 4,158,917 3,890,061 Liabilities Accounts payable 3, , , , ,615 Sundry liabilities and accrued expenses 76,087 Federal income taxes 90,943 Short-term debt and current installments of long-term debt 25,024 20,066 27,426 26,058 26,231 Current obligations under capital leases 4,729 6,968 7,650 8,406 1,092 Total Current Liabilities 200, , , , ,938 Long-term Debt 863, ,612 1,273,053 1,506,396 1,396,135 Obligations under Capital Leases 42,717 42,043 33,894 24,938 Deferred Federal Income Taxes 141, , ,711 Deferred Credits and Other Liabilities 147, , , , ,355 Minority Interest 132, ,766 Total Non-Currrent Liabilities 1,053,683 1,340,445 1,795,782 2,127,591 1,972,256 Total Liabilities 1,254,426 1,472,652 2,023,358 2,340,892 2,167,194 Common stock 40,791 40,791 40,791 40,791 40,791 Paid-in additional capital 199, , , , ,522 Retained earnings 1,203,528 1,640,742 1,996,826 2,170,098 2,442,907 Stockholders' Equity 1,442,013 1,881,103 2,240,329 2,419,706 2,708,220 Cost of Treasury Stock (17,579) (17,019) (34,522) (583,708) (838,994) Accumulated other comprehensive income/(loss) 1,938 11,944 1,504 (17,973) (146,359) Total Shareholders' Equity 1,426,372 1,876,028 2,207,311 1,818,025 1,722,867 Total Liabilities and Shareholders' Equity 2,680,798 3,348,680 4,230,669 4,158,917 3,890,061 Page 90

92 OSG Balance Sheet (Restated) Dollars in thousands at December Assets Cash and cash equivalents 479, , , , ,609 Voyage receivables 144, , , , ,500 Other receivables 12,815 22,202 71,723 84,627 64,773 Inventories 1,132 1,855 7,002 9,195 6,627 Prepaid expenses 8,252 14,908 23,995 28,105 43,780 Total Current Assets 645, , , , ,289 Capital Construction Fund 268, , , ,174 48,681 Vessels (At Cost) 1,422,239 2,288,481 2,501,846 2,691,005 2,683,147 Vessels Under Capital Leases 24,382 36,267 30,750 24,399 1,101 Vessels Under Operating Leases, Newly Capitalized 222,364 1,207,297 1,584,651 1,924,540 2,032,783 Deferred Drydock Expenditures 19,805 50,774 81,619 79,837 Vessel Held for Sale 9,744 53,975 Investments in Joint Ventures 227, , , ,905 98,620 Other Assets 82,701 53,457 53,762 87, ,237 Goodwill 64,293 72,463 9,589 Intangible Assets 92, , ,585 Total Non-Current Assets 2,257,545 4,170,690 4,969,799 5,278,704 5,244,555 Total Assets 2,903,162 4,555,577 5,815,320 6,083,457 5,922,844 Liabilities Accounts payable 3, , , , ,615 Sundry liabilities and accrued expenses 76,087 Federal income taxes 90,943 Short-term debt and current installments of long-term debt 25,024 20,066 27,426 26,058 26,231 Current obligations under capital leases 4,729 6,968 7,650 8,406 1,092 Total Current Liabilities 200, , , , ,938 Long-term Debt 863, ,612 1,273,053 1,506,396 1,396,135 Obligations under Capital Leases 42,717 42,043 33,894 24,938 Obligations under Operating Leases 222,364 1,207,297 1,584,651 1,924,540 2,032,783 Deferred Federal Income Taxes 141, , ,711 Deferred Credits and Other Liabilities 147, , , , ,355 Minority Interest 132, ,766 Plug for Liabilities 161,910 31, , ,273 (190,802) Total Non-Current Liabilities 1,237,215 2,438,192 3,283,158 3,977,223 3,814,236 Total Liabilities 1,437,958 2,570,399 3,510,734 4,190,524 4,009,174 Common stock 40,791 40,791 40,791 40,791 40,791 Paid-in additional capital 199, , , , ,522 Retained earnings 1,241,001 1,749,892 2,094,101 2,245,006 2,633,709 Stockholders' Equity 1,480,846 1,990,253 2,337,604 2,494,614 2,899,022 Cost of treasury stock (17,579) (17,019) (34,522) (583,708) (838,994) Accumulated other comprehensive income/(loss) 1,938 11,944 1,504 (17,973) (146,359) Total Shareholders' Equity 1,465,205 1,985,178 2,304,586 1,892,933 1,913,669 Total Liabilities and Shareholders' Equity 2,903,162 4,555,577 5,815,320 6,083,457 5,922,844 Page 91

