Modeling containership charterers is simplified (if you’re willing to do the work) by the fact that they provide detailed lists of the ships owned, capacity, lease rates, charter expiration dates, and operating costs. They also provide detailed information on what has been ordered and how it’s been financed. While the detail is complicated, it allows analysts to carefully model revenue growth, capital expenditures, and margins. The difficult assumptions to make regard what lease rates ship owners will be able to get as ships come off lease and what the short-term spillover effect will be of liner distress, with the worst case scenario being defaults and the inability to honor contracts. One particularly interesting company in this space, Global Ship Lease (GSL), is priced at a huge discount to peers because it only has one (financially distressed) customer! While the exogenous default risk is significant, GSL has the benefit of a very small order book for new ships, allowing more flexibility to deal with a weak credit environment.
It’s difficult to justify current valuations in this space without assuming a very slow recovery. With a useful life of 30 years, it seems unlikely that containerships are as worthless as the market seems to think they are. Granted, the current shareholders might not be around to benefit from a recovery if these companies default, but credit amendments have given these companies breathing room for at least another year. Because D&A is a major expense, the short-term financial strength of these companies may be hidden. Strong cash flow makes it unlikely for default to occur as a result of inability to make interest payments. It also seems impossible for me to reconcile the general pessimism about the future of shipping with the general optimism about the future of China and other emerging markets. China will have a lot of trouble growing exports without filling more containers.
At the risk of scaring readers off, I’m going to put the worst statistics up front. 1) Global supply of containerships is expected to grow by 40% over the next few years even if no new orders are placed. 2) 10% of the global fleet is already sitting idle. 3) The average daily charter rate for a 4,400 TEU (twenty-foot equivalent unit) containership decreased from $36,000 in May 2008 to $6,500 in September 2009. Obviously things don’t look good, but it would be silly to think the industry won’t respond. 1) Owners of small ships face the greatest uncertainty. Small ships are less efficient to operate and more likely to be idled in a weak economy. The companies I’m looking at own, and are expecting delivery of, mostly larger ships. 2) New ship production is being slowed so delivery can be delayed. 3) Scrap rates are increasing. 4) Ships are moving more slowly to save on fuel and taking the long-way around expensive canals, putting more capacity to use. John Manners-Bell from Transport Intelligence magazine thinks retailers could face supply-chain risk if they haven’t ordered enough Christmas inventory because both containership and air cargo fleets have cut capacity. Although sustainability is an issue, there is evidence of a slight recovery (or at least a bottoming out) in shipping volume and prices.
The first company in this space that drew my attention was Global Ship Lease. I also took a look at Danaos (DAC) and Seaspan (SSW) for comparison purposes because they are similar to GSL in terms of size and focus on container ships. I believe that GSL and SSW offer attractive investment opportunities. GSL has more upside potential and downside risk, with it possibly quadrupling if it’s parent company doesn’t default. And SSW offers a considerable amount of safety thanks to good management and very attractive returns in the range of 15% for investors willing to hold the stock long-term.
Global Ship Lease
The good news is that GSL is priced as though the global economy will never recover. If we take the present value of GSL’s charter contracts, assuming a 65% EBITDA margin and assuming that once the contracts run out GSL is never again able to lease ships for more than the cost of operating them, we get a present value of $669 million without including the 2 ships scheduled to be delivered in 2010. This is based off a discount rate of 7.5% reflecting a slight premium to the fixed-rate LIBOR hedges and margin GSL pays. This compares to a current EV of $685mm and a market cap of $68mm. Including those two additional ships, the PV of contracts rises to $736 compared to peak debt of $749 in my model. So if these charters continue to perform, GSL will eventually pay down debt and own its ships outright. For GSL to be worth less than the charter contract present value there will have to be no recovery in the global shipping market before the ships are scrapped in 2035.
The real problem with GSL is its dependence on CMA CGM. Except for two ships to be delivered in 2010, all GSL ships are currently leased by CMA CGM, which bears a significant default risk. So we need to get an idea for what the default risk is, and then see if GSL is trading at enough of a discount to entice investors.
