SFL Stock: Momentum Building On Multiple Fronts (NYSE:SFL)

Thesis

SFL Corporation (NYSE:SFL) is a diversified shipping company that owns 78 vessels that operate across various industries. From cargo containers, car transports, and deep-water drilling, SFL does it all. With a backbone structured around long-term contracts, SFL has been able to pay a dividend for nearly 20 years, including back-to-back raises in Q1 and Q2.

These dividend raises are backed by improving revenue streams across multiple fronts.

• Enhanced day rates for the deep water drilling vessel Hercules at $500,000/d and a robust offshore drilling market.
• The company is expected to take delivery of three new LR2 tanker vessels over the remainder of the year.
• Two LNG dual-fuel chemical carriers will be acquired in June and August of this year.
• Receipt of the company’s 7th car carrier vessel
• $240 million in backlog addition through multiple contract extensions in the company’s container fleet.

The multitude of long term drivers will allow SFL to continue to deliver reliable dividend growth and share price appreciation. These new developments continue my original thesis on SFL that I documented in January.

I still believe there is long term value in SFL despite the company being up 20% since my last evaluation of the company. As a result of this appreciation, I have dropped my rating in SFL from STRONG BUY to BUY.

Strength In The Offshore Drilling Market Continues

SFL has two drilling rigs/vessels in its fleet, a jackup rig called Linus and a deepwater drilling vessel called Hercules. While this is just a tiny fraction of the fleet, the total revenue generated by these two vessels is very important to SFL’s cash flows.

In Q1, Linus and Hercules combined for roughly 29% of the total revenue of the company. Both of these vessels command large rates due to their size and sophistication. The Linus rig was employed at a rate of roughly $200,000/d and the Hercules at $435,000/d.

The second half of this year looks very promising for both vessels as they embark on new contact rates. The Hercules begins its 200-day contract in Canada at a rate of $500,000/d, while the Linus rig received a market adjustment under its 8-year contract with Conoco. Starting in May, the rig will be employed at a rate of roughly $220,000/d.

The combined rate increases for these two vessels would translate into a 3% increase in revenue for SFL in Q3 and Q4. However, due to several one-time events, investors should also be prepared for a soft Q2.

First, the Hercules will be spending most of the quarter relocating from Namibia to Canada. During this time, the vessel only generates mobilization fees. Due to accounting methodologies, these fees are amortized throughout the entire contract, and thus will not be realized in earnings reports until Q3 and Q4. Due to this, the company has guided to realize lower income from this vessel in Q2.

Second, prior to the Linus rig embarking on its new rate, it must first undergo its required 10-year dry docking. This will take the vessel out of service for five weeks while also requiring $30 million in CAPEX spending.

Combined, Q2 will be negatively impacted by a general lack of activity in the energy fleet. However, Q3 and Q4 should result in robust performance when both vessels are fully employed at their elevated rates.

What happens after Q4 remains somewhat of a question mark for the Hercules semi-submersible vessel. This vessel has been operating on short term contracts for the last year, which is unusual in SFL’s business model. The Hercules vessel currently operates on a 200-day contract that concludes near year end. This leaves a big opening in potential revenue to start off 2025.

CEO, Ole Hjertaker, discussed the outlook for the Hercules vessel during the Q1 conference call.

From a period charter perspective we are of course more than monitoring the market looking at opportunities that are out there. But we cannot be specific on employment for the rig going forward. But we naturally look at all the opportunities that makes good sense for a rig of this caliber. There are very few harsh environment deepwater rigs in the market. It’s a relatively tight market. So, we believe having this asset there could prove to be very interesting over time.

To me, this is the long way of saying “we’re working on it”.

However, to compensate for the lack of a detailed update, we can look at what the rest of the offshore market is doing. Over the last year, drilling rates have steadily risen despite mediocre utilization rates.

While the current day rate for the Hercules looks to be outperforming the industry average, the workload in 2025 should strengthen the demand for this vessel. Competitor Diamond Offshore (DO) is tracking 53 floater opportunities for its fleet of drill ships and semi-submersible vessels. This significantly outpaces the demand in 2024, indicating a robust market.

With a large opportunity pool in 2025, it should not be difficult for the Hercules vessel to maintain similar day rates at industry averages. If it is able to sustain rates in excess of $500,000/d, SFL will be able to harvest significant increases in FCF due to flat operating expenses from this vessel.