93 OSG Cash Flow (Raw) Net Income 401, , , , ,665 Sales 810,835 1,000,303 1,047,403 1,129,305 1,704,697 Operating Income 509, , , , ,478 CFFO/Sales CFFO/Net Income CFFO/Operating Income CFFO 396, , , , ,677 CFFI (191,175) 45,259 (256,702) (34,895) (77,022) CFFF 199,528 (787,898) 228,897 (237,067) (448,466) OSG Cash Flow (Restated) Net Income 442, , , , ,559 Sales 810,835 1,000,303 1,047,403 1,129,305 1,704,697 Operating Income 550, , , , ,372 CFFO/Sales CFFO/Net Income CFFO/Operating Income CFFO 437, , , , ,571 CFFI 268,289 (37,181) 8,202,194 (6,730,002) (1,710,510) CFFF (787898) (237067) (448466) Page 92

94 Restating Distortions in Financial Statements The purpose of capitalizing the operating lease payments is to accurately reflect the right to use a vessel for an extended length of time. Similarly, the obligation to pay future operating lease payments must be accurately reflected in the liabilities section of the restated balance sheet. The method we employed involves the amortization future minimum lease obligations using a 5.2% discount rate (see appendix B) and recording the carrying value as an equally as an asset and a liability. Additionally, we substituted the operating lease payments on the income statement (starting in 2002) and replaced them with interest expense (carrying value X 5.2%) and depreciation expense [carrying value / (Total remaining revenue days/ average yearly revenue days)]. This process is essentially revenue neutral and reschedules expenses to reflect the nature of the longterm liability and asset. The net effect is a larger asset and liability account as well as higher net income in the short-run and lower net income in later years. Page 93

95 Financial Analysis, Forecast Financials, and Cost of Capital Estimation In order to fairly evaluate a company, an analyst must analyze ratios, forecast financial statements, and determine the cost of capital of the entire company. Calculating ratios is one of the most efficient ways to compare the company to other companies within the industry. These ratios also play a big role in forecasting Overseas Shipholding Group s financial statements. We will be using 6 years of past data from OSG s financial statements to forecast financials for the next 10 years. Lastly, we will calculate the cost of capital using standard formulas to further our evaluation of OSG. Financial Analysis Investors, analysts and creditors rely on financial statements when comparing a company with competitors in their industry. Financial ratios are most commonly used to produce smaller and more easily comparable numbers across the industry. These ratios assist in evaluating a firm along with its competitors and the industry as a whole. Financial ratios measure the profitability, liquidity, and capital structure of firms. The numbers computed by using these ratios can assist analysts in forecasting and comparing data over a large span of time. These ratios provide a straightforward way to compare Overseas Shipholding Group s overall financial worth to its competitors and industry. Liquidity Ratio Analysis Liquidity is the ability to convert an asset to cash in a short amount of time with either no difference or a slight difference in the value of the asset. It is important for a firm to possess enough liquid assets so that they will be able to account for any shortterm obligations that may arise. Investors use liquidity ratios when evaluating Page 94

96 companies to help determine whether or not they will have the ability to pay off their short-term debt obligations. If analysts discover that a company has high values for their liquidity ratios, it illustrates that the company has a large margin of safety when accounting for their short-term debts. The liquidity ratios we will discuss include the current ratio, the quick asset ratio, accounts receivable turnover ratio, days sales outstanding ratio, and the working capital turnover ratio. Many industries also include the inventory turnover ratio and the days supply inventory ratio, but in the energy shipping industry no inventory is held. Current Ratio The current ratio is a measure of a firm s ability to pay back its short-term liabilities with its short-term assets. It is calculated by dividing a firm s current assets by its current liabilities. In order to indicate that a firm has enough current assets to cover its short-term obligations, this ratio should be higher than 1. A ratio less than 1 illustrates that at the point in time when the ratio was calculated, the firm would not be capable of paying off its obligations. Having a ratio under 1 shows the poor financial health of a firm, but does not necessarily mean that the firm will go bankrupt because there are many other ways to access financing. (Investopedia) Current Ratio OSG OSG restated Frontline Teekay Tsakos Industry Avg. Page 95

