Seaspan Gives Us Another Arbitrage

| About: Seaspan Corporation (SSW)

Summary

The preferred stock is yielding 15 %.

The failure to redeem clause makes every preferred stock as safe as a bond.

Either the common stock is overvalued or the preferred stock is undervalued.

Seaspan Corporation (NYSE:SSW) is one company that handles the sale of shares quite well compared to its rivals. The company has three preferred stocks and one exchange-traded debt traded on the New York stock exchange. In my previous article, I pointed to one of the inefficiencies that turned out to be a 20% trade in nearly two months. The proposed trade was long SSWN at $22.20 and short SSW-E at $24.10. Current prices at the time of writing are $23.75 for SSWN (7% winner) and $20.90 for SSW-E (13% winner).

Now it's time to take a deeper look at Seaspan's 9.50% Series C Cumulative Redeemable Perpetual Preferred Shares (SSW-C). This preferred stock is very different from most preferred stocks because it has a failure to redeem clause. This is what the prospectus states:

(iv) the Series C Preferred Shares are not redeemed in whole by January 30, 2017 (a 'Failure to Redeem'), the dividend rate payable on the Series C Preferred Shares shall increase, subject to aggregate maximum rate per annum of 25% prior to January 30, 2016 and 30% thereafter, to a rate that is 1.25 times the dividend rate payable on the Series C Preferred Shares as of the close of business on the day immediately preceding the Covenant Default, Cross Default, Divided Payment Default or Failure to Redeem, as applicable, and on each subsequent Dividend Payment Date

In other words, this means that the preferred stock either gets redeemed by Jan. 30, 2017, or the company admits it has a serious problem, because the rate on the preferred stock will increase drastically. A company in such a situation will do everything possible to redeem the stock because by not doing so, the costs of financing for the whole entity will rise accordingly and the company will probably get a big cut in its credit rating.

Scenario 1: The preferred gets redeemed. This means that at some time between today and Jan. 30, 2017, a holder of the preferred stock will receive $25 + all accrued dividends. Let's assume that this happens on Jan. 30, 2017, as this is the riskiest scenario:

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Source: Created by author.

This means that you will receive four more dividends totaling $2.38 and $1.20 in capital appreciation, or nearly 15% yield to call. The calculation changes if SSW decides to redeem the stock earlier, but the capital appreciation at current price of $23.81 is 1.19/25 = 4.76%. A 15% yield to maturity on a one-year instrument means that the market is valuing this preferred stock like the company is in big trouble.

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Neither the behavior of the common stock nor the past results point to a company that cannot issue a preferred stock with less than 15% yield. To further support this, the current yield on the two other outstanding preferred stocks is in the 9%-10% range. The common stock pays nearly a 9% dividend. I have no idea why the market values SSW-C so low (even though it's the safest of all the preferred stocks and probably safer than the exchange traded note, SSWN, because of the failure to redeem clause). SSW-C has 10 million shares outstanding. This is $250 million in redemption value. The yearly dividend payment to common shareholders is nearly $140 million. I seriously doubt that the company will prefer to pay dividends on the common stock rather than redeem the preferred stock.

Scenario 2: The company fails to redeem SSW-C. Here I have only one sentence to write: Short the common stock -- that is all for this scenario.

How do I trade it? I am buying the preferred stock and closely monitoring the behavior of the common stock. As long as the common is stable, I will only average my position in SSW-C on any further weakness. Usually I would be hedged in a trade like this, but here I will keep the hedge as a last resort option because I do not want to lose all of the tiny profits from the preferred on my short position in the common stock. For anyone who is short the common stock, the preferred might be a nice hedging opportunity because the common stock refuses to sell while the preferreds are falling.

Conclusion

You rarely see shares such a strong company trade with 15% yield to maturity with a one-year duration. It is definitely not a risk-free investment, but the possible hedging opportunity makes the risk/reward ratio on this stock really favorable.

Disclosure: I am/we are long SSW-C.

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.