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© Vladimir Serebryanskiy

China’s state-owned Cosco Shipping Holdings will likely reach record revenues of Rmb90bn ($13.5bn) this year, based on a nine-month performance that validates projections for 2017.

But, as it continues to grow the size of its business, so too its net leverage continues to rise.

Cosco record revenues (Source: 4-traders.com)

Cosco record revenues (Source: 4-traders.com)

Is that a good or a bad thing? And, what might it lead to?

Pre-OOCL deal

Even excluding the pending consolidation of Orient Overseas International (OOIL) and its container shipping arm, OOCL – which recently received the green light from anti-trust regulators in the US and will be substantially funded by new debt – the pro-forma net leverage of the Chinese group in 2017 is already projected to be over 4x, which will likely rise significantly once the OOCL deal is completed, given the target’s cash flow profile and the limited synergies it offers, one reason being that OOCL is already a very well-run company.

(Note for the reader: net leverage is calculated as net debt divided by adjusted operating cash flows. Anything above 3.5x for up to six quarters in a row should be considered risky at this economic juncture, not just for Cosco, but all the main players in the industry.)

Picking a fight

Cosco is not a beast that can be analysed only by the numbers, because there are so many strategic implications derived from the relentless reshuffling and managing of its corporate tree and subsidiary structures that today’s loss could soon become tomorrow’s gain. On this basis, however, its latest trading update, released on 31 October, was truly encouraging.

Its latest presentation highlighted a “profit of Rmb2.7bn ($405m) during the reporting period”, with earnings per share (EPS) of Rmb0.27, up from a net loss of Rmb0.9 a share one year earlier, on a comparable basis.

Cosco revenues and EPS (Cosco Q3 presentation)

Cosco revenues and EPS (Cosco Q3 presentation)

Its asset base has changed significantly since 2015, and so far this year assets have grown slightly more than liabilities – which, in turn, were outpaced by the rise in equity in the first nine months.

This provides little help in isolation, I admit, but the balance sheet looks in good order – although it is hard to be upbeat about the income statement, and my consideration here would be the same even if Cosco had reported twice the amount of net income and EPS than it has generated so far this year.

Both these metrics, in fact, can be easily manipulated under normal circumstances in terms of corporate activity, and even more so when a corporate restructuring of this size takes place.

Cosco balance sheet (Cosco Q3 presentation)

Cosco balance sheet (Cosco Q3 presentation)

Stock investors are bullish nonetheless, I gather, but it is the cash flow that really matters – and on this basis Cosco is growing; but it is also burning more cash than in the past, with cash balances lower against one year earlier.

Cosco cash flows (Cosco Q3 presentation)

Cosco cash flows (Cosco Q3 presentation)

Nothing to worry about, particularly if you debate these issues with the local analysts.

I have worked with several Chinese analysts boasting equity research expertise during my career and, while they are among the best in the world on the number-crunching side of research, they often tend forget that debt is actually a liability that has to be taken into account when valuing any business.

“I think you are right, but Cosco has plenty of room to raise additional funding,” one sell-side analyst based in Hong Kong told me this week. Another, based in mainland China, argued that its growth rate and “revenue figures were more important than other factors”.

I think they both had a point to prove, which they did in private conversations.

After all, some liabilities can be heavily discounted, or even discarded, when your owner and employer is the Chinese government – all you have to do as an analyst is to acknowledge the liabilities, put them in your model and forget about them until they are no longer problematic.

An associated point to consider (at a time when Cosco’s rivals are also levering up), is that the Chinese are quick learners. In corporate finance terms, this means they can be more aggressive when they deploy new capital in the container shipping industry – in any industry, in fact.

Financial discipline

I previously argued in favour of financial discipline as being the way forward for Cosco, but given latest development in the industry, I am not so sure anymore. I haven’t made up my mind yet about the harm that ballooning leverage can cause, but when the competition, led by the Japanese carriers, time and again proves that, in dealing with cyclical swings, little or no attention is paid to economic returns, you just need to have a plan B if your plan A is destined to fail, for whatever reason.

Cosco is now emerging as a serious threat to European dominance in global container shipping, in a world where certain trades and habits are changing, while the financials of many of its rivals are a bit… well, scary would be an understatement.

Moreover, on this basis it seems Cosco has a clear competitive advantage, which supports the Chinese analysts’ biases.

In this context, the results released by Maersk Line last week point to a bearish view that may apply to the Danish company rather than the entire industry: some analysts’ notes have suggested Maersk is doing great, while others point to market share erosion as a risk that should not be underestimated.

(You’ll have my take next week.)

More debt, come on!

We know little about Geneva-based MSC’s books; its decision to disclose little, if any, financial detail is very smart, by the way. But we do know that lines such as Maersk, CMA CGM and Hapag-Lloyd are stretching their balance sheets to reach ever greater heights of scale.

Either way, I ended up feeling relieved with Cosco’s numbers, and I am willing to speculate beyond what they actually mean – in fact, I am willing to bet that by early 2020 there could be another asset to consolidate for the Chinese powerhouse.

First, the figures

Net cash flow from operating activities was Rmb5.2bn ($780m) in the first nine months, which means it will likely end the year churning out adjusted operating cash flow (AOCF) of about $1.1bn. Before OOCL is consolidated – the stock price of the parent company currently reflects a near-100% probability that the deal will go through – Cosco carries Rmb32bn of net debt ($4.8bn), which implies net leverage of 4.3x, which is well outside our comfort zone, and it will rise much higher with OOCL.

OOIL share price (Source: Financial Times)

OOIL share price (Source: Financial Times)

OOCL key 3Q figures (Source: OOCL)

OOCL key 3Q figures (Source: OOCL)

I will not bore you with the nitty-gritty of the calculations, but based on the main figures in the table above, and assuming constant profitability in line with the past for OOCL activities, the AOCF of a combined Cosco/OOCL entity could rise to $1.7bn, while net debt will likely be as high as $8.8bn. Excluding synergies, the net leverage of the combined entity surges to 5.1x, which is ok only if Cosco acquires another carrier after OOCL, raises new debt and pushes back refinancing risk to late 2020.

On top of that, it also has to hope that the market’s current recovery doesn’t fade away.

CCFI trends (Cosco Q3 presentation)

CCFI trends (Cosco Q3 presentation)

More CCFI trends (Cosco Q3 presentation)

More CCFI trends (Cosco Q3 presentation)

However, even if the momentum vanishes, remember that Cosco and CMA CGM are the key members of the OCEAN Alliance… A takeover of the French carrier would make a lot of sense for both companies at a time when some key investors want out of CMA CGM and an IPO doesn’t seem to be on the horizon.

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