CMA CGM is currently in negotiations with its creditors to at least extend covenant waivers, but evidence doesn’t indicate that negotiations are going well. Recent reports claim that creditors have asked for a change in control of a 100% privately owned business. Owner Jacques Saade will obviously be doing everything he can to avoid loosing his business to the banks or selling even a fraction of it at a distressed price. But the options available to him are limited. Also, because the business is private, we’re working in the dark with no financial statements. Recent news releases from CMA CGM indicated that management believes they will return to profitability in 2010.
The most encouraging news for GSL actually came from its own credit amendment announced on August 21. As part of the GSL amendment, CMA CGM agreed that it would not redeem $48 million of GSL preferred shares (which I’ve accounted for as debt) until 2016 and $24.4 million of common stock until 11/30/2010. If CMA CGM felt they were facing a serious liquidity crisis, selling minority interests would be the quickest way to raise cash without affecting operations and not an option they would want to take of the table. So either CMA CGM management didn’t realize how difficult their future negotiations would be or concerns about the true extent of their liquidity crisis by the investment community are overdone. This also demonstrates that CMA CGM believes GSL remains an attractive investment.
The biggest problem for CMA CGM is that they have a huge order book for new ships stressing capex cash flow for the next few years. The good news is that 75% of their ships are leased with many of those leases expiring soon. So even though they’re taking delivery of new ships, total capacity might not increase much. But without financial statements, it’s a difficult situation to analyze. Maybe the best piece of evidence is a BB- credit rating from Fitch on the senior unsecured debt. I don’t have access to a Bloomberg anymore so I can’t check that, but if anyone else would like to, I’d greatly appreciate more clarity.
To really understand these businesses, you'll have to be willing to open a spreadsheet. You can download my excel model below. As a base-case, I assumed that GSL generates revenue as expected from all of its charter contracts until they expire. Charter renegotiation is the big assumption. GSL isn’t really sensitive to the assumptions I make here because they only have two contract expirations in the next 5 years, but I’ll be using the same assumptions when I look at the other two companies. First I assume that any renegotiation is locked in indefinitely so early lease terminations will have a long-term impact on valuation. I assume that renegotiations in 2009 result in a break-even on operating costs, which are about 25% of historic revenue for each company I looked at. For each year in the future, I assume that rates increase by 15% of historical values. So if a ship is currently chartered at $10,000/day, and its rate is renegotiated in 2010, I assume it will generate $4,000 going forward (25%+15%). In 2011 it will lock in a rate of $5,500. A ship renegotiated in 2010 at $4,000 will not then generate $5,500 in 2011, it will continue to generate $4,000. In 5 years, charter rates will recover to the levels seen in the middle of this decade.
Another material assumption I made is that GSL uses all FCF to repay debt, and maintains a cash balance of only $20mm. Once its loan to value ratio falls below 75%, GSL will be able to resume dividend payments which expedites the return of value to shareholders. By reducing the debt level beyond what’s necessary, we give GSL room to expand its fleet when conditions improve. So the scenario I’ve built has room for both upside (better investment/return of capital opportunities or looser credit markets) and downside (CMA CGM default or further tightening of credit markets).
The assumptions I made on ship operating costs generally benefit GSL competitors as new ships increase the average ship size and drive operating efficiencies. GSL and SSW provide investors with detailed operating cost information on ships currently owned. I used these data points to make some estimates on what new ships and DAC ships will cost to operate. Looking at the two charts below, we can get a sense for how operating costs will vary as a function of size:
So using my simple linear regression, I estimate what the average cost of operations will be on a per TEU basis at the present date and after all scheduled purchases have been delivered. While larger ships are more expensive to operate, the average cost per TEU should go down. Knowing the average cost at the beginning and end, I shrink the cost per TEU linearly over the 5-year period. Total costs are obviously increasing because the fleets are growing, but without accounting for these operating efficiencies, the models for DAC and SSW come out wacky because they obviously pass some of these saving on to liners.
