Container shipping equities – Will newbuild orders act as a roadblock to higher returns?

Amid the backdrop of low interest rates, ample liquidity, robust freight rates and supply chain bottlenecks, container shipping stocks are at their peak as the world tentatively edges its way out of COVID-19 and lost demand is recovered. The valuations of some of the companies have already reached multi-year highs and investors are a lot happier than they have been in recent times.

The share prices of Maersk, HMM, Evergreen, Yang Ming, Wan Hai, Cosco and Hapag-Lloyd together gained more than 170% between 1 January and 31 December 2020, with Evergreen, Yang Ming and HMM posting a whopping rise of more than 200%. Although we have seen some correction this year, stocks are still trading at a record high.

Another positive aspect of 2020 was the recovery in return on invested capital (ROIC). While in the past, the ROIC for most operators has been consistently lower than the weighted average cost of capital (WACC), we saw a great deal of improvement last year. In fact, in some cases such as Hapag-Lloyd, the ROIC has even exceeded the WACC. The sample companies in the ROIC chart (Figure 2) are a good cross-section of the industry as it consists of some of the largest carriers.

Meanwhile, it is to be seen whether the high stock returns or ROICs would be sustained for the long term or not. We believe this will depend on how companies behave – whether they tilt towards another ordering frenzy that will delay market equilibrium or utilise their new-found profits wisely.

To discuss this further, we cover two important aspects:

1. How does the industry utilise its cash?

With carriers riding high in 2020 the question arises that what will they do with the profits? In our view, companies might be better served by using cash on their balance sheet to pare off debts – a long-term nemesis that has held back the industry. Also, if container shipping operators want to see their stocks trade at a higher level consistently, they need to win the trust of their investors that profits will be utilised appropriately.

For now, the aggregate cash balance of the 14 carriers at the end of September 2020 came in at USD 21bn, broadly the same as at the end of 2019, but the figure is likely to go up after strong 4Q20 results. So far, there has not been a great rush to pare down debt levels, considering weak balance sheets of carriers (see Figure 3). The total cumulative debt of these 14 carriers stood at USD 80bn at the end of September, a relatively small reduction of USD 2bn compared to the end of 2019.

With the industry poised for a fairly lengthy profitable run, carriers might feel that there is ample time to reduce the debt burden, although there have been some isolated efforts:

• Hapag-Lloyd used a substantial part of its recent profit for the early redemption of bonds. The company spent EUR 150mn (USD 178mn) on acquiring 5.125% senior notes maturing in 2024 at a premium of 2.6%. The debt was sold in July 2017.
  CMA CGM, besides issuing bonds worth EUR 525mn (USD 636mn), also prepaid its outstanding bonds due to mature in 2021. In line with its debt reduction strategy, the group will prepay USD 750mn of various debts by 1Q21. These include the NOL (now CMA CGM Asia Pacific Limited) notes due to mature in 2021.
• Maersk made repayments of USD 1.2bn towards debt and lease liabilities in 3Q20 and launched a new share buy-back programme of DKK 10bn (USD 1.6bn). The first USD 500mn tranche that started from December 2020 will be purchased in a staggered manner over 15 months.
  ZIM has launched on offer to buy back bonds due in 2023. The company offers about USD 0.60 per dollar on the face value of a USD 100mn loan. If successful, the carrier would save USD 40mn.
• Other carriers have eschewed such debt repayments and instead are looking to spend some of the new-found profits, acquiring vessels (new and old) and container equipment.

2. Is the recent bout of vessel ordering disruptive?

The table below provides a quick summary of some of the newbuild orders placed since November 2020. According to our analysis, these orders are at least worth USD 7bn.

In addition, the traditionally known financially weaker operators who have been profitable recently have also chosen to spend on either new boxes or new ships. Reportedly, HMM will spend KRW 229bn (USD 20.6mn) on the purchase of 43,000 dry containers and 1,200 reefer boxes and the delivery for which is scheduled for 1H21. ZIM is also keen to buy new tonnage, but there is no clarity on the number of ships.

Does this mean a repeat of the past cycle of vessel ordering/high debt and subsequent collapse in profitability?
Between 2006 and 2015, there was a boom in ordering that curbed the rally in rates, which resulted in a decline in industry profitability. The phase saw high debt levels as other modes of financing, including equity became difficult.

With a flurry of newbuild ordering by carriers and non-operating owners since November 2020, it seems that history might be repeating itself. This is because a profit phase is followed by a phase of vessel ordering. However, we think that this time is different for container shipping than previous phases.

Demand for containerships has been high since the past few months; consequently, ocean carriers are keen for as much tonnage as they can get, extending even to multipurpose ships with container slots. This is largely due to the cargo bull-run and elevated freight rates. As a result, carriers and non-operating owners are not only ordering newbuilds but also diving into the charter and second-hand market that has hampered demolition activity. Meanwhile, vessels that were slated to hit the market in 2020 will now be delivered in 2021 or even later due to the impact of COVID-19. Shipyards have also suffered due to the pandemic as manpower issues derailed the timely delivery of vessels. Any fresh orders now will mean increased congestion at shipyards and less capacity for new orders during 2021-22. Hence, despite a flurry of new large-sized vessel ordering, yards will take a couple of years to deliver them.

The large consolidation activity since 2010 has contributed to the decline in orderbook, as it lowers the need to buy new vessels for capacity addition, as seen in the case of Maersk which did not invest in new ships, post its acquisition of Hamburg Sud. Even Hapag- Lloyd, until the end of 2020, did not invest in large vessels since its acquisition of UASC. Also, we believe the increased environmental scrutiny means high capex requirement which may prevent many liner shipping companies from placing big orders on a sustained basis.

Conclusion

The renewed interest in newbuild contracting should not be mistaken for a signal that carriers will rush headlong into another ordering frenzy that will disrupt market equilibrium. Following a couple of years of conservative contracting that led the orderbook-to-fleet ratio slid to around 10%, new orders will be required to meet medium-term demand growth. In such a scenario, a decent stock return, as well as ROIC generation even above WACC, looks a recurring theme, in our view. That said, the risk remains that carriers and owners may get carried away with the new-found profits and overinvest in new tonnage. The most likely sources of this, in our view, are the state-backed carriers that want to support native shipbuilding sectors.
Source: Drewry