Analysis: cash is king – why profits aren't the only measure for the top liners
While most observers focus on about half a billion dollars of aggregate net losses for ...
The behaviour of the Hapag-Lloyd share price since late 2016 proves the bulls in container shipping circles may be right in largely ignoring the risks surrounding the sector’s leading players, which continue to show optimism after a solid start to the year.
The fundamentals of the German carrier, however, suggest that if a best-case scenario doesn’t play out, and rate levels become more difficult to maintain, the recently drafted optimistic scenarios could become a nightmare as soon as 2019 for its worldwide network, making it one of the most obvious takeover targets in the industry.
Down, up, and down
At the end of June 2016, when its shares still traded below the IPO price of €20, the German carrier announced its merger agreement with United Arab Shipping Company and took the lead in a consolidation game that has since seen a slew of M&A deals concluding with Cosco striking the most expensive acquisition in liner history via its OOCL acquisition.
Before tie-up rumours emerged in April 2016, the stock of Hapag traded around €16. It now changes hands at €37, mainly thanks to that deal.
The demise of Hanjin and tighter capacity came to the rescue on the back of a fast-consolidating market, transforming what was a dreadful investment for over a year – as I expected when Hapag was about to price its IPO in late 2015 – into a spectacularly high-yielding investment since the turn of 2016.
With hindsight, Hapag management embraced the only strategy it could entertain at the time, doing all they could to prevent a painfully slow death. Thanks should also go to its bankers, who have little choice but to help the company stay afloat, given the billions they are owed. But where does all this leave Hapag now? And who will end up being the ultimate winner?
Hapag itself could well be answer, I reckon.
Freight rates per trade arguably played in favour of the Hapag/UASC tie-up in the first half, as the chart below shows.
The same applies to the development of global container fleet capacity…
…as well as volume trends, which boosted Hapag’s top-line even before the consolidation of UASC was taken into account.
Based on all these elements, it is unsurprising that its shares trade at record levels of €38, which suggests financial investors continue to be happy to buy into a positive outlook for shipping lines – a view that is also shared by several sources in the liner industry I talked to recently.
Meanwhile, new orders for ultra-large container vessels are also encouraging, right?
Hapag has emerged in a more dominant position thanks to rising freight rates and a lack of alternatives on the routes it serves – however, their contribution to its interim P&L figures was more of a marginal embellishment than substantial gain.
And the balance asset, where assets and liabilities are booked, doesn’t look great either, although analysts at Moody’s and sell-side brokers think otherwise, given their projections.
While Hapag management talks of “qualitatively enhanced growth”, its earnings quality has deteriorated, in my view; and surely how that growth is financed is equally important.
Of course, Hapag minimises certain risks, saying that global GDP growth will accelerate above trends in the next 15 months or so, with volumes comfortably outpacing global economic growth…
The message here is clear: the economy will be the silver bullet the container shipping industry needs at a time when the main players consolidate at the fastest pace in history, determining different pricing dynamics along the value chain that, ultimately, will favour the top five carriers.
Currently, Hapag remains the smallest, and the most vulnerable, based on its current financial situation.
(A quick digression on the economy: you may not have noticed, but earlier this month the 10-year US Treasury yield hit its lowest level of 2.05% for 2017, down almost 60 basis points from its highest point – induced by the Trump rally – which says a lot about subdued growth prospects for the world’s largest economy, and hence for the rest of the world. Additionally, it is convenient to ignore that the bull market is almost nine years old, while benchmark indices continue to record new highs on a daily basis – however, as latent recessionary forces persist globally, a double-dip in the container shipping industry cannot be ruled out given that the worst year on record for the ocean carriers was little more than nine months ago.)
I have recently warned you that debt trends were not good, either for Hapag nor the broader industry.
The fact that credit rating agency Moody’s recently placed the rating of Maersk under scrutiny is only a minor event, though – the market leader, even following a possible downgrade, will remain in investment grade territory. Based on its current credit rating, it currently ranks two notches above junk.
The stock of the Danish behemoth shrugged off the news, but Hapag is an entirely different story, because its balance sheet is significantly more stretched and its credit rating deep in junk territory.
It is possible that Moody’s is right and, if so, in less than two years the German carrier will have materially improved its financial status.
After all, its free cash flow profile received a fillip at the end of the first half…
… and capex requirements will inevitably fall based on historic standards following the UASC integration (although, inevitably, its vessels will be older than rivals reportedly looking to place new orders).
Furthermore, some key returns figures were better than previously, as the chart below shows.
But the same table above also includes its total financial indebtedness – and that should raise eyebrows, having risen 78% to €7.3bn following the consolidation of UASC, while borrowed capital, which includes other liabilities, is even higher.
Hapag also consolidated additional cash and earnings of UASC when it acquired it – but it’s too early to know whether the deal was actually worth it. Little improvement in first-half ROIC (return on invested capital) metrics – which gauge how efficiently capital is deployed and is a key yardstick for Maersk’s management – prove my point.
Meanwhile, a tiny free float makes it all riskier for shareholders who are invested, one could argue. Although if a bear-case scenario plays out and the bulls are wrong, that might only be a minor concern.
Because then, Hapag – which for so many years was tipped to merge with Hamburg Süd before Maersk swooped – could easily become a target for Maersk once that line’s restructuring is complete, say, in 2019. It wouldn’t come cheap, and could well spark a bidding war.
When asked about the likelihood of Hapag being acquired by Maersk eventually, several executives, who I am grateful to for sharing their views on shipping market trends in recent weeks, agreed: “Such a combination would make a lot sense.”