First Ship Lease Trust - Risk Analysis

A few corrections on the DPU projections under the section "Risk versus Returns".

Rationale

The recent credit crisis, almost on a global scale, threatened to freeze up the available credit to companies. Many companies are dependent on such leverage to grow or sustain their business. Without these loans, some might not survive. The threat of the credit crisis to heavily leveraged businesses such as REITS and Shipping Trust are even higher.

The recent steep sell down in these collective group of debt based instruments is hence understandable. However, First Ship Lease Trust (FSLT) plunged the most among them, even reaching a intra week low of about 37 cents. This imply a staggering yield of 48.9% (assuming a quarterly DPU of USD 3.08 cents and exchange rate of 1.47 SGD to 1 USD). Is the associated risk for FSLT substantially higher compared to other shipping trust or REITS that the market would priced in such high yield for compensation? I will like to find out.

Creditors

The following is the list of creditors which provide FSLT with 3 loan tranches totaling 515 million USD:

1. The Bank of Tokyo-Mitsubishi UFJ Co., Ltd (“BTMU”)
   
2. Bayerische Hypo- und Vereinsbank AG (“HVB”)
3. Oversea-Chinese Banking Corporation Limited (“OCBC”)
   
4. Landesbank Hessen-Thüringen Girozentrale (“Helaba”)
   
5. Sumitomo Mitsui Banking Corporation, Singapore Branch (“SMBC”)
6. KfW

One of the greatest risk these banks can post to FSLT is for one or more of them to collapse. Their creditors could go after FSLT for immediate payment for one or more of its bullet payment facilities due on 2014. The ensuing fire sale of ships without demand for them in this market will almost result in the demise of FSLT.

The following list summarises the profile for the above creditors:


Few things to note:

1. Bank of Tokyo-Mitsubishi UFJ Co. Ltd (BTMU) and Bayerische Hypo- und Vereinsbank AG (HVB) provided the bulk of the credit facilities granted to FSLT. As far as perceived (my perception) risk is concerned, BTMU belong to one of the 3 largest banking groups in Japan and hence could pass the "too large to fail" criterion for possible bailout. But the same could not be said for HVB.
2. If the Tier-1 capital ratio can be trusted as a guide to measure the capacity of the bank to withstand reasonable loss, the HVB is obviously precarious compared to the rest.

Lessees

The following is the list of lessees of FSLT:

1. Geden Lines
2. Groder Shipping/ Rosneft
3. James Fisher
4. Berliau Laju Tanker
5. Yang Ming Marine
6. Evergreen Marine
7. Schoeller Holdings
8. Siba Ships

One of the greatest threat these shipping firms can post to FSLT is to default on their lease payments. This will force FSLT to recall the ships and look for new lessee in this slowing global economy, not an easy task.

Compared to a collapse creditor to FSLT, a defaulting lessee post less threat to FSLT. The immediate consequence is a cut in DPU.

The following list summarises the profile for the abovel lessees:


Few things to note:

1. Most of the lessees are privately owned. This resulted in insufficent financial data to ascertain their risk by retail investors like me.
2. Of those listed with readily availabe financial data. It can be seen that their credit risk is very high due to their high gearing. These are actually very large firms that should not fail in 'normal' times. But in this 'unusual' credit crunch where even banks can fail, their collapse due to insolvency is indeed material.
3. The only consolance is the midst of uncertainty is that most (except Yang Ming's 20%) of the lessees do not account for more than 15% of FSLT revenue. Though each of the lessees could post high risk by itself, collectively, the risk is mitigated by virtue of diversification.

Risk versus Returns

The above data is sufficient to show that investing in FSLT is indeed a VERY risky adventure due to the ongoing credit crisis that have yet to show signs of abating, the question now then becomes, is the returns worth taking the risk?


The above shows the hypothetical scenario of investing about $10,000 in FSLT at a unit price of 38 cents.

The following are the assumptions behind the projections in the table:

1. About 4 to 5 million USD per quarter could be diverted to pay off the recently secured tranche of 65 million USD loan for 3Q 2010 onwards. This could potentially reduce distribution income for FSLT by about a third, thus arriving at 2.05 cents USD.
2. The USD exchange rate is projected on the basis of eventual USD devaluation due to the series of capital injections and bailouts.
3. The DPU projections ignore the scrap dividend scheme that could provide funds to service part of the quarterly repayment (3Q 2010 onwards) for the 65 million USD credit facility.
   

