Analysis: Break-up talk of 'sleeping giant' Wincanton may be just market noise
London-based investor Gatemore Capital is calling on Wincanton to sell one of its two core haulage ...
Spurred by a recent history of deal-making, 2017 was a transformational year for Hapag-Lloyd, and it managed to shore up its core business over the past 12 months. However, could future M&A involve the takeover of other ancillary assets?
How about the purchase, for instance, of a freight forwarder, given the increasing paucity of suitable targets in the container shipping industry?
In principle, I would suggest that such an option should not be written off, considering the current competitive environment, and could make a lot of sense given Hapag-Lloyd’s track record in terms of financial engineering.
Admittedly, with the first quarter of 2018 already behind us, its short- to mid-term capital allocation plans have become more intriguing.
Financially, the German container line is better positioned than previously, thanks to the consolidation of Chile’s CSAV and UASC of the Middle East, particularly when we focus on its current financial position and heavy investment needs against comparable figures, and projections, between 2014 and 2016.
But just as the ocean carriers continue to battle for market share, certain risks are unlikely to subside before 2020, and it is easy to speculate that its enticing annual headline numbers, released at the end of March, implicitly point to the possibility that as soon as UASC-related synergies have fully materialised, deal-making talk will once more emerge.
The tie-up with UASC and a broader recovery in ocean trades last year contributed to a rise in its share price, which at one point was more than double its IPO level, reaching a record of €40 a share in September, before falling to the low €30s.
In terms of capital allocation, one likely challenge is the fact that there are simply fewer assets to buy in order to compete with its four largest rivals worldwide – and in this context, I am ruling out buybacks of a certain size due to certain financial constraints, although a progressively higher dividend remains a possibility.
A relatively lighter asset base would help it marginally improve its return on capital invested (ROIC) – a key metric in the industry and it was well below acceptable levels last year – but, more importantly, could act as a countercyclical buffer, if the right story is sold to investors. Running the ruler over a scenario according to which Hapag-Lloyd could add freight forwarding activities to its asset mix has made a lot of sense to me in the past few days.
Of all possible options, the most realistic target is Damco, which is owned by Denmark’s AP Møller-Maersk Group (APMM) and was led for almost six years by Hapag-Lloyd chief executive Rolf Habben Jansen before he began his current job.
A countercyclical deal targeting a company that has lowly capital needs would be consistent with its philosophy of little additional investment in new vessels. While both carriers both large and smaller continue to attract headlines highlighting their ambitious organic growth plans (which may be funded by local governments if events do not go according to plan), Hapag-Lloyd has refrained from placing orders given that its trailing performance was clearly transformed by the consolidation of UASC and its orderbook.
I would be greatly surprised if the German carrier placed any new ultra-larger container vessel (ULCV) orders, and the company itself has ruled this out in recent trading updates.
Last year’s volume growth was largely inorganic, boosting virtually all financial metrics, although freight rates were under pressure. As it grew, its geo mix also expanded.
Its balance sheet remained stretched, however, and although it has sought to reassure analysts – claiming that it had started to address its debt problem – it is still heavily exposed to cyclical swings, while also adding, almost inevitably, complexity to its chain of control.
In all this, there are variables the company can control, while others cannot be accurately predicted…
… and there are other obvious financial risks, highlighted below.
Its recent projections caught my attention because it is clear that ROIC must rise, given the structural imbalance between ROIC (too low) and cost of capital (not low enough), which is a bad combination on the road to value creation.
Taking this into account, it is easy to suggest that safe haven assets would naturally continue to outperform Hapag-Lloyd’s share price if volatility in the financial markets is here to stay.
Shocking the market
More importantly, though, trading multiples arbitrage is what really matters here under a scenario according to which Hapag-Lloyd would diversify from its core business.
Damco – which ranks just outside the top 15 in the global league tables for freight forwarders, based on data from Transport Intelligence – would likely command a fair value of between $1.5bn and $2bn. That’s up to 30% of Hapag-Lloyd’s current market cap. Regardless of how a deal might be financed, an acquisition of that magnitude could help the German carrier drive shareholder value. As a reference, its own stock trades at a 50% discount against major freight forwarders’ projected multiples, based on adjusted operating cash flows metrics.
Hapag-Lloyd shareholders are used to financial engineering, but typically in recent years, the M&A lever was pulled to pursue horizontal integration of services. Adding a freight forwarder to its books would represent a meaningful change and one that might even be instrumental to what I consider to be a possible next step in an industry that has changed more in five years than ever before: a merger between APMM and Hapag-Lloyd, that is.
The supply chain management and forwarding activities of Damco are currently part of APMM’s core transport and logistics unit, but whether the freight forwarder will continue to be treated as core in the future remains unknown until Maersk manages to wrap its ambitious corporate restructuring plan.
Here’s how this might play out: Denmark’s largest company needs new equity to repair its balance sheet and Hapag-Lloyd might come to the rescue and entertain M&A to de-risk its own balance sheet by raising new equity to partly fund, say, a $2bn deal for Damco, which would add $2.6bn to its top line (€9.9bn in 2017).
If Damco is properly managed and returns to its 2016 performance, it would offer above-average ROIC versus container shipping activities, but it would not be a game-changer in that respect.
Based on my calculations, I estimate a restructured Damco could add around 5-10% to Hapag-Lloyd’s net operating profit after tax (NOPAT, at $438m in 2017) and pre-UASC synergies, which would mean only 20 basis points accretion in terms of ROIC (to 3.3% to 3.1%), but would provide the basis for deeper talks between APMM and Hapag-Lloyd and a possible valuation fillip in terms of trading multiples.
One key element here would be the ability to shore-up cash flows and returns (at least marginally) while heavy investment, in the form of capital expenditures, remains low for longer. Alongside a solid capital structure and a “sound liquidity and equity base”, Hapag-Lloyd says that one of its core targets is to “achieve sustainable cash flows”, and this is the trickiest part of its ambition on an organic and inorganic growth basis.
Damco did not shine last year in term of profits and cash flows, but in the fourth quarter it reported a 12% increase in revenue to $737m ($657m, Q4 16), mainly driven by 8% growth in supply chain management volumes and 16% growth in air freight volumes. “The air freight growth is supported by strong turnaround of air freight activities in China. Ocean volumes ended 2% below same quarter last year,” it added. It has changed a lot over the years, so are executives in Hamburg and Copenhagen ready to open talks?
One side issue, of course, would be how to manage that relationship with the two alliances, Hapag-Lloyd being part of the THE Alliance and Maersk in the 2M. But it’s too early to speculate on that. So, much depends on the future plans of Mr Habben Jansen, who is only 51 years old and appears well set at the helm of Hapag-Lloyd. Following a reorganisation of the board, he is “now responsible for global sales activities”, and clearly he knows what works and what doesn’t at Damco.