Shipping’s Recovery Boosts Danish Ship Finance
The 2018 results reflect a year in which many developments began to take shape that will bear fruit in 2019 and beyond. Welcoming new members of the management team in early spring was swiftly followed by a comprehensive review of the strategic direction. The strategic review resulted in identification of clear actionable initiatives. These include effectively building out the presence with key clients, effectively utilising lending capacity, ensuring continued access to bond markets on good terms, and continuing to develop an agile and scalable organisation.
The strategy combines initiatives with a renewed commitment to DSF’s historical strengths: a long-term viable business model, a relentless focus on credit quality, ample reserves of capital and liquidity, operational efficiency, and the ability to attract highly talented and motivated individuals. These remain key ingredients in the future success. Execution of strategic initiatives commenced in the second half of 2018 and will for the most part complete during 2019. Some effects already began to materialise in the later part of 2018. The focus on being present with key clients was reflected in the addition of eight new clients, based in Europe and North America.
Strong business momentum, underpinned by gradually stabilising shipping markets, resulted in a 6% increase of gross lending, to DKK 39.2 billion at the end of 2018. At the same time, new lending credit quality and collateral coverage remained strong. DSF continued to enjoy good access to funding markets and the already strong liquidity position was further bolstered by net funding growth of DKK 1.1 billion year-on-year. Developments in 2018 sowed the seeds of attractive and sustainable financial returns, putting DSF in a good position for the future.
Shipping markets continued the long march to recovery and healthy earnings levels were achieved in the major segments. Although it is still too early to see the many developments initiated reflected in the present-year financial statements, the results from 2019 onwards will increasingly reflect run-rate results of strategic initiatives already underway at the turn of 2018.
Financial results 2018
Notwithstanding the ability to navigate difficult shipping markets and good progress on executing the strategic initiatives, financial results for 2018 did not yet evidence a reversal of the lower earnings experienced in 2017. Trends in the lending business were positive with increased loan demand from existing and new clients resulting in lending growth of DKK 2.2 billion year-on-year to DKK 36.7 billion (net of loan impairment charges) at the end of 2018, although the resurgence in activity occurred mainly in the fourth quarter and hence too late in the year to materialise in full-year earnings. DSF was able to issue a significant volume of bonds at attractive rates very close to the Danish reference rate.
A total of DKK 9.1 billion was issued in the Danish bond market, including one of the longest maturity DSF bond issuances since the financial crisis, at 9.3 years, in LCR compliant benchmark size. Average maturity of new issuances over the year was 5.6 years.
Issuance of ship mortgage bonds was increased as the volume of new loan offers started to grow significantly in the second half of the year. Effective issuance supported an overall positive net margin development for new lending. However, liquidity reserves and associated hedging costs in parts of 2018 were higher than normal, pending loan disbursements. Investment income at DKK 66 million was significantly lower, by DKK 257 million, than in the previous year, as a still-low interest rate environment and the beginning of a turn in the rate cycle pressurised markets. Investment returns in 2018 were, however, still ahead of market benchmarks. Excluding one-off exceptional items, mostly relating to management changes in the first half of 2018, operating costs were largely in line with the level observed in 2017. Loan impairment charges for the full year were a manageable DKK 35 million and the number of problem cases reduced by two.
The remaining portfolio saw average collateral coverage continue to improve such that 98% of outstanding loans are now covered inside 60% of ship market values and the portfolio average loan-to-value ratio stood at 52% (net of impairment charges). The average internal ratings assigned to new lending were stronger than the existing loan book. Overall, financial results showed positive momentum during the year after a comparably slow start. Net of loan impairment charges, both pre-tax and post-tax income improved in the second half of 2018 compared to the first half of the year.
Financial results relative to outlook
Financial results for full-year 2018 were lower than expected at the beginning of the year. Particularly, the results contribution from investment of own funds was significantly below the result achieved in the previous year. The expected increase in the net result from lending did not materialise in 2018. The resurgence in lending activity in the second half, resulting in a year-end balance largely in line with expectations, did not fully compensate for the lower average lending balance earlier in the year. Macro economic developments did not materially impact the prospects of the shipping industry or the company in 2018. Global economic growth continued its subdued trends from prior years and, as expected, 2018 was a year of mixed trends for international shipping. A few shipping segments are still struggling to move up from the bottom of a very protracted economic cycle while others appear to be steadily improving. Environmental regulations have not yet had a measurable effect on the ability of global shipping to meet its debt-servicing obligations, or on second hand vessel values. Increasing numbers of vessels were retro-fitted with emissions cleaning devices (“scrubbers”) in 2018, in many cases financed by additional borrowing. The effects of the implementation of IFRS 9 regulations resulted in a one-off reduction of equity by DKK 103 million (DKK 132 million before tax in line with prior guidance of DKK 125-150 million). Overall, the total allowance account remained largely unchanged, and write-offs in 2018 were, as expected, covered by existing loan impairment charges.