The Tanker Segment Continues To Grow

Q1 was a busy quarter in terms of fleet additions. The company agreed to terms to acquire three new build LR2 tanker vessels and two chemical carriers by the end of 2024. All of these vessels were acquired with long term contracts in place.

• Three LR2 tanker vessels were contracted for an initial five year term with a subsequent three year extension option. The initial five year term is worth $200 million across all three vessels, equivalent to $36,500/d.
• Two chemical tankers, built in 2022 and 2023, were contracted to initial eight year contracts with options for extension. The value of this contract was not released, but based on the changes in the company’s backlog from Q4, I estimate this contract to be worth in the neighborhood of $150-200 million.

Refined Product Tankers

With day rates in the spot market frequently exceeding $50,000/d, SFL clearly has left some money on the table by securing the three new LR2 vessels to long term contracts. However, in doing so, it has secured rates that are significantly above pre-covid levels that also mitigate medium term risk.

The number of new build vessels entering the market in 2025 through 2027 will be the most in over a decade. It’s not until 2028 that age begins to catch up with the industry in what could lead to elevated scrap rates. By securing a 5-year contract at a compelling rate of $36,500/d, SFL is leveraging the high rates of today to bridge over the years when the largest vessel supply hits the waters.

Chemical Tankers

Near term vessel supply forecasts for the chemical industry also points to another under supplied condition. The long-term contract secured by SFL has grown the company’s backlog by approximately $150-$200 million. This would translate into a day rate of approximately $30,000/d at the midpoint and in line with current market rates reported by peer Ardmore (ASC) in its Q1 conference call.

The combined impact of these five vessels for SFL would be an increase in quarterly revenue of approximately $15 million, or an increase of 6% in total revenue.

The Sum Of The Parts Makes SFL Attractive

Between five new tanker vessels and the increased contract rate for the Linus rig, SFL will increase revenue by approximately 7% under multi-year contracts. I project this will allow quarterly adjusted EBITDA to grow to over $160 million in 2025, once all of the vessels are delivered and in operation. This assumes a flat day rate environment for the Hercules vessel, implying further upside potential.

The total price tag of these new vessels totals $344 million, of which the company plans to finance $243 million. The remainder will be sourced from cash on hand which currently stands at $168 million. These new loans will push the total debt of the company to approximately $2.4 billion.

Despite the added interest expense, the table below shows that SFL remains capable of generating positive free cash flow, even after financing the dividend. This positive free cash flow will be utilized to help fund the capital requirements of the company’s newest acquisitions as well as being supportive of raising the dividend.

Click to enlarge

In the near term, I would expect most of the excess FCF to be allocated toward the $101 million in cash owed for the tanker vessel acquisitions. I believe investors will also see a continuation in small dividend increases as we move through the calendar year and into 2025.

As we approach the Q2 earnings report, I will be interested to hear management commentary on how it plans to finance the recently announced $1 billion order of 5 new build container vessels. These vessels will not be delivered until 2028, which will allow SFL sufficient time to self-fund a significant portion of this purchase within its FCF framework.

Risks

SFL’s business model and free cash flow characteristics highlight the positives of being a long-term contract oriented company. The stability created by these contracts and the 8% yield offered by the company are highly coveted by investors.

However, with stability and high free cash flow comes at the expense of valuation. SFL’s shares are not cheap in reference to several of its peers who operate more in the spot market.

Additionally, investors should realize that SFL’s highly contracted business model takes away much of the upside that is created by market disruptions such as the attacks in the Red Sea. These events to do not materially alter the company’s FCF, and investors should be cautioned to avoid investing coincident with these types of headlines. This will prevent overpaying for unaffected cash flows.

Investor Key Takeaways

Since Q1 earnings, SFL has made several announcements that will continue to grow the company’s near and long-term free cash flow.

1. The company has announced the acquisition of five new tanker vessels in 2024, the new build of five 16,800 TEU container vessels, as well as an expanded backlog which exceeds $4 billion dollars.
2. Attractive rates in the energy and tanker segments will boost near term revenues and FCF. However, Q2 will be negatively impacted by one-time events related to the Linus rig and Hercules vessel.
3. The cash generation ability of SFL supports dividend increases as well as financing the cost of recently announced vessel acquisitions.

These positive developments and stability of SFL’s cash flows are met with an expensive valuation, trading at a significant premium to peers who operate on shorter and higher premium contracts. I believe the company will be able to continue to increase the dividend while also funding CAPEX requirements for new vessels on order.

I have moved SFL down from a STRONG BUY to a BUY due to yield compression from share price appreciation.