Description

Global Ship Lease (“GSL”) has 70%+ appreciation potential over the next 12-months. The catalyst for revaluation will be the implementation of an initial $0.30-0.40/share dividend, which could be communicated as early as February 2015. While this would initially produce a $6/stock based on peer yields, we believe the dividend could easily compound at 15-20% annually, producing a stock that could reach $8.00+. We have been through similar iterations with GSL in the past but believe this time is different for a variety of reasons.

At current prices, GSL shareholders have been “Ian-munized.” For those not familiar, the vaccine is in reference to the disease of miscommunication and poor leadership of CEO Ian Webber. Despite a superior fixed rate charter schedule that locks in FCF through 2017, GSL trades at a whopping 40% discount to peers and 25% discount to liquidation value due to the lack of a dividend. Minority (and majority) shareholders have become restless, bond covenants restricting dividend payments will soon be satisfied, and the CEO must act to prevent a mutiny. All-told, we believe GSL will issue a dividend in the next 6-months and this can be communicated as early as Q1, which should drive the stock to $8/share (70%+ return) in a very short time.

Background

I initially wrote up GSL at $2.90 on VIC in November 2012. The thesis was dividend-driven but there were some counterparty risks and bank covenants that had to be dealt with as a precursor. The stock ran to the mid $6s before falling back to $3 after management failed (again) to refinance with a dividend friendly alternative. While today’s thesis is also dividend-driven, the path is quite different, the risks far less, the valuation more attractive, and the macro environment more amenable. Hence, a fresh write-up.

GSL operates 18 ships – 16 of which are contracted through 2017 with an average charter length of 6.5 years, equating to a $900mm backlog. It is important to note that the charter rates on these vessels are fixed and do not fluctuate (aside from two ships that are subject to spot rates) making revenues very easy to predict (management discloses the per ship charter rates in its releases). Operating expenses as well as G&A are also very predictable. The only variances of EBITDA are based on dry-dock and utilization, again which management discloses. The current run-rate of revenue, EBITDA, and FCF is roughly $140mm, $92mm, and $52mm.

Why Does the Situation Exist?

Despite superior fundamentals (charter coverage, cash flow profile and balance sheet), GSL trades at a 40% discount to peers and 25% discount to liquidation value due to the lack of a dividend. The situation is exacerbated and sentiment reduced as management has failed to provide shareholders a path to a dividend. As a reminder, GSL was founded in 2008 to be a dividend paying entity, similar to an MLP. The sector has a predominantly retail-oriented investor base and is valued on dividend yields and FCF. While the enterprise value of the company has fluctuated by +/- $300mm over the years, annual FCF has essentially remained constant (take that to your finance professor)!

We believe management has been able to stay at the helm due to the absentee nature of GSL’s two majority shareholders: French shipping giant CMA-CGM (45% owner) and Apollo co-founder Michael Gross (20%). Each has been absent for independent reasons but has since reemerged. We believe this is the precipitating factor for reinvigorating management’s priorities toward a dividend.

1. CMA-CGM helped form GSL in 2007, but took a back-seat soon after and was essentially an absentee shareholder. This was likely due to a combination of 1) internal liquidity issues that preoccupied management for several years (which was successfully navigated as CMA-CGM is now on strong financial footing), 2) a standstill agreement that expired in August 2013 that made the investment easy to forget for several years, and 3) turnover in their finance organization, which left the company without a point person on the investment. Effectively, we believe CMA may have “forgot” they owned the stock. All of this changed last year when CMA woke up, realized they could make money on their investment, promptly filed a 13D, and garnered two board seats. CMA has also been supportive of GSL by extending charter on four ships in 2014 significantly above market charter rates.

2. Michael Gross: Mr. Gross undoubtedly has a large and diverse portfolio. As the co-founder of Apollo, CEO of Solar Capital (SLRC), and likely numerous private investments, he has a lot on his plate. We would like to note that GSL is Mr. Gross’s largest public investment at a market value of $51mm but he has not been actively involved until recently. We believe the impetus for this is a shareholder revolt we detail further in the report. While we do not like feel it is appropriate to comment on the personal lives of management, it is a matter of public record that Mr. Gross recently divorced but kept all of his GSL shares, effectively doubling down on his position at these levels.

Key Investment Points

Our investment thesis is predicated on the following: 1) Shareholder revolt will encourage management to communicate a tangible path to paying a dividend, 2) the company will initiate a $0.30-0.40/share dividend in the next 6-months, and 3) GSL will re-rate to peer dividend yields and multiples driving the stock to $8.00+. We will begin by discussing valuation and then hit on the other investment points.

