Investing View: Bullish dry bulk shipping
Application of View: Buy Pacific Basin Shipping (2343.HK)
Fundamental Basis: The fundamentals for dry bulk shippers have improved dramatically over the last three years and we believe that this trend of improving fundamentals will continue for the next 5 years at least.
However, the market is not pricing in any of these improvements in fundamentals and it certainly isn’t pricing in any sustainable improvement in fundamentals over the medium to long term.
And that is why we are now presented with an opportunity to buy dry bulk shippers at 30-50% less than where they were trading at just two months ago, when they were already very cheap.
We’re perhaps even more bullish now than some two years ago, because of these reasons:
- Dry bulk shippers are trading more or less at the same level now as they were at the start of 2017.
- Earnings and cash flows for the industry have been positive as a whole for the last 12 months.
- A supply deficit (an excess of demand vs supply) is opening up, which will be pronounced by 2020 and will take a long time to balance.
Grab a coffee and sit with us as we work through our bullish thinking.
Up until 2016 virtually every dry bulk shipper (no, I’m not kidding) had either gone through a bankruptcy or they were forced to raise equity in order to keep the wolf from the door of bankruptcy and, of course, in the process diluting existing stockholders, pissing them off, and ensuring their most loyal investors (those already holding) not only hate the companies and entire sector but that they weren’t coming to the party of additional capital raises.
Small wonder the equity raises were done at such disastrous levels. Either which way, existing shareholders were essentially wiped out. You might say that’s tragic and I’d say no, it’s wonderful and it’s capitalism, which, I dare say, is a heck of a lot better than the alternatives we bipeds have tried over the years we’ve been grubbing around on this ball of dirt.
You might say that’s tragic and I’d say no, it’s wonderful and it’s capitalism, which, I dare say, is a heck of a lot better than the alternatives we bipeds have tried over the years we’ve been grubbing around on this ball of dirt.
In any event, the end result was that debt levels have been brought way down to manageable levels, companies were left with generous levels of cash on their books and they were in much better financial shape than at any time in the previous 20 years, though you wouldn’t know it looking at the share prices.
Since 2016 freight rates have improved across all vessel classes and dry bulkers have, as a whole, turned profitable for the last 4 quarters and free cash flow positive for the last 6 quarters. This has allowed them to increase liquidity and/or reduce debt levels even further.
It is important to note that dry bulkers have managed to generate a profit against a backdrop of freight rates that remain close to historical lows… or at least levels they were trading at some 18 years ago.
It’s a miracle that these shippers were able to show a net profit over the last 12 months given how low rates have been.
It’s quite incredible what can be achieved in what is a massively capital intensive business, when you wipe out all the debt originally used to get the entire operation up and going. Show me another sector where the capex is in the hundreds of millions of dollars and there exists no or low debt financing. It basically never happens except after catastrophic liquidations. Excellent.
One wonders how much cash they will generate should rates get back to 2004-2006 levels let alone those experienced in 2007-2008 because remember the margin expansion here can be quite breathtaking.
We’re not going to jump to too many conclusions based on the charts above because they are so noisy.
However, it does appear that the bottom was reached in early 2016, and we now have some 10 years of ultra low rates. If my experience is anything to go by, 10 years is long enough to work off any excesses that were previously built up and certainly this is what we’re seeing when perusing the financials.
What Are Valuations Implying?
Many dry bulk shippers:
- Still trade at substantial discounts to their book value
- Sit on actual P/Es below 10x and on forward P/Es, 1-year out of 5x and 2-years out 3x
- Have forward EBITDA/interest expense ratios of some 4-6x
Now you don’t need me to tell you that those are stupidly low valuations but I’ll tell you anyways. Those are stupidly low valuations. And remember this is an industry which is MASSIVELY capital intensive.
It seems to us that current valuations are implying that freight rates are about to collapse for an extended period of time, pushing dry bulkers back into bankruptcy yet again. It’s as if anyone even remotely interested in investing in this sector now just looks at it and says: ”Oh, for crying out loud, no!”. And that is a good thing.
That’s what the valuations are implying. Is that reasonable?
Let’s take a look.
The Growing Supply Deficit
By 2020 there will be a significant supply deficit in dry bulk capacity open up and, given the downsizing and lack of capacity of shipbuilders, this deficit will persist for more than a few years.
The key to understanding the long-term outcome of shipping stocks is to understand freight rates which are more a function of shipping capacity rather than demand for shipping space. This is because the supply of shipping space is a bit like that crazy girlfriend you just knew was bad for you. In other words seriously volatile. Shipping space is just way more volatile than the demand piece.
