No surprises: 2Q08 DPU in line with expectations

First Ship Lease Trust (FSLT) has announced its 2QFY08 results. Charter income came in at US$20.7m, accounting for 24.3% of our forecasts, in line with expectations while cash available for distribution was US$14.0m, accounting for 25.0% of our full year forecasts. Distributions Per Unit (DPU) for 2QFY08 was 2.8 US cents, slightly better than managements’ latest guidance of 2.77US cents for the quarter.

Incentive Fee threshold crossed again: management electing for units. An incentive fee of US$239,000 was paid to the trustee-manager as the Distributable Cash Per Unit (DCPU) has exceeded the 115% benchmark quarterly DPU of 2.13 US cents. As in 1Q08, management has elected to receive 99.99% of the incentive fees in the form of new units. We calculate the dilution to be minimal with the impact to DPU being approximately 0.0007 US Cents per quarter.

Distributions expected to grow to 3.05 US cents per quarter, implying yield of 12.9%. FSLT took delivery of two 4,250TEU containers from Yang Ming Transport Corporation (YML) during 2Q08. These two vessels will fully contribute to FSLT’s charter income and DPU from 3Q08 and are expected to increase FSLT’s DPU to 3.05 US cents per quarter, implying an annualized yield of 13.0%.

Acquisition of third sister ship in Oct 08 could boost annualized yield to 13.4%. FSLT has a conditional agreement to acquire a third vessel similar to the first two from YML by end Oct 2008. FSLT is currently in discussion with its lenders to increase its revolving credit line from US$200m to US$265m, enabling FSLT to take delivery of the third vessel. While management has not guided on the accretion to DPU for the third vessel, we estimate that FSLT’s distribution could increase to 3.15 US cents/ quarter in FY09 assuming similar financing and charter terms are reached.

Stable and visible distributions: Maintain BUY. We continue to like FSLT for its stable and visible distributions which are supported by its long bareboat charters which have an average remaining lease term of approximately 9 years. The staggered redelivery of its diversified fleet of tankers, bulkers and containerships also helps to mitigate risks associated with the cyclical nature of shipping. With the completion of the acquisition of the second Yang Ming vessel, management is guiding for a DPU of 3.05 US cents per quarter from 3Q08 onwards, implying an annualized yield of 12.9%. We maintain our BUY recommendation on FSLT with a target price of US$1.24 (S$1.61) based on a yield based target of 9.0%.

Distributions in line

Comment on Results

First Ship Lease Trust declared its 2Q08 results today and announced a distribution of 2.80 UScts per unit for the quarter, which is in line with our expectations of 2.77 UScts per unit. The total distribution amounts to US$14.0m and represents 100% of distributable cashflows. The DPU payout for 2Q08 is 8 % higher qo-q and 28% higher y-o-y. Revenue for 2Q08 came in at US$20.7m, up 71% y-o-y.

The increase in revenue and net distributable income y-o-y is mainly due to the incremental cashflows from the acquisition and leaseback of six vessels – 2 product tankers with Groda in Nov’07, two crude oil tankers with Geden in Apr’08 and two containerships with Yang Ming Marine in May and Jun’08. A full quarter’s cash flow impact from the acquisition of the two Ying Mang ships is thus, expected to come into effect only from 3Q08 onwards. In addition, the third vessel to be acquired from Yang Ming, which is currently under construction and expected to be delivered by end October’2008, should bolster earnings from Nov’08 onwards. The Trust is currently negotiating an increase in its revolving credit facility by US$65m in order to facilitate the acquisition. Postacquisition, debt to equity ratio would stand at 1.2:1 (slightly higher than long term target of 1.16:1).

Recommendation

Thus, FSLT will continue to provide investors with steady distributions backed by accretive acquisitions and we maintain our DPU forecasts for 3Q08 and 4Q08 at 3.05 UScts and 3.07 UScts, respectively. Our DPU projection for the full year remains unchanged and we maintain our BUY recommendation at a target price of S$1.65, which is pegged to a target return of 9.4%. The stock is currently trading at a dividend yield of 12.8%-13.8% in FY08-09, which we believe translates to yield spreads that are unjustified when compared to US peers.

Market conditions suited for lowerrisk investments

First Ship Lease Trust (FSLT) is a business trust formed to own and lease vessels on an exclusively bareboat charter basis. Its policy is to distribute 100% of available cashflows which are tax-exempt to all classes of investors.

Dividend paying with growth. FSLT has grown its fleet since IPO – from 13 vessels to 23 by end Oct 08. Its portfolio is diversified across eight customers and five shipping subsectors. Regular and stable distributions is the basis for the trust and growth will come from accretive acquisitions. YTD, FSLT has already acquired vessels worth US$350m (incl the third Yang Ming vessel), ahead of its acquisition target of US$300m for 2008.

