Global Ship Lease: Undervalued and Undiscovered

About Global Ship Lease (GSL):

• Current price is 1/4 of estimated intrinsic value of $13.50 per share
• Trades at half tangible book value
• Dividend yield exceeds 25%
• Enjoys highly predictable revenues, expenses and cash flows with adequate dividend coverage
• Planned growth fully financed at low, fixed rates

Summary

In my opinion, Global Ship Lease is a classic “no-brainer” investment. The dividend, which I believe is safe, offers investors a 25%+ annualized return without any stock price appreciation. If the price does achieve a fair valuation ($13.50) in the next year, investors could conceivably earn a total return of 350%. So long as its counterparty CMA CGM honors its contracts and remains solvent, investors should profit handsomely. In this piece, I will tell you why I believe both are likely.

The Business

Revenues: Global Ship Lease makes money chartering container ships under long-term contracts. Unlike some dry-bulk shippers (which transport commodities such as iron ore as opposed to container shipping boxes), GSL's rates are fixed and do not fluctuate with an index such as the Baltic Dry Index. So long as the ship remains in good, operating condition, GSL earns the same contractual rate regardless of whether the customer uses it or not. In this sense, it is much like a leased car. BMW does not care whether that 7-Series gathers dust in your driveway so long as your monthly payment clears. The average length of a GSL contract is 10 years. However, given the correlation between the Baltic Dry Index and GSL, the market seems confused about the difference between a container shipping business built on long-term fixed rate contracts and a commodity shipping business built on spot rates:

The only time GSL experiences spot rate pricing risk is when an existing ship's contract comes up for renewal. The earliest such expiration is in 2012, more than three years away. In order to spread out the company's spot market risk, management has staggered ship expirations so that only a portion of the fleet will be exposed at any given time:

Management's policy of only purchasing ships when they can be simultaneously leased further limits spot market risk. If spot rates are uneconomic (as they are today), management simply stays on the sidelines.

In GSL's case all of its current ships are chartered to French shipping company CMA CGM, the third largest container shipper in the world. (Two future ships to be delivered in 2010 will be contracted to Zim Integrated Shipping Services Limited which has a fleet of roughly 100 ships.) These ships are re-leased by CMA CGM at higher, short-term rates and CMA CGM earns the spread. The short-term contracts are often one year in length. GSL is the wholesaler and CMA CGM is the retailer. From an investor's perspective such customer concentration should raise a cautionary flag. We will return to this concern in a moment.

Expenses - Operating: On the expense side, the company contracts with a third-party service company to maintain and operate its fleet. The amount this service provider can receive under the contract is capped. At present, the service contract is for a three year period. All fuel costs and fuel price risk are borne by the customer. Management also had the foresight to include a $100,000 ceiling in its contracts for any capital expenditures required to improve the ship (such as installing systems to reduce bunker fuel emissions). The remainder must be borne by the customer. Lastly, the company carries the following coverage: hull and machinery insurance, war risks insurance and protection and indemnity insurance (which includes environmental damage and pollution insurance). It should be noted that as of September 2008, the company did not carry loss-of-hire insurance which would compensate it in the event that the company's ship was disabled for an inordinate amount of time. Investors would do well to pay attention to this risk in the future.

Corporate overhead is expected to be around 4% of sales going forward – an amount that should be leveraged with growth, as long as management contains costs. Other expenses include a dry docking expense accrual for normal maintenance on the ships.

Expenses - Financing: GSL was fortunate enough to obtain an $800 million revolving credit facility prior to the onset of the credit crises. Most of this debt was swapped into fixed rates at around 4% under agreements that expire in March 2013. It has roughly $40 million remaining on the facility after funding its order book.

Counterparty Risk: The Central Issue

While GSL's straightforward revenue and expense model makes ballpark valuation an easy task, the elephant in the room remains the company's counterparty risk. By way of background, CMA CGM is the world's third largest container shipper with various other economic interests in ports, container leasing and cruise lines. With respect to GSL, two fears exist: first, that CMA CGM would try to cancel or modify the lease agreements and second, that CMA CGM might actually go bankrupt. In my estimation, the first is highly unlikely for the following reasons:

1. CMA CGM owns 43% of GSL's common shares. Any annual savings CMA CGM would achieve by voiding or renegotiating their leases would likely pale in comparison to their equity value they would destroy in the process. Furthermore, it would eliminate their $21MM annual income from the GSL dividend.
   
2. As reported December 17, 2008 in the Financial Times, CMA CGM has the ability to hand back 150 of its 385 ships to their owners in 2009. GSL represents a mere 17 ships in its fleet. CMA CGM would surely prefer to reduce capacity in a way which didn't simultaneously destroy its own investment.
   
