FSLT cuts distributions to reduce debt

It will pay 2.45 US cents per unit for Q2, down from 2.8 a year earlier

FIRST Ship Lease Trust (FSLT) has cut its guidance for future payouts to unitholders to retain cash for repaying its debts, the latest sign of the pressure faced by shipping trusts here.

It will pay US$12.7 million, or 2.45 US cents per unit, for the second quarter, down from 2.8 US cents a year earlier and unchanged from the first quarter of this year.

That represents 74 per cent, or nearly three-quarters of the trust’s US$17.1 million net cash from operations for the three months to end-June. The remaining cash was used mainly to reduce its debts.

From the third quarter, however, it expects to pay out just 1.5 US cents per unit, or about half its free cash flow – the cash generated from operations, less any capital spending. The retained cash will be used to pay down its debt voluntarily to achieve ‘a more balanced capital structure’, it said.

FSLT’s share price fell yesterday after the announcement, ending 4.3 per cent lower at 66 cents.

Philip Clausius, chief executive of FSLT’s trustee-manager, said that ‘all our lease contracts continue to perform as expected’ despite the difficulties faced by the shipping industry worldwide.

‘Notwithstanding the very challenging market conditions, our broadly diversified lease portfolio remains robust and we expect it to continue generating stable cash flows.’

Its lease revenue rose 20.2 per cent to US$24.8 million in the three months to end-June, compared to a year earlier. FSLT said that none of its lessees has tried to renegotiate lease terms and that all lease rentals have been received promptly, including the rentals for this month.

The distribution reinvestment scheme, which gives unitholders the choice of receiving their distributions in the form of new units instead of cash, will not apply to the second-quarter payout, FSLT said. In the first quarter, the scheme saved the trust US$3.8 million in cash, which FSLT said would be used mainly to reduce its debt.

When FSLT listed here in March 2007, it had no debt. After listing, however, it funded a rapid expansion of its fleet by taking on more than US$500 million in bank debt to add 10 vessels to its initial fleet of 13. When the financial crisis struck last year, FSLT and Rickmers Maritime, another Singapore-listed shipping trust with substantial debt funding, were hit by higher interest costs as lenders invoked market disruption clauses and a plunge in demand for ship charters.

In October, FSLT cut its guidance for fourth-quarter distributions to 3.08 US cents per unit from 3.11 US cents due to the higher interest expense. In January, it said it would stop its policy of paying out all its distributable cash each quarter and instead use some of the cash to pay off its debt.

Since the start of this year, FSLT has been reducing its debt voluntarily, though it still has a large amount left. At the end of June, FSLT had US$501 million in secured bank loans outstanding, compared with US$513 million at the end of last year.

But FSLT stressed that all its vessels are fully financed and that it has no need to refinance any loans until 2012.

Mr Clausius said FSLT would continue to reduce its total debt and talk to lenders regularly to avoid any potential breaches of loan-to-value covenants that could be triggered by a fall in the value of vessels.

HOLD on covenants and counterparties

Watch for DPU guidance next week. FSL Trust (FSLT) will announce 2Q results next week on 21 Jul. We do not expect any big earnings surprises, and accordingly our attention will be on DPU. The trust had previously guided for 2Q distributions of 2.45 US cents per unit. Two key pieces of information to look out for: 1) whether the distribution reinvestment scheme (DRS) will apply this quarter; and 2) guidance for 3Q DPU. FSLT changed its ‘100% payout’ model in 1Q09, by scaling back payout and instituting the DRS. We have previously noted that the relative success of the DRS in the last quarter may protect the trust’s distribution payout ratio from further cuts.

Pre-paying loans may not be enough. Of course, this depends on the trust’s lenders reaction to FSLT’s attempts to voluntary prepay loans. Last quarter, a total of US$7.8m (roughly 46% of 1Q cash earnings) was earmarked to voluntarily prepay debt. US$3.8m stemmed from DRS proceeds, while US$4m was from retained cash earnings. We note that this amount is still small compared both to total loans and to our expectations of the quantum of the decline in vessel values.

Possibly seeking covenant waivers. We estimate that FSLT’s next vessel valuation will be in the Oct/Nov period (but lenders can call for a revaluation at any time). We believe the question here is not really if the loan-to-value (LTV) covenant has been breached but the tolerance level of lenders to such a breach. Peer Rickmers Maritime [SELL, fair value: S$0.39] had previously announced it is negotiating for LTV covenant waivers with its lenders, while US peers such as Danaos [NOT RATED] and Global Ship Lease [NR] have recently announced successful grants/extensions of such waivers. We expect FSLT to also negotiate for the same – in our opinion, it should be able to secure such waivers but our concern is with pricing. A possible cost structure could be a combination of one-time fees along with higher interest margins over the waiver period.

Covenants and counterparties. We have a NEUTRAL view on the shipping trust sector. We like FSLT’s diversification but the shipping industry is undeniably facing tough times. As such, our concerns on covenants and counterparty health remain unchanged. Securing an LTV covenant waiver could be an important next step for FSLT. Maintain HOLD with S$0.58 fair value estimate. This values FSLT at a 30% discount to our ‘normal’ case discounted FCFE value of S$0.83 (10% discount rate).

Reinvestment Scheme results

Distribution Reinvestment Scheme (DRS) results. FSL Trust (FSLT) announced that unitholders holding around 155.5m units or 30.9% of the total number of issued units have elected to receive 1Q distributions in the form of units. FSLT has issued about 15.6m units, increasing the total outstanding unit base to around 518.7m units. The manager said that this level of participation was stronger than expected.

Prepaying loans. Proceeds (or retained cash) from the DRS amount to US$3.8m, have been earmarked for voluntary debt repayment. Recall that FSLT had already retained US$4.6m or 27% of 1Q cash earnings, of which US$4m was used to repay debt (also voluntary). In aggregate, FSLT will prepay US$7.8m, or roughly 46% of 1Q cash earnings and 1.5% of total loans. Using 1Q data, its gearing post-prepayment comes to around 1.37x debt-to-equity. Retained cash in 2Q09 will again be used to prepay loans.

Implications for LTV. Loan-to-value covenants are a key concern for the shipping trust sector in light of the ‘new world order’ of falling asset values and low lender risk appetite. The manager’s decision to launch the DRS and to voluntarily reduce FSLT’s payout ratio is a pre-emptive gesture of good faith to lenders. In FY09, FSLT could potentially pay off US$16-31.2m (annualized, without and with the DRS) or 3.1-6.1% of total loans. We note that this amount is still small compared both to total loans and to our expectations of the quantum of the decline in vessel values. But whether this level of prepayment is a gesture, or a game-changer, is up to the trust’s lenders. The ball is in their court, now.

Implications for DPU. We had previously suggested that outcome of the 1Q09 DRS may affect FSLT’s course of action going forwards. The DRS was a success, relatively speaking. FSLT now has more options, in our opinion – we believe it may prefer to keep the scheme in play rather than making further cuts in the distribution payout. Deterioration in the external environment, or adverse feedback from the lenders, could of course tilt this decision the other way. Our updated earnings estimates assume the DRS will apply for the whole of FY09. Our new fair value estimate is S$0.58 (up from S$0.45 previously). This values FSLT at a 30% discount to our ‘normal’ case discounted FCFE value of S$0.83 (10% discount rate). We believe this is a fair reflection of the shipping environment today. Maintain HOLD.