With hindsight, it can easily be illustrated that even though macro-economic hindrances originate from different sources, they all tend to challenge (in one form or the other) the established rules. By now, we all must have read a lot about the pandemic and its related effects and should be comfortable classifying FY20 as one of the strangest years in human history. Even though consumer confidence took a beating, economic stimulus and altered buying patterns kept the ball rolling. The shipping industry, which forms the kernel of international trade, too witnessed a year of unforeseen volatility. In this update, we look at two closely allied sectors – container shipping, and container ports & terminals – to see their performances through the eyes of an equity investor.
Drewry’s Liner index outperformed Ports & Terminals
Comparing Drewry’s Liner index with the Port index demonstrates that the former has unequivocally beaten the latter in FY20 (Liner: +119.6% vs Port index: -22.4%). The gap widened further as we moved into FY21 with the Liner index inching ahead, driven by rising freight rates, robust profitability and surging demand caused by the pandemic-driven shift in consumption habits towards goods.
Digging into details of the Liners’ outperformance, let us look at key drivers behind this gap:
1. Superior performance of container shipping
The container shipping sector is going through a purple patch like never before generating an industry-wide EBIT of about USD 27bn, with an operating margin of 13.0% for FY20. The fundamentals remain strong with liners set to enjoy a prolonged cycle of profitability extending into at least the next couple of years. Even if the chips are down, it looks highly unlikely that shipping lines will go back to the deeply loss-making cycle again. This was clearly evident in the second quarter of 2020 when carriers found a way to be profitable, despite plunging demand, by deploying robust capacity management techniques.
While capacity management strategies such as suspending services, blanking scheduled sailings and re-routing vessels were effective for the container shipping industry, they negatively impacted other related parties. From the shippers’ perspective, service cuts and reduced supply capacity meant space limitations to transport goods and delays in delivery dates, affecting their supply commitments.
The port and terminal sector, on the other hand, was faced with multiple problems including lockdown restrictions, limited availability of labour and volatile vessel arrivals, resulting in port congestion across major trade routes.
Growth in global container port throughput decelerated to -1% in 2020, down from 2% in 2019 and 5% in 2018. In 2020, some 793 mteu was handled by container ports worldwide, reflecting a reduction of 9 mteu over 2019.
This reduced throughput impacted the revenues of port operators. As we moved into FY21, the variance between revenue growth between Liners and Ports & terminal operators continued to increase.
Record freight rates and the liner shipping industry’s higher degree of operating leverage meant that increased sales translated into big profits. It should be noted that under a high fixed cost structure, incremental sales beyond the break-even point are converted into incremental profits. Despite the significant increase in profitability, the average Liner industry EBIT margin (13% in FY20) lagged behind the Port operators (24% in FY20), with the port sector generally benefitting from limited competition, stable cost structure and higher ability to service a focused market.
2. Constant tussle between shipping lines and container shipping ports
Since container shipping firms operate in an increasingly competitive and market-driven environment, they not only aim to lower their shipping costs, but also enhance their services to increase their competitiveness.
For ports, the number of ship calls is an important factor because it influences the volume of cargo that can be moved through a port. A port with a higher degree of connectivity is attractive to both importers and exporters, and can help boost the port’s market share. However, with the recent consolidation in the liner shipping industry, ports are losing their bargaining power which is reflected in their declining EBITDA margins.
3. Liner’s debt reduction attracted more attention despite better gearing of ports and terminal operators
The sharp economic downturn in 2Q20 led the central bankers to ease the liquidity situation in order to mitigate the falling consumer confidence. Port and terminal operators, which typically operate at low net gearing (net debt/equity), remained at the forefront, raising additional capital to strengthen their balance sheets. Recently HPHT announced issuing USD 500mn guaranteed notes to refinance its short-term debt. Similarly, both CMPH and ICTSI raised USD 600mn and USD 800mn respectively in FY20 to retire their higher-priced debt and to fund their acquisition-led expansion. Santos Brasil too raised additional capital of BRL790mn (USD140mn) to extend the company’s debt maturity. Adani Ports, the largest port operator of India, also raised USD 500mn from the international debt market which was in quick succession of its previous issues of USD 300mn in December 2020 and USD 750mn in July 2020. The money raised is envisioned to refinance or retire higher-priced debt and to fund its acquisition-led expansion.
Shipping lines too used their increased profitability to pay down their debt drawing far greater attention. Many also used ‘Green bonds’ to refinance their debt. For example, Hapag-Lloyd issued a sustainability-linked bond worth EUR 300mn (USD 357mn) and achieved a lower interest rate of 2.5% to refinance its earlier bond of EUR 300mn due in 2024 with a 5.125% coupon. Similarly, Seaspan priced a new USD 300mn sustainability-linked bond in the Nordic market at 6.50% for general corporate purposes including the possible re-payment of debt. These initiatives by container companies created a positive sentiment. Backed by solid performance, the sector also witnessed a series of credit rating upgrades. While Moody’s upgraded CMA CGM’s rating from B2 to B1, Hapag-Lloyd’s rating was revised from Ba2 to Ba3 and Maersk’s was upgraded to Baa2 on 22 March 2021.