3. Lastly, though tenuous in today's climate, CMA CGM has no legal right to renegotiate the agreements. On the last conference call, CEO Ian Webber specifically reassured me that GSL has no desire to revisit the lease terms at this time.

The next question is bankruptcy. It would be foolish to assume that CMA CGM's chance of bankruptcy equals zero. However, we can make an intelligent approximation by comparing the company's credit ratings with historical defaults. While the major ratings agencies have done a poor job with structured finance products, they have a more seasoned track record with corporate finance. In December, Moody's, S&P and Fitch all took negative ratings actions on CMA CGM, essentially lowering it from BBB- to BB. The table below shows that the historical five year cumulative default rates for BB companies is under 10%:

The chance of bankruptcy in any single year is roughly 1/5 of that, or 2%. Put differently, if history is any guide, there is a 90% chance CMA CGM will not be bankrupt in 5 years. Nonetheless, this past year has demonstrated that historical models often underestimate extraordinary risk. To be conservative, let's double the default rate and assume that the cumulative default probability for CMA CGM is 20%, or only an 80% chance it will be left standing in 2014.

What factors might shift this probability assessment? If cash flows are inadequate to cover periodic interest and principal payments, bankruptcy is generally avoided in two ways:

Raising capital:

• Selling common or preferred equity
• Refinancing the debt into longer maturities
• Selling assets

Reducing debt:

• Paying debt down (either with funds on hand or through capital raises as outlined above)
• Shedding debt-like obligations (leases)
• Repurchasing debt in the open market or through tender offer or direct negotiation
• Negotiating with creditors for an instrument exchange

CMA CGM's ability or inability to affect any of these change its odds of bankruptcy. Here are the most obvious "levers" it can pull:

• Repurchase debt: Subsequent to the rating agency downgrades, CMA CGM offered to repurchase a portion of its bonds at 46, above the then trading price of 34. According to Euroweek, it successfully repurchased $75MM of its $300MM 7.25% seniors. It is also offering to repurchase half of its Euro denominated bonds at 46.
• Let ship leases expire: As mentioned above, roughly 150 of its 385 ships can be handed back to their owners in 2009, if the company desires. This would dramatically shrink the company's lease payments.
• Slow CAPEX: The credit rating agencies cited CMA CGM's aggressive capital expenditure plans as a primary reason for downgrade. The company has a large ship order book, has plans to purchase many containers, is building a new headquarters, and has committed capital to building terminal facilities. Management could theoretically, cut back on some of these expenditures, even if it meant incurring penalties to break contracts.

The closely held nature of CMA CGM might give management a stronger incentive to avoid bankruptcy than say, a publicly traded U.S. company whose management owns few shares, whose shareholder base is dispersed and whose management can keep their jobs in a Chapter 11 reorganization. Nonetheless, let's stick with the 20% default rate assumption. Under this scenario we'll assume the worst: that GSL will not be able to find anyone else to lease its ships, and the ships' scrap or sale value is not enough to leave anything for equity holders. In short, we'll assume that if CMA CGM defaults, GSL stock goes to zero.

Valuation: What Is GSL Worth?

Given its predictable revenue and expenses, its consistent dividend payment and normal return on equity, GSL is a textbook candidate for a single stage Gordon Growth Model valuation. According to the Gordon Growth Model:

Next Year's Dividend: $0.92. This is what the company projects.

Cost of Equity: 10%. For cost of equity, which is simply the return that the market requires from the company to be adequately compensated for risk, I'm going to assume 10%. This is slightly above the historical market rate of return which, according to John Bogle's Little Book of Common Sense Investing was 9.5% over the last 100 years. Whether this is the correct rate is up for debate and is, frankly, an individual issue.

On one hand, if the pundits are correct, and we are entering an era of lower returns this would imply a lower cost of equity on a dividend paying stock with fixed revenues and expenses. On the other hand, proponents of the capital asset pricing model will point out that the company's beta exceeds 1.0 and it should have a higher cost of equity than the market. Personally, I side with Charlie Munger who says that the concept of cost of equity (as defined by CAPM) is "bonkers", but that's an entirely different discussion. What matters most are the implied returns that an investor receives given the price. Here, you should use your own hurdle rate. However, let's assume that in today's environment, investors would be satisfied with a 10% return.

Growth: 3.2%. Growth can be calculated as Retention Rate x Incremental ROE. Retention rate is simply 1 - dividend payout ratio. In other words, a company's organic growth depends on how much capital it reinvests and the return it earns on that reinvestment. (This is organic growth. The company can, of course, raise outside capital but its returns will only create value if it issues equity when the cost of equity is below its incremental return on equity.) In this case, GSL management has said that their deal hurdle is a low double digit IRR. Let's assume this means 12%. Pro-forma dividend coverage for GSL is 1.37x, which means they’ll pay out 73% of their cash flow and retain 27%. As such, sustainable organic growth is equal to 12% x 73% = 3.2%.