97 OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a As illustrated in the graph and table above, from 2005 to 2006, OSG reached a high value of over 3.5 and was able to maintain it over the last three years. This value is notably larger than its top competitors on this scale. Although OSG does maintain a significantly larger current ratio than its competitors, all have been able to sustain a ratio higher than 1. Due to the fact that Teekay was the only energy shipping firm that fell to a ratio below 1 in 2006, and because it was by such a small margin, we can conclude that this energy shipping industry posses the ability to cover their short-term obligations. However, because OSG has produced a current ratio above the industry average since 2004 they would be able to cover nearly twice as much short-term debt as their top competitors. These facts make OSG the safest investment based on current ratios. Quick Asset Ratio The quick asset ratio is very similar to the current ratio. The only difference in the quick asset ratio is that only the most liquid assets are included in the value of the current assets. To calculate this ratio add cash, cash equivalents, marketable securities, accounts receivable, and then divide that amount by the firm s current liabilities. Since some current assets can be more difficult to liquidate, and may even be worth a different amount then the books represent, the quick asset ratio is a good indicator of Page 96

98 the most liquid assets being able to cover the firm s short-term liabilities. The value for this ratio should be 1 or higher, similar to the current ratio. If it is greater than 1 then the firm will be able to cover their short-term debt with their most liquid assets, while a ratio less than 1 implies they cannot. Quick Asset Ratio OSG OSG restated Frontline Teekay Tsakos Industry Avg OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a The graph and table for the quick asset ratio reiterates the good standing of OSG s liquidity. Their quick asset ratio is significantly higher than any of their top competitors, which is a great advantage for their industry. This shows that OSG would be much more capable of covering their short-term debts by using only their most liquid assets. When compared to Frontline s ratio, which has been below 1 for the last 6 Page 97

99 years, and Teekay s ratio, which has fallen beneath 1 over the last 3 years, OSG has outstanding financial health in this area. When considering the quick asset ratio, OSG would be considered the soundest investment. Accounts Receivable Turnover A common way for a firm to obtain revenue is to perform a service for their customer based on the customer s promise of a future payment. After the agreement is made and the service is rendered to the customer, the revenue earned by the firm is known as accounts receivable. The accounts receivable turnover is a calculation that measures how efficiently a company is extending credit to its customers as well as collecting its customer s debts. A high accounts receivable turnover implies that a firm is able to recover its outstanding receivables in a timely manner. A low rate indicates that it takes the firm a prolonged amount of time to collect its customer s debt, which shows that the firm is remaining in debt for an extended period of time. This ratio is calculated by dividing the firm s total net sales by its accounts receivable Accounts Receivable Turnover OSG OSG restated Teekay Frontline Tsakos Industry Avg. Page 98

100 OSG OSG restated Teekay n/a Frontline n/a Tsakos n/a Industry Avg n/a As seen in the graph and table above, OSG has a much consistently lower accounts receivable turnover than the rest of the industry. This proves that it takes OSG a greater amount of time to collect on their customer s outstanding receivables than their top competitors. However, because the turnover rate has stayed relatively consistent for OSG over the last 6 years there should be no major concern. The steady rate indicates that OSG will still collect on their outstanding receivables, even if it takes a much longer period of time than the industry average. Though this fact remains, they are still at a great disadvantage when compared to their competitors. Investors are much more confident in firms who can quickly realize their accounts receivable. Days Sales Outstanding The days sales outstanding ratio is used to indicate the amount of time it takes a firm to collect its outstanding accounts receivable. By dividing the number of days in a year by a firm s accounts receivable turnover, we are able come up with a more accurate measure of exactly how many days it takes a firm to collect its customer s debt. The higher the ratio the longer it takes a firm to collect its short-term debt. It is better for a firm to have a lower days sales outstanding ratio to prove they can quickly collect accounts receivable and in turn possess more of their assets. Page 99