Stock Should Be Worth $8+

GSL’s valuation and risk/return profile is at one of the most compelling levels we have seen in the company’s history. We believe the current NAV provides significant downside protection while relative valuation provides a glimpse of the stock’s potential, once a dividend is announced.

• GSL trades at a 25% discount to NAV based on independent third-party valuation. NAV of the company use to be highly elusive but is now firm as the company was required to appraise both its ships and charters as part of its 2014 refinancing. NAV is currently $6.11-6.42/share and provides a floor on the company’s value today as it ascribes zero value for capital deployment.

• GSL trades at a 40% discount to peers for no apparent reason other than the lack of dividend and management’s inability to communicate a path towards one. Each 1x multiple point of EBITDA translates into $2.00/share of equity value. In addition to its superior balance sheet and charter coverage, GSL will also sport the fastest growing fleet in the peer group. At peer EBITDA levels, GSL would be valued at $14/share.

NAV can be elusive but we have a very good idea of the company’s value, both standalone and with charters attached. During the secured notes offering in early 2014, GSL had its ships appraised by Howe Robinson, one of the biggest appraisal companies. From our understanding, the appraisal came in at $648mm with the charters ($5.55/share, net of debt). However, this NPV not only does not account for several NPV accretive actions since the appraisal, it also does not give the credit for any reinvestment of capital. In essence, it is the liquidation value of the company if the current charters run out and ships are sold. Adjusting the NPV for both the October purchase of the Tianjin (plus charters) as well as the restructure of the preferred stock, gets us to a pro-forma NPV range of $6.11-6.42, a 25% discount to the current share price.

Source: Our estimates.

Investment Point #1: Mutiny Ahead -- The 99% Fights Back!

For sentiment to improve, GSL needs to pay a dividend or at the least communicate a path to paying a dividend. Part of the difficulty in getting Captain Webber to comply is due to a shareholder base that is effectively controlled by the 1% (CMA-CGM and Michael Gross own 65% collectively). Essentially the common sailor, err shareholder, is at their behest. We believe the dynamics are changing as minority shareholders are getting scrappy and the situation is starting to look a lot like Zuccotti Park.

1. Minority shareholders are fed-up with the lack of strategy and value creation, and are proactively (and independently) communicating this to the majority. Based on correspondence, we believe the majority of the minority has expressed their discontent to Mr. Webber, Mr. Gross, and representatives from CMA-CGM. The investment case for GSL is fairly simple: investors want a dividend or at least settle for a tangible path to attaining one in its absence.

2. We believe the message is resonating with CMA-CGM and Mr. Gross. Persistence pays…and it is our understanding that the volume of correspondence (especially to Mr. Gross) has struck a chord and will necessitate action. We believe Mr. Gross is re-engaged in the company’s activities (partly due to the shareholder revolt) and more importantly, 100% behind the dividend. As expected under a true banana republic, Mr. Webber has now been more vocal in support of the dividend.

3. We are seeing improvement. Management has not laid out a tangible path to a sustainable dividend, as there strategy (or lack thereof) for the last several years has been to eliminate expectations and then “surprise to the upside.” We do not necessarily believe this is part of Mr. Webber’s DNA but rather from the beat-down he has received ever since the company eliminated its $0.92/share dividend in 2009. In fact, when GSL was formed, Mr. Webber was quite aggressive in communicating the large dividend the company was paying. When things did not go as planned and the company tripped a bank covenant, Mr. Webber suffered a royal flogging (which some would argue was commensurate with the crime). We believe it is finally time to return to the company’s roots and come out from under their rock as the company gets its mojo back. A change in rhetoric can be seen on the Q3 conference call when management proactively mentioned “dividend” on 13 separate occasions in its prepared remarks versus an average of 7 on prior calls. We believe this is more than just a coincidence.

4. Communication will undoubtedly lead to improved sentiment in the stock. To see why this will be the case, we need only to refer to the sell-side analysts that cover the stock:

   1. Euro Pacific Capital: Price target of $7 based on 7.5x multiple of $89mm in 2016 EBITDA. The 7.5x multiple is less than the 9x multiple the same analyst awards DAC, a company with far inferior fundamentals, and the $89mm EBITDA estimate is below the current run-rate. Analyst says no dividend until 2016.

   2. Clarksons: Downgraded on 1/7/15 and lowered NAV estimate to $5.78 (from $6.30 without providing any clarity). Analyst notes: company in growth mode, dividend on the horizon, container market improving. Obviously sounds like its time to downgrade!

