TORM Stock Is Still Cheap And Well Positioned (NASDAQ:TRMD)

Intro & Thesis

Since I upgraded the shares of TORM plc (NASDAQ:TRMD) from “Hold” to “Buy” in mid-July 2023, they have risen by of 62.64% (dividends included), significantly outperforming the broad market. Since my last update in January 2024, the stock has risen by 9.8% – and it continues to grow:

To date, my view on TRMD stock has not changed much: Based on the company’s recent results and considering the state of the industry as a whole, I think investors should expect new highs ahead. And while they wait for that, the company apparently won’t stop focusing on shareholder returns and rewarding investors for their patience.

Why Do I Think So?

If you haven’t heard of the company before, TORM is one of the largest pure-play product tankers out there (~$3.1 billion in market cap) with its fleet ranging from Medium Range to Long Range 2 tankers, transporting clean petroleum products across the seas.

The interest of various income-seeking investors has shifted from containerships to tankers in recent couple of years, as geopolitics and fundamental factors such as the low order book in this shipping niche led to expectations of much higher total returns. Pure-play product tankers have been one of the main beneficiaries when we look at the dynamics of freight rates in recent months.

Many expected that such a rapid rise in rates as you could see above would quickly turn around in 2023 and we would see tankers’ financials go through the same process as we have seen with ZIM Integrated Shipping (ZIM). And indeed, in Q4 FY2023 TORM saw a slight dip in TCE rates. But the firm continued to achieve impressive averages, with LR2 vessels leading the pack at USD/day 47,718, followed by LR1 vessels at USD/day 37,326 and MR vessels at USD/day 34,745. TORM’s time charter equivalent earnings (TCE) in FY2023 reached $1,084 million, marking a notable increase from $982 million in FY2022. This growth was further underscored by a record-high EBITDA of $848 million (vs. $743 million the previous year), and a net profit of $648 million (up from $563 million YoY). In other words, TORM’s operating leverage has obviously proved to be stronger than one would have thought a few quarters ago, while the return on invested capital (ROIC) has also increased by 1.2%, which is a good sign:

Watch the payout ratio: it has risen to 83%, which means that more of the company’s profits are now being paid out to shareholders as dividends (the dividend payout itself is up almost 25% YoY). TRMD is rather poorly covered on Wall Street, with only 1 analyst forecasting the dividend for FY2024. According to his/her calculations, the implied yield is 16.50%:

However, I think that the actual dividend payout could be even higher.

First off, we must not forget the current state of the industry. The product tanker market’s strength and volatility, influenced by geopolitical tensions and refinery dislocations, fueled increased ton-mile demand, supporting positive supply and demand dynamics in 2023, the management noted in the earnings press release.

As far as I can tell from the latest headlines and press analysis, the instability in the Middle East is by no means abating. For example, the Houthis recently shot down a US Reaper drone that cost $30 million apiece, so one can hardly speak of a reduction in tensions in the region.

The widespread rerouting of vessels from the Strait of Bab el-Mandeb could continue – the disruption in the Red Sea will not ease in the foreseeable future in this case. Prior to the disruption, ~12% of global clean petroleum product volumes and a significant 45% for LR2 vessels passed through this route, according to TORM’s IR materials. However, the attacks have caused a 46% decline in the number of product tankers arriving at the Gulf of Aden compared to the first half of December 2023. As a result, redirecting vessels away from the Red Sea to circumnavigate the Cape of Good Hope has increased travel distances by 30-70%, impacting logistics and operational costs. The entire cost increase falls on the shoulders of the end customers, while TORM and its competitors get more operating days and are entitled to charge higher freight rates due to the shortage of ships on the market (which is what has happened in recent months). This means that as long as the situation in the Middle East remains as it is and nothing moves, rates are likely to be under bullish pressure, in my opinion.

Another important point is that TORM has acquired 22 newer eco-ships and disposed 7 older vessels during FY2023, so its fleet structure today looks significantly more optimal so to speak since the new vessels may bring in considerably more in terms of TCE.

The product tanker market is predicted to experience a serious amount of scrapping activity in the coming years – in other words, the replenishment of supply is likely to gradually level off. At the same time, according to BIMCO, demand for product tankers will increase by 5-6% in FY2024 and 1.5-2.5% in FY2025, creating favorable conditions for maintaining rates well above historical averages.

If my assumption of rate stability proves correct, I see no reason to expect a turnaround in TORM’s financials anytime soon. The company has too low a break-even point in terms of EBITDA and EBT, and therefore the safety margin for continued FCF generation and dividend payout coverage should be sufficient for at least 2 years ahead in my opinion.

With all this, TORM cannot be called an expensive stock today. Seeking Alpha Quant System has an “A” score for TRMD’S Valuation grade, and key forwarding multiples look cheap indeed compared to the median values of the Energy sector:

It is important to remember that TORM plc is a company whose operating activities are very much tied to the industry cycle. The market consensus today predicts that TRMD’s EBITDA will fall by 19.8% next year and 24.3% the year after. I don’t have much confidence in this forecast because the current state of the industry tells me that the conditions for such a sharp decline are not even on the horizon. But let’s assume that the consensus here is correct – what can we as potential investors hope for in terms of a fair valuation? TRMD’s forwarding EV/EBITDA ratio is currently near its local historical bottom. With EBITDA down 19.8% year-over-year, I think the multiple will increase to at least 6x, as is often the case in cyclical industries. Even with today’s conservative EBITDA forecast of $748 million next year, this gives an enterprise value of almost $4.5 billion, which after adjusting for net debt gives an equity value of ~$3.7 billion.

This means that my calculations indicate a growth potential of around 18% for the stock, not taking into account the dividend yield of 16.5% (coming from the consensus). In other words, TRMD stock could still have significant upside and return potential even after its phenomenal performance over the past few years:

Where Can I Be Wrong?

Perhaps I’m wrong in my assessment of geopolitics – perhaps the current situation is just a temporary phenomenon that will soon change. Without this additional bullish stimulus, freight rates could fall and TORM’s financial position could become even worse than the current consensus suggests.

Furthermore, among the fundamental factors, I refer to the forecast of increasing scrapping in the coming years, which may not be entirely accurate given the shortage of ships. In other words, the risk of continuing to operate old ships while new ships appear could trigger a sharp drop in rates, which would be bad for TORM.

There is also a valuation risk for TORM, which lies in its comparatively higher valuation ratios compared to its peers in the shipping industry. As another Seeking Alpha analyst KD Research noted recently, TORM may offer value based on EV/Sales, but the stock’s valuation is relatively expensive compared to its peers like Scorpio Tankers (STNG) and Hafnia Limited (HAFN), “especially considering factors such as fleet quality, PNAV, and LTV (loan-to-value ratio).”

The Verdict

Despite the obvious risks surrounding the company’s cyclical business today, I’m inclined to believe that the bull cycle in product tankers is far from over. The continuation of the current positive market trend is favored by both geopolitics and the imbalance between supply and demand that has built up over the years. I think the average TCE over the next 5 years will be higher than the average over the last 5 years – if I am correct, it’s unlikely that the current consensus forecast for TRMD’s EBITDA numbers will hold. I calculate a massive total return potential for TRMD despite its relative expensiveness compared to direct peers – I explain this existing premium by a shareholder return policy that is more understandable than that of peers. In my opinion, this premium is well deserved and not so large as to be a reason to avoid TORM plc. I therefore reiterate my previous “Buy” rating.

Thank you for reading!