101 Days Sales Outstanding OSG OSG restated Frontline Teekay Tsakos Industry Avg OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a As indicated by the graph and table above, OSG has a much higher days sales outstanding ratio than the rest of their top competitors. Since this ratio is directly related to the accounts receivable turnover ratio, the information depicted in this graph falls in line with what was previously determined. When compared to the industry as a whole, OSG takes a significantly longer amount of time to collect on their outstanding accounts receivable. If OSG, who has averaged nearly 70 days to collect their outstanding accounts receivables the last 6 years, were taken out of the industry, the total average would drastically lower to 30 days sales outstanding. This means that OSG has accounts receivable for specific customers for nearly 40 days longer than their Page 100

102 competitors do. Its takes over twice as much time for OSG to collect cash as the industry average. This is a drastic difference in the amount of time it takes OSG to obtain their accounts receivable. Since OSG takes so much more time to collect their receivables, they have a significantly larger portion of assets held in the accounts receivable section of their balance sheet. This is not a sign of financial strength for OSG and could be a concern for potential investors. Working Capital Turnover The working capital turnover ratio is used to analyze the relationship between the money used to fund operations and the sales generated from these operations. (Investopedia) The working capital of a firm is found by subtracting the firm s current assets by their current liabilities. The amount found by performing this equation is typically what the firm will use to fund operations and purchase inventory. In order to find the working capital turnover ratio, a firm will divide its net sales by its working capital. The higher the working capital turnover ratio, the better off a firm is because it will be generating more revenue from sales then the amount of expenses they are using to fund the sales Working Capital Turnover OSG OSG restated Frontline Teekay Tsakos Industry Avg. Page 101

103 OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a In order to keep the graph relatively simple, we omitted Teekay s working capital turnover because they are inconsistent, with numbers much lower and higher than the industry average. From 2004 to the present, one can see that OSG s numbers, and the numbers of the other two competitors, have remained relatively consistent by keeping their working capital turnover between the 2:1 and 4:1. Although OSG possessed the lowest working capital turnover in the industry in 2006 and 2007, we can see that it s climbing back up in Since we do not have any of their competitor s numbers for 2008 this information is not much help. We can only conclude from the data that the industry as a whole is relatively consistent and no one firm is at a great advantage in this area. Conclusion Now that we have calculated all of the various liquidity ratios for OSG and its top competitors in the energy shipping industry, we can accurately compare the level of liquidity each firm possesses. We concluded from the current ratio that OSG is the most capable of all the firms to cover its short-term debt obligations. The same information was derived from the quick asset ratio for OSG. They are the most competent firm in the industry when it comes to maintaining a high level of liquid assets on their balance sheet. These two ratios show that OSG is significantly healthier financially when judging Page 102

104 by the liquidity of current assets. This gives OSG a significant advantage over their competition in the liquidity analysis as a whole. When we analyzed the accounts receivable turnover ratio and days sales outstanding ratio for the industry, we concluded that OSG has a much more difficult time collecting its outstanding receivables compared to their competitors. This puts a great deal of pressure on their liquidity analysis since it is such a substantial difference from the industry as a whole. Finally, when we determined the working capital turnover for the industry we found the OSG and its top competitors all maintain a relatively similar ratio. An additional fact that can be concluded from the overall liquidity analysis the irrelevance of the cash to cash cycle. The cash to cash cycle is the summation of days sales outstanding and days supply inventory. Since inventory is not relevant to OSG, their days supply inventory in nonexistent. Since OSG does not possess a days supply inventory ratio, their cash to cash cycle cannot be calculated since only one component of the equation is employed. Ratio Performance Trend Current Ratio Outperforming Stable Quick Asset Ratio Outperforming Stable Accounts Receivable Turnover Underperforming Stable Days Sales Outstanding Underperforming Decreasing Working Capital Turnover Average Increasing Page 103