   3. Sidoti: Price target of $7 based on 6x 2016 FCF estimate.  Analyst says this 6x multiple is a discount to 9x awarded the industry due in large part to "lack of dividend."

Investment Point #2: GSL Will Be Able to Initiate a $0.30-0.40/Share Dividend in 6-Months

We expect GSL to meet its fixed charge coverage ratio covenant in 1Q15, which should pave the way for an initial $0.30-0.40/share dividend. Based on peer yields, this will drive the stock to at least $6/share. As it becomes apparent that GSL’s $1.10/share of annual cash generation will transition from “restricted” cash flow to “free” cash flow, we believe GSL will be valued upwards of $8.00/share.

Background: When GSL refinanced its bank debt in early 2014 it essentially swapped a very restrictive bank covenant (loan-to-value) for a less restrictive bond covenant (fixed charge ratio) as well as a restricted payments basket. Currently, GSL is able to use $15mm to pay a dividend but management has withheld as their goal has always been to pay a “sustainable” dividend. Once the fixed charge coverage ratio is above 2.25x, the company can access a “builder basket,” which is essentially a non-restrictive payments basket. We believe the company will meet the fixed charge coverage ratio in the next several months, paving the way for a dividend.

When Can A Dividend Be Paid? In order to meet the covenant, GSL needs $5mm in incremental EBITDA, which management plans to get by acquiring a ship with charter attached. Management has already identified the ship and we believe it is of similar size and economics as the Tianjin, which was purchased in October 2014 (press release).

We estimate GSL will have $30mm of cash at 12/31/14 as well as $40mm of undrawn revolver. We think GSL could announce the acquisition as early as February with a March close. We expect the purchase price to be roughly $55mm and based on comps, this would generate around $9.4mm in EBITDA. On a pro-forma basis, GSL would then be generating $100mm+ of EBITDA. Pro-forma numbers are important since the fixed charge coverage ratio is based off of LTM pro-forma numbers. We believe this ship gets GSL over the 2.25 EBITDA/interest ratio. All of this could be announced on February’s Q4 earnings call.

How Large Can the Dividend Be? Once GSL meets the covenant, the company can access $15mm in unrestricted cash (currently available), $34mm of proceeds from the preferred stock issued earlier in the year, and 50% of net income. Net income is currently close to break-even but will be additive to the “builder basket” with each incremental ship purchase. Management’s goal has always been to issue a “sustainable” dividend and through conversations, we define this as 8-quarterly payments without interruption. Based on this, management could issue a $0.50/share annual dividend as soon as the fixed charge coverage ratio is met. To be conservative, we are assuming a $0.30-0.40/share initial dividend.

Under the bond indenture, GSL would still be capped on the total payments that could be used for dividends. The bonds are callable in April 2016 and if the company can refinance the bonds with less restrictive covenants, the majority of its $1.10/share of annual FCF could be used for dividends (which was the dividend policy when the company previously paid out $0.92/share). As a side note, CMA-CGM unsecured bonds yield in the 7s vs. GSL secured bonds in the 9s (the coupon is 10%). CMRE, which is an industry bellwether, pays out roughly 40% of FCF and trades at a 6% yield. There is a high correlation in the industry between payout ratios and dividend yields.

Risks / Where We Expect Pushback

1. Nothing Happens. The biggest near-term risk to the investment is that the status quo prevails, no corporate action is taken, no dividend is paid, and GSL is a value trap. Our anecdotal evidence (shareholder discontent and communication, management’s discussion of the dividend, etc…) helps to placate the risk. Even if management were to do nothing, GSL shareholders would benefit from value accretion of generating $100mm of FCF over the next two years. Assuming the EBITDA multiple stayed flat at 6.1x (still a 40% discount to peers), the stock should appreciate to $7 by the transfer of ownership from debt to equity owners.

2. Cycle Turns. While charter rates are still near multi-year lows, there is the risk that rates in 2017+ (when GSL charters begin renew) will be lower than today’s rates and certainly lower than the fixed rates on GSL’s current charters. While that is a valid concern, it is a risk borne by all industry participants, not just GSL. Therefore, it does not explain GSL’s current 40% discount to peers today (only the lack of a dividend answers that).

Catalyst

1) Shareholder revolt will encourage management to communicate a tangible path to paying a dividend

2) the company will initiate a $0.30-0.40/share dividend in the next 6-months

3) GSL will re-rate to peer dividend yields and multiples driving the stock to $8.00+.