LTV covenant clouds dissipate

Secures covenant waiver. FSL Trust has secured a two-year waiver for the loan-to-market value covenant in its credit facility. The waiver, subject to documentation, will extend until the end of 2Q11. During this period, the minimum coverage ratio of the charter-free fair market value of the trust’s portfolio over its outstanding indebtedness will be reduced from 145% to 100%. In return, FSLT must repay US$8m per quarter during the two-year period (or US$64m in total). The trust has already prepaid US$12m voluntarily. Margins over US$ LIBOR also increase by between 50 and 70 basis points (bps) during the period. The margin increase is reduced to a 25-bp hike after the waiver period.

Re-affirms DPU guidance. The manager estimates that the additional interest expense during the waiver period averages US$0.7m per quarter. The manager re-affirmed its DPU guidance of 1.5 US cents per quarter. We estimate this works out to a payout of less than 50% of cash earnings. We note there might be some one-off expenses (both cash and non-cash in nature) in 3Q09 as FSLT is likely to re-align its interest hedges to reflect the new amortization schedule.

T&Cs as expected with some positives. The conditions and pricing were in line with our expectations. We were expecting US$35m annual payment (versus US$32m actual). We were off by about 5 bps in our cost of debt
assumptions. The positive surprise was the lower margin increase postwaiver period (we were not so optimistic). The new minimum coverage ratio is fair in our view, especially with outstanding indebtedness falling as quarterly loan repayments are made. The ‘official’ current fair market value of the portfolio was not disclosed.

Remains our top sector pick. A major overhang has eased, taking pressure off the manager and the stock. Industry concerns remain but we like the new, more sustainable payout model and FSLT’s diversified vessel mix. We reiterate that unitholders should constrain their expectations regarding DPU growth; with the new payout model, a significant DPU increase would require acquisitions (and fresh equity) in our view. Note this is a revolving credit facility, so FSLT has the option to tap into the undrawn amount as it grows with each periodic repayment. Our discounted FCFE value is up from S$0.84 to S$0.86, incorporating actual waiver terms. Our fair value estimate edges up a cent to S$0.77, reflecting an “industry uncertainty” discount of 10%. Maintain BUY.

FSL Trust secures 2-year loan-covenant waiver

But interest margin raised 50 to 70basis points during waiver period

SHIPPING trust First Ship Lease Trust (FSLT) has announced some relief amid the sector’s finance woes by securing a two-year waiver from the loan-to-value covenant for its credit facility, although it comes at a higher price of a 50 to 70 basis point increase in the interest margin for the duration of the waiver period.

During the waiver period, which will extend until the end of the second quarter in 2011, the minimum coverage ratio of the charter-free fair market value of FSLT’s vessel portfolio over its outstanding indebtedness will be cut from 145 per cent to 100 per cent.

FSLT will also make quarterly loan repayments of US$8 million during this period, which will progressively reduce its outstanding loan balance and lower its refinancing risk at the respective loan maturities in 2012 and 2014. To date, FSLT has already voluntarily pre-paid US$12 million of its loans.

‘We are very pleased to secure this arrangement with our lenders, which addresses a key concern for investors in relation to any potential LTV covenant breach,’ said FSLT trustee-manager FSL Trust Management CEO Philip Clausius. ‘With our voluntary pre-payments and now agreed amortisation on these loans, we have established a clear framework for FSLT’s balance sheet going forward. We are now able to affirm with confidence our quarterly DPU guidance of 1.5 US cents from Q3 FY2009 onwards,’ he added.

Based on FSLT’s closing price of 60 Singapore cents yesterday, this represents a prospective annualised yield of approximately 14 per cent.

In connection with the waiver arrangement, however, all loan tranches under FSLT’s credit facility will bear a higher interest margin of 1.7 per cent over the three-month US dollar Libor on the outstanding loan amount during the waiver period. The margin increase will be reduced to 25 basis points after the expiry of the waiver period.

The extra interest expense arising from the higher interest margin during the waiver period averages US$700,000 per quarter and will not affect FSLT’s DPU guidance of 1.5 US cents per quarter.

As the credit facility is revolving in nature, FSLT will be able to re-draw on the committed but undrawn portion of its credit facility after the waiver period.

FSLT’s current portfolio comprises 23 vessels which are all leased on long-term bareboat charters. These are all fully financed and there is no committed capital expenditure or requirement for additional funding.

FSLT also reiterated that it has been receiving prompt lease rental payments from its lessees and there has been no request by any of its lessees to re-negotiate lease terms.

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.

DPU cut will pay off in long run

• Guides for lower DPU payout of 1.50UScts from 3Q09 onwards, down from 2Q09 DPU of 2.45UScts
• Move will accommodate amortizing loan structure to avoid breaching loan covenants
• FY10 dividend yield still a healthy 13%
• Maintain BUY on easing covenant/ refinancing concerns, target price revised up slightly to S$0.72

Move necessary to sustain business model. While 2Q09 DPU of 2.45UScts was in line with previous guidance, management sprang a surprise by reducing its DPU guidance to 1.50UScts from 3Q09 onwards – down 39% from the current level. This would translate to a payout ratio of about 50% of its quarterly cash generated, and the remaining cash (about US$8m) would be used for debt prepayment as described below.

From bullet loans to amortizing. To avoid breaching the loan-to-value covenants on its borrowings, management is in the process of working out an agreement with its lenders – whereby they prepay debts on a regular basis in exchange for the covenant waiver. In effect, this is a shift to an amortizing loan structure.

Valuation should reflect lower risks, better growth prospects. While we cut our FY09 and FY10 DPU forecasts by 20% and 38%, respectively, we look forward to a more sustainable quarterly DPU of 1.50UScts and a definitive agreement with lenders in the
near term. Moreover, once the covenant breach uncertainty is out of the way, FSLT may find it easier to tap the equity markets and acquire potentially DPUaccretive assets at cheap valuations. Thus, with the stock trading at 13% FY10 yield, we still find the risk-reward ratio favourable and maintain BUY at a TP of S$0.72.