105 Profitability Ratio Analysis Profitability ratios allow us to analyze how effective a firm has been at generating revenues to create profit during a given year. Investors use these ratios to evaluate if a firm s profits follow a positive and stable trend or if there are reasons to be concerned. Investors view consistent profitability as a sign of financial health. The most common ratios used for this analysis include gross profit margin, operating expense ratio, operating profit margin, net profit margin, asset turnover, return on assets (ROA), and return on equity (ROE). When comparing these ratios over a five year period and with industry competitors it is important to note that a high ratio is desirable in most situations. Gross Profit Margin Gross profit margin is calculated by dividing a firm s gross profit during a given year by the net sales for the same year. Gross profit is equal to revenues minus the cost of goods sold. In the energy shipping industry, commission and voyage expenses are subtracted from revenues to find the gross profit. A high margin indicates that a firm is making a profit from performing a service and managing the cost related to that service. Efficient firms consistently achieve high levels of gross profit margin Gross Profit Margin OSG OSG restated Frontline Teekay Tsakos industry average Page 104

106 OSG OSG-restated Frontline n/a Teekay n/a Tsakos n/a industry average n/a Since the energy shipping industry is a service industry, the voyages that the firms take part in will be considered their product. Voyage expenses include fuel, canal tolls, and port charges. In highly competitive industries such as this one, keeping product costs down is important to remain profitable and offer competitive rates. Overseas Shipholding Group has consistently had a gross profit margin above the entire industry over the past six years with an average of about 95%. OSG s high margin can be attributed to its ability to keep voyage expenses low relative to its competitors. The rest of the industry has also been stable over the same time period with averages under 85%. OSG s consistent high margin when compared to the industry is very desirable when evaluating profitability. Operating Expense Ratio The operating expense ratio is found by taking operating expenses and dividing by the net sales. In the energy shipping industry, operating expenses include vessels expenses, time and bareboat charter hire expenses, and general and administrative expenses. A low operating expense ratio is desirable because it indicates that a firm is efficiently controlling cost related to business operations, and ultimately less is taken away from gross profits. Page 105

107 Operating Expense Ratio OSG OSG restated Frontlilne Teekay Tsakos industry average OSG OSG-restated Frontline n/a Teekay n/a Tsakos n/a industry average n/a According to the graph and table above, OSG s operating expense ratio has been above the industry average for each of the past six years. In 2007, OSG had an operating expense ratio 30% higher than the industry average. One of the reasons for this is that OSG has a greater amount of charter hire expense relative to its competitors. Investors will look negatively on this ratio because it shows that OSG has too many operating expenses when compared to the rest of the industry, and it will decrease overall profitability. Although this is the case, the restated financial statements slightly improve this ratio. The restated operating expense ratio is consistently lower than the original and has a decreasing trend since Page 106

108 Operating Profit Margin The operating profit margin is found by dividing operating income by net sales. This is another measure of operating efficiency that is used to evaluate profitability. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt (Investopedia). It is desirable for a firm to achieve a high sustainable operating profit margin. Operating Profit Margin OSG OSG restated Frontline Teekay Tsakos industry average OSG OSG-restated Frontline n/a Teekay n/a Tsakos n/a industry average n/a According to the graph, OSG has followed the industry trend over the last five years. Although this is the case, since 2006 the operating profit margin has been below Page 107

109 the industry average and has been moving in the negative direction. This is not a positive sign when evaluating profitability. The significant decrease in the operating margin for OSG is a result of the increase in all operating expenses, especially a 250% increase in time and bareboat charter hire expenses between 2004 and Controlling charter hire expenses in future years will be beneficial for OSG to improve its operating expense ratio, operating profit margin, and ultimately increasing profitability. Also, OSG s restated financial statements do not impact operating profit margin. Net Profit Margin The net profit margin is found by dividing the net income by the net sales in a given year. This ratio measures the actual amount earned for every dollar of revenue. The higher the net profit margin, the better the firm is viewed by investors. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors (Investopedia) Net Profit Margin OSG OSG restated Frontline Teekay Tsakos industry average Page 108

110 OSG OSG-restated Frontline n/a Teekay n/a Tsakos n/a industry average n/a Overseas Shipholding Group has closely followed the industry trend over the past six years. Overall, the average for the industry has varied from about 20% to 50% during this time. This variation is due to the changes in net sales for every company in the energy shipping industry from year to year. Since 2006, OSG s margin has slipped below the industry average and could be a slight concern for investors. There is no affect on this ratio when considering restated financial statements. Asset Turnover Asset turnover, or asset productivity, is calculated by taking the sales of a given year and dividing that by the total assets of the previous year. This lag is necessary because the previous year s assets are used to generate revenue in the current year. A high ratio indicates that firms are efficiently using their assets to create income. Page 109