So here is the million dollar question: Are we likely to see freight rates drop materially over the next 5 years as the valuations of dry bulk shippers imply?
We think not… or at least not to the extent currently priced, and this is to do with the widening supply deficit in shipping capacity relative to demand.
From a demand perspective, we don’t see any material change which would see a material reduction in demand for dry bulk capacity.
From a supply perspective, at the height of the commodity boom in 2011 the global shipping order book-to-fleet ratio stood at 36 percent.
The order book-to-fleet ratio is a key measure used by the shipping industry to determine the outlook for future supply of vessels. It’s a useful indicator of supply growth because a proportionately high ratio will lead to a fast-growing fleet and, if history is any guide, oversupply in the market as these ships are delivered.
A 36% order book-to-fleet ratio means there were enough existing new ship orders to increase the 8,600 total cargo fleet size as of 2011 by more than 3,000 new ships over the coming years.
This ratio peaked at 52% in 2009. That means that there were enough ships being built that year to grow the global fleet size by a whopping 52% — nearly 5 times higher than a decade earlier.
But if we zero in on the dry bulk sector (exclude tankers, containerships, cruisers, etc.), the ratio is even more pronounced on the upside and downside. Note that this was only up to 2017. Today the ratio is much lower.
Traditionally, a ratio of 15% is seen as what is required to replace aging vessels coupled with historic demand growth.
So even with significant order cancellations, from 2011 to 2016 an average of 400 new dry bulk cargo chips were still being delivered into the market each year — nearly a 5% annual increase for those five years.
Meanwhile, less than half of that number of old ships were being sent to the scrap heap. That means global shipping capacity continued to expand by approximately a net 2.5% rate each and every year.
This increase in shipping capacity would have been OK if it was met with increased demand for shipping space but that wasn’t the case. Global trade of goods and services has declined by some 7% from 2011 to 2016 as commodity prices collapsed. That’s not enormous but coupled with oversupply it was a disaster for shipping.
So for 5 years up until 2016, the global shipping industry had been plagued by overcapacity, with many shipping firms operating their ships at a loss. It was a sector to short… or at least steer clear of.
But it now seems that this over capacity has been, and continues to be, worked off. Furthermore, it would seem that a capacity deficit is quickly developing. Shipyards have gone very quiet, many have shut down completely and a few years from now there is virtually nothing on shipbuilder’s order books:
It’s not just a 14-year low:
As of the start of August 2018, the orderbook stood at 3,000 vessels of 76m compensated gross tonnage (CGT), its lowest level in CGT terms since April 2004, Clarksons said.
This represented a 38% decline in the size of the global order book in CGT terms since March 2014, which marked the end of a year-long expansion.
The size of the global order book declined rapidly following this period, by 32% in CGT terms to April 2017, before falling at a steadier rate thereafter.
Furthermore, Clarksons says the orderbook has declined rapidly in comparison to the global fleet, with the volume of CGT on order as a percentage of the fleet reaching 9.9% as of start August, a historical low.
A graphical representation:
And from a slightly different perspective: fleet and demand growth.
This component is hard to prove because obtaining data is extremely difficult. But our research strongly indicates that capacity of the world shipbuilding industry is significantly less than it was 5 and 10 years ago and it appears due to contract even further.
Come 2020 shipowners are likely to be in for a shock when they place orders for new ships. There may not be the capacity to build them which will result in long lead times. Excellent!
As a shipbuilder, would you be thinking of cutting back on staff, etc. when faced with an order book like this? Now, granted it is a few months old, but talking with industry and reaching out we’ve found that nothing material has changed in the last 6 months:
Over the last 5 years we have seen many shipbuilders hand out the pink slips to employees, pack their bags and file the required paperwork that amounts to “oh, fuck it, I give up”. Bankruptcies have been de-rigueur.
We have also seen many of the bigger shipbuilders scale back operations significantly as their order books continue to contract. What is happening at the world’s largest shipbuilder, Hyundai Heavy, is a classic example of what is going on in the wider shipbuilding industry, which is predominantly Asian based:
Why Pacific Basin Shipping?
- The company is well run — one of the few dry bulk carriers that averted bankruptcy and large scale capital raises.
- Valuations are extremely compelling.
- The company is well financed with low debt and high cash levels.
- It operates in the smaller dry bulk ship market giving it diversity in terms of customers and cargos, i.e. it has little direct dependency on iron ore or coal as most other dry bulk carriers are.
- Its ships are versatile and can access most shallow water ports that typically occur in many regional Asian locations.
Understanding Pacific Basin Shipping (PB)
PB is the world’s largest owner and operator of modern handysize and Supramax ships. The company operates approximately 7% of global 25-42,000 dwt handysize ships of less than 20 years old; and approximately 3% of global 50-65,000 dwt Supramax of less than 20 years old.
