The lowdown on shipping trusts

[d.o.g.]

Debt payment is derived from cash-flow from depreciation (which is considered to be an expense). After debt payment, PST still has US$27 million worth of cash to either retain or distribute to unit-holders.

More accurately, cash flow is what is left from revenues after paying cash expenses. Debt is paid out of this cash flow, and what is left over is then split between unitholders and PST itself.

Depreciation is a method of reconciling cash flow and income. Because the cash has already been spent, when depreciation is recognized it is a non-cash accounting charge, however it cannot be ignored because it represents a real liability: the need to replace the existing fleet in future.

Using a VTL ratio of 60%, PST is able to acquire a US$23 million vessel annually free from any new equity fund raising. The increased revenue from the new ships will increase the amount of cash PST retains quarterly.

You have to take into account the fact that the existing fleet is rusting away and will eventually need to be replaced. That's what the annual depreciation of US$16m is for: to renew the fleet, not expand it.

The fleet can be expanded only AFTER paying for depreciation. If you buy a US$23m vessel annually the net increase in fleet value is only US$7m because US$16m of that new value is needed to offset the depreciation in the existing fleet.

It is true that the market value of ships does not always match the accounting book value. But ignoring depreciation will not make the rust go away. No bona fide shipowner will ignore the need to replace the ships. An investor in a shipping trust IS a shipowner and had better think along such lines if he wants to keep his capital intact.

[Nick]

Debt payment is derived from cash-flow from depreciation (which is considered to be an expense). After debt payment, PST still has US$27 million worth of cash to either retain or distribute to unit-holders.

More accurately, cash flow is what is left from revenues after paying cash expenses. Debt is paid out of this cash flow, and what is left over is then split between unitholders and PST itself.

Depreciation is a method of reconciling cash flow and income. Because the cash has already been spent, when depreciation is recognized it is a non-cash accounting charge, however it cannot be ignored because it represents a real liability: the need to replace the existing fleet in future.

Using a VTL ratio of 60%, PST is able to acquire a US$23 million vessel annually free from any new equity fund raising. The increased revenue from the new ships will increase the amount of cash PST retains quarterly.

You have to take into account the fact that the existing fleet is rusting away and will eventually need to be replaced. That's what the annual depreciation of US$16m is for: to renew the fleet, not expand it.

The fleet can be expanded only AFTER paying for depreciation. If you buy a US$23m vessel annually the net increase in fleet value is only US$7m because US$16m of that new value is needed to offset the depreciation in the existing fleet.

It is true that the market value of ships does not always match the accounting book value. But ignoring depreciation will not make the rust go away. No bona fide shipowner will ignore the need to replace the ships. An investor in a shipping trust IS a shipowner and had better think along such lines if he wants to keep his capital intact.

Hi d.o.g,

Isn't the decrease in asset value offsetted by a similar decrease in debt level ? The fleet is being 'renewed' by a similar decrease in loan payment which keeps the NAV constant.

Trust ABC

Asset: $100 (10 year lifespan)
Debt: $50
Equity: $50

Profit: $8
Net Cash-flow: $18
Debt Payment: $10
Distribution: $6

After 5 years,

Asset: $50
Debt: 0
Cash: $10
Equity: $60

Debts fully paid...depreciation cash-flow continues to be retained,

After 10 years,

Asset: 0
Debt: 0
Cash: $70 ($50 + $20)

Throughout the first 5 years, the Trust is only retaining $2. However NAV remained stagnant because it was paying down its debts in line with depreciation. The $2 being retained is NOT for fleet renewal - it is for fleet growth. Similarly, in PST, the US$9 million being retained is not for fleet renewal - it is for fleet growth. Fleet renewal comes from its cash-flow from depreciation being used to repay loans and after 12 years time (current loans fully repaid), it can be used fully to replace the equity portion of its current fleet.

[valueinvestor]

After 10 years,

Asset: 0
Debt: 0
Cash: $70 ($50 + $20)


Hi Nick,

Fully understand the illustration except the final part on the Cash:$70 , I thought cash should be $20 only ( 2x10). Kindly enlighten, thanks.

[Nick]

After 10 years,

Asset: 0
Debt: 0
Cash: $70 ($50 + $20)


Hi Nick,

Fully understand the illustration except the final part on the Cash:$70 , I thought cash should be $20 only ( 2x10). Kindly enlighten, thanks.

The Trust generates $18 cash-flow from its operations annually. Since it only pays out $6 to shareholders, it retains the remaining cash-flow of $12 per year. Initially, it used to used its $10 cash-flow from depreciation to repay debts but since it was fully paid off in the fifth year, it was retained for fleet renewal (equity portion).

$2 retained for growth X 10 years
$10 retained for renewal of equity portion of assets X 5 years

[d.o.g.]

Isn't the decrease in asset value offsetted by a similar decrease in debt level ? The fleet is being 'renewed' by a similar decrease in loan payment which keeps the NAV constant.

