FSL – OCBC

Covenant concerns

Trailing yield is misleading. First Ship Lease Trust (FSLT) is currently trading at a trailing yield of about 40%. This is seemingly attractive, but misleading. Even in our best case ‘standstill scenario’ (where nothing happens), this yield is not sustainable. We estimate that FSLT’s DPU will decrease even if the trust’s income and equity base is unchanged. This is because of the trust’s debt repayment schedule. While FSLT had traditionally secured debt financing on bullet repayment terms, lenders require the most recent 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.

Diversified portfolio. FSLT has the most diversified portfolio of the three Singapore-listed shipping trusts. The other two trusts are containershipfocused, while FSLT owns containerships, dry bulk carriers, and tankers. However, we do not believe any sub-segment is completely immune to the reversal in the shipping and leverage cycles. Counterparty risk, which can lead to rate reductions or charter defaults, is a concern. We also note that FSLT has suspended its acquisition program as it awaits better debt and equity market conditions. Unfortunately, its ability to hunker down and ride out the cycle is limited by debt covenants.

Covenant concerns. 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. Lenders require a minimum coverage of 145%. The fair market value of the current portfolio would have to fall about 20% to breach this covenant. The shipping cycle has peaked and we believe asset values have further to fall. Another 20% decline is certainly not outside the realm of possibility. A breach triggers a technical default – in this event, we understand the cost of debt ratchets up and distributions are halted. FSLT’s lenders may require an immediate equity top-up to correct the breach or FSLT may be able to negotiate gradual repayment terms (where a portion of quarterly cash income goes to lenders). Distributions could be reduced, or even cut to zero in such a scenario. The ultimate outcome depends on the health and risk appetite of FSLT’s lenders. We have adjusted our estimates slightly and our fair value inches up from S$0.43 to S$0.46. Maintain HOLD.