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Sunday, 3 February 2008

Shipping Trust - Comparing First Ship Lease Trust (FSL) and Pacific Shipping Trust (PST)

What is a shipping trust?

Shipping trust a company that make money by acquiring ships and leasing out to shipping operators. They stay in business by leasing ships at a higher rate of return than the interest rate on the debt they incur to purchase the ships. Most of the profit derived are distributed as dividend to the shareholders.

For more information, see the following overview on Shipping Trusts.

How does shipping trust stay in business?

Shipping trust have to make sure the rate of return on lease exceeds the interest rate on the loan incurred. Normally, shipping trust have access to credit facilities that offer competitive interest rates.

How dividend calcuated?

Distribution (DPU) to shareholders are paid out of operating cash flow instead of accounting profits (for typical companies). This means that are arrived at:

DPU = Revenue from lease - All Management, trust fees & other trust expenses + Depreciation.

Depreciation is an accounting item that accounts for the slow depreciation of ships over their useful life. However, this does not impact the cash flow.

Case Study 1 - First Ship Lease (FSL)

2Q 3Q 4Q Projected

Revenue 12.672 12.819 15.224 22.377
Depreciation (9.161) (9.052) (10.360) (15.735)
Mangement Fees (0.507) (0.513) (0.609) (0.895)
Trustee Fees (0.025) (0.024) (0.028) (0.042)
Other trust expenses (0.276) (0.327) (0.443) (0.938)
Finance Income 0.098 0.169 0.182 -
Finance Expense (0.472) (0.928) (2.048) 12.614
NPBT 2.329 2.144 1.918 4.766
Income Tax 0.022 0.030 0.036 0.067
NPAT 2.307 2.114 1.882 1.882

Added non-cash items and other adjustments 9.220 9.036 10.218
Units 500 500 500 500
DPU (USD cents) 2.30 2.23 2.42 3.56

Total Assets 527.236 516.874 629.234 919.234
Total Liabilities 47.049 48.653 169.824 459.824
Equity 480.187 468.221 459.410 459.410

Liabilities to Equity Ratio 0.0980 0.1039 0.3697 1.0009

Implied Interest Rate on Lease (Quarterly), IRL 2.40% 2.48% 2.42% 2.43%
Implied Interest Rate on Debt (Quarterly), IRD 1.00% 1.91% 1.21% 1.37%
Net Interest Spread (IRL - IRD) 1.40% 0.57% 1.21% 1.06%
IRL on Assets less IRD on Debt 12.20 11.89 13.18 16.07

NTA (SGD) 1.35 1.32 1.30 1.30
Change in NTA over previous quarter
-2.49% -1.88%

DPU (SGD cents) 3.25 3.14 3.41 5.02
DPU w.r.t. NTA 2.40% 2.38% 2.63% 3.88%

The above shows the past 3 quarters of FSL. FSL was debt free prior to listing on SGX and started to acquire ships solely from debt. Its policy is to acquire ships until its debt-to-equity ratio is 1.

As of last quarter, 3Q, its debt-to-equity ratio is 0.3697. It recently announced that it had secured another USD 200m credit facilities, bringing total undrawn financial capacity to 290m.

Once fully drawn down, FSL will have about 900m in shipping assets, giving it a projected DPU of about 5 SGD cents per quarter.

Sustainability of Distributions, DPUs
  1. The implied interest rate on lease, IRL (revenue/assets) over the quarters are quite consistent; quite so for the implied interest rate on debt, IRD (finance expense/debt) too.
  2. The difference between lease returns and cost of debt, (IRL x assets - IRD x debt) is comparable with revenue every quarter. Deducting trust fess & other expenses and adding back depreciation, the remainder is the distribution units for shareholders.
Taken together, this means that, so long as lease returns exceed cost of debt by sufficient margin (Net Interest Spread), about 1%, the DPU should be sustainable over several years at least. (Lease terms are normally about 10 years).

Major Risk Factors (to shareholders)
  1. DPU are paid out in USD, whereas the trust units are in SGD. Numerically, there is no doubt the DPU can be sustained and grow as projected, but the actual yield in SGD may decline if USD continue to depreciate in short term.
  2. Shipping vessels are depreciating assets, typically over 30 years. The existing ships will slowly depreciate from the assets in the balance sheet. Note the declining NTA (in red) above.
Case Study 2 - Pacific Shipping Trust, PST

1Q 2Q 3Q 4Q

Revenue 8.514 8.609 8.703 8.703
Depreciation 3.219 3.219 3.219 2.421
Finance Expense 2.263 1.811 4.562 4.183
NPAT 2.700 5.523 0.589 1.649

Total Assets 267.747 266.595 262.224 259.722
Total Liabilities 120.915 116.745 115.357 114.880
Equity 146.832 149.850 146.867 144.842

