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Sunday, 19 October 2008

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.

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5 Comments:

Anonymous Anonymous said...

Good analysis on FSLT, exactly what we want to know at current crisis. Cheers!

19 October 2008 at 20:40  
Anonymous donmihaihai said...

hi,

I think there is another way of looking at it that is in case FSLT defaulted and need to sell off its vessels. That is in strictly distressed case.

At this case, total assets - total liabilities = net assets > double of market cap of FSLT, then it become increasing. Vessel has value and no bank want to call loans result in having trouble selling them.

# 2X market cap is I anyhow use one. But the greater it is more than Market Cap, the greater the margin of safety.

19 October 2008 at 23:28  
Blogger Market Uncle said...

Hi Donmihaihai,
That's another way to look at it. One word of caution though, Ships are valued at projected revenue they can bring in (i.e. shipping rates). With the bursting of the commodity bubble, shipping rates had almost collapsed. With that, the value of the ships will also plunge. Thus, the value of FSL's assets will be written down as well.

So a huge margin of net assets over market cap will be required for a conservative margin of safety.

20 October 2008 at 21:11  
Blogger SGDividends said...

Market uncle...this analysis is extremely good and best of all simple.

Having read that, from my perspective, i would 100% steer clear of it and yet, if im not wrong, you are still holding it,
you must be a highly risk taking person!

Respect.

25 October 2008 at 19:53  
Blogger Market Uncle said...

Hi sgdividend,
Any sound investment offers a potential return for a certain risk. It is up to the potential investor to decide whether or not the returns is worth the risk.

For FSL, the risk is very high indeed. But from my point of view, the returns are much higher. If I'm putting all my eggs into FSL, then I'll obviously be crazy risk taker. But since FSL only constitute part of my diversified portfolio, then I see myself as just taking a calculated risk. Anyway, the risk diminishes as my portfolio diversifies.

29 October 2008 at 20:56  

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