Investment Thesis (Long): Global Ship Lease

Global Ship Lease (“GSL”) is a $2.90 stock that should be worth at least $6.00/share in the next 6-12 months. The catalyst for this revaluation will be the implementation of an initial $0.45-0.60 dividend (with visibility of payment through 2017). One of two events are required to initiate the dividend: 1) GSL needs to restructure, which can only happen if its sole customer (CMA CGM) restructures, or 2) GSL must meet a Loan-to-Value (LTV) covenant. Investors need to believe one of these events will happen for the stock to work and we have conviction they will.

The situation becomes even more compelling as the stock has sold off 20% through earnings as shareholders misinterpret the timing of these events. Investors had expected the company to be LTV compliant in 2013; in the Q3 release, GSL disclosed it had received a waiver for compliance until December 2014. Misinformed shareholders have interpreted this as a testament that compliance would not be achieved in 2013 when in reality, the situation has not changed at all. The waiver merely gives the company optionality when to run the test and we believe this occurs in 2013.

Background

GSL operates 17 containerships that are all contracted to CMA CGM -- the world’s third largest shipper, operating 394 ships out of France. CMA CGM is a private company with public debt; it obtained a 45% equity interest in GSL when Michael Gross (Apollo’s co-founder and GSL’s chairman) formed a SPAC that acquired the ships from CMA in 2008.

Shipping is an inherently difficult business due to high capital costs, oversupply and economically sensitive charter rates. Despite this, shippers typically trade near market multiples, and this is mostly due to dividend yields that average 10-15% over time. In 2009, a large debt burden and lower fleet valuations forced GSL to eliminate its $0.92/share dividend when LTV tripped. With no payout to support the stock, the market values GSL at 5.6x 2013 EPS (2.1x FCF) versus its peers at 8.9x EPS (5.2x FCF).

For further industry data, see Morgan Stanley’s monthly “Maritime Industries” report. 

Why Does the Situation Exist? 1 Analyst, Small Market Cap, Limited Float, OH MY!

GSL does not make it to many investors’ wheelhouses these days, mostly due to its small market cap ($135 million), limited float (36%), and only analyst covering the stock (Euro Pacific Capital initiated in July). Aside from negative industry sentiment, potential investors cite three reasons to sink the investment thesis: 1) the lack of dividend, 2) counterparty risk from CMA CGM, and 3) risk that high priced fixed contracts will reset at lower market rates. The market views these collectively as impairment but we see opportunity in each of them, and an outsized bounty to go along with it.

Financial Overview: Contracted Backlog Provides Visibility into 2016 and 50% FCF Yield

A key differentiating factor between GSL and other shippers is its long-duration, contracted backlog, which it negotiated when it purchased the 17 vessels from CMA CGM. Most shippers are highly sensitive to charter rates, which can fluctuate widely. For example, take a look at the quarterly EBITDA of TEU and DCIX, which have shown large variations, and compare it to GSL, which consistently produces $25-26mm of EBITDA each quarter.

Of the 17 ships GSL operates, 15 are contracted through 2016 and 2 are contracted until mid-2013. Therefore 90% of run-rate revenues are fixed through 2016 – equating to a $1.1bn of backlog.  It is important to note that the charter rates on these vessels are fixed and do not fluctuate (aside from two of the ships that were up for renewal this year and have since been renewed) making revenues very easy to predict (management discloses the per ship charter rates in its releases). Operating expenses borne by GSL as well as G&A are also very predictable. Which brings the only variances of EBITDA based on dry-dock and utilization, again which management discloses.

Moving down the income statement, the only real variable is interest expense. As you can see from the model above, interest expense is declining annually. There are two components to this decline:

1. Debt Reduction:  When GSL fell out of LTV compliance, part of the agreement with the bank group was that all excess free cash would be swept to paying down debt. Current quarterly amortization runs in the $15mm range.
2. Runoff of Swaps: GSL has swaps with a notional value of $580mm, which it contracted into in 2008 to convert its floating bank loans to a fixed rate. This obviously has not worked well for the company given the interest rate environment. The pay fix / receive floating swap cost GSL $18mm in added interest expense in 2011. Approximately $200mm of these swaps expire in 2013, which will produce a $7mm savings. Since the company is deleveraging, there is no need to enter into additional swaps to replace those expiring.

These moving pieces, together with lower dry dock expenses, should generate $11mm of additional FCF in 2013, and $6mm in 2014.  That equates to roughly $1.40-1.52 FCF/share in 2013-2014 for a 50-60% yield.

