Shipping is still a mess. Tanker rates have picked up a little bit and dry bulk rates seem to have at least leveled off, but overall rates are still not very good. That presents a fairly uninspiring backdrop for Ship Finance (NYSE:SFL), one of the world's largest tanker fleet owners. Although Ship Finance seems built to last, investors may wonder if the risk of further worsening conditions and/or a dividend cut is worth the potential of a sector recovery and the above-average dividend yield.

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Restructured Deal with Frontline was a Must
Ship Finance does not operate the ships it owns, instead it charters them out to operators on long-term contracts. Unfortunately, a very large percentage of the firm's ships (and nearly all of its oil tankers) are chartered to Frontline (NYSE:FRO), the recently-struggling shipping firm controlled by John Fredriksen. For related reading, see Play the Bottom in Shipping.

Given the difficulties that would no doubt have ensued from a messy and prolonged collapse, Ship Finance likely saw little choice but to willingly participate in Frontline's restructuring. As part of the deal, Ship Finance will accept $6,500 less per day in charter rates for four years. As compensation, Ship Finance received $106 million in upfront cash and a readjustment of the profit split. Ship Finance will receive 100% of profits up to the old base rate and then 25% of profits after that (versus 20% previously).

In short, this restructuring gives Ship Finance some upfront cash that strengthens the balance sheet, gives Frontline a more viable and survivable cost structure and lets Ship Finance participate in the upside if the markets should recover. All in all, not a bad deal.

A Decent Balance Sheet, but not Much Flexibility
By the standards of the shipping industry, Ship Finance has a fairly healthy balance sheet. That said, with over $1.8 billion in net debt and less than $100 million in cash at year-end, the company does not have much flexibility for further transactions.

That's unfortunate, as low rates have created some values in fleet assets. It wouldn't be surprising if Ship Finance would like to expand its drilling rig business or expand into LNG tankers, but that may be hard to achieve today. That said, the company does have dry bulk and containership new builds on the way, and the container market is improving.

Probably other Better Plays Today
I've long liked the Ship Finance business model (apart from its over-reliance on Frontline), but I'm not sure the rewards are worth it at this point. Containerships look like a better play today, and Box Ships (NYSE:TEU) and Costamare (Nasdaq:CMRE) are purer plays on that market. Elsewhere, while Golar LNG (Nasdaq:GLNG) had a remarkable run in 2011 and has been weak since, the fundamentals in the LNG market look relatively solid these days.

Along similar lines, investors looking to play a better environment for offshore drilling rigs would likely be better pleased with names like Ocean Rig (Nasdaq:ORIG) or Seadrill (NYSE:SDRL) (which leases 3 rigs from Ship Finance).

The Bottom Line
With the adjustments in the Frontline agreement and overall market conditions, I do think there is a risk that another dividend cut could come in 2012 - probably to something in the range of 25 cents to 28 cents (versus 30 cents today). Ship Finance has long worked hard to maintain a high payout, but the company's management is also conservative when it comes to protecting liquidity and financial flexibility.

With shipping in the doldrums, conventional analysis doesn't offer up a very promising target for these shares. Looking at full-cycle EBITDA, though, it seems reasonable to value these shares at around $15. That suggests about a 10% capital appreciation potential from today's price and another 7 to 9% in dividend yield (depending upon whether another dividend cut should be expected). While that's not exactly a dreadful prognosis, it's hard to get excited about taking on that sort of risk for a relatively small and uncertain reward. For related reading, see Is DryShip's Shipping Business Really Worthless?

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.