If we’re comfortable guessing that GSL will be worth 10x 2013 earnings, which of course takes into account D&A so those earnings should be somewhat sustainable, we get a share value of $8.88 in 2013. Discounted back at 15% we get a value of $4.63 today. Compared to a current share price of around $1.25, we can see that the market is assuming an enormous default risk. Even if CMA CGM defaulted tomorrow and said it would not honor existing charters, GSL might still be undervalued at $1.25. Creditors wouldn’t benefit from dissolving the company given the complete lack of a market to sell ships into. If GSL could borrow against its future and negotiate 10-year contracts at high enough rates to just barely cover operating, interest, and corporate expenses, the ships would still have 15 years left of useful life to generate returns for shareholders.
All of these disaster scenarios are unlikely. The single most likely scenario is that CMA CGM honors its contracts. The downside risk is a wipeout, but the probability of that happening still can’t be much greater than 25%. And time is on the side of investors. Every day that passes is another day that GSL ships are on the water generating returns greatly in excess of what investors normally demand. The current earnings yield is around 50%.
One other problem with Danaos is that they capitalize interest expense on debt allocated for future ship deliveries. This is standard practice in the industry, but it hides the future cost of owning ships if we simply drag margins forward unless we assume improvement in the credit markets. If you look at their interest expense compared to their debt, it seems like they’re paying less than 2%. But their fixed-rate LIBOR hedges have them locked in at over 5% before accounting for the margin they pay. To start, I assumed interest expenses of 7.5% for all three companies. DAC was only paying a weighted average interest rate margin over LIBOR of 2.14% at the end of Q3, but the weighted average interest rate hedge was 4.8%. This compares to a 3.5% margin for GSL but a weighted average interest rate hedge of 3.59%. So the 7.5% assumption is a fair and conservative estimate for both. In the case of DAC, the bottom-line takes a huge hit from this assumption. With GSL we see top line growth and NI that eventually recovers to 2009 levels. With DAC we see top line growth, but the interest coverage ratio slips below 1x pushing DAC into the red. This also assumes that management forecasts for CapEx include capitalized interest expenses. If this isn’t the case, CapEx will actually exceed my model’s forecasts, further compounding the situation.
Part of the reason for this problem is that Danaos’ RoIC doesn’t cover interest expenses. GSL is earning RoIC of 7-8.5%, compared to only 6.5-7.5% for DAC. Part of this is probably because GSL has a younger fleet and lease contracts were signed just before the bubble burst. DAC also has a large number of lease agreements ending soon. Since I used the renewal rate assumptions discussed above, DAC locks in lower rates on 9 ships in 2010 and another 9 in 2011. Operating at an already low RoIC, this assumption pushes them into the red. Cash flow, however, remains positive, and DAC is able to continue paying down debt at a slow but steady rate.
We see evidence of margin deterioration already surfacing when we compare the last twelve months to the twelve months before that. LTM revenue was $313mm with $93mm of net income after adjusting for one-time and non-operating expenses. The twelve months before that showed revenue of $292mm and NI of $108. Interest expense as a function of revenue grew by 5% over one year as less interest was capitalized. This isn’t a problem for GSL because the order book is small relative to existing operations.
In reality, DAC and GSL face similar risk. Current operations should be sustainable, but capex commitments (in the case of GSL it’s the capex commitments of CMA CGM) are threatening stability. However, DAC appears to be more exposed to the risk of a prolonged weak credit environment (because margins are narrower and ships have yet to be financed) and a weak leasing market (because more ships are coming off lease in the near future). Despite these risks, DAC is trading at a premium to GSL in terms of EV/Revenue, EV/EBIT, P/E, and P/B.
My model values DAC at only $0.45/share, but the valuation isn’t really fair because it’s dependent on how far out we look. Operating leverage pushes DAC into the red for a number of years. But because cash flow remains positive, they slowly repay debt and reduce interest expenses. My valuation is heavily dependent on earnings in 2013 of only $0.05/share, the first year DAC returns to profitability. However, if I drag my model out to 2014, we see earnings of $0.27/share, increasing the present share value to $1.38. The 10x multiple on 2013 earnings is really a terrible assumption because it ignores the enormous growth DAC will see in 1013-2017 as a result of nothing but financial leverage working itself out. So anyone using my model to value DAC should be aware of this limitation and consider looking a few years further out to get a better idea of what a normal run-rate might look like.
