Laggards with yield and growth

Buy FSLT and Rickmers
FSLT and Rickmers have lagged the STI by 17% and 14%, respectively, over the last three months. In FY08, we expect FSLT’s yield of 12% to be the highest among Asian stocks that DB covers. Rickmers’ 8% yield is not far behind. Further, we expect acquisitions to see DPU growth of 22% for FSLT and 10% for Rickmers during FY07-09. We prefer FSLT because of its superior yield and forecasted DPU growth.

Steady cash flow from acquisitions; Second hand vessel prices may surprise.
Cash flows are backed by LT contracts with the earliest expiry in seven years time and not affected by rate volatility. Experience in the US indicates that yield compression will happen as dividend accretive investments are made. There is also an under-appreciated possibility that second hand vessel prices may actually go up in situations of tight demand and limited supply, enhancing book value. We estimate that FSLT’s book value is 10% understated because of the rise in bulk vessel prices.

Under-researched laggards; Management keen to see share price perform.
We think there is great room for the laggard performance to turn around over the coming 12 months, especially since this sub-sector still appears to be underresearched, with only three brokers covering FSLT and Rickmers. In our view, managements of both FSLT and Rickmers seem committed to seeing the share price better reflect the underlying value, therefore enhancing the equity fund, raising options in the future.

DCF valuation and yield; Key risk is credit risk.
The two key valuation matrices we have employed are DCF and dividend yield. We have valued FSLT at US$1.10/share based on an assumption of US$200m worth of acquisitions in each of FY08-09. This translates to a yield of 9% in 2008. For Rickmers, the acquisition pipeline is more visible and we have assumed that it increases its capacity by 2.9x by end 2010. We have a TP of S$2.25/share, which is based on DCF and would imply a FY08 yield of 5.8%. The key risk to shipping trusts relates to credit risk of the charterers. Future cash flows will be in jeopardy
if one of the clients of the vessels does not pay charter fees.

State of the shipping industry

RECENTLY I dropped in on Marine Money Asia Week, a conference that looked at the latest finance and investment opportunities for the shipping and oil service sectors.

I sat through several sessions, and for someone not too familiar with the sector, they were useful in providing information to better understand the dynamics of the industry. So I thought I’d share some of the insights provided by conference speakers with BT readers this week.

Dry bulk sector

Merrill Lynch analyst Teddy Tsai presented a report on Asia-Pacific shipping. He sees the dry-bulk sector peaking in the fourth quarter of this year. Freight rates in the segment, measured by the Baltic Dry Index, have surged more than 200 per cent from the start of 2006 until now. Mr Tsai’s model predicts the peak to be just above 7,500, easing subsequently to about 6,000. However, as of last week the index had broken above 9,000.

He reckons temporary factors that have caused the surge in the BDI – such as port congestion and pent-up demand in China – will ease next year. And a significant supply of dry-bulk carriers will enter the market in 2009-2010.

Mr Tsai’s advice: Take profit on selected stocks and focus on growth-oriented plays.

Meanwhile, London-based research firm Simpson, Spence & Young (SSY) noted that the total dry-bulk order book has surged to 160 million deadweight tons (dwt), with the bulk of deliveries taking place in 2010 as new shipyards come on stream.

The orders are concentrated on the Capesize sector – ships too large to traverse the Suez or Panama canals (that is, larger than Panamax and Suezmax vessels). To travel between oceans, they must go around the Cape of Good Hope or Cape Horn.

On the demand side, the Chinese ore trade is expected to sustain firm rates of growth in the Capesize sector. Based on expected demand and the order books, SSY reckons the supply of dry-bulk carriers will exceed demand by 2010. The number of dry-bulk vessels on order is equivalent to 40 per cent of the existing global fleet.

But SSY said there are three uncertainties: One, the rate of growth in Chinese iron ore imports; two, the ability of greenfield shipyards to meet delivery dates; and three, the number of very large crude carriers (VLCCs) being converted to very large ore carriers (VLOCs).

Right now, dry-bulk companies are enjoying boom times. And the participants in the dry-bulk panel discussion – Hong Kong-listed Pacific Basin Shipping, Oslo-listed Jinhui Shipping, Bangkok-listed Precious Shipping Public Company and Singapore-listed Courage Marine – all painted a picture of abundance.

Said Khalid Hashim, managing director of Precious Shipping: ‘We are in a super cycle. The dry bulk space is going to keep everyone in good spirits for the next 10 to 15 years.’ But he admitted there will be corrections of one to two years in between. Typically, the upcycle is five to seven years. The current pick-up started in early 2003, making the cycle at the tail of the fifth year.

Klaus Nyborg, deputy chief executive of Pacific Basin, said the engine for the dry-bulk market is China. Not like the tanker segment, where the engine is the US.

Added Thomas Ng, managing director of Jinhui: ‘As long as China continues to perform we will continue to do well.’

Mr Nyborg said the Handysize segment – dry-bulk vessels of 15,000-50,000 dwt – is the most attractive. These vessels carry many different products and are not dependent just on iron ore. The average age of the global fleet is 17.8 years and a ship’s expected useful life is 25 years. New orders are low relative to those for other types of vessels. So going forward, supply will not increase too significantly.

According to Mr Nyborg, the current spot market net rate for Handysize is US$37,500 a day versus a vessel’s cost of US$9,370 a day.

