Best stock to invest in – Shipping Panic Creates Preferred Arbitrage Opportunity



Best stock to invest in

Tom Konrad, Ph.D., CFA

  • Seaspan Worldwide has several classes of publicly traded
    securities, with different claims on its income streams.
  • The company owns container ships leased under long term
    contracts to shipping companies. 
  • The shipping industry is in a massive downturn, raising
    concerns about its customers’ ability to pay.
  • The company’s preferred shares have sold off more than half as
    far as its common stock- far more than justified by its
    relatively low risk.
  • There exists a 5.5% yield opportunity to buy the preferred and
    hedge the risk by buying puts on the common.

Seaspan Corporation operates as an independent charter owner and
manager of containerships. The company charters its containerships
under to long-term, fixed-rate time charters to various container
liner companies. Its fleet consists of 92 vessels, which are
typically newer, larger, and more fuel efficient than other
fleets.

Seaspan’s top customers included COSCO Container Lines, Mitsui
O.S.K. Lines, MOL, Yang Mine and Hapag-Lloyd.  It also had
three ships chartered to bankrupt Hanjin shipping.  Although
one of these ships has already been rechartered, the bankruptcy
highlighted the fact that Seaspan’s income and (more importantly)
dividend are not safe.

Available Cash Flow

A recent
article
on Seaspan by transportation professional James
Sands looks at the prospects of a dividend cut going
forward.  He seems to think that a dividend cut is possible,
and may even be likely because the company may decide to expand
its fleet by purchasing vessels for sale at distressed prices.


Seaspan’s dividends currently amount to $13 million a quarter to
preferred shareholders, and $38.3 million to common
shareholders.  Cash available for distribution to common
shareholders (CAFD) was $90 million in the third quarter (after
the $13 million payment to preferred shareholders.)  Third
quarter revenue was $225 million.

Understanding Cumulative Preferred Stock

The company’s preferred shares (SSW-PD, SSW-PE, SSW-PH, and
SSW-PG) are what is known as “cumulative” preferred. 
Preferred equity falls in between common stock and debt (bonds) on
the spectrum of risk and reward: safer with less potential for
upside than common stock, but higher yield and riskier than
bonds.  Preferred shares must receive their full dividend so
long as any dividend is paid to the common shareholders. 
Cumulative preferred shares have the additional provision that, if
dividends are ever suspended, all unpaid preferred dividends must
be paid in arrears before any dividend is paid to common
shareholders.

This means that preferred dividends are much less risky than
common dividends.  Expenses are mostly fixed, so declines in
revenue will flow mostly flow through directly to CAFD, so let us
assume that each $10 decrease in revenue reduces CAFD by $9.

Dividend Cut Estimates

Under these assumptions, let us consider the effects of the
following percentage declines in quarterly revenue:

Seaspan Quarterly
Revenue, CAFD, and dividends.  All numbers in million
$.
% Decline in Revenue Quarterly Revenue CAFD Common dividend Preferred divideds
no decline $225 $90 $38.3 (2.3x coverage) $13 (safe)
10% decline $202 $70 $38.3 (1.8x coverage) – cut possible $13 (safe)
20% decline $180 $50 $38.3 (1.3x coverage) – likely to be cut $13 (safe)
30% decline $157 $29 Dividend cut inevitable, possibly to 0 3.25x coverage, may be delayed
40% decline $135 $9 Dividend will be cut to 0 1.7x coverage, likely to be delayed
50% decline $112 -$11 cannot be paid cut to $0, will only be paid if revenues
recover.

In summary, Seaspan will continue to have enough cash flow to
continue paying the preferred dividends unless revenue falls by
more than 50%.  Since the vast majority of Seaspan’s revenue
comes from long term leases with major shipping companies, this
would require that at least a third of its customers (as a
percentage of revenues) go bankrupt- the only way to avoid paying
a long term lease.  Revenue may also decline over time as
leases end, offset as Seaspan re-leases the vessels, possibly at
lower rates.

Now comes the tricky part- predicting the future.  If a
large number of shipping companies go bankrupt and scrap or idle
older, less efficient vessels, revenues and lease rates should
improve for the remaining vessels.  Since Seaspan’s vessels
are generally newer and cheaper to operate than most of the world
fleet, Seaspan should be a net beneficiary of this trend. 
Hence, a 50% decline in revenue seems nearly impossible. 
Keeping this in mind, here are my guesstimates of the likelihood
of the above scenarios:

% Decline in Revenue Likelihood Expected common dividend cut Expected preferred dividend cut
no decline 10% 20% no cut
10% decline 30% 30% no cut
20% decline 30% 50% no cut
30% decline 20% 80% 10%
40% decline 5% 100% 50%
50% decline 5% 100% 80%

Using these probabilities, I can estimate the expected dividend
cuts for both the common and preferred.  Using these
probabilities, the overall expected dividend cut for the common is
52%, and the expected dividend cut for the preferred is 8.5%.

If my guesstimates are correct, another way to say this is that
the common dividend is likely to be cut six times as much as the
preferred dividends.  This makes sense, since the common
dividend has to be cut to $0 before there can be any cut to the
preferred dividends.

