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Letter to Investors
For October 2010
www.islainvest.com csmith@islainvest.com (305) 522-1333
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Dear Investors,
The Tarpon Folio returned 5.6% for the month of October compared to 3.7% for the S&P 500. On an annual basis, Tarpon is down 2.1% in its second year, which ends on November 20th, but is up 86.6% since inception almost two years ago, compared to a rise of 46.8% in the S&P 500 over the same period.
The performance of our holdings in October continued to be volatile - at least as measured by their stock prices. The businesses themselves appeared to continue operating admirably on balance, which is far more important to me. Tarpon's overall results in October were influenced in no small way by a surprising 74% rise during the month in the shares of Global Ship Lease (GSL), which I write more about below.
We also saw some glimpses of future greatness in a few other names that rose markedly but pulled back in price by the end of the month, and we had an overblown one-day drop just yesterday in the price of one of our banks. That said, nothing this month materially changed my estimates of the intrinsic value of any of the companies we own.
While I'd like to think that large increase in the share price of GSL was somewhat inevitable, that's entirely different from being predictable. Months like the last two are a good reminder why it's important to stay in that batter's box.
I'm also in the early stages of planning the 2011 Annual Investor Meeting and will send out more details soon. I've penciled in February 19th as the day of the event - the Saturday of President's Day weekend - but please consider that just tentative until further notice. I've got a few more things I need to lock down before I give the all-clear to buy airline tickets. So, please stay tuned.
On now to our employees of the month!
- Cale
Why We Own Global Ship Lease
A quick note before I get into Global Ship Lease (GSL):
GSL's share price increased dramatically in October, which is obviously good news for Tarpon investors. The even better news is that I believe GSL is still undervalued. That said, the odds are slim that the performance of its shares in October will be repeated again in November. So, just a request to keep things in perspective.
And if you're not an investor in Tarpon, but look to these letters for stock ideas, I'm afraid you missed a good month for one of them. Fortunately, there is an easy way to solve that problem:
Invest here.
KnowwhatImean?
Background on Shipping
Global Ship Lease is a cutting edge biopharmaceutical company focused on the commercialization of therapeutic rapid-acting immunotherapy and refractive disease treatments.
Nah, I'm just kidding. I have no idea what that means. But it was a lot sexier than describing Global Ship Lease's actual business. Which is, well, shipping things. By lease. Around the globe.
All the good domain names were taken, apparently.
In any case, shipping is probably the most important lousy industry you've never really thought about. At first glance there's just not much to mull over when it comes to millions of identical 40-foot containers. It's a commodity business in the sense that these days it effectively costs next to nothing for big companies to move goods overseas. There are also a ton of competitors, the industry is notoriously cyclical and capital-intensive, and most firms find themselves at the whim of large, powerful customers. In container shipping in particular, there are a ton of new ships - more than 30% of today's existing fleet - currently being built. Overcapacity and rate wars are a recurring, permanent, and predictable part of this industry.
That said, there is no more efficient way for companies to transport their goods overseas than via containerships. By some estimates, 90% of the world's "non-commodity goods" (think flip flops, margarita machines, tiki huts) will see the inside of a container this year. And the world's ports handle about 1.5 million of those 40-foot containers every week.
Because of all those boxes, scale is the holy grail when it comes to shipping operators. Bigger ships haul boxes at lower cost. Specifically, lower costs per container means a firm can charge lower rates, which means they'll attract more freight to move, which means they'll be able to fund even more investments in even bigger ships, which will then lower their costs even more. So in good times, despite being in a tough industry, the economics of ship operators can be pretty attractive.
These have not been good times, however. And when things are bad in shipping, they're, like, The-Adventures-of-Pluto-Nash bad. The economics of the industry explain why - and those can be boiled down to two words:
Fixed costs.
Specifically, shipping companies typically borrow large sums to buy and/or build new ships in pursuit of scale. An operator's fleet of ships typically represents 90% of the company's fixed assets and 70% of the total cost of running the business. Because so much of those costs consist of principal and interest payments on debt, they need to be paid no matter what.
Fixed costs also mean that in a global recession, shippers take it directly on the chin - in four ways, no less:
1 - A decrease in the amount of cargo being shipped means an operator's fixed costs per container increase, while
2 - operators cannot maintain profitable rates, since they're in a race to lower rates and book at least some cargo to service their debt, and
3 - both of those things mean the value of the company's ships decreases, which
4 - means that the holders of debt that is collateralized by those ships may make aggressive demands to protect themselves from declining cash flows and dropping asset values.