Debt repayment is a separate issue from depreciation. Whether the debt is paid or not does not affect NAV since NAV is computed as assets minus liabilities.

Paying down debt doesn't stop the ships from rusting. Whether you choose to buy with cash upfront, or borrow first and repay later, at the end of the day you are left with a rusting hulk that you need to replace.

PST could just as well not pay down the debt and let the cash build up. Either way there is no effect on NAV.

It just so happens that in PST's case the debt repayment approximates depreciation. So it's a convenient way of using the cash.

Throughout the first 5 years, the Trust is only retaining $2. However NAV remained stagnant because it was paying down its debts in line with depreciation. The $2 being retained is NOT for fleet renewal - it is for fleet growth. Similarly, in PST, the US$9 million being retained is not for fleet renewal - it is for fleet growth. Fleet renewal comes from its cash-flow from depreciation being used to repay loans and after 12 years time (current loans fully repaid), it can be used fully to replace the equity portion of its current fleet.

Using your numbers, the $2 for fleet growth amounts to a growth rate of 4% ($2 vs $50). After 10 years the fleet is scrapped and you have $70 cash or 40% more than when you started. Again this corresponds to a simple growth rate of just 4% per year.

In any case your numbers are not realistic as the shipping industry does not earn anywhere near 16% on equity as implied by your $8 profit on $50 equity. 8% on equity would be more appropriate, in which case only $4 of profit is generated. With a 75% payout, $1 is retained, leading to a growth rate of 2% ($1 vs $50).

[valueinvestor]

After 10 years,

Asset: 0
Debt: 0
Cash: $70 ($50 + $20)


Hi Nick,

Fully understand the illustration except the final part on the Cash:$70 , I thought cash should be $20 only ( 2x10). Kindly enlighten, thanks.

The Trust generates $18 cash-flow from its operations annually. Since it only pays out $6 to shareholders, it retains the remaining cash-flow of $12 per year. Initially, it used to used its $10 cash-flow from depreciation to repay debts but since it was fully paid off in the fifth year, it was retained for fleet renewal (equity portion).

$2 retained for growth X 10 years
$10 retained for renewal of equity portion of assets X 5 years

Well explained, many thanks .

Another question about shipping trust is when the orginal lease
( 5 or 7 or 10 years ) expires, the ships will be older by then , it will not command the same rentals and rentals should be adjusted down, the revenues will be hit, thus affecting the DPU and yield. Is the unit holders going to face lower yield down the road if they remain invested ?

[Nick]

Isn't the decrease in asset value offsetted by a similar decrease in debt level ? The fleet is being 'renewed' by a similar decrease in loan payment which keeps the NAV constant.

Debt repayment is a separate issue from depreciation. Whether the debt is paid or not does not affect NAV since NAV is computed as assets minus liabilities.

Paying down debt doesn't stop the ships from rusting. Whether you choose to buy with cash upfront, or borrow first and repay later, at the end of the day you are left with a rusting hulk that you need to replace.

PST could just as well not pay down the debt and let the cash build up. Either way there is no effect on NAV.

It just so happens that in PST's case the debt repayment approximates depreciation. So it's a convenient way of using the cash.

Throughout the first 5 years, the Trust is only retaining $2. However NAV remained stagnant because it was paying down its debts in line with depreciation. The $2 being retained is NOT for fleet renewal - it is for fleet growth. Similarly, in PST, the US$9 million being retained is not for fleet renewal - it is for fleet growth. Fleet renewal comes from its cash-flow from depreciation being used to repay loans and after 12 years time (current loans fully repaid), it can be used fully to replace the equity portion of its current fleet.

Using your numbers, the $2 for fleet growth amounts to a growth rate of 4% ($2 vs $50). After 10 years the fleet is scrapped and you have $70 cash or 40% more than when you started. Again this corresponds to a simple growth rate of just 4% per year.

In any case your numbers are not realistic as the shipping industry does not earn anywhere near 16% on equity as implied by your $8 profit on $50 equity. 8% on equity would be more appropriate, in which case only $4 of profit is generated. With a 75% payout, $1 is retained, leading to a growth rate of 2% ($1 vs $50).

Ok I understand where you are coming from. Yes...I do agree that growth rates is small - approx 3-4%. But despite the low growth, its distribution yield remains relatively high. However, you are right to point out that cash-call is expected since organic growth is just too slow. I have already estimated that PST will need at least US$35-40 million new equity to fund its latest set of acquisition assuming 60% VTL.

---

After 10 years,

Asset: 0
Debt: 0
Cash: $70 ($50 + $20)


Hi Nick,

Fully understand the illustration except the final part on the Cash:$70 , I thought cash should be $20 only ( 2x10). Kindly enlighten, thanks.