111 Asset Turnover OSG OSG restated Frontlilne Teekay Tsakos industry average OSG OSG-restated Frontline n/a Teekay n/a Tsakos n/a industry average n/a Since 2005, the energy shipping industry has been relatively stable when compared to previous years with averages between 30% and 35%. OSG maintained an asset turnover ratio slightly below the industry average until Although Overseas Shipholding Group is the only company to report their 2008 numbers at this point, it is a positive sign that it had a significant increase in productivity during that year. This significant increase in asset turnover can be attributed to 50% increase in revenue between 2007 and Page 110

112 The asset turnover of OSG using its restated financial statements is lower than the original turnover for OSG and the rest of the industry. This is due to the fact that there were more assets added after restating operating leases. It is a positive sign when analyzing profitability that there was an increase in this ratio since Return on Assets ROA gives an idea as to how efficient management is at using its assets to generate earnings (Investopedia). It is calculated by dividing a firm s net income in a given year by the total assets of the previous year. Alternatively, ROA can be measured by multiplying the firm s profit margin by the asset turnover. The lag is necessary because of the asset turnover portion of this equation. A high ROA is desirable for firms that want to remain profitable Return on Assets OSG OSG restated Frontlilne Teekay Tsakos industry average Page 111

113 OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a In the energy shipping industry, the industry average ROA has fluctuated between 5% and 20% over the past five years. OSG has remained consistent with a return on assets that closely matches the industry average on a yearly basis. In 2008, OSG experienced an increase in ROA which was caused by the increase in the asset turnover during the same year. Since the energy shipping industry has revenues that vary from year to year, ratios such as this one will be less stable when compared to other industries. For this reason, it is important for firms to have a ROA that is not consistently below the rest of the industry. When taking into account the restated financial statements for OSG, the ROA is consistently below the industry average and the original OSG ROA. This is caused by the increase in the amount of assets that were added because of operating leases. Return on Equity Return on equity is calculated by taking the net income in a given year and dividing that by the owner s equity of the previous year. ROE is a comprehensive indicator of a firm s performance because it provides an indication of how well managers are employing the funds invested by the firm s shareholders to generate Page 112

114 returns (Palepu & Healy). A high ROE ratio is desirable because it means that the firm is efficiently using equity for profit Return on Equity OSG OSG restated Frontline Teekay Tsakos Industry Avg OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a In the energy shipping industry, ROE ratios vary over time because of the changes in industry sales from year to year. Overseas Shipholding Group has consistently stayed with the industry average over the past six years, if Frontline is omitted from the average as an outlier. However, in 2008, OGS did experience an increase in ROE due to the significant increases in revenue and net income during that year. Currently, there are no concerns about ROE when analyzing profitability, but if Page 113

115 OSG continues to experience similar increases in the future it can positively affect its position in the industry. Additional, there is no impact to ROE when considering the restated financial statements. Conclusion After comparing OSG s profitability ratios with its competitors in the energy shipping industry it can be concluded that its profitability performance is mixed. OSG s ability to control cost such as voyage expenses has allowed it to be an industry leader when measuring the gross profit margin. On the other hand, OSG is consistently below the average in the areas of operating expenses ratio and operating profit margin because of the high charter hire expenses that OSG takes on when compared to its competitors. Recent information from 2008 indicates that OSG is headed in the right direction in these areas which improve their overall position of profitability. Net profit margin, asset turnover, ROA, and ROE have all been similar to the industry averages, but also have an increasing trend since 2007 which is favorable. Ratio Performance Trend Gross Profit Margin Outperforming Stable Operating Expense Ratio Underperforming Decreasing Operating Profit Margin Underperforming Decreasing Net Profit Margin Average Decreasing Asset Turnover Average Increasing Return on Assets Average Increasing Return on Equity Average Increasing Page 114

