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Is First Ship Lease Trust’s Business Model Sustainable?

When we’re looking to invest in shares for the long-term, it’s important to pick one that has a sustainable business model. But while it’s easy to say that you’d want to find such a share, it might not be that simple to actually analyse a business and determine how good or bad it is.

So, let me use First Ship Lease Trust (SGX: D8DU) as an example for the analytical process.

What is the trust all about?

First Ship Lease Trust is a business trust that owns a portfolio of vessels which it then leases out to shipping companies on a bareboat charter basis. In the shipping industry, a bareboat charter would see the owner of the vessel rent out its vessels without any crew or operational support; in this way, the lessee is entirely responsible for the operations of the vessel and all First Ship Lease Trust does after handing the vessel over would be to sit-back and enjoy the rent.

It’s also pertinent to point out that First Ship Lease Trust is more than just an owner of vessels – it’s actually a financing solutions provider. That’s because First Ship Lease Trust’s vessels are often bought from its lessees themselves in a sale-and-leaseback arrangement – vessel owners would sell their vessels to First Ship Lease Trust and the latter would then lease the vessels back to the former. This is a method for First Ship Lease Trust’s lessees to offload some assets on their balance sheet and raise some cash.

How does the trust earn its keep?

So, if First Ship Lease Trust is viewed as a financing company, then what it earns will be the spread between the interest it’s paying for its borrowings and the rental rate it charges its lessees; this is a sensible way of analysing First Ship Lease Trust’s business-model since the bulk of its acquisitions are financed through borrowings (that’s judged from its total debt load of US$347 million as compared to its cash hoard of just US$21 million).

What this creates then, are two layers of ‘expenses’ for First Ship Lease Trust’s lessees when they rent the vessels: Firstly, there’s First Ship Lease Trust’s own interest expenses, and secondly, there’s the spread between the trust’s interest expense and the rental rates it charges.

Now, if a ship operator would require financing, why would it not want to head to a bank itself to borrow and incur just one layer of expense (i.e. the interest cost for its borrowings), as opposed to turning to First Ship Lease Trust for financing options and having to incur two layers of expenses in the process? A likely – and logical – conclusion would be that most of First Ship Lease Trust’s lessees wouldn’t be able to obtain favourable terms from banks and are thus required to turn to the trust for financing.

My conclusion is also supported by the fact that a number of First Ship Lease Trust’s clients – like TORM and Fisher James, for instance – are facing all sorts of credit issues themselves. In 2012, First Ship Lease Trust had even suffered a default on its lease by one of its clients, Berlian Laju Tankers. And, that wasn’t even the first time the trust had seen its clients default on its leases.

If your clients are often in financial difficulties and can’t pay up for the goods/services rendered, it says a lot about the quality of your business.

Are management’s interests aligned with investors?

Often, it is important for investors in real estate investment trusts and business trusts to look into the compensation plans of the managers of the trusts. That’s because there can be cases where the compensation structure for management is not closely aligned with the interests of unit-holders.

In First Ship Lease Trust’s case, the trust’s management gets a 4% cut from the net cash lease rental collected. Due to the structure of the operating leases that the trust has, all rentals are considered as revenue. And so, what we see is management getting entitled to a full 4% of total rental (i.e. revenue) collected, regardless of whether the operating leases are able to generate a profit or not. This is a situation whereby management and unit-holders’ interests aren’t properly aligned as unit-holders can only benefit if the leases are able to generate a profit; the misalignment is also exacerbated by the poor results – the trust has clocked losses in three of its last four completed financial years – that has been turned in by the trust under the watch of the current management.

Foolish Summary

There’s more to share about First Ship Lease Trust and I’ll be exploring other areas of its business soon for a more complete picture of the analytical process. So, stay tuned!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.