No material market impacts have been observed in 2018 relating to upcoming financial regulation, or from the announcements of several competitors of their intent to scale back or withdraw their shipping market lending exposure. The funding conditions in the Danish high-grade bond market, particularly in the second half of the year, remained strong compared to original expectations, allowing the issuance of longer-dated bonds and a moderate amount of own bonds buybacks.
Outlook for 2019
Business momentum coming into the new year is strong on the back of increased client engagement in the second part of 2018. DSF enters 2019 with a healthy pipeline of accepted loan offers, indicating a strong start to lending activity, supported by a strong liquidity position and continued good access to funding markets. A healthy operating performance with increased net interest income from lending is expected, and financial results from 2019 onwards will increasingly show the run-rate benefits of initiatives for which DSF laid the groundwork in 2018. DSF will this year continue to invest in effectively utilising available lending capacity and strengthening the organisation for sustainable performance, laying the foundation for strong business and financial performance in the coming years.
Strategy execution costs are fully budgeted in the projections and expected to result in temporarily higher costs in 2019 compared to 2018 levels, excluding other non-recurring items. The net profit for the year is expected to be in the range DKK 325-425 million, assuming no net loan impairment charges, investment income at 2018-level and unchanged USD/DKK exchange rate compared to 2018. Overall, shipping markets have seen improvements on the back of a steady increase in demand for seaborne transportation and stabilisation in orderbooks in most segments.
Although the troubled offshore sector appears to be gradually moving out of its depression, recovery of rates in the sector is expected to take several years and DSF expects some of the already challenged clients in the sector to remain under pressure in the coming years. Credit quality has stabilised for some challenged clients and the number of problem loans reduced. However, it is expected that a limited number of non-performing loans to offshore clients will remain troubled in 2019 and beyond with an attendant risk of realising credit losses.
The total allowance account of approximately DKK 2.5 billion provides adequate coverage for expected credit losses and no major changes to the level of the accumulated loan impairment charges are currently envisaged. Unexpected market or credit events could lead to a reassessment of the outlook. The business outlook for 2019 remains subject to market factors and can be shaped by elements outside of DSF’s direct control. Uncertainties about global politics and global trade may impact the shipping market. An uncertain outlook for financial markets, including primary and secondary bond markets, interest rate and foreign exchange markets, may affect the financial performance.
On balance, management remains optimistic about DSF’s prospects coming into 2019 and expects the 2019 financial results to materially exceed the results realised in 2018.
The steady expansion of the global economy, which has progressed since mid-2016, is projected to level off from its 2017-level of 3.1% to 3.0% in 2018 and 2.9% in 2019. International trade and investment have softened due to a tightening of financial conditions in some parts of the world, escalating trade disputes and increased geopolitical tensions. The cyclical upswing among commodity exporters has lost momentum, partly reflecting a substantial slowdown in some large economies, and is projected to plateau over the next couple of years. For all regions, risks to the macro outlook are increasingly tilted to the downside. China’s Belt and Road Initiative looks likely to help support continued steady expansion in global seaborne trade but may not be enough to counterbalance adverse factors that are currently clouding the outlook. Still, the World Bank maintains an optimistic view on world trade predicting robust growth of 3.6% in 2019 compared with 3.8% in 2018. DSF expects that macro developments will nevertheless continue to underpin a healthy debt service capacity amongst its performing clients. Escalating global trade tensions and the risk of lower economic growth in China remain risk factors in 2019. Although this has not yet had material negative effects on global shipping, the effects will be carefully monitored. Brexit is also a concern, but any impact will mainly be on the short-sea trade. Bunker (fuel) prices have been on the rise since early 2016.
While a continuation of this trend could reduce the effective supply of vessel capacity if ships reduce speed (“slow steaming”) to save fuel, or reduce emissions, this effect has not yet been observed as a material factor. Sustainability and technology have been among the most discussed topics in the shipping industry during 2018. Both themes represent unique opportunities for the shipping industry to address and enhance its contribution to the global economy. For individual ship owners, the increased focus on climate change, the introduction of new environmental regulation and a general push to digitalise global supply chains have initiated an industry transition that includes technological upgrades of vessels and infrastructure. DSF believes that digitalisation of the shipping industry and the industry’s increased focus on sustainability are likely to be mutually reinforcing through the use of new technologies. DSF will increase its focus on the sustainability agenda in 2019 and continuously engage in discussions on how the industry can become more sustainable, supported by increased digital adaptation.
Source: Danish Ship Finance