Liabilities to Equity Ratio 0.823492 0.779079 0.785452 0.79314

Implied Interest Rate on Lease, IRL (Quarterly) 3.18% 3.23% 3.32% 3.35%
Implied Interest Rate on Debt , IRD (Quarterly) 1.87% 1.55% 3.95% 3.64%
Net Interest Spread (IRL - IRD) 1.31% 1.68% -0.64% -0.29%

Units 337 337 337 337
NTA (SGD) 0.614342 0.626969 0.614488 0.606015
Change in NTA over previous quarter
2.06% -1.99% -1.38%

DPU (SGD cents) 1.4664 1.4664 1.5087 1.5228
DPU w.r.t. NTA 2.39% 2.34% 2.46% 2.51%

PST is in a more mature state than FSL. Its debt-to-equity ratio are nearly 0.8, compared to FSL's 0.37. Similarly to FSL, PST's NTA are dropping nearly every quarter, although much slower.

One note of caution, though, its Net Interest Spread, IRL - IRD is negative in 3Q and 4Q. This means there might be a possibility PST is having difficulty getting debt at a cheaper rate than it can get from leasing ships. Not a good sign for distribution sustainability.


Another shipping trust, Rickmers Maritime, does not have sufficient reporting quarters to be compared here. But just by looking at FSL and PST, it shows up the inherent risk in shipping trust's business model:

They make money by leveraging between the returns on ship lease and the cost of borrowing. This is similar to banks giving lower rates on deposits and lending these out on higher interest rate. The margin, though meagre, is normally sufficient to support their profits.

However, for shipping trust, this business model built on leveraging can quickly collapse if the interest rate increase and lease rates fail to keep up. Though they normally go into hedging to minimize the risk, the danger still exists.

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Blogger Mr ICICI said...


vessels get old after 30 years, asset value goes down. however, debt level never goes down. hence, gearing ratio will go up. refinancing of the existing debt will be more expensive. what's your take on this?

you mentioned the following:

'Taken together, this means that, so long as lease returns exceed cost of debt by sufficient margin (Net Interest Spread), about 1%, the DPU should be sustainable over several years at least. (Lease terms are normally about 10 years).'

in my opinion, the above method is applicable for reits where assets are non-depreciating and might even increase in value over time. However, for FSL, since vessel values will always decrease over period of time, shouldn't the lease returns cover both cost of debt AND capital value erosion of the ships?

what do u think?

4 February 2008 at 22:55  
Blogger Market Uncle said...

Thanks for posting your comments.


I agree that ships are depreciating assets and NTA indeed went down over the quarters for both FSL & PST, as illustrated by the table I posted.

A few questions need to be answered before concluding the viability of this business model (for shareholders at least):

1) Can the shipping lease continue to find competitive financing facilities?

2) Can they continue to expand their fleet by taking on more debt?

3) Can these added ship lease returns earn higher rates of return than ?:
i) refinanced loan interest
ii) new loan interest for new ships

If the answer to all 3 questions above is yes, the shipping lease is safe. But the risk is there, and is intrinsic to shipping lease.

Ultimately, you are right to say that the lease returns MUST cover both cost of debt and capital value erosion.

However, they are supposed to payout operating cash flow less fund expenses. So long as they can raise debt cheaper than they can get by leasing ships, they are fine.

In the end of the day, as far as shareholders are concern, as long as the DPU rate of return (currently around 10++% for FSL) exceed the depreciation of NTA (currently less than 5%, annualised), shareholders are save.

However, future DPU payout depends heavily on the financing capability on the shipping lease. The risk is not immaterial, otherwise, why is the yield above 10%? i.e. nothing escapes the rule: returns must commensurate the risk taken.

5 February 2008 at 23:48  
Anonymous mr icici said...

Im going to write responses to a few of your comments. Let me know your thoughts on these.

'Ultimately, you are right to say that the lease returns MUST cover both cost of debt and capital value erosion.'

- if that's the case, shouldn't the net interest spread include the deduction of the depreciation rate of the assets (in addition to the cost of debt)?
if you calculate the net interest spread this way, you will find that the net interest spread is greatly reduced.

'However, they are supposed to payout operating cash flow less fund expenses. So long as they can raise debt cheaper than they can get by leasing ships, they are fine.'

- hence i have to disagree to this statement. the leases have to cover not just the cost of debt, but the depreciation rate of the ships. the ships will depreciate to a certain value at the end of 30 years, but the amount of debt that needs to be refinanced remain the same. This cost has to be somehow considered and imputed. For REITs, this is not necessary as their assets are perpetual. moreover, property prices tend to appreciate in the long term, in line with inflation.

'3) Can these added ship lease returns earn higher rates of return than ?:
i) refinanced loan interest
ii) new loan interest for new ships'

- hence, i think we should add a third point with regards that the ship lease returns should also cover the depreciation rate as the ships has a fixed useful life, unlike the property assets of REITS.

13 February 2008 at 00:29  
Blogger Market Uncle said...

I just happen to come across the discussion on shipping lease at Learnt quite a great deal, especially the exchanges between you and d.o.g.

