FSL – OCBC

Multiple layers of risk; maintain HOLD

3Q results as expected. First Ship Lease Trust (FSLT) announced that it generated US$23.7m of revenue in 3Q08, up 84.8% YoY, thanks to the acquisition of six vessels in the past year. The trust will distribute US$15.3m, or 3.05 US cents per share for 3Q08, up 9% QoQ and 36.8% YoY. This translates into an annualized distribution yield of 38%. The results were generally in line with our expectations.

Latest loan terms will impact DPU. While FSLT had so far secured debt financing on bullet repayment terms, lenders require the newest US$65m loan tranche to be amortized from Sep 2010 until the loan’s maturity in Apr 2012. We assume FSLT will have to use its cash income to pay down the loan from 2010 onwards. As FSLT is currently paying out 100% of its cash income, we estimate that DPU would fall 7.5% to 40% YoY over 2010-12 on the existing equity base and portfolio.

Loan-to-value at 175%. FSLT disclosed that the latest fair market value of its vessel portfolio as of mid-October is US$896m, or about 11% less than the original acquisition cost. This represents 175% of FSLT’s outstanding loan value of US$513m. One of the loan covenants mandates a minimum coverage of 145%. The fair market value of the current portfolio would have to fall about 20% to breach this covenant, triggering a technical default.

Multiple layers of risk. While a credit market breakdown has been averted, credit markets are still illiquid due to risk aversion arising from mass deleveraging and an imminent global recession. FSLT has a diversified portfolio with long lease terms, but it is not immune to its environment. Counterparty defaults may lead to a rate reduction or at worse, an idle ship. Asset values in turn are likely to depreciate as the industry turns. These risks are magnified by the use of leverage. If the loan-to-market value covenant is breached, lenders may demand that FSLT start using its cash income to pay down debt. Distributions could be reduced, or even cut to zero in such a scenario. We believe that recent price levels fully reflect the current risks and maintain our HOLD rating. Our fair value estimate of 43 S cents prices in a bear case scenario with a 25% fall in charter income, a 50% fall in terminal asset value and zero distributions from 2009 onwards (income is diverted to pay down debt).