[Note to readers: I made a mistake in the first edition of the article, which made the analysis flawed. For some reason when I updated my valuation model after the bond deal, the EBITDA figure wasn’t excluding depreciation. Apologies for the mistake.]
Just hours after submitting my first article on Global Ship Lease Inc.(NYSE:GSL) the company announced the pricing of their bond issue, which was at an interest rate of 10% and bond price of 98.5%. The pricing of the bond deal changes the picture for shareholders going forward, as the company's interest expenses will increase significantly. This makes the bonds look more attractive than the equity at the current trading price of the bonds and equity.
So, what has changed?
The company issued the pricing at which it will issue $420 million worth of First Priority Secured Notes due in 2019. The notes bear an interest rate of 10% and had an issue price 98.5% corresponding to a yield to maturity ("YTM") of 10.4%. The intended use of the raised capital is to pay back the company's former creditors under its credit facility, which had an interest rate of LIBOR + 3.75%, as of the latest waiver.
You are probably wondering why the company would more than double the interest rate on their debt and not simply keep their previous credit facility and keep a lower interest rate?
It's because the company breached the leverage ratio on of its old debt covenants, as it measured leverage by the company's fleet's second-hand market value and not stated equity value. Creditors extended waiver multiple times postponing the planned leverage covenant test and "only" increasing the interest rate by 25 bps. It's important to keep in mind that the company's cash flow hasn't suffered in this period of depressed second-hand vessel prices.
Europe's 100 biggest banks have especially been eager to get shipping loans of their books due to the European Central Bank's ("ECB's") recently announced Asset Quality Review ("AQR"). The AQR is a review of the balance sheets of Europe's 128 biggest banks and has to take place before the end of year. The banks undergoing the review may not use the auditor they use for their normal audits. Some bankers are concerned that some of the more creative accounting techniques used for bad shipping loans could fail the AQR, according to the Financial Times. (See also another article by the Financial Times describing the banks' concerns).
Management emphasized the constrained access to private bank debt in the recent investor presentation, especially from the so-called "chips", European banks that are the biggest lenders to the shipping industry.
Impact on profitability
The forced selling by banks has reduced liquidity to ship-owners (including Global Ship Lease), which has increased their price of borrowing. This impacts the profitability of ship-owners negatively and thereby shareholders' part of cash flow. A greater share of the company's cash flow will now go into the pockets of bondholders. I will first detail in this article how it affects the fundamentals of the equity of Global Ship Lease negatively and will then show you how to use this situation to your condition by acquiring the bonds of the company at the current valuation.
Due to the above-mentioned bond deal my earnings estimates for the company going forward has decreased significantly. Exhibit 1 shows the projected development in the net margin and EPS excluding investments in new vessels for Global Ship Lease, Inc. from 2014 to 2018.
Negative effect on the equity of Global Ship Lease
The decreased profitability influences the cash flow of the equity negatively going forward. One has to update ones DCF analysis following the recent bond deal. Exhibit 2 shows the result of the updated DCF analysis, assuming capital expenditures as per the management’s recent guidance in its investor presentation.
(Click to Enlarge)
Exhibit 2 shows us that at a 10% WACC, $72 million in capital expenditures and subsequently no growth in earnings, the implied fair value per share is in the range $4.07 to $4.99 (0%-1% perpetuity growth rate). The upper-band of the implied fair value is 14.7% over the current share price of 4.35, which leaves little upside left.
But, the above-mentioned DCF-analysis is assuming a $72 million investment in new vessels at an IRR of 11%. One of the benefits of the recent bond deal is the company has raised a $40 million credit revolver, which as of the bond deal wasn’t used. These $40 million will be used to invest opportunistically in new vessels. The current second-hand prices of vessels are at all-time lows as set forth in the company’s recent investor call. The following slide is slide 7 from the company’s investor presentation, which has a chart on it, which illustrates the development in the second-hand price of container vessels and new built container vessels:
These $40 million can be used to acquire approximately two 5-year old vessels. At the current spot rates these would operate at a day rate of approximately $9,000, which is derived from the development of the New ConTex Type 4250 24 Month Charter Index (Exhibit 3, shows the development in the index).
Exhibit 4 is a sensitivity analysis stress testing the day rate's and operating expenses ("OPEX") per day's influence on the IRR:
The red filled cells in Exhibit 4 are cells that are below 10%, as this is the yield of the capital that will be finance such potential acquisitions. It's important to remember the sensitivity analysis is assuming a $20 million acquisition price per vessel, which all other things being equal, would increase if charter rates increase.
The sensitivity analysis shows us that the company needs a day rate that is it at least $11,000, before an investment in a ship, with the raised capital earns a higher return than the newly raised capital's cost. At the current day rates it seems rather unlikely, at least in the short-term. In order for the company to successfully invest the newly raised capital with a return that is substantially higher than its cost of capital, is to make macro bets on the direction of charter rates, by buying ships before a big increase in charter rates.
The company did provide us with guidance on the total capital it will have to invest following this bond deal and at which likely IRR they would be able to employ the capital at. Management told us that they would have a total of about $70 million cash available for investment and would be able to employ the capital at double digits to high teens IRR. The estimated IRR are based on comparable deals that the company intends to make.
However, one has to keep in mind that the higher interest rate applies to all of the company's bond debt and not only the additional capital freed. This is important to keep in mind, as this more than trade-offs the potential IRR over the interest rate.
The company might be able to invest the money at or slightly below its cost of capital at the current charter rates, which is ok for bondholders but bad for shareholders.
Why the bonds are attractive
The revenue and cash flow of the company is highly predictable as its weighted average remaining contract coverage is 7.8 year, as of last week, which is considerable higher than when the bonds mature in 2019. The following is slide 5 from the company's investor presentation on March 17, 2014, which shows the company's current contract coverage:
Based on the company's contract coverage, bondholders can be fairly certain that the company will be able to repay principal and interest on the debt.
Why investors haven't bought the bonds… yet
It's important to understand that the current mispricing in the bonds, is due to the reduced liquidity to ship owners from European banks who are panic selling up to the AQR by the ECB. The company's former creditors were primarily the European banks that will have to undergo the AQR during 2014. These banks are highly likely to buy back the bonds at the current price of the bonds, as they offer a more attractive yield-to-maturity than the old credit facility.
So in addition to an attractive there are highly like to be a capital appreciation of the bonds throughout the latter part of 2014 and throughout 2015. This is due to banks ending the AQR.
My former bullish thesis doesn't prevail, as the company will not deleverage, which was the pre-dominant value driver in the thesis. Following the recent bond deal, bondholders get a larger share of cash flow, given the higher interest rate. The reason behind the high interest rate is due to European banks' panic selling due to the AQR by the ECB.
Once the AQR ends (ultimo 2014), European banks (former creditors of the company) are highly likely to start buying the bonds, as they offer a more attractive yield-to-maturity than their old credit facility to the company. The bonds currently trade at 102, with a coupon of 10% corresponding to a yield of 9.8% and yield-to-maturity of 9.479%. This is higher than the annualized return of the S&P 500 in the date range January 1871 to December 2013, which was 9.07% or 6.86% adjusted for inflation.
The return on the investment is likely to be enhanced by capital appreciation in the coming year, due to banks buying back into shipping loans after the conclusion of the AQR.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Abdalla Al-ayrot manages money on behalf of several investors and these investors might be long the stock mentioned in this article.