Positioned to exploit opportunities. FSLT is well positioned in the global ship finance market, estimated at US$75bn pa. There is no conflict with potential lessees as Trustee-Manager, FSLTM, does not engage in ship operating activities. Shipping cycle volatility is mitigated by its staggered lease expiry profile with the earliest maturity in 2014, an average remaining lease period of approximately 9.2 years and a diversified vessel portfolio as sub-sector shipping cycles are usually countercyclical to each other. FSLT signs bareboat leases rather than time charters, and is not exposed to operational costs (such as fuel, crew-related expenses) and risks.

Risks. Its single largest risk is the credit risk associated with its lessee base. This is minimized as all vessels are leased to international operators and payable monthly. Near term opportunities for acquisitions is probably limited given that FSLT has marginally exceeded its targeted capital ratio and the weak equity markets.

Initiate with a Buy, TP S$1.65. We believe that FSLT’s yield spread versus the US peers is unjustified. FSLT is offering a yield of 12.7% and 13.7% in FY08-09 and is trading at a P/B of 1.1x. For comparison, US peers are trading at yields of 9.1% and 9.5% for FY08-09 respectively; and at a P/B of 3.1x. TP of S$1.65 pegged at a target return of 9.4%, the average of the US and Singapore peers.

Downgrade to HOLD

FSLT has achieved our fair value estimate. First Ship Lease Trust (FSLT) has done well since our last report dated 25th April, up 12% despite broader market weakness. This recent recovery is on account of an increase in DPU – we are projecting FY08 DPU of 11.6 US cents (+27% YoY) and FY09 DPU of 12.53 US cents (+8% YoY). FSLT is offering a high 12.5% FY08 DPU yield1, a whopping 900 basis points premium over the 10-year Singapore government bond. In contrast, the S-REITs are trading on average at 400 bps over the 10-yr rate.

Acquisition spree in 1H08. The DPU spurt we estimate for FY08 and FY09 has been achieved through a larger than expected acquisition spree. In 1H08, First Ship Lease Trust (FSLT) announced the acquisition of two crude oil tankers and three containerships worth US$350m. Four of the five vessels have already been delivered. Financing for the fifth vessel, a US$70m containership, with an expected delivery in end October, has yet to be arranged. We have updated our estimates to reflect the higher than expected capex at a higher finance cost. We estimate asset yields to be lower than previous buys however, making this round of acquisitions less accretive.

Reaching limits to gearing. We estimate that with the completion of this round of acquisitions, FSLT will have overshot a sustainable debt-toequity level of 1x by the end of this year. We believe there is reduced prospect for further gearing at current equity levels. Unlike S-REITs, shipping trusts do not see positive rent reversions in the near term. DPU is therefore capped at FY09 levels. An equity infusion to continue growing DPU could be dilutive as FSLT continues to trade at prohibitively high yields.

Downgrade to HOLD. We remind investors that because of its aggressive payout strategy, FSLT’s high yield consists of both a return on capital (income) and a return of capital (depreciation). It is consequently important to look at both yield and net asset value, which has been falling in tandem with DPU growth (see chart). FSLT is currently trading at S$1.23, 2.5% above our fair value estimate and FSLT’s 1Q08 NAV of 88 US cents. As it is now trading close to our fair value of S$1.20, and has outperformed with a 12% gain over a 2-month period in a slowing market, we downgrade FSLT to HOLD.

New Acquisitions Boost Distribution Yield To 14.8%

First Ship Lease Trust (FSLT) has entered into a conditional agreement to acquire three 4,250 TEU container vessels from a wholly-owned subsidiary of Taiwan-based Yang Ming Marine Transport Corporation (YML) for a consideration of US$210m. The three vessels are scheduled for delivery to FSLT by end-May, end-June and end- October this year. The vessels will concurrently be leased back to YML on a fixed basis for 12 years.

Acquisitions significantly boost DPU. FSLT has guided that the acquisition of the initial two vessels will be significantly accretive to FSLT’s distribution per unit (DPU), raising DPU for 2Q08 to 2.77 US cents (from 2.05 US cents) and from 3Q08 onwards to 3.05 US cents (from 2.87 US cents).

No guidance on third vessel as funding not secured. While FSLT has not provided guidance on the DPU accretion for the third vessel as financing has yet to be secured (US$60m required), we estimate the potential accretion at 0.07 US cents per quarter from 1Q09 onwards (assuming similar debt financing and charter terms as the first two vessels). We have assumed similar charter terms for the third vessel and have factored the acquisition into our earnings calculations. However, until the financing terms are clear, we are not factoring additional accretion to DPU from the third vessel into our forecasts.

The paradox: Rising DPU but falling EPU. We continue to like FSLT for its stable and visible distributions that are supported by its long bareboat charters that have an average remaining lease term of 9.2 years. FSLT offers investors an interesting paradox due to its aggressive depreciation policy that depreciates its assets at 5-7% p.a. As such, while this latest acquisition is DPU accretive, EPU has plunged as earnings after interest for these vessels are less than the associated depreciation (2008: -65.6%, 2009: -93.3%, 2010: -93.3%). However, we remind investors distribution yield should be the focus for FSLT and maintain our BUY recommendation on FSLT with a target price of US$1.24 (S$1.61).