FSL: Is the Business Model Substainable?

From the analysis by d.o.g., the sustainability of the business of the trust seem to hinge on the below:

1. Ability to raise new equity - depends market sentiment at that point in time
2. Ability to quicky grow earning accretive fleet size, hopefully to support high share price for #1


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d.o.g.

Forum Sage
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Posts: 810
Registered: 10-12-2003
posted on 31-1-2008 at 12:58 AM


Quote:
ICICI
for business trust, the debt actually matures and gets repaid off
It is vitally important to understand what is happening with the debt carried by the shipping trusts.

In the specific case of FSLT, the debt is not being paid down over time - payments are interest-only until maturity, when a bullet principal payment comes due in 2014.

Before we look at numbers, here is some logical reasoning:

1. FSLT carries debt which must be repaid or refinanced eventually.
2. There is no guarantee that FSLT can raise money in the equity markets.
3. A conservative analysis assumes FSLT cannot raise money from the equity markets.
4. Ships age and wear out eventually.
5. All cashflows from vessel charters are paid out to unitholders.
6. Therefore, no internal funds are available to replace scrapped vessels.
7. The fleet shrinks in size and value over time, and liquidates when the last ship is scrapped.
8. Throughout this period, no principal payments on the debt have been made.
9. Since the fleet size and value are shrinking, the debt cannot be refinanced indefinitely.
10. No perpetual refinancing means the debt must be repaid.
11. The money to repay the debt must come from vessel charters or vessel sales.
12. Any valuation of FSLT must include a cash outflow to pay the debt.
13. Current yield ignores the future debt repayment.
14. DCF would accurately capture the outflow to repay the debt.

The ability of FSLT to survive as a going concern in the long term depends on its ability to continuously raise funds from the equity markets. It is equivalent to a company with a 100% cashflow payout policy, where no money is allocated to replacement capex. Eventually the equipment wears out or is obsolete. Since the company never kept any money to replace the equipment, it has to do a rights issue regularly or else liquidate. This is basically how FSLT is operating. If unitholders don't pay up, it will eventually liquidate with only scrap value for unitholders.

Like it or not, FSLT's payouts are part profits and part capital. The payments cannot be sustained in the long term - a rights issue must be done by 2014, or else assets must be sold to reduce the outstanding debt.

FSLT is a classic DCF case study. Most of the inputs are available from the IPO prospectus and the announcements - ship specifications, charter rates, charter duration, charter customers, buyout clauses, debt servicing schedule, even ship names!

The remaining inputs - future charter rates, future interest rates, discount rate - have a large influence on the value of FSLT. If you make reasonable assumptions, you'll get a decent approximation of what FSLT is worth. Of course, there is no reason why FSLT should trade anywhere near what it is actually worth.

Personally, I found the DCF exercise highly informative. I would strongly encourage all current and potential FSLT unitholders to do a DCF analysis and make a decision then, rather than simply buying on current yield alone.
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d.o.g.

Forum Sage

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posted on 31-1-2008 at 11:24 AM



Quote:
musicwhiz
I am assuming the payments will terminate up till 2014, and hopefully by then the trust would have acquired additional assets to boost its profile and structure. Thus, any rights issue would then be well supported by unit holders who will be expecting more yield accretion after 2014.
This is missing the point entirely. If the unit price does not do well in the stock market, the trust CANNOT do a rights issue to acquire assets because it would not be DPU-accretive. Acquisitions would then have to be financed by debt which has to be paid back eventually. Anyway the remaining debt facility is only US$100m which doesn't buy much.

In other words the survival of FSLT as a going concern depends wholly on market sentiment - if the market yield is low, it can raise funds to buy vessels to renew the fleet. If not, sayonara.

If you think a bit deeper you will realize that even when the yield is low and equity can be raised, bigger and bigger acquisitions are needed to make an impact to DPU.

Worked example:

Units outstanding: 500m
Assets owned: $500m
Stock market yield: 6%
New assets: $250m
New asset yield: 9%
Units issued: 250m
New total units: 750m
Total assets owned: $750m
New stock market yield at same price: 7%

Suppose the price appreciates so the yield is back to 6%. To increase yield to 7%, the trust must again grow by 50% if it buys assets yielding 9% i.e. now it has to buy $375m of assets, reaching $1,025m of assets. The next round, it has to buy 50% of $1,025m, or $512.5m, and so on.

Since new investor money is buying assets rather than paying existing investors, shipping trusts are not a pyramid scheme. Still, the scale of acquisitions required to increase DPU grows at an unhealthy rate. If this 50% p.a. growth rate was sustainable, one trust would eventually control the world's fleet.

Quote:
musicwhiz
As for using DCF to estimate the fair value, what estimates do you suggest for use in terms of future charter rates and scrap values of the current vessels ? Also, what discount rate should we factor which will give a realistic and reasonable assumption ? I am still learning about DCF and have yet to incorporate it into my valuation techniques (to my regret).
Scrap value is based on dollars per ton of steel content. You can Google for recent and long-term average prices for scrap steel. Cargo ships are pretty much all steel by weight; instruments and equipment don't weigh that much in percentage terms. For future charter rates, you can look at long-term averages, or use the renewal rates specified in some of the contracts.

Discount factor - you have to decide on an appropriate rate of return for yourself. As some have pointed out, this is roughly equivalent in concept to IRR. If the discount rate is set to the desired IRR then the value you get is the price you should pay to get that IRR.