116 Firm Growth Rate Ratios Understanding and evaluating the growth rates of a particular firm can generate a good basis for assessing that firm s potential to maintain its future growth without having to depend on outside sources of financing. If a firm can rely on its own internal funds when expanding into the future it will hold an advantage over other firms who borrow money to expand. When comparing firms by their growth rates you can also get a better understanding of how well the firm will be able to compete in the future. If a firm has to rely on outside funds to maintain an increasing profit they will be much more hesitant to expand and grow when compared to the firms who can finance their own growth. The two growth rate ratios we will use to evaluate OSG and their top competitors in the energy shipping industry are the internal growth rate and the sustainable growth rate. Internal Growth Rate The internal growth rate, or IGR, is the maximum level of growth attainable for a firm without acquiring outside sources of funding. If the IGR is applied to a firm then the only possibility for a firm to continue to increase in size is by utilizing their cash flows and retained earnings. The IGR can be calculated by multiplying the firm s return on assets, or ROA, by 1 minus the dividend payout ratio (dividends / net income). It is advantageous for a firm to possess a high IGR to prove that by using only internal funds they can continue to finance capital and assets. Page 115

117 Internal Growth Rate OSG OSG restated Frontline Teekay Tsakos Industry Avg OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a As illustrated by the graph and table above, the energy shipping industry has a relatively stable IGR as a whole. The decline in the industry s average IGR is due to the fact that each firm has been consistently paying out more cash dividends. When a firm earns a profit throughout the year, they can choose to distribute a portion of that money to their shareholders in the form of dividends. Although paying out dividends to shareholders can show a firm s financial health, it can significantly lower their IGR. The funds used to pay dividends are no longer held by the firm and this reduces the firm s retained earnings. Page 116

118 Only one of OSG s top competitors, Frontline, has had a negative rate over the past 5 years. This is due to the fact that they did not have enough net income to cover the amount paid as dividends to their shareholders. If Frontline were taken out of the industry average, the average would significantly increase and the remaining three firms would be in much closer relation to it. Since these firms all possess positive rates with only a slight degree of differentiation among them, no one firm in particular is at an advantage when judged by their IGR. The majority of the firms used for comparison here have the ability for potential growth based solely on internal funding. Sustainable Growth Rate The sustainable growth rate, or SGR, is a measure of how much growth a firm can sustain without being forced to borrow money to supplement existing funds. This growth rate is typically employed to give an idea of a steady maintainable rate for a firm when they are growing at rapid rates that cannot be upheld. When a firm surpasses their SGR, they are forced to rely on outside sources of financing to stimulate their personal financing activities and future growth. The SGR for a firm can be calculated by multiplying a firm s IGR by 1 plus their debt over equity Sustainable Growth Rate OSG OSG restated Frontline Teekay Tsakos Industry Avg. Page 117

119 OSG OSG-restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a The information provided by the graph and table above shows how closely the IGR and the SGR are related. It is once again made apparent that the industry, as a whole, is moderately stable and has a positive sustainable growth rate. Over the past 5 years OSG has stayed close to the industry average, with only minor fluctuations above and beneath it. When taking into account the restated financial statements, the overall SGR improves due to the increase in the debt to equity ratio. Even though this is a good sign for their personal financial health, their top competitors (with the exception of Frontline) all possess relatively similar rates. It can be concluded once more that there is no one firm in particular with an advantage from the rest of the industry based on their SGR. The greater part of the industry holds stable, positive rates with no reason to predict a change in the near future. Conclusion OSG has performed around the same level as the industry average for the last 5 years. Although this is a good sign since the majority of the industry has held steady and positive growth rates, they are not drastically outperforming their top competition. These ratios show that there is room for potential growth, but they do not give potential investors a solid reason to believe OSG will grow at a greater rate than their Page 118

120 competition in the upcoming years. Based on both the internal growth rate and sustainable growth rate of OSG, they will continue to perform at the industry average for several years to come. Ratio Performance Trend Internal Growth Rate Average Increasing Sustainable Growth Rate Average Increasing Capital Structure Ratios The capital structure ratios are used to determine how a firm raises money to fund its assets. Companies have to decide to either borrow from a bank and increase liabilities or obtain money from the sale of company stock. The decisions that a company makes can affect its credit rating and future interest rates and expenses. The ratios that are used to analyze the capital structure of a particular company include debt to equity ratio, times interest earned, and debt service margin. Debt to Equity The debt to equity ratio indicates the firm s risk at financing its assets and is found by taking total liabilities and dividing by stockholders equity. Finding the right combination of liabilities and equity is important for a company to remain competitive in its industry. Firms with a high ratio have the opportunity to earn more revenue than firms that rely on internal financing. The downside: credit ratings for these firms will decrease because too much debt is considered risky. The interest rates to borrow will grow and it will become more difficult to raise future funds because they will be considered more likely to default. A low debt to equity ratio is also not preferable. Too much equity financing can indicate that you are not making the most productive use of Page 119

