How Do These Shippers Boost Their Returns?

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As investors, we need to understand how our companies truly make their money. A neat trick developed for just that purpose -- the DuPont Formula -- can help us do that.

So in this series we let the DuPont do the work. Let's see what the formula can tell us about Frontline (NYS: FRO) and a few of its peers.

The DuPont Formula can give you a better grasp on exactly where your company is producing its profit, and where it might have a competitive advantage. Named after the company where it was pioneered, the formula breaks down return on equity into three components:

Return on equity = net margin x asset turnover x leverage ratio

What makes each of these components important?

  • High net margins show that a company can get customers to pay more for its products. Luxury-goods companies provide a great example here.
  • High asset turnover indicates that a company doesn't need to invest as much of its capital, since it uses its assets more efficiently to generate sales. Service industries, for instance, often lack big capital investments.
  • Finally, the leverage ratio shows how much the company is relying on liabilities to create its profits.

Generally, the higher these numbers, the better. That said, too much debt can sink a company, so beware of companies with very high leverage ratios.

So what does DuPont say about these four shippers?

Company

Return on Equity

Net Margin

Asset Turnover

Leverage Ratio

Frontline(29.3%)(23.1%)0.245.33
Nordic American Tankers(7.0%)(74.5%)0.081.14
Ship Finance International16.1%45.8%0.103.60
Teekay(8.8%)(17.3%)0.193.40

Source: S&P's Capital IQ.

Only Ship Finance international (NYS: SFL) is offering a positive return on its equity.  This is due to the fact that it is the only listed company offering positive net margins -- and very high margins at that.  Its asset turnover, on the other hand, is near the bottom, and its leverage ratio is close to the middle, though it still sits at a high level in absolute terms.  Frontline's ROE is in the low negative numbers, with low negative net margins, though it does have the highest asset turnover and leverage ratio of the listed companies, which in this case actually hurts its ROE. 

Many of these companies are suffering from a tough economic environment for dry bulk shipping due to shrinking demand, an oversupply of cargo shippers, and an inability to gain access to credit.  As an oil shipper, Frontline is also suffering from a reduction in oil production due to civil conflict in Northern Africa and the Middle East.  In addition, increased oil exploration and new oil discoveries in the U.S. have led to a reduced demand to ship oil from other places, which affects Frontline, along with Ship Finance International and Nordic American Tankers (NYS: NAT) .

Some of these companies are more insulated from the industry crisis than others.  DryShips (NAS: DRYS) has managed to protect itself from some of the pressure of the economic climate by locking in contracts that take up 54% of its dry-bulk capacity at an average rate of about $35,000 per day for 2012.  However, unless the industry improves before these contracts expire, even this advantage may dry up. Teekay's large dividend (currently at 4.9%) gives it a nice buffer, in that it could decrease the dividend to conserve cash in the short term, if necessary.  If it can weather this rough climate for bulk shipping, it may emerge with a competitive advantage over companies that couldn't do the same. 

Using the DuPont formula can often give you some insight into how a company is competing against peers and what type of strategy it's using to juice return on equity. To find more successful investments, dig deeper than just the earnings headlines.

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At the time this article was published Jim Royal, Ph.D.,does not own shares in any company mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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