FSL – OCBC

Finally looking sustainable – upgrade to BUY

New amortizing strategy. FSL Trust’s 2Q results were in line with our expectations. As per guidance, 2Q DPU is 2.45 US cents. Key for us: FSLT has introduced longer-term DPU guidance from 3Q09 onwards – the trust is targeting a payout of 1.5 US cents per quarter or around 50% of free cash flows. Retained cash will principally be used to prepay loans. We understand this new guidance is driven by discussions with lenders. We expect loan-to-value covenant concerns to become a non-issue once these discussions conclude. Everything has a price of course, and here lenders look to be demanding a new amortizing strategy and likely higher interest margins. Our new assumptions: 1) FSLT will pay down around US$35m of debt every year; 2) all-in interest costs will rise from about 5.25% to 5.85%. This is subject to revision when the actual agreement is finalized and disclosed.

Finally looking sustainable. 3Q DPU is down to even below IPO levels (with 13 vessels then versus 23 now). Unitholders will have to accept that this reduced payout is the hangover after the 100% payout “party” they have enjoyed for so long. A consolation – in our opinion, this is finally a realistic number. Right since when we initiated coverage over a year ago, we have been saying the trust’s aggressive payout was unsustainable. With this new approach, FSLT now looks more like a viable long-term investment vehicle for serious shipping trust investors.

Expect stability, not growth (without new equity). We reiterate that the time for steadily accelerating DPU has gone. Meaningful DPU growth will necessitate acquisitions – but in our opinion, any new vessel buys would need to be financed on the back of fresh equity. Consequently, unitholders should constrain their expectations to a stable stream of income based on the 50% payout regime.

Upgrading to BUY. Our updated discounted FCFE value for FSLT is S$0.84 (10% discount rate, prev: S$0.83). In our view, the balance sheet side of the trust’s challenges is mostly resolved (with conditions/pricing still uncertain). The other concern that remains (industry-wide) is counterparty risks. We ascribe a 10% “industry uncertainty” discount to reach a fair value estimate of S$0.76 (prev: S$0.58). This implies a total return of about 28% (15% upside, 13% yield). We like FSLT because of its 1) new more sustainable business model; and 2) its diversified vessel mix of containers, tankers and dry bulk carriers. For these reasons, FSLT is now our top pick for the sector. Upgrade to BUY.