Times are so good that if one owns a Panamax – a vessel with the maximum dimensions that can pass through the locks of the Panama Canal – one can pocket $20 million profit a year. And that’s more than the profit made by a lot of Singapore-listed companies, said Hsu Chih-Chien, chairman of Courage Marine.

Courage Marine operates 10 bulk carriers – five Handysize, two Handymax (typically 35,000-60,000 dwt) and three Panamax with a total tonnage of about 455,463 dwt.

Mr Hsu is more conservative compared that his peers. He said the dry-bulk market will be good for the next two or three years but there is a question mark beyond that. As such, Courage intends to stick to its old and tested formula of buying second-hand vessels to enjoy the current cycle.

‘We won’t dare to take the market beyond two to three years,’ said Mr Hsu. ‘For new-building, the vessels will only be delivered in three to four years’ time.’

Even with second-hand vessels, he has reservations given the very high prices now, unless a deal is exceptionally good. Second-hand vessels are currently more expensive than orders for new-builds.

Shipping trusts

Another sector that is very bullish is shipping trusts. All three trusts listed on the Singapore Exchange – First Ship Lease Trust (FSL), Pacific Shipping Trust and Rickmers Maritime – are trading at a dividend yield in excess of 8 per cent. In comparison, shipping trusts in the US are trading at yields of about 6 per cent.

Any yield compression in the trusts in Singapore will see significant price appreciation. For example, FSL is trading at a yield of about 10 per cent. A compression of yield to 7 per cent would mean a 50 per cent increase in its share price.

Ashok Pandit, Deutsche Bank’s head of South & Southeast Asia Equity Capital Markets, said the lack of appreciation of shipping trusts among investors here has kept their prices depressed despite their strong growth.

It’s the same in the US. Shipping trusts did not perform in the first six to 12 months after their market debut. Investors waited for them to develop a track record before bidding up the price. Similarly, shipping trusts in Singapore will need to demonstrate their ability to acquire earnings-accretive vessels.

Of the three trusts in Singapore, Pacific Shipping and Rickmers are in the container segment. The former operates 10 vessels and the latter six, with 12 to be delivered.

FSL is diversified. It has four container vessels, seven product and three chemical tankers, and two dry-bulk carriers.

The panellists pointed out that unlike real estate investment trusts or Reits, where the underlying assets can appreciate in value over time, ships are depreciating assets. However, they can deliver sustained dividends. As the vessels are chartered out for seven to 10 years, they are not affected by the shipping cycle.

DBS Vickers pointed out in a report that one of the short-term risks of shipping trusts in Singapore is the weak US dollar. ‘All shipping trusts generate US$-based cashflows,’ it said. ‘In the case of Rickmers, which is S$ listed, the yield for FY08 can drop from 8.2 per cent to 7.8 per cent in the event that the US$ depreciates 5 per cent from current levels.’

Offering yield plus growth

Story: We attended Marine Money’s session on Shipping Trusts yesterday that was held at the Grand Hyatt Hotel. Sitting on the panel were management from the three SGX-listed shipping trusts – Rickmers Maritime, Pacific Shipping Trust and First Ship Lease.

Relevance: We hold the view that shipping trusts offer attractive yields, averaging 9.4% for FY08 and are lagging US peers which are trading at an average yield of 6.7%. Maintain Buy for Rickmers Maritime (Buy, TP S$1.80) and Pacific Shipping Trust (Buy, TP S$0.52). We have no rating for First Ship Lease.

Panel represented by management from the three SGX-listed shipping trusts. Rickmers Maritime (RMT) was represented by CEO Thomas Preben, Pacific Shipping Trust (PST) by CEO Capt Subhangshu Dutt and First Ship Lease (FSLT) by President and CEO Philip Clausius.

Significant yield compression seen for US peers. Peers in the US operate under a Master Limited Partnership, a structure that is quite similar to a Shipping Trust structure. Yields have been compressed to an average 6.4% compared to listing yields of c.8%. The main trigger, we believe, was that these MLPs demonstrated an ability to grow via acquisitions. For comparison, RMT is offering a yield of 8.2%, while PST is trading at 9.7% and FSLT at 10.3%.

Growth through acquisition post listing. In our opinion, RMT and FSLT have demonstrated the ability to grow via acquisitions only after a few months of listing. On the other hand, PST has taken about a year to put in place growth initiatives. To elaborate :

(a) RMT’s Sponsor, the Rickmers Group, granted a Right of First Offer (ROFO) to RMT at IPO. Under this, nine 4,250 TEU container vessels were identified for injection into RMT. So far, RMT has entered into an MOU to acquire four 4,250 TEU vessels for delivery between Feb and Dec 2009. Separately, RMT has also entered into an MOU to acquire four 13,100TEU vessels for delivery between Aug and Nov 2010. Thus, capacity will rise 170%, from 40,910 TEUs to 110,310 TEUs by end 2010.

(b) Under the Right of First Refusal granted at IPO, PST plans to acquire two new 4,250 TEU container vessels from PIL for charter to CSAV, raising its capacity by 61% from 13,864 TEUs to 22,364 TEUs by end 08.

(c) Since IPO, FSL has acquired three product tankers, adding to its IPO fleet of four product tankers, three chemical tankers, four container vessels and two bulk carriers.

All three are below IPO prices, short-term risk is the weak US$. Besides a new asset class, we think that another factor for its underperformance has been the weakening US$. All shipping trusts generate US$-based cashflows. In the case of RMT which is S$-listed, the yield for FY08 can drop from 8.2% to 7.8% in the event that the
US$ depreciates 5% from current levels.