Global Ship Lease: Cash Flow More Important Than Dividends

Global Ship Lease (GSL): Covenants Present Little Risk

Summary

Some investors are worried that a fall in ship prices could trigger a technical default on Global Ship Lease's loan covenants which, in turn, might:

1. Result in the suspension of its dividend, and
2. Prohibit further drawings on its credit line

In this piece I’ll discuss why:

• Halting dividends alone has no affect on intrinsic value, and
• A freeze of GSL’s credit lines is an unlikely event

Loan Covenant Risk

Following my last piece (Global Ship Lease: Undervalued and Undiscovered), I had the privilege of speaking with several fellow GSL shareholders. Many were concerned about the possibility of GSL halting its dividend due to a technical default on its bank loan based on the following disclosure in the company's F-1:

Global Ship Lease’s ability to borrow amounts under the credit facility will also be subject to, among other things, all of its borrowings under the credit facility not exceeding 70% of the aggregate charter-free market value...Global Ship Lease’s credit facility provides that it may not pay dividends if there is a continuing default under the facility. Global Ship Lease is prohibited from paying dividends if the payment of the dividend would result in a default and any payments to be made into the retention account are not fully up to date. Global Ship Lease’s ability to declare and pay dividends therefore depends on whether it is in compliance with its credit facility.

The current environment makes this a real possibility.

Cash Flow Drives Intrinsic Value

Yet, dividends are a red-herring. Cash flow is the real issue. Even if the banks halt the dividend, so long as they allow access to the credit line, the company will generate substantially the same amount of cash. This means its intrinsic value will not change.

To illustrate, I used the company’s ship deliveries, contracts and operating costs to forecast GSL’s financials on a quarterly basis for the next three years. (Full year summaries appear below):

click to enlarge

I made the following simplifying assumptions:

• No common or subordinated dividends are paid
• Non-cash working capital, intangible assets, intangible liabilities, and preferred, common and subordinated stock remain constant
• Excess cash is not reinvested during the explicit forecast period and no interest is earned on the excess cash balance
• Additional ships are added on the last day of the quarter and no revenue or expenses are reflected in the periods in which they added
• Preferred dividends paid at a 5.5% rate
• SG&A escalates to $7 million in 2011 remaining around 4% of sales

Using these numbers, I ran a discounted cash flow analysis:

Assuming a cost of equity of 10% and a growth in perpetuity of 4%, today’s intrinsic value is $13.4. Moreover, in one year the intrinsic value grows to $14.7 and to $16.0 in two years:

Since DCF models are inherently sensitive to assumptions, below I’ve included a table of intrinsic value based on two key drivers – cost of equity and terminal growth rate:

Access to the Credit Lines

Of course, these computed values assume the company still has access to its credit line to fund future expansion, specifically the purchase of the CMA CGM Berlioz and Hulls 789 & 790. Prohibition of future borrowing on the credit lines, in my opinion, is a remote possibility. Fortunately, four shipping-related credit agreements have been amended in the past two months which serve as an indicator of how GSL’s banks might react. While some amendments reduced borrowing capacity or imposed pre-payment requirements, none have eliminated further borrowing altogether:

The revenue visibility of these companies is interesting. Except for Navios (NMM), all face substantial re-charter risk in a pretty weak environment. In contrast, GSL has no re-charter risk until the end of 2012. If I were a banker concerned about my borrower’s ability to pay, I would worry less about GSL and more about those companies with unpredictable revenues.

One thing is clear. Most borrowers saw roughly a 100 basis point hike in borrowing costs as part of their credit amendments. As part of my DCF model above, I assumed that GSL’s current borrowing rate cap (3.54% on the first $444 million) rises 200 bps to 5.45%. I also assume that all further borrowing occurs at a 6% rate.

Conclusion

Global Ship Lease’s management has frequently reiterated the importance of the dividend. In the event of a technical default, management will certainly try and negotiate a waiver to the covenant so that the dividend remains intact. Even so, GSL’s intrinsic value is determined not by its dividend, but by its cash flow. A suspension of the dividend that leaves cash flow unchanged has no effect on intrinsic value. Of course, if the credit line is severely restricted this would impact cash flow. In light of recent credit amendments, I see this as a low probability risk. As such, I believe today’s share price of $3.40 offers a compelling discount to the estimated intrinsic value of $13.40.

DISCLOSURE: The author and funds that he manages are long GSL and GSL warrants. All comments reflect the sole personal opinions of the author.

Comments

[elliot_mllr:]

Dividends are at least as important to cash flow to an investor who bought the share because he or she relies on the dividends.

Feb 05 03:20 PM

[Michael Dem...:]

Fair enough. If the dividends are canceled, I do expect to see some selling by those who purchased the stock for income. My point is, that the intrinsic value could remain the same.

Another scenario which I didn't spend time writing up but did do a little modeling on is...what happens if the credit line is restricted entirely, what is the company worth at that point based simply on the cash flows already in place? I did not include litigation expenses and other costs related to Zim and cancellation of newbuildings (I doubt CMA CGM would sue for not being able to close the purchase of the Berlioz...in fact they might finance it themselves via preferreds), my analysis concluded the intrinsic value was somewhere between $6 - 9 in such a scenario. So, let's just say it's $6. You're getting a double even if the covenant negotiation is unfavorable. Personally, I think you're being fairly compensated for the risk of entering pre-amendment, but I realize many don't feel comfortable until they see the "GSL amends credit agreement" headline.

Feb 06 10:14 AM

[User 328329:]

What are your thoughts on the warrants, that if excersised at a price of $6 by Aug. 2010, would nearly double the share count? Although the company gets the cash, how do you see that affecting the dividends that now have to be paid to ~2X as many? Just seems like it the stock may hit a road block above $6, but I like the stories and the company. Any thoughts?

Feb 13 01:17 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 04:01 PM

[HeadHoncho:]

Where can I find details on the warrants? $6 exercise before 8/10, is that it?

Nov 05 10:34 AM