Shipping Trust

PART 1

For those who treat shipping trust as a business.

Shipping trust is a business for only the Management but not for the unit holders. The units are more like preferred shares with variable dividend rate. The growth in the "business" will not result in the growth of the "intrinsic value" of the units.

After all, the units are just part-ownership of the ships that the trust owns. From value investing point of view, the overarching question will be "Am I over-paying or under-paying the assets less an annual management fee?"

To the management, more ships equal more fees equal more value for themselves. To unit holders, more ships when divided over more unit results in no net gain per unit. (Assuming debt is optimized)

PART 2

I think the intrinsic value of a shipping trust lies in its ability to use debt at a lower interest rate to fund the purchase of an asset that generates a higher rate of return. The "intrinsic value" of the trust does not change significantly whether the trust is fully leveraged or running without debt, even though the dividend payout as well as the level of risk the management is taking could be different. The different dividend payouts (and hence yields) resulted in different valuations. But in my opinion, there is still minimal change to the intrinsic value of the trust.

I agree that because debt level affects yield which in turns affects valuation, these create opportunities for investors to purchase the units at depressed valuations.

PART 3

If I were the management of a shipping trust, what will be the intrinsic value?

1. Capability of management in utilizing capital (i.e. borrow cheap and lend dear)
2. The amount of capital (through issuing units) the trust can raise
3. The amount of leverage the trust can use
4. The amount of earnings that the trust can keep (to fund growth) and hence the amount of dividend paid

From the 4 factors, can we improve any of them without a corresponding dilution through issuance of new units?

1. Yes
2. No
3. Yes
4. Yes

You are right to say that the intrinsic value of the trust can change. My point is that any improvement on the intrinsic value will rely on:

1. an improvement on the management
2. a change in the leverage policy (to yield on the positive side, of course)
3. an adjustment of the payout ratio

I think our "disagreement" stems for the definition of intrinsic value. How intrinsic is intrinsic? You mentioned that the trust has so far committed only $290mn of debt. I agree that if the trust borrows more, it can earn more. However, the ability to leverage should already be factored in when we estimate the intrinsic value, whether or not the money has been borrowed. To me, if a trust CAN borrow up to 50%, that figure, among others, determines the intrinsic value, whether or not it HAS actually borrowed anything at all. If it hasn't the DPU will be lower, if it does DPU will be higher. The use of leverage affect the DPU. The ability/restriction to borrow, as defined within the trust corporate policy, affects the intrinsic value.

PART 4

The discussion is coming to full circle. I started with "Whose business is this - Unit Holders or Trust Managers?" and then said that the trust is like preference shares. If I can add now, that means that the unit holders get LIMITED upside but ALL the downside.

- On Debt to Equity
I believe there is some information in the Trust Deed on the maximum leverage the trust can use. You may verify this as I did not get to look at it myself. A more appropriate estimate would be to look at other trusts, including those listed elsewhere. The total amount of debt cannot be estimated over the lifetime of the trust, but the debt to equity will not go too much out of proportion. And the debt to equity is what matters to the unit holders because any increase in debt without an increase in units will result in a higher ratio.

- On Interest Rates
The management must be shrewd enough to borrow (cash) cheap and lend (the ship) dear. They must also borrow long and lend long. This will "hedge" their interest rates and earn the unit holder money.

- On Equity Issuance
Each time the Trust issues more units, the trust manager benefits if he can use the funds successfully.

- On Net Distributable Amount
The trust will distribute at least 90% of the Net Distributable Amount. That means that the trust can retain only up to 10% of the profit for reinvestment. I view such terms negatively. If the trust can have a 15% return on invested capital, I would rather have my dividend reinvested. On the other hand if the return is bad, I would rather not own the units. The third option would be to use the dividend and purchase more units if the return is good. That leads to the question: What is the ROE? After all, business-like investing is about ROE.

To sum up, rather abruptly (sorry), investing in a shipping trust is really investing in a fixed income instrument. I don’t view it as a business because the interests of management and the unit holders cannot be aligned. I would look at the margin of safety from the perspective of whether or not the trust will have the financial capability to continue paying dividend (my expected return) as opposed to a discount to the intrinsic value.

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More discussion at:
http://sgmusicwhiz.blogspot.com/search/label/First%20Ship%20Lease%20Trust