SSW also has the most favorable credit terms. The weighted average fixed-rate LIBOR swap is 5.15% for the current notional amount and 5.34% for the peak notional amount (notional amounts vary over the term of the swap contract). More importantly, margin over LIBOR is extremely low, averaging 0.65% for currently outstanding debt and 0.69% on total available credit. So in the worst case scenario, SSW would be able to fund almost all future purchasing obligations at a 6.03%. Assuming the same 7.5% that I used for GSL and DAC wouldn’t make sense.
One other advantage SSW has over the competition is a fleet of larger than average ships. Seaspan’s average ship size is 4,435 TEU, compared to 3,665 for GSL and 3,951 for DAC. After acquisitions, Seaspan’s average ship size should be 5,895 compared to 3,726 for GSL and 5,606 for DAC. The effect this has on reducing costs of operation are significant, and it might give SSW an edge if it finds itself trying to lease ships into a weak market after a customer default to two.
Other than the interest rate, I’ve used the same assumptions for SSW that I used for GSL and DAC. The share value my model produces is $12.04, compared to a current share price of $9.
Now that I’ve estimated a share price for each company, it makes sense to see if these share prices translate into fair enterprise values or market caps that make sense on a relative basis.
The numbers above compare the share values my model produced to my expected 2010 financial statements. First we notice that GSL is still trading at a discount to peers even after the share price has quadrupled on an EV to revenue or EBIT basis. DAC is trading at the highest premium because they need to raise a significant amount of debt in 2010 to stay afloat. Assuming DAC doesn’t go bankrupt or somehow cancel its purchase agreements, EV will have to rise. But at the moment it’s difficult to say what the cost of this will be. It might be bankruptcy.
On a market cap basis, GSL appears to be the company trading at a premium. However, my model predicts GSL EPS will fall by half in 2010, recovering quickly as interest is paid down. My 2011 multiple is only 6.5x. This compares to negative NI for DAC because it can’t meet interest expenses. SSW steadily grows NI each year, but at a slow pace, earning 5.4x my 2011 NI estimate. CFO multiples appear low, but keep in mind this isn’t FCF. FCF doesn’t make much sense to use for comparison purposes (at least not in early years) given the purchasing agreements which greatly exceed D&A and even CFO itself.
With the most efficient ships and cheapest financing costs, SSW is valued at the richest book value multiple, as it should be. With significant financing risk, DAC is valued at the lowest book value multiple. In the middle, at 0.7x book, is GSL. So the multiples my valuations have generated seem to be reasonable.
For comparison purposes, I’ll also include the same data as above with current share prices:
In my opinion, GSL is the best play in containerized shipping. There is definitely downside risk, but I think investors with risk tolerance will be more than fairly compensated for it with very attractive returns. Even in a scenario where CMA CGM defaults on its obligations, there might be more than $1.25 of value for shareholders. Shares would be fairly valued around $4, I have no trouble imagining shares rising to over $8 if conditions improve.
SSW also presents an attractive opportunity. Good management practices have shielded the company from at least five years of severely depressed economic conditions. Diversified lenders, diversified customers, credit and lease agreements in place, and an attractive yield make SSW difficult to resist.
DAC is probably the closest to fairly valued. The risk it faces financing its purchase obligations is enormous. Unfavorable terms can lock them into difficult to repay loans which will siphon value away from shareholders. Also, the short-term risk of renegotiating lease terms for ships coming off lease in the next two years is also significant. If shipping economics improve, no doubt DAC will benefit. But management will be facing a lot of tough decisions in the face of uncertainty over the coming year, and it’s very difficult to say how things might work out for shareholders.
Disclaimer: I own shares of GSL and SSW in my kaChing portfolio