Is Ship Finance International Limited (SFL) Destined for Greatness?

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Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let’s take a look at what Ship Finance International Limited (NYSE:SFL)‘s recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you’re about to see tell Ship Finance’s story, and we’ll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company’s become more efficient over time. Since profits may not always reported at a steady rate, we’ll also look at how much Ship Finance’s free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Ship Finance’s share price has kept pace with its earnings growth, that’s another good sign that its stock can move higher.

Is Ship Finance managing its resources well? A company’s return on equity should be improving, and its debt to equity ratio declining, if it’s to earn our approval.

Healthy dividends are always welcome, so we’ll also make sure that Ship Finance’s dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let’s take a look at Ship Finance’s key statistics:

SFL Total Return Price Chart

SFL Total Return Price data by YCharts.

Passing Criteria 3-Year* Change Grade
Revenue growth > 30% (13.2%) Fail
Improving profit margin 9.9% Pass
Free cash flow growth > Net income growth (65.4%) vs. 23.8% Fail
Improving EPS 12.8% Pass
Stock growth (+ 15%) < EPS growth 82.3% vs. 12.8% Fail

Sources: YCharts and Yahoo! Finance
*Period begins at end of Q3 2009.

SFL Return on Equity Chart

SFL Return on Equity data by YCharts.

Passing Criteria 3-Year* Change Grade
Improving return on equity (12.7%) Fail
Declining debt to equity (37%) Pass
Dividend growth > 25% 18.2% Fail
Payout ratio < 50% 74% Fail

Sources: YCharts and Yahoo! Finance.
*Period begins at end of Q3 2009.

How we got here and where we’re going
Three out of nine passing grades isn’t a particularly impressive showing, regardless of Ship Finance’s weighty dividend. That dividend is always at risk of being cut, should business deteriorate even modestly, as it currently takes up three quarters of the company’s net income. Despite weakening revenue and free cash flow, Ship Finance’s stock has shot up over the past three years — most likely the result of yield-seekers piling on. Can Ship Finance improve its fundamentals and continue to justify this optimism? Let’s take a look.

In some respects, Ship Finance is already in much better shape than its shipping peers. The collapse of the highly watched Baltic Dry Index hasn’t had anywhere near the impact on Ship Finance as it’s had elsewhere, because Ship Finance has historically focused on crude oil transport. In fact, Ship Finance began as an oil-focused shipping spinoff from Frontline Ltd. (NYSE:FRO) , which sold it most of its original fleet.

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