Paragon Shipping: Arbitrage From Irrational Market Valuation

Back in August, I wrote a buy recommendation article on Paragon Shipping (PRGN). PRGN traded that day at $1.29 a share, resulting in a six-month loss of 29.1% while the S&P 500 gained 21.5%. In my article, I predicted that PRGN had around 71% upside, just on liquidation value alone. As the stock price has dropped alongside S&P vessel values, PRGN still represents a huge liquidation upside.

I am a valuation person: fundamentals, especially balance sheet strength, are my main concern. Obviously, business trajectory and management are also important in this analysis. This approach allowed me to bust Netflix (NFLX), Abrecrombie & Fitch (ANF), and Green Mountain Coffee Roasters (GMCR) last year, while riding Microsoft (MSFT), Intel (INTC), and Aeropostale (ARO) to huge gains. PRGN is a stock that is a "market reject,"; it is going to take big shifts and big news to move this stock in the right direction. However, when PRGN finally emerges, it will bring massive returns.

Pundits often criticize my fascination with the dry bulk sector with comments such as "late 2013 is the absolute earliest that this sector will show signs of recovery" or "all of these companies are headed for bankruptcy." While the former might be true (it might even take until mid-2014), the latter is anything but logical regarding a few special shippers.

Approach:

I prefer to value these companies on their fair market value- or "liquidation value." Of course, in a forced liquidation, assets will be sold for below current market; however, banks own large collateral in these vessels, and they will give companies such as Paragon time to make proper sales. I doubt the liquidation will occur; in fact, I believe that PRGN will emerge in 2014 as a profit earning machine. A future P/E of less than 1 is realistic in my opinion. If this does occur, what does it matter if it takes 2-3 years? A 4-bagger in 3 years is still an annualized return of 59%.

The second approach I take is looking purely at operating cash flow while checking interest coverage and upcoming payments. How solid are the charters - are several expiring - is the TCE sticky? Normally, in a strong market, an investor would want income to more than cover depreciation, as that cash should technically be set aside for new vessel purchases. However, in a weak market any amortization or depreciation should be discounted since it is a non-cash expense. Nobody believes the book values on these companies, so I am surprised amortizations have not picked up even faster.

Massive Amortization:

In FY11, Paragon wrote down a $277M impairment loss in an effort to make their book values closer to actual market levels. I applaud this move, and I wish that other shipping companies would make similar moves. It is unethical in my opinion to carry ships on the balance sheet with a book value of close to 3x market rates. SBLK has taken similar steps, but most other companies are simply ignoring the overhang.

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Balance Sheet Analysis:

First off, how much are we paying for PRGN? With 58.7M shares at $0.915 and $210M in liabilities minus $58.6 in current assets, PRGN is up for the price of $205M.

The 21.1% stake in TEU is worth $32.6M and advance vessel payments for newbuilding Handysize vessels are valued at $28.4M. $66.8M in additional payment obligations also remain for the 2012 vessels. The resulting valuation is $210.8M for 14 drybulk vessels (at year-end 2012). On a side note, it would not surprise me if Hull 612 and Hull 625 actually slip to Q1 2013 due to Paragon's continuing efforts to renegotiate prices and redelivery dates (they dropped two Kamsarmax purchase options over the past year). Shipyards are desperate, and this bodes well for PRGN.

The book on these vessels (after huge write-downs) is $363.8M ($268.6 for current 10 and $95.8 on 4 newbuildings). Although the book value is likely close to market with the additional write-downs, strict reported book is still worthless in my opinion. Through valuation of the following sources (plan announced by Starbulk Carriers last month. The operating cash-flows from Q4-11 by itself are enough to repurchase 12% of their stock.

Irrational Downside Arguments:

The only two arguments for PRGN to be trading at current levels is that either (1) future losses will abound and destroy the balance sheet, or (2) ships will depreciate at an additional 32.4% while cash flows are flat at best over the next few years. I believe that both of these assertions are far out of line considering the decade+ lows on the S&P values and the break-even cash flow TCE of approximately $5684 (66.5% below Q4-11 TCE).

Patience and Leverage:

It might take a while for PRGN to rise back up in value- it could easily hit 50 cents before it ever sees anything north of $2. In fact, PRGN traded at $0.57 at the end of January. $54M of equity will leverage an investor into a fleet of 14 vessels with an average age of 6.6 years and total DWT of 853,572. The balance sheet is above water by approximately $154.9M, which with 58.7M shares outstanding, there is an intrinsic valuation of $2.64 per share. This represents 188% of upside, just based on a "rational valuation."