While our thesis is predicated on utilizing the free cash flow to pay a dividend, the accretion to equity holders via debt paydown alone should also have a material impact on share appreciation. Currently, the company has $138mm of equity and $449mm of net debt. At the end of 2014, the company will have generated $120mm of FCF, thereby altering the capital structure. Assuming the current EV/EBITDA multiple holds, this theoretically would imply a $4.70 stock price.

CMA CGM Counterparty Risk Profile is Improving

GSL’s stock is highly dependent on the credit profile of CMA CGM since all of GSL’s ships are leased to CMA CGM. This creates significant counterparty risk and along with the lack of dividend, largely explains the stock’s discount to peers.

CMA CGM’s core business is improving significantly and a restructuring should be announced imminently. This reduces counter-party risk and could enable GSL to complete its own restructuring, thereby bypassing the LTV covenant altogether and issue a dividend far sooner than most expect.

Brief Background on CMA: CMA CGM is the world’s third largest shipper, operating 394 ships and based in France. The company is by and large, one of the better operators in the industry based on its profit and return metrics; albeit, the industry has poor metrics, and CMA has $5.5bn of public debt. Full financials are available by requesting access on the company’s IR web site (the company is sometimes fickle about granting access but proof of bond ownership usually appeases them).   

To better understand CMA’s risk profile over time, it helps to look at a chart of its bonds (links below). The bonds were trading in the 90s until the summer of 2011, when charter rates got cut in half. CMA bonds went from 90 to 30 and GSL stock went from $7 to $2.  It is important to note that while CMA’s cash flows were volatile during these quarters, GSL consistently earned the same amount of cash, whether it was a $1bn enterprise value in 2011 or a $600mm today. The situation was magnified given CMA had $2.5bn of bank debt coming due in June 2013 and started producing negative EBITDA in 2H11.

Bond Charts:      http://www.boerse-frankfurt.de/de/anleihen/cma+cgm+11+19+regs+XS0618662562

http://www.boerse-frankfurt.de/de/anleihen/cma+cgm+11+19+144a+XS0618676190

Most of that has changed and here is where things get interesting: In order for GSL stock to work, the market needs to get comfortable with the risk profile of CMA CGM. There are several data points to support an ever improving risk profile, but the ultimate catalyst will be a capital restructuring that we expect to be announced imminently:

• CMA’s Fundamentals Are Improving: driven by a more favorable macro environment and cost cutting. The inflection point occurred in Q2 when both volumes and rates started to recover. Simultaneously, CMA began executing on a $400mm cost savings initiative. The confluence of these events has produced meaningful improvement in quarterly EBITDA, which is demonstrated by the rally in the bonds from the mid-50s in July/August to the mid-70s today.

1. The company is announcing Q3 results on November 20^th and has guided to further EBITDA improvement. We’ve seen a couple sell-side fixed income notes that put the estimate around $300mm. We are modeling $350mm but think the company can do closer to $400mm.
2. There has been “excess” concern with rate erosion in Q4. Freight rates have eroded by 30%+ on the important Asia/Europe route. This data was well known to CMA when they reported Q2 results in September and they have ample flexibility to address this:

                                                               i.      CMA is reducing capacity and expects the imbalance to rationalize.

                                                             ii.      Cost savings should mitigate the impact. $106mm remains to be realized in 2H.

                                                            iii.      Current rates are still 3x higher than December 2011 lows of 490. During that quarter, CMA still managed to generate $20mm of EBITDA.

                                                           iv.      The company guided to profitability for the year – even after having visibility into the rate erosion.

• The Balance Sheet has been Bolstered by Equity Injections and Asset Sales:

1. On October 16^th, CMA announced a $250mm equity injection for 10% ownership, consisting of $150mm from the French Government and $100mm from the Yildirim Group. The Yildirim first acquired 20% of the company in 2010 for $500mm and had the option to acquire an additional 10%. From our conversations with industry participants, both parties were very eager to provide the equity and the French actually wanted to inject $400mm for a 10% stake at a $4bn valuation. However, given how the aesthetics of how that would look after Yildirim decided to exercise its option at a $2.5bn valuation, CMA decided to take a lower investment at a lower valuation to appease the French Government. The equity injection was a necessary precursor for a full blown restructuring. 
2. CMA has been active in selling non-core assets to raise additional capital. Future sources include:

                                                               i.      Minority Stake of Terminal Link: estimated to close in Q4

                                                             ii.      Sale of 6 vessels: estimated to close in 1Q13

                                                            iii.      There has also been talk of asset securitization and sales of other JVs

• A Full Restructuring Should Be Announced Imminently, Which Will Serve as a Catalyst to GSL. CMA has openly talked about restructuring for over a year now. In its most recent release (September 10, 2012), CMA stated that discussions were ongoing an agreement would occur in the coming weeks. That was 9 weeks ago. At issue is $2.5bn in bank debt due in 2013. A precursor to a deal with CMA’s banks involved receiving an equity injection, which just happened. We think the banks are now amenable to restructuring the debt. While this does not eliminate the problem, the refinancing risk is significantly reduced and we would expect the bond prices to trade up significantly on this news.