Putting it all together:

We can also rework the equation to look at the implied return (price appreciation excluded) given today's price, which equals 32%, 3X a 10% hurdle rate:

Now bringing to bear the default probability we covered earlier, we can construct a probability-weighted return scenario to see if this is a rational investment.

Though this calculation is meant to be illustrative, you can see it produces a nice expected return. This oversimplification assumes that a rational price will be reached within one year. It also assumes that a bankruptcy occurs before any dividends are received. A more thorough analysis can be constructed using various time lengths to fair value and bankruptcy. Given these assumptions, GSL offers an attractive risk-adjusted return.

Undiscovered

Lastly, Global Ship Lease remains an undiscovered/under-followed company with little to no analyst coverage. This is in part because it came public through a merger with Marathon Acquisition Corp. Many databases, including the SEC’s, still assign its ticker "GSL" to the ticker's previous owner Global Signal. Citigroup, which picked up coverage on two of its peers (Danaos: DAC and Seaspan: SSW) declined to cover GSL because of its limited history even though it was the lead underwriter of Marathon’s original offering. In my experience, undiscovered stocks companies provide some of the best opportunities.

Opportunities for Shareholder Value Enhancement

The returns offered by GSL’s common shares are twice that of any shipping-related investment management is likely to find. With $40 million remaining on its revolver, management, in my opinion, should consider a tender offer for a significant number of its shares. This would reduce shares outstanding and allow them to increase the dividend going forward. A management team with as strong an operating background as GSL’s is surely tempted to favor expanding its fleet, but a share repurchase would be a more effective deployment of capital than a new ship deal and would create greater shareholder value in the long run.

Unfortunately, most management teams prefer to repurchase shares at exactly the wrong time – when the waters are still but their stock is overvalued. Today the opposite exists. It takes courage to make a bold maneuver in the face of market uncertainty. I recognize, however, that lending covenant loan-to-ship-value ratios, restricted cash requirements and a relatively thin float present complicating factors on this front. Even if the company does not conduct a share repurchase, nothing stands in the way of an investor conducting their own repurchase with dividend proceeds.

Conclusion

Assuming no price appreciation, GSL's shares offer immediate returns exceeding 25% through its well-covered dividend supported by stable cash flows. The outstanding question is its counterparty, CMA CGM. In my estimation, the odds are 80% or greater that CMA CGM will make good on its lease commitments. In light of this, I believe the dividend is safe. Lastly, a return to a normal valuation provides opportunity for significant capital gains. In my opinion, GSL represents a tremendous value in this current environment.

As always…do your own due diligence.

Further Reading and Resources:

Global Ship Lease Investor Presentation

Global Ship Lease F-1 Filing

DISCLOSURE: The author and funds that he manages are long GSL and GSL warrants. Neither the author nor any funds that he manages have positions in any other company mentioned in this article. All comments reflect the sole personal opinions of the author.

Comments

[NotAsSmartA...:]

Well written by someone obviously keen on GSL and stock valuation methods.

However analysis misses several important points.

Firstly can GSL comply with loan covenants, particularly LVR (Loan to Valuation) when ship valuations are declining. GSL must provide regular valuations to its bankers.

Secondly GSL has mainly panamax size vessels and the Baltic Exchange Panamax index shows no sign of recovery (Unlike the capsize index) www.investmenttools.co...

Thirdly, the number 1 and 2 container shipping companies in the world have orders with shipbuilders for a new breed of super sized container ship, that will keep downward pressure on container hire rates once the financial crisis over.

Food for thought!

Jan 26 03:39 PM

[Michael Dem...:]

Thanks for the comment. I guess my response is:

1. Clearly container ship rates, just like dry bulk rates, are down precipitously at present. The advantage of GSL is that they are on fixed rates, not spot rates. The spot rate they need to be concerned about is the one in 2012 when their first ship comes up for renewal.

2. You're correct that loan-to-value ratios are a concern. To this I would only ask, what happens if they have a technical default on an LTV basis? What do you believe the odds are that the bank consortium is going to call the loan? Personally, I believe they are low. Stephen Moyer's "Distressed Debt Analysis" puts it better than I can in this footnote: "Technical default gives the lender significant leverage over the borrower, including, in certain circumstances, the right to demand immediate repayment. However, since acceleration of the debt would likely only lead to a payment default...which would then cause the loan to be characterized as nonperforming, the lender will usually work with the borrower to amend the agreement (for a fee of course) and "cure" the default.

In an environment where lenders are stretching the definition of non-performing to loans that are 120 days delinquent instead of 90 so they don't have to report bad non-performing numbers, I think what is more likely is that we'll see an amendment surface prior to any technical default in which GSL either gets LTV based on the cash flow stream of the ships and/or pays a higher rate, thus curing the default.