All of which brings us to GSL.
Introducing Global Ship Lease
GSL is really in the business of moving cargo. It just does this by operating ships. More specifically, it buys containerships, then operates them under long-term, fixed-rate, take-or-pay contracts - meaning the company doing the shipping either uses Global's shipping services as previously agreed, or they pay a penalty.
Those sorts of contracts are attractive because they provide a tremendous amount of predictability when it comes to cash flow, and they're a pretty good deterrent when it comes to discouraging a customer from trying another shipper.
Plus, based on those contracts, ship operators like Global Ship Lease can really program in their own growth. It just has to be balanced with credit risk of their charterers. And therein lies a primary reason why GSL was trading at just two times cash flow this summer: all 17 of its ships serve a single customer - and that company appeared to be in dire trouble.
CMA CGM is a privately owned French company that is the third largest container transportation and shipping business in the world. It employs over 17,000 people and though it also runs containership operations similar to GSL, it's a much more sprawling enterprise that includes luxury cruises, terminal operations at various ports, railways, logistics and passenger ferries.
Like all companies associated with transporting goods, CMA CGM suffered mightily during the recent recession, and had it defaulted on its own debt, then a wipeout of the equity at GSL seemed likely. In addition, as per those four points of doom above, GSL's banks effectively forced the company to divert all its cash flow towards paying down debt. That meant its once-healthy dividend was suspended. And GSL's share price plummeted.
One of the many odd things about this summer in the stock market, however, was that GSL's share priced stayed depressed even as concerns about its big, sole customer CMA CGM began to diminish. There is no disputing that CMA had a very tough year in 2009, but business has bounced back and then some in 2010. The company should throw off well over a billion dollars in cash this year, according to recent media estimates. And had you the desire to track the prices of CMA's unsecured debt trading in German, you'd see the bond market's confidence in CMA CGM return as the summer went on - meaning the credit risk to GSL was dropping, too.
Perhaps just as relevant, however, is the fact that CMA CGM is actually the parent of GSL. Global Ship Lease was effectively carved out of CMA CGM several years ago, and the latter still owns a significant stake in GSL - over 45%. In addition, CMA is currently also getting paid by GSL, albeit very modestly, to provide ship management services to our company. So despite being separate companies, the ties are still very strong.
This, to me, represented diminished risk for GSL - or at least less risk than the market seemed to be presuming. If you're going to only have one customer, after all, it's reasonable to presume that if that same customer also owns almost half of your business, your interests are going to be aligned. And if that business also represents a potentially significant investment return for the customer, all the more reason to breath a tad easier.
Now it's true that in this case that single customer has an incredible amount of power over the business, but GSL is lugging boxes across the pond here, not patenting cold fusion reactors. The key variables that drive revenue in this business are very transparent to all players, and macro forces tend to affect most industry players more or less simultaneously. So as long as GSL is maximizing the efficiency of its business - controlling what it can, in other words - there's really no reason CMA needs to meddle. And it's already got control of ship management, as I mention below.
Global's relationship with CMA CGM also provides what is probably best referred to as a pseudo-moat. Again, the only real competitive advantage in shipping lies in economies of scale and the low cost of operations they enable - and GSL is way too small to claim any scale. So it has no moats in the traditional sense.
That said, Global does have, by nature of its unique relationship with CMA CGM and long-term contracts, two of the same advantages that are afforded to businesses with real moats - a reasonably high degree of predictability in earnings, and a systematic means by which it can significantly grow. Put another way, the odds of another ship operator stealing GSL's business away from CMA CGM is slim to none. After all, CMA already has a huge fleet of its own containerships it could give that business to if desired. So while the long-term durability of GSL's relationship with CMA CGM is very much open for debate, the company does appear effectively shielded from competition for the time being. And given how cheap GSL shares were this summer - and back into last year, for that matter - it was clear that even this pseudo-moat was not being fully appreciated by the market.
To be clear, while the risks of dependency on a sole customer appear to have eased considerably, GSL still has several lesser challenges ahead of it - most notably that the company needs to come up with more capital to close a funding gap for two new ships it has already ordered. Yet despite the dramatic rise in share price this month, and the existence of several other near-term challenges for the business, I continue to hold our shares.
Why is that, you might ask?
The dividend, my friends.
What Are Shares Really Worth?