• GSL Restructure Could Follow. GSL has been exploring its own restructuring for some time in order to reduce the restrictive covenants on its bank debt. The goal would be to eliminate the restrictive cash flow sweep provision that prevents GSL from using its cash for anything aside from debt repayment. A potential scenario could envision GSL issuing $100mm of high yield bonds to prepay a portion of the bank debt and in return GSL would gain control of its cash flow again. We believe GSL is speaking with banks currently in order to prep the market for a deal when the opportunity arises. The one hold up is that high yield market participants are requiring CMA bonds to trade in the 80s to get such a deal done. This is somewhat of an arbitrary number but one we have heard from both lenders and creditors. A CMA restructuring is the likely impetus. Conversations with lenders put the interest rate on such a note in the 12-13% range, which would cost GSL about $2-3mm in incremental annual interest expense over its current cap structure. The benefit would be the immediate use of its cash flow (beyond the scheduled amortization amounts).

Loan-to-Value Should be Met in 2013, Paving Way for Dividend Sooner Than Expected

We expect GSL to meet its loan-to-value covenant in 2013, which should pave the way for an initial 0.45-0.60/share dividend. We expect this will drive the stock to at least $6/share, representing an 8-10% dividend yield and a 7x EBITDA multiple, which are both a discount to peers for the customer concentration risk.

Background: In 2009, GSL breached its loan-to-value covenant in its credit agreement. To appease creditors, GSL suspended its dividend (0.92/share annually at the time) and agreed to use all cash on the balance sheet (>$20mm) for debt repayment. A dividend cannot be reinstated until after 11/30/12 and LTV<75%.

There are two components in figuring out whether the company will pass the test: the loan value, which is easy to model given the predictability in cash flow, and the asset value, which is much more difficult to compute.

1. Loan Value: Since all free cash flow is swept to debt amortization, predicting loan value is quite simple. Based on our cash flow model, we believe the loan value will be $377mm when the test is run in 2013.
2. Asset Value: The asset value is the fair market value for GSL’s 17 ships. As can be expected with illiquid assets, this value is hard to predict. The ships were last valued in November 2011 at a range of $550-$660mm, which put it outside the LTV range since the bank debt at the time was $500mm.  We estimate the loan value to be $377mm in Q3 2013, which would require an asset value of $500mm. While some of the inputs to the valuation model have not been favorable lately, we believe there is ample cushion to achieve compliance.
   1. Morgan Stanley estimates GSL’s fleet value at $538 million in its monthly Maritime Industries report.
   2. Third-party firms put the value much higher. There are several firms that specialize in fleet valuation. While we have not contracted with one of these firms to run our own third-party valuation (mostly because we think it is unnecessary given where LTV will be in a year), we have spoken with a fund that has. The independent valuation came in at around $700mm. While the valuation was run several months ago when charter rates were higher, we still believe the analysis points to significant leeway in meeting LTV in 2013.

Risks

GSL has a significant amount of risk and we are not trying to sugar coat the situation. However, most investors fail to adequately understand the risk profile and typically pass on the investment by assigning negative asymmetry to the situation. We have tried to address many of the risks in the write-up, but others include:

1. CMA Tries to Renegotiate its Contracts. Our estimates are based on contracted rates. However, there is the belief in the market that CMA CGM could re-negotiate the rates. This is completely speculative and was borne during a period when CMA CGM was in severe financial distress and the market saw contracted rates that were 75% above current rates.  CMA CGM’s profile has vastly improved. We have spoken to legal experts in this field and they have concluded it would be a violation of French contract law to break these contracts.

2. GSL Management Uses Cash Flow for Purposes Other Than Paying a Dividend. Management has expressed interest in growing its fleet. After LTV compliance, should management decide to use its cash flow to make vessel acquisitions in lieu of paying a dividend, the share price would react negatively. We believe management realizes the importance of paying a dividend to achieving a decent valuation and they have expressed this as their priority (see Q3 transcript).