3. Lastly with respect to the "super-sized" ship comment, I can only assume you read the front-page Marketplace section article in today's Wall Street Journal titled "The Mega Containers Invade". Look closely at the picture. You'll see the name CMA CGM stamped on the side of that megaship. You'll also notice that CMA CGM is featured prominently as one of the companies embracing the megaships. CMA CGM is part of the arms race, but so long as they own a chunk of GSL, I doubt you'll see them abandon their leases.

On Jan 26 03:39 PM NotAsSmartAsTheWriterB... wrote:

> Well written by someone obviously keen on GSL and stock valuation
> methods.
>
> However analysis misses several important points.
>
> Firstly can GSL comply with loan covenants, particularly LVR (Loan
> to Valuation) when ship valuations are declining. GSL must provide
> regular valuations to its bankers.
>
> Secondly GSL has mainly panamax size vessels and the Baltic Exchange
> Panamax index shows no sign of recovery (Unlike the capsize index)
> www.investmenttools.co...

>
>
> Thirdly, the number 1 and 2 container shipping companies in the world
> have orders with shipbuilders for a new breed of super sized container
> ship, that will keep downward pressure on container hire rates once
> the financial crisis over.
>
> Food for thought!

Jan 26 10:41 PM

[NotAsSmartA...:]

Thanks for the reply Michael. I own a small number of GSL shares and comment as follows:

Your point 1: I agree

Your point 2: Again I agree! Interest charges can be expected to increase as LVR increases. However I would not support a share buy back at this time. In the current climate I would prefer to see if the LVR remained below the 75% required especially after the next round of fleet valuations.

Your point 3: Some time ago I came across an excellent article by Jan Svendsen’s and Jan Tiedemann’s about these new super sized containerships. It is worth reading. Here is the link: containerinfo.co.ohost...
Further research shows that Maersk (No1) and MSC (No2) are alreading dividing up trunk routes between themselves without unnecesary price cutting to suit their super size tankers.

More food for thought.

Jan 27 03:59 AM

[Michael Dem...:]

I have been corrected on two points and I wanted to provide the update:

1. CMA CGM does not re-lease at year long rates, they sell the cargo space aboard the ship on a per container basis and thus are exposed to the spot market

2. The 100K for required capital improvements to the ship come, not in the form of cash reimbursement to GSL, but rather higher lease rates to cover the financing cost of the improvement

Jan 27 02:01 PM

[elliot_mllr:]

In support of Mr. Demaray's point number 2, please see the amendment entered into yesterday by Genco and its lenders, essentially waiving the loan to value default until such time as the company is no longer in default. This makes continued funding available to Genco, although it does preclude dividend and share buy-backs.

Jan 27 02:06 PM

[Sargasso:]

Do Ian Webber's earlier problems with a class action suit investigation concern you?

"Mr. Webber was named, along with his former employer CP Ships Limited and other officers of that company, as a defendant in a securities class action case before the United States District Court for the Middle District of Florida (the "Court").The consolidated amended class action complaint alleged violations of Section 10(b) and Rule 10b-5 of the Exchange Act against all defendants and Section 20(a) of the Exchange Act against the individual defendants.The parties have reached an agreement to settle this class action proceeding in its entirety, pending approval by the Court.Under the proposed terms of the settlement, Mr. Webber denies all wrongdoing and will be fully released from any liability in this matter.The settlement has been preliminarily approved by the Court and a final approval hearing is expected to occur on October 2, 2008.Mr. Webber was also named, along with CP Ships Limited and several of its officers and directors, as a defendant in a purported securities class action pending in Canada. "

Jan 28 12:10 PM

[Michael Dem...:]

Sargaso,

Great question about the class action. Looking at the facts, it's a difficult one to answer. The charge was under-accruing in order to inflate earnings. Of course outright accounting manipulation is always serious concern for shareholders. Was it malicious or an oversight?

Here's what we do know:

- Suit was settled for $1.25MM
- Suit was brought by Millberg Weiss (for the uninitiated, you can find out more about Milberg Weiss here: en.wikipedia.org/wiki/... )
- Company's shares immediately dropped on announcement of accrual error to $12.85 on August 9, 2004. Yet, one year later in October 2005, CP Ships was sold for $21.50.

Again, I think accounting manipulation is a bad thing, but it's difficult to tell if it was an error or malicious intent. The company broke the story itself. Clearly enterprise value was not permanently impaired.

Jan 28 01:09 PM

[lbsterling:]

Nice call on GSL.
The dividend is safe, shares are undervalued at $2, etc.
Any plans for an update of this article?

Jul 17 04:00 PM