Effects on the Stock Price

Understanding the effects of dividend cuts on the stock price
requires knowing why shareholders own the stock.  Preferred
shareholders are income investors, and so are motivated almost
exclusively by dividends.  Common shareholders are motivated
by a mix of income and potential capital gains.  SSW
investors are likely more motivated by income than average, given
that the stock’s dividend yield is currently over 15%.  Let’s
say that common shareholders are motivated one third by capital
gains and two-thirds by income.

If that is the case, my estimated dividend cuts should have led
to an approximate 35% decline in the common shares, and an 8.5%
decline in the preferred.  Reality has been different, as
shown by the chart below:

Over the last 6 months, SSW (black line) has fallen 36% (close to my
estimate), while the preferred share classes (red and orange lines)
have fallen about 19%, more than half as much as the common. 
Also shown are Seaspan’s exchange traded notes SSWN (blue line),
which have declined only 2%, a fall which could be completely
explained by recent increases in interest rates.  The
performance of SSWN shows that the market thinks that Seaspan is
little more likely to go bankrupt than it was six months ago.

Arbitrage

While the decline in SSW is eerily close to my very rough
estimate (36% vs 35%), the decline in the preferred shares is
completely out of proportion.  The preferred shares have fallen
more than twice as far as my model would predict.

I believe this is due to excessive risk aversion among the preferred
shareholders.  Valuing income above all else, I believe that
the preferred shareholders are over-reacting to the actual
risks.  The only other options are that my model is wrong, or
that common shareholders are not taking the risks seriously enough.

While my model is very rough, the fact that risks for common
shareholders are much higher than those for preferred shareholders
is an inevitable consequence of the way preferred shares are
designed.  Perhaps the expected common dividend cut should not
be six times the expected preferred cut, but it could as easily be
ten times as large or three times as large.  The resulting
declines in the common stock should hence be a significant multiple
of the declines in the preferred.  I find the actual ratio of
only 1.9x far too small.

Investors could in theory take advantage of this mispricing by
buying the preferred stock and shorting the common.  If the
common “should” decline 3x as much as the preferred, they can short
$1 of the common for every $3 of the preferred they buy. 
Taking SSW-PG, the company’s cumulative 8.2% preferred as an example
(currently yielding 10% at $20.50) an investor could short 1000
shares of SSW for $9,500, with an annual cost of $1500 in dividends,
and buy 1390 shares of SSW-PG for $28,500 which pay annual dividends
of $2,850.  Hence, a net investment of $19,000 would yield a
net $1,350 in dividends (6.8%) and be largely hedged against risks
to the company.

Unfortunately, Seaspan shares are difficult to borrow, and so a more
achievable hedge is to use long-dated puts.  May 2017 SSW $7.50
puts can currently be bought at approximately $0.60 per share. 
While these do not insulate the investor against small declines in
SSW, they are an excellent hedge against the large declines in the
stock, which would occur if the common dividend were cut to $0 and
the preferred dividends were at risk.  For a hedge similar to
the 1000 shares of SSW sold short above, an investor would need 10
contracts which would cost $600 plus commission and hedge the
position for six months.  During that time, the 1390 shares of
SSW-PG would pay $1425 in dividends, so the net annual yield would
be 5.5% on the whole hedged position, assuming that new puts could
be sold for similar prices every 6 months.

5.5% is an attractive yield for a stock market investment, made even
more attractive by the relatively low risk nature of this hedged
investment in preferred stock.  It also has the potential of
significant capital gains if the preferred shares recover to
something closer to their true value.

This is why I have been buying SSW-PG and hedging part of that
position with puts on SSW.

Endnote: Is Seaspan Green?

Regular readers may wonder why I’m interested in Seaspan
at all, given that I do almost exclusively green investing. 
Global container shipping is a key part of world trade, the
antithesis of the “buy local” movement.  Buying local is often
seen as green, but in my opinion, that depends on what you are
buying and how it was made. 

I admit that this is very subjective, so if you think that global
trade is always bad, you should avoid investing in Seaspan. That
said, here is why I consider Seaspan green:

  1. Shipping is, pound for pound, the most fuel efficient way to
    move goods over long distances.
  2. Seaspan’s ships are among the world’s most efficient.
  3. Fuel efficiency can be further improved by “slow steaming,”
    a.k.a. going more slowly.  Slow steaming requires more
    ships to move a fixed number of goods the same distance in the
    same amount of time, and so this easy way to reduce fuel use has
    the effect of increasing the demand for ships, which in turn
    benefits Seaspan.

In short, I expect that Seaspan should be a net beneficiary of
worldwide efforts to reduce greenhouse gas emissions and fuel
use.  This precisely my definition for a “green” stock. 
I invest in companies I believe will gain from efforts to fight
climate change and other environmental problems.

DISCLOSURE: Long SSW-PG. Long Puts on SSW common.

DISCLAIMER: Past performance is not a guarantee or a reliable
indicator of future results.  This article contains the
current opinions of the author and such opinions are subject to
change without notice.  This article has been distributed for
informational purposes only. Forecasts, estimates, and certain
information contained herein should not be considered as
investment advice or a recommendation of any particular security,
strategy or investment product.  Information contained herein
has been obtained from sources believed to be reliable, but not
guaranteed.

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