Quote:
musicwhiz
do you think the yield will begin to compress in the near future after shipping trusts make more yield accretive acquisitions ? This has happened for Seaspan and Danaos (both USA-listed shipping trusts) over time.
This depends entirely on market sentiment which is inherently unpredictable. It is foolish to gamble that the price will always be high enough that the trust can regularly raise funds to survive. It is a vicious cycle - if the yield is low to start with, it is easy to raise funds for DPU-accretive acquisitions. If the yield starts high, it is difficult. As the yield goes up it gets harder to raise funds.

For FSLT, the yield is so high that raising funds is impossible in the near term, and very difficult in the mid-long term. In other words, FSLT is probably doomed to liquidate or be taken over eventually, rather than survive, let alone grow. The 100% cashflow payout policy guarantees that the existing fleet can only shrink in value and size over time. Only favourable market sentiment can save FSLT, by allowing it to raise funds from unitholders to renew the fleet.

In order for FSLT to survive, *somebody* must drive the price high enough that it can raise funds and do DPU-accretive acquisitions. Think about the conglomerate boom in the US in the 70s - corporations were continously issuing shares at 20x PE to buy companies traded at 10x PE - it was always EPS-accretive. But once their stock prices fell, the acquisitions stopped, and the companies had to get EPS the old fashioned way - by actually doing business.

Closer to home, when the REITS were trading at 4% yields, they went on buying sprees to buy assets at 5% yields since it was DPU-accretive. Now that they are trading at 5-6% yields, the acquisitions have dried up. Some are trading at 8-10% yields and will not be able to buy assets at all except with debt, and then only to a limited extent. They will probably get taken over in future.

Quote:
musicwhiz
if the shipping trust were to acquire assets consistently throughout its life such that the terminating point of the leases are staggered over several years, would this mean that we would have to continually tweak out DCF forecast to take into account the new acquisitions and the cash flows associated with them ?
Yes. In the case of FSLT this is trivial because its additional debt capacity is less than US$100m which buys only a couple more ships. Just assume it buys clones of one of its existing ships today. Like I said previously, FSLT is a classic DCF case study. Seldom will you find securities so well suited to a DCF analysis.

Quote:
KKT
based on projected yearly payout of 14c, you will get back the initial capital outlay in less than 7.5 years time, that is assuming no acquisitions, which is unlikely. By then, from what I can see from their financial statements, the value of the ships will be more than able to pay off the loans. Granted we haven't take into consideration the discount rate which is kind of offset by not taking in new acquisitions into account.


Saying you will get back your capital in 7.5 years is correct only if you assume the time value of money is ZERO. The discount rate CANNOT be set at zero because there is always the alternative of Singapore government bonds. At the minimum, it has to be set at the long-term SGS rate, and sensibly it should be quite a bit higher to compensate for business risk. To borrow a phrase from the police, "low risk doesn't mean no risk". Even discounted at the current 7-year SGS rate of 1.9%, you will find that 7.5 years of $0.14 payouts yield a PV of only $0.97.

In fact, before the 7.5 years are up, in 2014, 6 years' time, the debt must already be refinanced or paid back. Since the fleet will be older then, most likely only partial refinancing is possible i.e. some principal must be repaid. Whether you sell ships or commandeer cashflow to make a partial payment, future cashflow is reduced.

Acquisitions at the current price can only be done via debt which still needs to be repaid, and anyway US$100m doesn't buy enough ships to make much difference to DPU. Try it yourself and see. Equity-funded acquisitions are a gamble on market sentiment and should not be factored in at all.

Quote:
tanjm
FSL has embedded a number of purchase options on a number of its ships - ie. the lessee has the right to purchase the ship.
Yes. This is a "sure lose" proposition for FSLT because when those ships come off lease, if charter rates are good the ships are worth more, but the lessee buys them at a discount. FSLT on the other hand has to buy in the open market at a high price. But if charter rates are poor then, the lessee walks away and FSLT is stuck re-chartering the ships at a low rate.

Why did FSLT take such a "sure lose" route? The answer is that in exchange for being able to get a bargain purchase price in future, the lessees agreed to pay slightly better charter rates. FSLT has sacrificed future profitability for current cashflow.

The 100% cashflow payout policy, early buyout clauses and bullet-payment debt all indicate that FSLT management is intent on maximizing short-term cashflow, even at the cost of future viability.

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d.o.g.

Forum Sage




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Posts: 810
Registered: 10-12-2003
posted on 1-2-2008 at 11:05 AM


Quote:
mantra
they are totally bewildered as to why the stock price continues to sag when they have delivered ahead of their own targets.

The investment merits would improve dramatically if they reduced the payout ratio and retained sufficient cashflow to renew the fleet. Then rights issues would truly grow the company instead of merely keeping it alive.

Since being listed doesn't affect the business operations of a company, let's suppose FSLT was not listed, and you were the sole owner. Then:

1. The fleet wears out over time and must be replaced;
2. All cashflow is paid out;
3. No money is available to renew the fleet;
4. The fleet shrinks over time

Now the management calls you up and says: Please give us some money to buy ships. We'll sell you shares at a cheap price. The ships will generate cash which we will pay back to you. However, next year, and every year after that, we will ask you again for more money to buy ships. If you don't give us the money we will have to shut down.

What would your reaction be? Personally I'd have a few choice words for management who can't keep a company running on its own steam, and need continuous cash injections just to stay alive.

A 100% cashflow payout is totally inappropriate for an asset-heavy business, because then it requires continuous rights issues to replace worn-out assets.