After some pondering, I came to the following:

My objective: Whether FSL is worth investing, essentially establishing its value.

1) I'll be interested to know whether its DPU is sustainable, at least up to 2014 when the debt for most of its current assets are due.

2) If DPU is sustainable, is it sufficient to give me returns above my cost of capital?

To answer 1), the Net Interest Spread shows that the DPU is at least sustainable up to 2014.

To answer 2), using simple DCF, there are two valuations,

i) if all loans are drawn down to buy DPU accretive ships, the forecasted DPU is 5 SGD cents/quarter, or annualised 20 cts. Assuming this is achieved in 2009, DCF to present is 95.8 cts

ii) using current DPU of 3.4 SGD cents/quarter, or 13.6 cts annualised, DCF value is 78.7 cents.

Both valuation assumed cost of capital of 10% and paid out up to 2014.

At my average price of 112 cents for FSL, I'm assuming FSL is still worth at least 112 - 78.7 = 33.3 SGD cents.

Current ships depreciate at less than 7% p.a. This means NTA is still worth about 90 cents by then.

Thus as far as before 2014 is concerned, FSL is still worth 78.7 + 90 = 168.7 cents >> 112 that I'm paying.

But of course, the forex risk might render my valuation irrelevant.

What's your comment´╝č

16 February 2008 at 00:24  
Anonymous donmihaihai said...

Hi market uncle,

Among all local stock-related blog, I like your the best. Look forward for more writing from you in the future.

Using your valuation of 168.7 cents for FSL, I find that there are no margin of safety being given for the market value of vessels(or NAV if you try to predict using depreciation rate)while a discount of 10% is given to the cashflow (or DPU).

I think it is prudent to give a margin of safety for vessel value determine thru B/S as it is usually subject to the market force of supply/demand plus other. For myself, if I will to trying to value it, I will give a big discount for any type of vessels from 2012 onward because of the current extraordinary bloom in shipping.

Anyway, from 112 cents to 168.7 cents. The annualise return for 6 years is 7.07%.
1) If FSL close the gap in less than 6 years, annualise return increase
2) If FSL vessel value is greater than 90 cents at 2014, annualise return increase as well.
3) If FSL vessel value is lesser than 90 cents at 2014, annualise return decrease.

Personally, for me, I won't invest in any stock with a projected return of 7.07%


27 February 2008 at 21:10  
Blogger Market Uncle said...

Hi donmihaihai,

You are right to point out that the valuation did not provide margin of safety for the residual NAV by 2014.

Personally, I account for NAV after the valuation, i.e. comparing the traded price and the valuation. Then buy only if there is sufficient margin of safety. Hence in this case, the margin of safety will not be as big as I estimated.

2) The valuation of 168.7 is FSL's CURRENT estimated value, not 2014's target price. (Since you pointed out, now I know its lower) i.e. I can't predict what price it will be in 2014.

I won't know what will be my estimated annualised return until I sell it.

Hence, I'm merely buying because of the margin of safety and will be prepared to hold on till 2014 if the price don't move to its value.

27 February 2008 at 23:23  
Anonymous donmihaihai said...

Hi market Uncle,

For pt 2) Exactly, we always buy base on current estimation. Now I won't buy if the current estimation show that future projected/estimated return is low. And it strike me very unwise to buy a stock where current estimation clearly shown that it is not that cheap at all and hoping that either the market will someday give me a high exist price due to its ineffectiveness or the management start to do wonder to the company or tail wind begin to blow.

14 March 2008 at 01:34  
Blogger Market Uncle said...

Hi donmihaihai,
With current data, the fair value is estimated. The margin-of-safety comes in useful to account not only for the projected returns, but also for erroneous estimation for my case due to failure to take into account any crucial factors.

Comparing current price and current estimated fair value, I did not regret making the purchase.

On another note, there is a factor I failed to recognized on purchase: the economic cycle on USD-SGD exchange rate.

I'm still reading George Soros book: alchemy of finance. He gave good historical summary on the influence of economic cycles on USD exchange rates.

Going forward, if USD exchange rate recovers greatly in time before 2014, there will be further upward valuation on FSL.

But my current valuation of FSL will still ignore this speculative factor.

17 March 2008 at 21:33  
Blogger Mike Dirnt said...

This comment has been removed by the author.

15 May 2008 at 00:49  
Blogger Mike Dirnt said...

hi market uncle,

very good analysis you done there on FSL. may i know how do you get the implied interest on debt? i can figure out how you calculate IRL but not the other.

im an fsl shareholder as well. :)

15 May 2008 at 01:03  
Blogger Market Uncle said...

Hi Mike Dirnt,
Its just an estimation:

implied interest on debt = finance expense/liabilities

15 May 2008 at 20:35  
Blogger Mike Dirnt said...

i didnt realise the estimation is there in the paragraph. after i asked, then i found out :)

thanks anyway.

17 May 2008 at 15:08  

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