4. Liner freight rates drove higher stock returns
Container shipping spot rates are still at stratospheric heights – and show no sign of abating. On the other hand, importers are locking-in container shipping rates that are as much as 50% higher than a year ago to avoid the volatile and even steeper prices in the spot market. With higher contract rates locked in, another highly profitable year is virtually guaranteed, and we think the industry will reset profitability records once again in 2021, despite several opex headwinds in the form of higher fuel costs and charter rates. This sentiment is largely reflected in the stock prices.
Liner spot rates act as a barometer for earnings of the carrier industry and closely align with liner stock prices which explains the exceptional returns for container shipping investors.
Separately, one can argue that stocks of port and terminal operators have not recovered as much as they should have, contending that investors that take positions now could gain as the stocks catch up.
5. Container shipping companies are more volatile than ports & terminal operators
During 1Q20 when COVID-19 had just started to spread and demand had plunged, all stakeholders were in a state of panic which led to high counterparty risks. Survival of major shipping lines, including CMA CGM, was at stake amid falling stock and bond prices.
However, in following quarters the market recovered and freight rates shot up, leading to a recovery in operational performance and also triggering an unprecedented gain in stock prices. Container shipping charter rates jumped back to the levels before the crisis began, and in some cases, they went even higher. Classic Panamaxes (4,500-5,500 teu) are now garnering their highest rates in more than a decade – up to USD 40,000pd.
The same degree of follow-through was however missing in stock prices of port and terminal operators as the sector was engulfed in a myriad of problems despite reporting a largely stable financial year. In 2Q20 and early 3Q20, many ports reported that blank sailings had resulted in mega-sized vessels calling less often, but when they did, the large volumes created higher peaks. Ports were thus faced with operational challenges such as slower ship-to-shore and gate operations, which in turn had a knock-on effect on landside distribution networks. Since container vessels move on a scheduled rotation, delays at the first port in the rotation cascaded down to all the other ports served by that carrier in that rotation, hampering the performance of all these ports.
Once the recovery picked up pace in 3Q20, volume surged as a result of higher consumer demand, overwhelming many ports and terminals, of which many are still struggling with reduced staff due to COVID-19.
The supply chain is now caught in a vicious cycle – high demand, low port productivity and dysfunctional liner services causing cargo rollovers, leading to restricted access to containers and more congested terminals, which in turn further reduces port productivity. The grounding of the 400-meter long and 60-meter wide 20,150 teu containership Ever Given in the Suez Canal in late March this year is likely only going to push back efforts to improve port productivity.
6. Battle for eyeballs
Container shipping companies often grab more eyeballs than their peers from container ports and terminals with the recent publicity on container-shipping spot rates attracting more investors. Whether it is inventory restocking or stimulus spending, it is being considered as a non-energy, non-tech way to play the COVID-19 recovery.
We think this has more to do with the way shipping lines use marketing tools to their advantage with their managements speaking on various media platforms and analysts regularly quoting them and discussing their stocks.
In comparison, the port and terminal stocks have lacked this kind of attention. For instance, a lot of weightage was given to robust profit announcements by major shipping lines which was missing from ports and terminal operators. IPOs have also played their part as bankers not only market the company, but also the industry. Zim, a container shipping company, recently got listed on NYSE. On 30 December 2020, the Israeli company had filed for an IPO issue at USD 15 per stock (priced below the target USD 16-19) to raise USD 218mn. Despite failing to generate the anticipated investors’ interest in its IPO, the stock price has by now increased almost three times, returning close to 200% (as of 12 May 2021) since it started trading on 28 January.
7. Investors in port and terminal operating companies benefit from higher dividend yield, but stock prices lag shipping lines
Ocean Network Express (ONE), announced approximately USD 500mn in dividends to its three parent companies – NYK Line, Mitsui OSK Lines (MOL) and K Line – a first since its inception in 2018. Maersk and Hapag-Lloyd too have paid handsome dividends to their investors. Maersk more than doubled its dividend pay-out on per-share basis, paying DKK 330 per share in FY20 (vs DKK 150 in FY19) at a dividend yield of 2.4% which is the highest in five years. The Executive Board of Hapag-Lloyd also proposed a EUR 3.50 per share dividend for FY20, significantly above FY19’s EUR 1.10 per share, translating to ~65% pay-out ratio and 2.8% yield.
Despite these higher dividends, container companies lagged behind the port and terminal operators which have paid dividend yields of 3.5% on average to their investors. The yield varied across the port portfolio with Chinese companies leaping ahead, paying their shareholders an average dividend yield of 5.5%. Yet, the stock prices of port and terminal operators lag those of shipping lines.
As vaccination programmes advance and details of fiscal plans emerge, many investors may rethink their investment strategies. In our view, investors with higher risk tolerance will be better off staying invested in container shipping despite high valuation given the backdrop of strong growth, low interest rates and at least a two-year high growth potential. On the other hand, income investors should consider parking their funds with port and terminal companies which benefit from stable business and higher dividends yields. Also as mentioned before port and terminal operator stocks have not recovered as much as they should have, contending that investors who take up positions now could pocket huge gains when the stocks catch up. On the risk side, the more the good news is priced into the markets, the more the stocks are vulnerable to negative surprises. Investors may also consider taking advantage of bouts of volatility to invest.
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