Actually, that's not the only reason we're holding tight. GSL is also still cheap - and it's relatively easy to demonstrate that point to yourself with some back of the envelope calculations if so inclined.
Again, GSL has those predictable cash flows due to its long-term contracts. In its SEC filings the company fully discloses the length of each charter contract, as well as the amount they are paid on a daily basis for chartering each ship. The company's expenses are relatively easy to gauge if not handicap, too, since GSL actually outsources "ship management" to a division of CMA CGM.
These services include the day-to-day technical services like crewing, maintenance, buying supplies and towing, for instance. GSL pays an annual fixed management fee, and reimburses the management company for operating expenses up to a capped amount. Global also pays drydocking expenses and insurance premiums. Global Ship Lease does not bear the costs of fuel or anything else associated with loading, unloading or transporting containers. That's all on the customer.
So, throw in some overhead, adjust for depreciation and a few other non-cash items, and you can determine the company's free cash flow - and, ultimately, a range of possible values that centers around $7.00 per share.
That can be a pretty wide range, mind you, depending on how granular your assumptions become, and that sort of approach arguably ignores some things that a more formal model would not…but, well, yesterday shares closed at $4.60. So I think it's safe to say that there is still a large gap between the company's real value and what the market thinks it's worth.
Also, if you value GSL on a relative basis - meaning compare certain financial metrics head-to-head with competitors of comparable size and strategy - it's not too difficult to come up with a value of $9.00 per GSL share, either. I tend to put much more credence on valuations done using former approach, mind you, but when things appear so cheap, it never hurts to get a second opinion.
In either case, though, the point is that GSL shares, on a reasonably objective basis, still look cheap.
Wait, It Gets Better
Back to dividends.
You'll remember GSL had to suspend its dividend to keep the bankers happy. If operations continue to improve - and providing the aggregate value of the company's vessels increases back above a specific lender-mandated level - then not only will Global's current borrowing costs decrease, but the company will be allowed to resume its dividend once cash flow, assuming it exceeds $10 million per quarter. While that day could be as much as a year away, I suspect it will be sooner. Regardless, though, it should be worth the wait.
It's difficult to estimate with a high degree of confidence the amount of the dividend that Global will eventually begin paying out again. The company is mum. Based on past history, though, as well as some educated guesses based on estimated cash flows, it can be instructive to run a few different scenarios. I believe it's probably overly conservative to estimate the dividend would only be $0.30 per share per year, but we'll start there. It's probably more likely the dividend would be closer to $0.60 per share, and should things improve further, an eventual resumption of the $0.92 a share dividend that the company paid out before the Great Recession would seem well within the realm of possibilities.
So if you were invested in Tarpon prior to the end of July, when I bought our shares in GSL, your cost basis is about $2.35 per share. Should GSL eventually begin paying out that dividend of $0.30 a share, then, your yield would be 13% a year. At a dividend of $0.60, you'd then be earning 26%. Per year. Forever, maybe. Doing nothing more than just brushing your teeth, even. And should the dividend hit the old $0.92 payout level, that's a potential yield of 39% a year for pre-July investors in the Tarpon Folio.
But those who feel late to the party shouldn't exactly be fretting, either. Even if you bought shares at the close yesterday of $4.60, your annual dividend yield would be 6.5% at the $0.30 a year rate; 13% at the $0.60 a year level; and 20% at $0.92.
Again, these levels are ultimately all speculation on my part. But dividends don't lie, and it's that sort of simple math, I suspect, that was driving GSL's returns in October. Those kinds of yield are obviously attractive to many investors, especially these days, and I suspect more will begin to take notice as operations at GSL continue to improve and the fears surrounding CMA CGM continue to recede.
That said, nothing in investing is guaranteed. There are certainly risks that could prevent us from realizing those sorts of returns, or that might extend the timeframe over which we might see the first dividend. And shares almost certainly won't continue their recent dramatic ascent unabated over the next few months.
But in GSL I think we have very good odds of, over the long-term, benefitting from both significant share price appreciation and a very high yield. That's a rare combination.
The best part is that the hard work is over. All we've got to do now is wait.
Please email me if you have any questions.
A tip of the hat to Michael Demaray of Elevated Capital for the original GSL idea.
The Tarpon Folio is an innovative, investor-friendly alternative to the traditional actively managed mutual fund. It's built on a model we call a Spoke Fund®.
It is more transparent, takes more concentrated positions and is significantly less expensive than the vast majority of mutual funds. The portfolio is managed for long-term growth using value investing principles.
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