While investors should be cautious with preferred stock in a rising interest rate environment, there are some preferred stock issues with yields that are high enough to warrant a closer look. Preferred stock can be problematic because it does not offer a maturity date (for the vast majority of issues), and they are often non-cumulative. Preferred stock also places the investor in a part of the capital structure that can be likened to being in limbo. You do not participate in the upside as a common stockholder, and you do not get the benefit of a debtholder who enjoys a maturity date. Right now interest rate risk seems most concerning. However, if the yield is high enough, the impact of interest rate risk is generally less of a concern. International Shipholding Corporation (ISH) offers two preferred stock issues, both issued in 2013, which are worth a close look.
The first issue is ISH-A, 9.50% Series A Cumulative Redeemable Perpetual Preferred Stock, liquidation preference of $100/share. See the prospectus for more details. Last price was $106.86, so the current yield based on the dividend is about 8.9%.
The second is ISH-A, 9.00% Series B Cumulative Redeemable Perpetual Preferred Stock, liquidation preference of $100/share. See the prospectus for more details. Last price was $103.77, so the current yield based on the dividend is about 8.7%.
One of the key attractive features of preferred stock is the preferential income tax rate, which for most investors is 15%. As a fixed income investment, it makes sense to look at the tax equivalent rate compared to other fixed income investments. In this case, ISH-A and B would result in a tax equivalent yield of well north of 10%. (e.g., a 9% instrument taxed at only 15% nets an investor 7.65% after taxes; to get the same 7.65% from a normal interest-paying bond, assuming a 35% tax bracket, you need an 11.77% equivalent interest rate). Every tax situation is different, but this analysis should be part of your thinking when buying any interest or dividend paying security.
The analysis of preferred stock should be a credit analysis, not equity analysis, even though technically it is part of the shareholders' equity of a company. Since preferred stock has no upside and pays a fixed dividend, which is like an interest coupon, it is more like mezzanine debt or unsecured, junior subordinated debt with no maturity date. For credit analysis, the key issues are ability to service interest expense and pay the preferred dividend, and comfort that the company is not going to go bankrupt.
An overview of the company and its business can be found elsewhere (see the presentation from the company's investor relations page), but here are some of the key credit highlights and analyses:
1. ISH was founded in 1947 and operates a fleet of 50 vessels. The company went public in 1979. From a credit perspective, these dates are important. ISH is a proven company with a long track record of successful operations through expansions and recessions.
2. Point 1 above is bolstered by a stock price, which has certainly taken its dips like most others in the last two crashes, but now trades near all time highs, see the chart below. Seeing the stock price hold up back into the early 1990s provides comfort that ISH is a survivor.
3. In November 2012, the company acquired United Ocean Services (UOS), which positioned ISH as the largest Jones Act dry bulk operator in the U.S. Without going into the Jones Act, it essentially protects the company from international competition in U.S. waters. Many of the negative dynamics that the worldwide shipping industry has seen in the past few years are less of an issue for ISH. This sizable and important acquisition further cemented ISH's position in this niche market.
4. 65% of the company's revenues are from fixed contracts (higher in Q4 2013, but 65% is management's expectation for 2014), which provides a more predictable revenue stream. This figure is up from about 54% prior to the UOS acquisition. We view this jump as a major positive for the company. The relatively steady nature of the business is evidenced by the company's revenue line going back more than 10 years. Revenue in 2002 was $227 million and for 2012 was $243 million. The average is about $260 million. Yes, there have been ups and downs and no real growth, but the point is to show general long-term stability, one of the keys to a good credit.
5. 2013 results benefited from a full year of UOS, with Revenue at $310 million and EBITDA coming in at $59 million (which we note was a bit below earlier guidance of $60-$63 million). The outlook for 2014 is positive, with EBITDA projected by management in the range of $65-$72 million.
