Shipping Trusts: Pacific Shipping Trust and First Ship Lease FSL Trust

Introduction

There are two shipping trusts listed on the Singapore Exchange, Pacific Shipping Trust and First Ship Lease (FSL) Trust. Both are in the business of owning, managing and leasing their ships out. Both have a reasonably large portfolio of ships, with FSL’s being somewhat larger than Pacific’s. The charts below show the stock performance of Pacific and FSL Trust respectively.


Competitive Comparison

According to the two prospectus industry reports on the global shipping lease market, the market is highly fragmented and each player can only command a fraction of the market. Lease and utilisation rates therefore depend largely on global supply and demand for shipping transport. Because shipping is the only feasible cost-effective way to transport large quantities of freight from country to country, the demand for shipping has generally exceeded supply enough to cause shipping rates to rise. The Chinese growth engine ensures steady exports out of the Middle Kingdom across the Pacific and westward towards Europe. Meanwhile, China's great demand for natural resources such as coal and oil have ensured imports of the same. The transportation of all these imports and exports requires shipping transport.

The respective fleets of both trusts are leased to their clients on long term leases, which means that it is unlikely that capacity underutilization will be a problem in the near future. Furthermore, the broader shipping capacity of the industry as a whole is near full capacity. This indicates that it is unlikely that there will be a shortfall in demand in the ship leasing market in the near future.

The basis of comparison for this research note between these two trusts is primarily on decomposing their respective financial statements.

Financial & Profitability Analysis

	Pacific Shipping Trust	FSL Trust
Revenues (FY est.)	$34,246	$64,247
Operating Profit (est.)	$19,448	$13,704
Net Profit (est.)	$16,446	$11,637
Total Assets	$266,595	$527,236
Total Liabilities	$116,745	$47,049
Equity	$149,850	$480,187
Liab/Assets	43.79%	8.92%
ROE	10.97%	2.42%
ROA	6.17%	2.21%
Operating Margin	56.79%	21.33%
Net Margin(Persistent)	48.02%	18.11%
CFO/PBT	1.438	5.799
Shares Outstanding ('000)	337000	500000
EPS	$0.049	$0.023
NAV	$0.44	$0.96
Stock Price	$0.43	$0.87
P/E	8.81	37.17
P/B	0.97	0.90
Payout per unit (est.)	$0.0424	$0.0877
Payout Yield	9.86%	10.14%
PBDA	$29,382	$58,254
PBDA Margin	85.80%	90.67%
CFO/PBWC	0.979	1.167
CFO/PBDA	1.093	1.175

The table above shows key comparative ratios for the two trusts. The numbers for revenues and profits are estimates and are used as a guide only. Actual results may differ materially from the estimates. This is because the trust has only recently been listed and there are no FY numbers for analysis. Nevertheless, it is better to be approximately right than precisely wrong, so we use the estimates for analysis.

The first thing to note when comparing the financial statements of the two trusts is that FSL Trust has a much higher depreciation charge in comparison to Pacific. The financial statements do not reveal the details as to the depreciation rates. Thus it is better to use Operating Profit before Depreciation & Amortisation (PBDA) and Operating Profit Before Working Capital Charges (PBWC) as comparative numbers rather than profit before tax or operating profit. This number is calculated in the rows below, along with associated ratios.

1. Operating Efficiency

From a comparative standpoint, FSL Trust appears to be operating more efficiently than PST, with PBDA/Revenues of 90.67% compared to PST of 85.8%. Furthermore, PST seems to derive operating profits from “fair value gains on derivatives” (see cash flow statement). This looks like a rather suspicious item, and it is not clear why a shipping trust should have such a significant exposure to derivatives. [see update below for more info on the derivatives]

2. Cash Flow Quality

FSL’s CFO/PBWC is 1.167 compared to PST’s 0.979. FSL’s CFO/PBDA is 1.175 compared to PST’s 1.093. On both counts, FSL appears to have a better quality of cash flow compared to Pacific.

3. Leverage

What really sets the two trusts apart is that Pacific is much more highly leveraged than FSL. Pacific has a liabilities/assets ratio of 43% while FSL’s is 9%. Yet the payout yield for FSL based on latest share prices, is higher than Pacific. If we try to lever FSL’s balance sheet up to Pacific’s level, ceteris paribus,FSL shares will be expected to have a leveraged yield somewhere in the region of 11-12% based on latest share prices.

This is a very attractive number for any business trust. And assuming the market is pricing Pacific efficiently, that means that FSL at its current price of $0.87 is undervalued somewhere around 25-30%.

Evaluation

Based on a comparative valuation between the two, it appears that FSL Trust is clearly the undervalued stock according to latest market price of $0.87. Independently on its own, FSL Trust gives a much better yield than REITs (10% vs 5-6%), and exceptional return for its stability compared to other businesses. Furthermore, FSL has excess credit capacity to make accretive acquisitions which will further add to the yield quality of the stock.

FSL Trust is on my buy watchlist at a price around $0.85-$0.87.

Update: A WallStraits Forum member has replied to my post and has raised a few good points:

Originally posted by tanjm
I did a quick read of your report as I am vested in BOTH.

Some things to note:

1. PST strategy is to highly leverage at the beginning, with a term loan matching the long leased tenures of the ships it rents out. These term loans are amortizing i.e. the principal is paid down evenly over the life of the loan. This means that a part of PST's cash flow is continuously paying down the principal of the loan. At the end of about 10-12 yrs, PST will be debt free. What this means, from a distributable cash flow perspective, is that PST distributions will increase over time EVEN IF PST does nothing. This is because as the loan principal is paid up, the interest costs will decline and its present yield will increase.

2. PST has interest rate swaps in place to hedge its term loans. The actual term loan is actually a floating interest rate. The purpose of the swap would be to effectively lock in a interest rate of about 6% over the entire life of the loan. The nature of this hedge is that any gains on the swap will offset any losses on the interest payments of the loan and vice versa. As an accounting practice, PST has to log any book value gains or losses of the swap, but this practice has no effective bearing on its ability to pay distributions.

3. FSL sponsors have subordinated their distributions from their share of the trust to locked in increases of the distribution up to 2009. Effectively, this means they have "gauranteed" (up to the limit of their own share of the distribution) that distributions will increase for the first couple of years.