Potential returns depending on how long FSLT can survive and whether they manage to refinance their existing loans:

Loan facilities:

1. 7 year non-amortizing USD$250 million ("Tranche A") --- repayable in full on 27th March 2014
2. 4 year non-amortizing USD$200 million ("Tranche B") --- repayable in full on 2nd April 2012
3. USD$65 million amortizing loan ("Additional facilitiy") --- linearly amortize from USD$65 million to USD$35 million from September 2010 to 2nd April 2012.

3Q 2010 - Principle recovery

Looking at the table, assuming FSLT manage to keep afloat until 3Q 2010 when the loan repayment to the 65 credit facility begin, full capital recovery (breakeven point) in terms of dividend would be collected.

1Q 2012 - 45.9% returns

Before April 2012 when the 2nd bullet payment of USD$200 million ("Tranche B") is due, accumulated dividend will provide a profit of 45.9%. Over a period from Oct 2008 to Apr 2012, i.e. about 3 years, dividend return translates to about 13.4% compounded returns.

1Q 2014 - Double returns

Assuming the credit crisis is over by April 2012 AND assuming FSL manages to refinance the USD$200 milliion loan at reasonable cost that does not affect the DPU much, then before March 2014 when the bullet payments are due, accumulated dividend will already double. Over a period from Oct 2008 to Feb 2014, i.e. about 5 years, dividend return translates to about 15% compounded returns.

All 3 milestones assumes FSLT shares becomes worthless at each juncture, when the payments are due.

My Action

The ensuing credit crunch post material threat to all leveraged businesses in my portfolio. I have no faith they could survive this credit storm. After some consideration, I decided to consolidate my leveraged businesses into few counters. I sold off Surface Mount Technology and recently acquired Cambridge Industrial Trust (both at a significant loss) and averaged into FSLT. Thus only two significant leveraged businesses in my portfolio remains, Multi-Chem and FSLT.

Going forward, I will not pump more cash into leveraged businesses. There should be more great businesses going at further discount as this financial crisis dragged on. There is not better time than now to acquire as many good businesses at attractive prices. Fire sale do not occur everyday. The only problem I face is insufficient cash to invest. So patience is still the key.

Conclusion

While the crisis brood fear and anxiety amongst the market. It is also during such times that opportunities began to appear. Looking back 10 years from now. I believe I will not regret investing now.

Credit Crunch vs Asian Financial Crisis

It is not difficult to notice that majority of the news nowadays centred on the ensuing credit crisis and the potential knock on effects on the economy. Though Singapore had technically entered a 'recession' after 2 consecutive quarterly contraction, the 'real' one have yet be felt... there are still queues at restaurants and the ERP rates had not gone down.

I happen to watch some evening news on Channel 8 a few days ago. An analyst (I think he is) commented that the comparing the current credit crisis with the Asian Financial crisis in 1997, the proposed solution by the US and European nations then for Asian nations stand in stark contrast to that for their current problems. I decided to verify his comment and pen my thoughts.

Similar problem, different solutions

Both crisis are the consequence of severe economic excesses gone wild (the almost inevitable product at the tail end of a boom-bust cycle). And coincidentally, both have similar roots with a property bubble that burst. The prescription by IMF included cutting back government spending to reduce fiscal deficit, allowing insolvent financial institutions to fail as punishment. This was aim to restore confidence.

Fast forward 11 years to 2008. To treat the current problem where many financial institutions have over leveraged, the prescription now was to bail them out if they had grown too big to fail in order to restore confidence. The consequence of such action could result in deep fiscal deficit for these European nations and United States.

Proposed solutions

From US to Europe, government and central banks inject tremendous amount of money into the financial market. Approving, pledging trillions of dollars to bail out or provide loans to banks and other financial institutions almost dying from the current credit freeze. The concerted effort seem to look like a last minute massive blood transfusion to revive a patient strugging to survive from a huge gapping, bleeding wound.