The Trust generates $18 cash-flow from its operations annually. Since it only pays out $6 to shareholders, it retains the remaining cash-flow of $12 per year. Initially, it used to used its $10 cash-flow from depreciation to repay debts but since it was fully paid off in the fifth year, it was retained for fleet renewal (equity portion).

$2 retained for growth X 10 years
$10 retained for renewal of equity portion of assets X 5 years

Well explained, many thanks .

Another question about shipping trust is when the orginal lease
( 5 or 7 or 10 years ) expires, the ships will be older by then , it will not command the same rentals and rentals should be adjusted down, the revenues will be hit, thus affecting the DPU and yield. Is the unit holders going to face lower yield down the road if they remain invested ?

Yea...that remains a very high possibility. Rental rates should remain the same - but maintenance cost will definitely increase.

[Nick]

Hi d.o.g,

I was reviewing our exchange this morning to pick up new knowledge about the shipping trust sector as a whole. Thank you for sharing your views with us.

I have a question - Can I measure fleet growth value by judging the ratio between the retained profit and the Trust's equity ? This would mean that PST equity growth will be around 8.5/238 x 100% = 3.5%.

I cannot calculate FSLT ratio since they are paying out more than they earn. For Rickmers, I assume a quarterly net profit of US$7 million and it maintains its distribution of US$2.4 million, it is retaining around US$4.5 million a quarter or US$18 million a year. The current book value is US$322 million which will translate to book value growth of 5.5%.

This numbers agree with your stance that shipping trust are low growth companies. But, isn't this a better business trust model as opposed to those with depleting assets (ie leasehold properties, BOT plants, vehicles) and yet maintain 100% cash-flow payout ? Is there a better business trust model out there ? Perhaps, growth should be taken out of the equation altogether and Trust should be operated as closed end funds LOL !

[d.o.g.]

Can I measure fleet growth value by judging the ratio between the retained profit and the Trust's equity ?

It works as a crude first approximation. But keep in mind that the fleet's book value will not always correspond to its market value.

I cannot calculate FSLT ratio since they are paying out more than they earn.

So FSLT is shrinking.

isn't this a better business trust model as opposed to those with depleting assets (ie leasehold properties, BOT plants, vehicles) and yet maintain 100% cash-flow payout ? Is there a better business trust model out there ?

Ships ARE depleting assets. Until the crisis the shipping trusts were happy to do a 100% cash payout as they figured they could always raise fresh equity to renew or expand the fleet.

The business trust model is fundamentally broken because it allows the trust to pay out cash in excess of earnings. When payouts exceed earnings it means that money is not being set aside to replace depreciating assets. In the absence of future fundraising the trust will eventually wind up when its assets fall apart. REITs have gotten away with it so far because well-located real estate can appreciate in value faster than the buildings depreciate.

[Nick]

Can I measure fleet growth value by judging the ratio between the retained profit and the Trust's equity ?

It works as a crude first approximation. But keep in mind that the fleet's book value will not always correspond to its market value.

I cannot calculate FSLT ratio since they are paying out more than they earn.

So FSLT is shrinking.

isn't this a better business trust model as opposed to those with depleting assets (ie leasehold properties, BOT plants, vehicles) and yet maintain 100% cash-flow payout ? Is there a better business trust model out there ?

Ships ARE depleting assets. Until the crisis the shipping trusts were happy to do a 100% cash payout as they figured they could always raise fresh equity to renew or expand the fleet.

The business trust model is fundamentally broken because it allows the trust to pay out cash in excess of earnings. When payouts exceed earnings it means that money is not being set aside to replace depreciating assets. In the absence of future fundraising the trust will eventually wind up when its assets fall apart. REITs have gotten away with it so far because well-located real estate can appreciate in value faster than the buildings depreciate.

Just curious here - most REITs own leasehold properties locally. I understand that the lease for industrial properties tend to last for 40-60 years while retail properties last for 99 years. Does this means that their assets are depleting as well albeit at a much lower rate or can they renew the leases with minimal capex ? I understand that Indonesian leases can be renewed at extremely low prices according to First REIT CFO and they have renewed leases for 2 plots of land since listing with minimal capex. Is it the same for local properties ?

I agree about distributions must be based on the accounting profit as opposed to the operating cash-flow. PST escaped the shipping recession fallout since its biz model was pretty conservative (long term loans, no LTV covenants, low payouts). FSLT and RMT learnt this the hard way. Noticed that KGT is doing the same thing as well ? Is KGT operating as a self liquidating trust ?

I also noticed that quite a number of Western shipping companies tend to pay high yielding dividends. Omega Navigation used to have a terribly flawed dividend payout plan while newly listed Golden Ocean has just proposed a 3Q DPU payout of US$0.05 which is a significant amount of its 3Q EPS of US$0.09. Granted that their dividends will fluctuate since shipping rates are always on the move, are such companies better than a shipping trust as a yield investment ?

Thanks for sharing