Hapag HQ2

Mergers can often throw a lifeline to troubled companies that may have little chance of survival on their own – how true is that for Germany’s Hapag-Lloyd and Chile’s Compania SudAmericana de Vapores (CSAV), which completed their tie-up this week?

The deal effectively amounts to a takeover of the cash-strapped Chilean line by Hapag-Lloyd, and hinges on massive cost synergies of $300m, equal to 9.3% of CSAV’s 2013 revenue.

The combined entity is expected to become the fourth-largest liner shipping company in the world, with revenues of almost $12bn and a fleet of around 200 vessels with a total capacity of about 1m teu.

The operational rationale for the deal in an industry in which economies of scale are so important is obvious – however, closer analysis of the carriers’ balance sheets suggests considerable financial challenges lie ahead.

On a pro-forma basis, the combined entity will carry about $3bn of net debt, once proceeds from a $500m cash call are factored in. This would be the first rights issue, essentially structured as a private placement, which should be executed by the end of the year.

On top of that, $500m of new equity will be injected within a year, “concurrent with a potential IPO,” according to Hapag-Lloyds’s initial plans. But it remains unclear where this second tranche of equity will come from.

On a trailing basis, and before synergies are included, the operating cash flow of the combined entity is negative, mainly due to CSVA’s bloated cost base.

Enter synergies, which add to the operating cash flow of the combined entity. Assuming $200m or more of yearly cost savings can be achieved before 2016, the forward net leverage should hover above 20 times, on a pro-forma basis, before a second cash call is carried out.

Low growth and high debts could sink the combined entity if costs are not eliminated sooner rather than later. And even then, it will likely have to meet interest costs to the tune of $200m a year. This is a problem, as proceeds from asset sales have to be ruled out in a sector where overcapacity dominates.

The combined entity claims it will be able to close the gap on the top three players in the global container shipping industry, although that depends on how competitiveness is gauged.

A couple of weeks ago, Hapag-Lloyd issued a €250m five-year bond with a coupon of 7.5%. In contrast, market leader Maersk can raise three times as much debt at a cost that is less than half that of Hapag-Lloyd’s.

By comparison, sovereign debts with a 30-year tenure in some troubled European countries, such as Italy, offer yield-starved investors a gross return that is about half that of Hapag-Lloyd – which says a lot about the inherent credit risk associated with the new entity.

In short, its shareholders run the risk of having to pour cash into a money pit for a very long time.

Bondholders are the winners here, of course, particularly if existing shareholders continue to support the company, as seems likely with few alternatives.

Hapag-Lloyd chief executive Rolf Habben Jansen made the headlines last week when he said that an IPO was not “a top priority”. Investors would be unlikely to rush to become part of the family, anyway.

Nonetheless, the company is going to need new funds to remain operationally competitive in the brave new world of container shipping, where, to paraphrase Maersk’s senior management, carriers have to adopt a deflationary mindset where freight rates are perpetually under pressure and the only response is constant cost-cutting.

As a result, the combined entity will have to add more ultra large container vessels to its fleet to boost competitiveness, even though it remains unclear whether this tactic will actually work if every line adopts it.

In the midst of the credit crunch, when liquidity froze, Hapag-Lloyd narrowly escaped bankruptcy and had to rally local stakeholders to stave off a hostile takeover bid from Singapore’s NOL. This time around, Germany’s biggest shipping company has opted to strike a cross-boarder deal to stay afloat – but was the deal the brainchild of Hapag’s management or its bankers?

It has chosen a partner in whose financial results in 2013 the word “loss” was mentioned 214 times – an implied “loss per page ratio” of 1.2 times. The key question is whether $300m of annual synergies will be enough to turn those losses into profits.

According to vesselsvalue.com the value of the now combined Hapag-Lloyd-CSAV fleet is just over $3bn, with a demolition value of $992m – a 70% discount to the assumed book value of the combined fleet seems about right under a base-case scenario.

With the last of Hapag-Lloyd’s 10 13,000teu Hamburg Express-class vessels delivered earlier this year, the line has just seven new buildings under construction – the 9,300teu series, ordered by CSAV before merger talks began, is being built at Samsung and is due for delivery next year.

The vessels will be the largest to serve the west coast of Latin America and were ordered partly in response to the scaling-up of CSAV’s main competitor on the trades, Hamburg Sud. The combined value of the newbuildings is $613.6m, according to vesselsvalue.com.

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