Global Ship Lease: Anomaly Investing

Apr 20, 2023

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Overview

Based in London, Global Ship Lease (GSL) owns and charters container ships. The shipping industry is complex and often misunderstood. Though often taken for granted, the shipping industry is an important part of the backbone that makes up the world economy. Don’t believe me? Just look at your everyday life. I recently waited over six months for a book, and still check weekly to see if Costco finally restocked my favorite protein shakes. These examples are of course idiosyncratic, but also illustrative of something that has affected many people throughout the last few years. Despite being in the limelight, the shipping industry is still very misunderstood- even by those involved in the industry. It is often painted with a broad brush by those who do not understand its nuances. This leads to companies with strong businesses trading as if they are going bankrupt. As legendary investor Mohnish Pabrai would say, these companies trade at “anomaly valuations.”

Starting in early 2022, recession fears caused day rates (the price per day to charter a ship) to drop. This resulted in indiscriminate selling of all things related to shipping. This is where the opportunity comes in. GSL has very little spot exposure for the next several years. The company contracted out most of its fleet on long-term deals near the top of the cycle. A masterclass operationally, though clearly something that is not appreciated or understood by the market. The best argument against this would be counterparty risk- a decline in the shipping business would cause liner companies (the charterers and/or GSL’s customers) to force GSL to renegotiate the terms of their contracts. This is something we will explore later, though it is extremely unlikely.

The Business

GSL signs long-term contracts with charterers, giving them strong visibility into their future cash flows. This is the best place to start analyzing the company. Nearly the whole fleet is chartered for throughout 2023. As the company does, I will use adjusted EBITDA, as a proxy for operating cash flow. Obviously one should alway be cautious when using adjusted EBITDA numbers as a proxy for cash flow. That said, the company is mostly conservative in this policy. The only adjustments that need to be made are for payments to its single class of Preferred Shares and for stock based compensation, which is minimal. All in, this should reconcile the difference between adjusted EBITDA and operating cash flow. Based on the small possible difference in next year's adjusted EBITDA due to the small number of ships that are not chartered, GSL expects to generate $448-453M in adjusted EBITDA. Subtracting out $19M should account for Preferred payments and stock based compensation, results in an operating cash flow number of $429-434M. To reiterate, the significant majority of this is locked in, leaving little room for downside in this figure.

After spending big on ships to expand the fleet from 2018-2021, GSL is done with acquisitions, unless an exceptional opportunity arises. This has greatly lowered capital expenditures, as can be seen in the last three quarters. To be conservative, I will subtract $10M for capital expenditures, though it is more likely that this number is closer to $6-6.5M. After accounting for this $10M, GSL will do $419-424 in free cash flow, 1.7 times the current market cap. All of this is on top of $129M in cash already on the balance sheet and $966M in tangible book value available to common shareholders.

GSL is being valued based on current day rates. This is far from representative of the fundamentals of the business. Though there is a logical thought process as to why this makes sense, it does not reflect the reality of the company. Having signed long-term contracts, GSL has strong cash flows locked in for several years. This can be well illustrated by the company's projected numbers for 2024, where it again has most of the fleet contracted out. The company expects to do between $473M and $493M in adjusted EBITDA. Expenses are expected to be similar, so I will again take out $29M to jump from adjusted EBITDA to free cash flow. The result is $444-464M in free cash flow in 2024.

As we go out further into the future these numbers become less certain. That said, much of the fleet is contracted out until 2027. In the high probability scenario that GSL generates more than its market cap in cash over the next two years, its current valuation implies a negative value to the contracts after 2024. This also implies a negative scrap value to the fleet, which in itself could be more than the company’s entire market cap.

Risks and Rebuttals

Counterparty Risk
- One point that has caused the mispricing of the company is concerns over counterparty risk. The concern is charterers would renegotiate with the ship owners at lower rates. Historically there is very little precedent for this, and it only occurs when liner companies default. On the back of the shipping boom that occurred due to the supply chain issues, liner companies have the strongest balance sheets in their history. Though it is not a concern, this can be easily monitored as three of their top four lessees (Maersk, ZIM, and Hapag-LLoyd) are public companies. These three companies account for 62% of contracted revenue. They are all reputable, well capitalized customers

Debt
- Going into companies with large amounts of debt is one of the biggest red-flags that get investors in trouble. In the case of GSL it presents a true opportunity. Though GSL’s $807M in net debt seems large, it is a non-issue for the company for several reasons. The first is that the certainty and visibility of cash flows make managing the debt load much easier for management. Second, is how well management has handled the debt. At the end of 2021 and beginning of 2022 the company purchased caps on their floating rate debt. They also improved their rating from both Moody’s and S&P in the middle of 2022, and refinanced some of their existing debt load. This resulted in their average cost of debt being reduced in the last year, despite the increasing interest rate environment. The last, and most important part of the debt situation that makes it a non-issue for the company is the nature of the debt. The significant majority of the debt is collateralized against the ships, and is non-recourse to the business. If GSL were to default on its debt, it would simply have to give up a ship (or group of ships) and business would otherwise go on as usual.

Governance
- There are often concerns around governance in the shipping industry. This is not a concern for GSL, management has a shareholder first mentality. The company is using this prosperous period to pay down debt, and return cash to shareholders. The cash return is coming in the form of both dividends and stock buybacks. Currently, the dividend is sitting at 7.3% and there is a high probability it will increase in the near future. Management has also used the current valuation gap to implement a $40M buyback program, of which $10M is still available. I expect the buybacks to keep rolling in even after the current authorization is up. All of that said, it is quite clear that this is not a company with governance issues.

Valuation

GSL will generate $419-424M in free cash flow in the next year. After taking out the approximately $68M in expected dividend payments and subtracting conservative amounts of cash for buybacks and debt repayment, the company should still have at least $500M on its balance sheet. While I could easily justify a $1.05 billion market cap based on 2.5 times free cash flow (within the company’s normal historical range), I believe that this is still too conservative given the clarity of the cash flows going forward and the cash already on the balance sheet. At 5 times free cash flow the company would be at a $2.11 billion market cap, of which more than 20% would be in cash. Even before accounting for a reduced share count this would put the stock at $58.56, significantly higher than current price levels around $20. Even if you do not believe in the five 5 times free cash flow figure, and opt to use a more conservative 2.5 times for example, it is very clear that GSL is set for immensely undervalued

Summary

Global Ship Lease is a true example of Anomaly Investing. It is a misunderstood company, whose stock price has been unjustly beaten down because of this lack of understanding. Strong fundamentals, backed by rock solid contracts and a tangible book value well above the current market price presents a rare opportunity to be able to achieve a very high return with truly little downside.

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