121 your capital; the capital is not being used advantageously as leverage for obtaining cash (US Chamber of Commerce). Debt to Equity OSG OSG Restated Frontline Teekay Tsakos Industy Avg OSG OSG-Restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a In the energy shipping industry, having a good credit rating is important because firms need to finance the shipping vessels that they purchase. Poor credit ratings will drastically increase interest expenses and hinder a firm s ability to remain profitable. According to the graph above, OSG has a debt to equity that has been consistently stable and at the bottom of the industry. OSG and Tsakos are the only two firms in this industry to stay below a 2:1 ratio since The restated financial statements impact Page 120

122 this ratio because of the increase of debt when taking into account the operating leases. This increase is significant and will ultimately affect other areas such as the sustainable growth rate. This ratio can explain why one of OSG s competitive advantages is its high credit rating. In turn, the high credit rating allows OSG to reduce financing costs and remain financially flexible when compared to the rest of the industry (OSG 10K). On the other hand, Frontline has consistently increased over the last six years with a debt to equity ratio of almost 8:1 in In a recession, Frontline will have a difficult time paying off its debt and have high interest expenses and rates. Times Interest Earned The ability to obtain low interest rates in the energy shipping industry is very important because of the amount of interest expense that firms in this industry face. The times interest earned ratio indicates if a company has the income to cover the interest expenses that need to be paid. It is measured by taking the net income before interest and taxes (NIBIT) in a given year and dividing that number by the interest expense of the same year Times Interest Earned OSG OSG restated Frontline Teekay Tsakos Industry Avg. Page 121

123 OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a When analyzing the times interest earned there are no concerns in the capital structure if a firm has a ratio over 4:1. If a company has a ratio of more than 7:1, banks would be more willing to loan to a particular company because this ratio explains the firm s ability to pay off interest expenses. A high ratio is desirable to a point. A high ratio can indicate that a company has an undesirable lack of debt or is paying down too much debt with earnings that could be used for other projects (Investopedia). Overseas Shipholding Group has an average ratio of 6:1 over the last six years which is not a concern. This ratio means that OSG has $6.00 dollars for every $1.00 of interest expense that needs to be paid. Also, there is no impact to this ratio when taking into account OSGs restated financial statements. Debt Service Margin The debt service margin ratio measures if a firm has enough cash flows to cover the current payments of long term debt. This ratio is found by dividing the current year cash flows from operations by the current installment of long term debt for the year before. The current installment of long term debt appears on most financial statements under current liabilities as either notes payable current or current portion of long term Page 122

124 debt. A high ratio is desirable when analyzing the capital structure because the firm has more cash to cover current debt obligations Debt Service Margin OSG OSG restated Frontline Teekay Tsakos Industry Avg OSG OSG restated Frontline n/a Teekay n/a Tsakos n/a Industry Avg n/a OSG has a debt service margin that has remained significantly above the rest of the energy shipping industry over the past six years. This is due to the fact that Overseas Shipholding Group has less current long term liabilities than their competitors. This ratio stays the same when taking into account OSG restated financial statements. In 2007, OSG experienced a decrease in cash flows from operations of over 60% which can explain the drop in debt service margin during this time. Page 123

125 Altman s Z-Score The Altman s Z-Score is a formula with five financial components that measures a public company s likelihood to become bankrupt. Real world application of the Z- Score successfully predicted 72% of corporate bankruptcies two years prior to these companies filing for Chapter 7 (Investopedia). A lower Z-Score results in a greater probability that a firm is headed towards bankruptcy. If the Z-Score is less than 1.81 for a company, the model predicts this to be an unhealthy company that is in high danger of bankruptcy. If the Z-Score is between 1.81 and 2.67, the model predicts a company in the grey area. Finally, if the Z-Score is more than 2.67, the model predicts a healthy company that is unlikely to become bankrupt. The Altman s Z-Score is calculated using the formula below Altman's Z Score OSG OSG restated Frontline Teekay Tsakos Industry Avg. Page 124