Saturday, May 1, 2010

Analysis of First Ship Lease Trust (Singapore)

At it's current price (SGD0.60), FSLT's attractiveness as an investment boils down to 2 questions:
  1. Is a price of SGD 362m (the market cap) a good price to pay for (a) ownership of the 23 ships that the trust owns, and (b) assuming responsibility for SGD 650m of bank debt.

  2. Will the trust management be able to manage well (ride the cyclical shipping demand / manage capital) to the benefit of unit holders.

Here's the thought process behind this:

First, assuming the management does not buy more vessels, and just continues running the existing ships until they are obsolete. Typically ships have a lifespan of 20-25 years, and the average age of the ships in the trust is about 5 years. So the question is: is SGD 362m a good price to pay for 23 ships with 20 years of life left, and taking on SGD 650m of debt that was originally taken on to buy the ships.

The answer probably depends on two things: (1) were the ships purchased at rock bottom prices? and (2) what's the probable lease income from the ships after the current lease term expires in 5-7 years time.

Ships are a commodity, and shipping rates are cyclical. Ships lessees tend to lease ships mainly by price, so having the cheapest ships is key. When the industry is in a funk and excess capacity abounds, ships that were purchased at high prices are effectively money losers for owners, as the lease rates may be even less than the cost of the loan taken to buy the ship. So the future level of distributions ("dividends") from this trust depends on whether the ships were purchased at a rock bottom price and/or the amount of loans outstanding.

The other thing is that because the ships will become obsolete after 20 years, the intrinsic value of the trust drops every year. So having a high dividend/distribution yield is critical for investors to counter this. At the end of 20 years, the intrinsic value of the trust is the scrap value of the ships minus any outstanding loans.

Of course, if the ships were purchased at a rock-bottom price, then the trust can sell the ships even during a down cycle and make some money to return to unit holders. The ships are carried on the books at SGD 1.18b, so a key variable is whether this is considered cheap in the maritime industry.

So the next question is, can the management counter this inherent drop in value by buying new ships? The answer is yes, and this leads us to the second angle.

Because of the legal-financial structure of this type of trust, they generally do not retain their earnings. They more or less have to distribute all the cash coming in from leases/income streams. From an accounting standpoint, this means that the distribution is typically more than the accrued income shown on the income statement. This is because the reduction in equity caused by the depreciation expense can be distributed, unlike in normal companies where dividends are generally not to be distributed if there are no more retained earnings in the shareholder's equity. (In other words, the trust is a self-liquidating vehicle)

The implication is that anytime they want to buy new ships, they will need to either take on more loans or raise equity by issuing more units. Whether this is beneficial or detrimental to existing unit holders depends on (a) the price at which the new units were raised, relative to the Net Asset Value per unit of existing units, and (b) the returns on the capital raised - ie. whether they are able to buy good ships at cheap prices using the money raised. Both of these factors are very much determined by the decisions made by the trust management. (This is broadly true for companies too, any time new shares are issued, it can either be good or bad for existing shareholders, depending on the management's business acumen and decisions)

This variable depends entirely on the business acumen of the management team.