Health status

Looking at the current health status of the 'rescuing' countries who are trying to donate blood when they had none or little, I am quite surprised how they can realise the amount they pledge. The following two links shows the current account surplus or deficit of major countries and their foreign reserves:

• List of countries and their current acount surplus or deficit
• List of countries and their foreign reserves

Current account surplus or deficit measures the trade balance while the foreign reserve measures the foreign (liquid) assets of the country. Both are indicative how financial sound the country are in terms of crisis survivability.

From the list, it is easy to see how deep in the 'red' are the major countries hard hit by this credit crunch, i.e. US, United Kingdom, France etc.

Potential consequences


There are a huge number of financial institutions that had over leveraged. The painful de-leveraging process and the asset write downs that could easily terminate them if not because of the massive bailouts by central banks and government.

The worst case scenario I could foresee is a series of bailouts and nationalization of financial institutions until the central banks and government ran out of resources and implode on themselves, i.e. government default like Russia in 1998. That would then spark of a global recession and Asia will just have to survive on growing but sustainable inter country trade, waiting for these industrialized western nations to crawl out of financial nuclear winter.

The 'best' case scenario, or rather a moderate one, would be an eventual devaluation of their currencies, British pound, US dollar and Euro. They could supply, pump in, guarantee all deposits, debts etc. But the eventual flood in money supply would be met with a severe erosion in value, to be felt in months or years to come.

Conclusion

There is no fast solution to this credit problem. Any such thoughts are too native and simplistic. The rally today could just a few sparkles in an otherwise dying heap of fire. Australia and New Zealand dollars had devalued as expected when they had to cut their unsustainable interest rate, soon or later, more frequent trips to European or American tour would be possible.

Stock picking and chicken rice

Motivation

The recent stock market turmoil unsurprisingly caught the attention of many man on the street. A friend happen to chat with me and chance upon this topic. She asked whether it is the good time to enter now and if so, what stock should she buy.

I wouldn't comment on the first question. Market timing is an impossibility for mere humans. On the 2nd question, I offered my point of view.

Stock picking and Chicken Rice

If a friend approach you one day and ask you to invest $10,000 in his Chicken Rice stall, assuming you are keen in pursuing this business opportunity, what will you do? Assuming he is indeed a friend you can trust, will you just hand him the $10,000 and wait for him to hand you your share of profits some time later? Or assuming he is someone you just met, will you just hand him the $10,000 and hope for the best?

Most probably you'll choice neither options. A rationale person will at least do most, if not all of the following:

• Try out his cooking
• Check out his chicken rice stall
• Survey the location, the customer turnover potential
• Assess the competition, e.g. how many chicken rice stall in the vicinity
• Discuss the partnership details, profit sharing etc.

In other words, you will want to UNDERSTAND the business you want to buy. All investment has inherent risk and you will want to satisfy and convince yourself this business is worth risking your $10,000 of hard earn money.

Investment vs Gambling

It is completely rationale for one to buy into some business he or she can understand. But when it comes to stocks, why should it be different? If one simply treats a stock as a mere number on the screen when one login to POEMS and buy for anticipation the number will increase one day, what different is this venture compared to driving up to Genting and putting a chip on a number on the casino table? Even buying 'blue chip' stocks this way does not necessary constitutes as investment. Buying one in times of irrational market excuberance will see the 'number' shrink tremendously during bear market with irrational fear.

As Benjamin Graham puts it,

"...An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative..."

Understanding is the key

The effort to perform 'thorough analysis' into any business or investment vehicle before one part with his or her hard earned cash should not be underestimated. It can be tedious, time consuming but nonetheless rewarding. She asked me how I started, what books I read and when I told her I started reading in 2005 and had completed the list of books on the left column (and still reading more), she almost show her disbelieve.

To drive home the point on understanding, one need to look no further then the DBS High Notes 5 issue due to Lehman's bankruptcy. Several blogs and articles had been written on this topic highlighting the plight many conservative investors who thought the product was very safe. They were unaware of the risk involved. Had they actually read and understood the product, they could have done otherwise. Any investment product comes with a prospectus that the potential investor should have read before parting with his or her cash. But how many actually went through those font 1 arcane details? Even if one went through, how many are able to finish and decrypt the wordy lines seemingly meant to discourage understanding?

Conclusion

Invest in something one can understand. If the product seems complex, it is either beyond your realm (I don't think so) or its structured to hide something. Either way, its better be left untouched.