At JB Capital Management we invest with the objective of realizing superior medium to long-term returns by investing in companies that at their current prices offer attractive returns when considering their inherent risks. We therefore don’t attempt to beat the market on a short-term basis or even on a long-term basis but rather to generate a satisfactory income for our investors just like any other business.
In line with above, two of our top long investments are in the container ship long-term chartering companies Seaspan (SSW) and Global Ship Lease (GSL). In this note we will focus on SSW but the conclusions for both are very similar.
First the Conclusion
We have added SSW and GSL to our core long positions as part of our long/short global equities strategy. We are particularly attracted to the clear visibility of cash flows, implicit rates of return of around 19% and the improving industry fundamentals.
We slightly favor SSW over GSL as it currently pays a dividend and has a more diversified customer base. On an NPV level they are, however, similar so from a diversification perspective it can be justified to invest in both.
- SSW business model:
The traditional long-term charter is built by e.g. SSW agreeing to purchase a new building from a ship building yard while simultaneously agreeing to have it financed around 60-80% by banks and chartering it to a container line for 7-15 years at fixed rates. The bank gives a loan that is both backed by collateral and by revenue from the container line. SSW will get a rather fixed income during the charter while assuming the residual value risk of the ship and finally the container line secures additional capacity without weakening its balance sheet while in certain situations being able to extract a tax benefit.
Considering SSW business model we believe the most appropriate model to value its business is a discounted cash flow wind down model. We have used the following conservative assumptions: discount rate of 10%, future charter rates after expiry = current two year charter rates, second hand ship value calculated from current charter rates, 3% cost inflation and 0% revenue growth, future financings done at LIBOR plus 1%, long-term interest rates of 4%, worst case shareholder dilution, zero scrap value and only 60% per TEU increase in charter rates for ships larger than 4500 TEU (for ships larger than 4500 there aren’t reliable rates available).
This leads to a price target of 17.5 USD per share versus a current price of 10.50. When using more neutral assumptions the price target is 23.
Chart 1 below graphs the historic price developments in SSW and GSL share prices and Contex index, which is made of multiple different ship sizes for 2-year charter rates published by Hamburg Shipbrokers Association.
(Click to enlarge)
Chart 1 shows clear correlation between the SSW and GSL share prices and Contex and a very strong upward momentum for Contex. We believe the increases in charter rates reflect the pick up in demand through increased international trade and the reduction in supply through demolition of older ships, deferrals of new buildings, few new orders and slow steaming. In the medium term this should lead to global supply and demand balance to the benefit of charterers and ship owners.
(Click to enlarge)
In Chart 2 it is interesting to note that the discounted cash flow model leads to share prices that would make SWW and GSL catch up with the general market. Another perhaps less surprising outcome is that the equity would start trading close to book value adjusted for accrued income and paid dividends should the price targets be realized which makes sense for a performing lease.
SSW Business Risk
Since loans are not given for the entire economic life of 30 years for the ships the companies will from time to time need to obtain financing typically at the time of the expiration of the individual charters. A large part of the falls in share price for SSW in the past years have been over uncertainties as to whether there would be financing available for the unfinanced ships.
Our take: Given that both companies have relative little financing coming up in the foreseeable future and given that they have both recently obtained financing at reasonable terms we consider this risk manageable.
- Counter party default/risk of lower re-chartering rates:
When the agreed charter rate is significantly higher than the market spot rate SSW is exposed to the risk of its counter parties defaulting and having to re-charter the ship at lower rates. A variation on this theme is one where the charterer attempts to renegotiate the terms of the agreement while relying on the potential difficulties in enforcing the contracts.
Our take: While this risk was considerable in 2009 the market prices have firmed up significantly in the last 6 months largely mitigating this risk.
- Residual value:
In every lease/charter agreement the residual value is one the key variables when setting the rate. Given that is a risk borne by SSW this is a key risk.
Our take: We don’t have particular in future secondhand ship value but we do expect them to have a strong correlation with the key cost drivers for building ships being labor and steel prices. As the charters’ maturity dates are spread over the next 15 years and as we expect global trade to continue to grow we think it is reasonable to expect SSW to realize reasonable residual values on average.