6. Let's look at the credit statistics. The Q4 2013 balance sheet shows total debt of $198 million, less $28 million of cash, or $170 million of net debt (a reduction of about $6 million from prior quarter). To that we add about $57 million of preferred stock, which is being treated here like mezzanine debt, to get to $227 million of total debt according to our definition. Divided by EBITDA of $59 million gets us to 3.85x total leverage - not unreasonable, especially given the general stability of the business and large asset base. If ISH hits the low range of its EBITDA target in 2014, leverage through the preferred would come in at about 3.2x (also assumes required debt amortization of $18 million in 2014, which would be paid out of free cash flow). Note that a quick look at a Moody's report from 2006 showed that leverage back then was more than 6x, so over time the company has deleveraged significantly and it appears that the trend will continue. We also examined a metric called Debt/EBITDAR, which converts the leases (ISH leases some ships under operating leases) into a debt equivalent, and adds back the lease expense to EBITDA. The figure most recently reported by the company was 3.88x (excluding preferred stock), also a reasonable figure in our view.
7. Interest and preferred dividend coverage also looks good. ISH enjoys a low interest on its secured loans, with $9.5 million of interest expense in 2013 against approximately $218 million of average debt for a blended 4.3% rate. With a lower debt in 2014, the interest should come in around $8.5 million. Adding in preferred stock dividends of about $5 million, results in total interest+dividends of $13.5 million - resulting in about 4.4x EBITDA to interest coverage, a good ratio for this type of credit.
8. ISH recently arranged for a new $50 million revolver due in September 2018. The company has the support of its lenders and there is no evidence of stress in any of its loans or lending relationships. Several recent sale/leaseback transactions also evidence support from the lending community. All important credit positives.
9. According to recent appraisals, the vessels owned by ISH are worth approximately $461 million. Although these types of appraisals should be viewed with high skepticism, it does cover the value of the debt+preferred stock by 2x. Even assuming the appraisal is vastly inflated, there does appear to be plenty of asset value here. Note that in March 2012 ISH sold 2 vessels for $74 million; although a close examination of each vessel would be needed to truly assess the appraisal, the sales bolster the idea that these ships can actually be sold for tens of millions of dollars. The fact that Jones Act ships must be built in the U.S. impacts the value positively, as it again insulates the company's ships and their value from international competition. Note the company's market cap is $189 million and the enterprise value is $372 million based on the latest stock price - indicating about a 20% discount to the value of the company based purely on the asset value of the ships, and a 6.3x EBITDA valuation versus leverage in the high 3x range.
Finally, we believe that there is a reasonable possibility that the ISH preferred stock issues get called sometime around their respective call dates of 4/30/18 and 10/30/18. Some may view this as a negative (i.e. wanting to keep the high dividend as long as possible) and others as a positive (i.e. getting a high yield for a short duration security). When we compare the borrowing rate of 4.3% to the preferred yield of 9.0%-9.5%, management has a clear incentive to try and reduce this at the call date. With what appears to be steady deleveraging and growing EBITDA, leverage may reduce to the point where the preferred stock can be repaid with senior debt. However, if the business deteriorates, the preferred stock may stay out long term.
Shipping is still an industry with its difficulties and the company will likely take a hit in the next recession. However, it has already proven that it can manage through this. Capital expenditures are also a cash flow drain, as the company needs to upgrade ships and buy new ones over time to remain competitive. A detailed cap-ex analysis would be needed to understand future cap-ex needs and what are "maintenance" versus "growth" cap-ex needs but again, history tells us that management has been able to successfully balance free cash flow with cap-ex. While a repeal of the Jones Act would have a major negative impact on ISH (perhaps devastating), the law has been around since 1920 and no administration has made any serious attempts to repeal it.
Note that an investment in ISH preferred stock should be viewed as much higher risk compared to an "investment grade" bond, and more akin to a mezzanine loan that some of the BDCs are making these days. The long successful track record of ISH, the stability of its business, its protected markets solidified by the recent acquisition of UOS, hard asset value, reasonable leverage and high interest+dividend coverage, are all factors which make the preferred stock of ISH worth considering.
Please see the Downtown Investment Advisory profile page for important disclaimer language.
Additional disclosure: I personally have a position in ISH-B and in client accounts.