I’m Putting Real Money on Seaspan Options

I've been a bull on Seaspan (ATCO) for a couple years now, since my first purchase of the common stock for my Special Situations portfolio in early 2011. In this piece, I'm going back for more, but this time it's... (no, it's not personal) it's options. I'll recap the Seaspan thesis and provide some potential outcomes on my upcoming purchase of $300 in Seaspan's May 2013 $20 calls and offsetting sale of one May 2013 $20 put.

Background
As I noted in my original write-up, Seaspan is pursuing a "progressive dividend policy" as it ramps up its fleet size. The largest portion of that fleet build-out is over, though the company continues expanding its capacity, with the recently announced deal to buy five new 14,000 TEU ships to be delivered in 2015. In keeping with its usual practice, Seaspan signed those vessels to a 10-year, fixed-rate charter. The company has an average charter contract of seven years, giving Seaspan excellent revenue visibility.

So what about that progressive dividend?

The company's cash available for distribution is about $300 million. But it pays out just 20% of that cash flow despite dividend raises of 33% last year and 50% the year before that. Historically, Seaspan paid out more than 80% of its cash flow. That's a huge amount of room for the company to increase its payout. From today's very low rate, even a 100% dividend bump gets the company to only a 40% ratio. Seaspan typically announces its dividend increase with fourth-quarter results in late February or so.

Let's play hypotheticals for a moment: Even a more modest bump of 50% followed by two years of 33% increases and two years of 25% increases after that – that's very high dividend growth, to be sure. But that just gets Seaspan back to an 80% payout ratio, assuming no growth in cash flow. But we know the company is adding incrementally to its fleet and growing cash flow.

In addition, that time frame would be another five years out – a full seven years past the time when the company cut the dividend to focus on hoarding cash flow and building its fleet. I don't think insiders – who own more than half of shares – want to wait that long for the stock to appreciate. And ultimately we should expect the stock to go up at the rate of dividend growth.

Management has shown that it can allocate capital well. Last year, the company bought back more than $170 million in stock. This for a company with a market cap now of just $1.1 billion. But with the float below 50% of shares and wide bid-ask spreads already, it doesn't seem to make a lot of sense to buy in more shares, regardless of the attractive valuation. And that's with more than 30% of the market cap in cash, when the next quarter is reported, so the company is not cash-constrained. With that war chest, Seaspan could have easily made a tender offer, like it did last year. But it didn't.

Last year the company's use of cash for buybacks and dividends totaled about 80% of forward cash available for distribution – just about in line with historical norms for its payout ratio. This year, without a buyback, I think there's plenty of room for a dividend increase that's well above normal. (Remember, last year's bump was 33%). How much could that be and what effect would it have on the stock and options?

For much of last year, the stock traded in the range of a 6%-6.5% dividend yield. I'll take the average as a normalized yield in order to figure the following prices and returns.

*Options price assumes a purchase at $0.25 per contract

So, the options offer potentially huge upside if we can get even just last year's dividend increase. But I think there are reasons to think we can do even better, as I've noted above. Of course, any price below $20 and we'll end up with $0. Time will tell.

Because I'm using options, which have the potential for a complete loss, I'm sizing this position small – just 1% of my capital. If we get anything above last year's bump, we'll have a very nice return on our hands. And that would really propel the portfolio.

To offset the purchase of the Seaspan calls, I'll be writing one May 2013 $20 put. That would make the portfolio liable for buying 100 shares of Seaspan, should the stock close lower than $20 by the May expiry. I would not mind buying the stock at $20, though, so I'm alright using the sale to offset the purchase and making this bet on Seaspan largely "free."

Foolish bottom line
With this type of asymmetric payoff, I'll be adding about 1% of my capital, or around $300, of May 2013 $20 calls to my Special Situations portfolio on the next market day and writing one May 2013 $20 put.

Interested in Seaspan or have another stock to share? Join me on my discussion board and follow me on Twitter (@TMFRoyal).