The company is Hong Kong headquartered and HKEx listed with 12 offices worldwide.
The Dry Bulk Shipping Market
In terms of 2018 global dry bulk trade by volume (5.2bn tonnes), Pacific Basin focuses on the minor bulk and grains segments.
More specifically – the product breakdown of PB’s 2018 cargo volumes in 2018.
The diversity of product lines means that PB is not dependent on the volumes of a few commodities (like iron ore or coal). PB’s smaller vessels give it the ability of operate in smaller ports – typical of many regional ports in the Asia Pacific region. The smaller ships and geographical exposure of PB enables it to achieve higher utilisation of its ships.
It goes without saying that the prosperity of PB is highly dependent on how handysize ship charter rates perform.
It is remarkable how tightly cointegrated the two time series are! So rather than spending hours analysing Pacific Basin Shipping time is better spent on understanding the market for handysize ships.
The Baltic Handysize index was a bear market from 2008 to 2016. This has been some 10 years of miserable market conditions and a very long time to “unwind” most, if not all, or the excesses that built up prior to 2008!
But you may say that the index is “rolling over” and a new downtrend has begun? Well, I guess beauty is in the eye of the beholder, i.e. folks see what they want to see. On closer inspection of the chart it just seems like random noise to us:
Rather than trying to pick a “trend” in the charts above, time is better served looking at the long-term fundamentals of the handysize market — the intersection of demand and supply. We have already briefly discussed the order book for dry bulk ships above. Here is a more micro look at the global order book for dry bulk ships:
This was dated October 2018 (data from Clarksons), and it gives a good indication that there are very few handysize ships on order, actually the lowest in close to a generation. In addition handysize ships are significantly older than the larger class ships. Together with the new IMO emission rules scrapping rates will ultimately be a lot higher. How can it not?
The end result is that we are going to see a lot more scrapping of older vessels and combined with the lack of new builds the global handysize fleet will enter a deficit with a shortage of modern and economical handysize vessels.
The lack of demand for new builds will also be a function of the value of second hand vessels. The gap between a recently built second hand vessel and a new build means that it just doesn’t make sense to buy new ships. There are plenty of high quality second hand Japanese build vessels on the market right now.
From a behavioural perspective, just stand back and think for a minute: the global shipping industry has just witnessed the worst financial crisis in “living memory”. There are very few dry bulk carriers who were NOT forced into bankruptcy or opted for material recapitalizations (basically the same outcome with existing shareholders interests being highly diluted).
This crisis was created by a huge oversupply of shipping capacity and a build up of a mountain of debt. Do you think that current management will be willing or even able to embark on a program of capacity expansion? Even if management were willing to do so the odds are that shareholders would block them (or sack them). Crazy, I know, but that’s how psychology works.
We are only likely to see ship owners embark on expansion when profits have been rising for an extended period of time and the herd feels “safe” to bet on a sustainable uptrend. Time heals the wounded but the wounds and emotional scars from “the great shipping depression” will take a very long time to heal.
We believe it’s a great risk reward probability event right here and we’re readying for an extended period of high freight rates! The looming supply deficit will persist for a very long time.
Pacific Basin Shipping – Valuation
Valuing shipping companies is challenging due to their cyclical nature. Not only are shipping companies earnings cyclical but so too are the valuations of their assets (ships). At the bottom of a cycle (or somewhere near the bottom) most shipping companies will be making losses and with little demand for ships the valuations placed on them will often be substantially below their depreciated (book) value.
So to make money (beat the crowd) one has to anticipate what the crowd is going to anticipate, i.e. front run. This will generally mean that you are buying shipping stocks when P/Es are high (if they are making a profit), dividends are low or non existent, and the P/Book ratio is well below 1x.
Pacific Basin sits on a P/E of 18x, but when you look at its forward P/E, 1, 2, and 3 years out the P/E drops to 10x, 6x, and 5x respectively. It trades at a 30% discount to book value. Its ROE currently is 4% but that will increase to 6%, 10%, and 13% 1, 2, and 3 years out. In terms of dividends, it is a small 1.7% yield now but that moves to 4%, 6%, and 8% over the next three years.
Pacific Basin certainly isn’t expensive. We think it is dirt cheap. But what is perhaps more important, the company has the ability to weather the storm. It has one of the lowest debt/equity ratios in the industry (0.81x). Its debt isn’t due until 2021 and given that it has no issue in meeting its interest obligations (EBIT/interest expense of 5.6x), we don’t think that Pacific Basin will have any issue rolling those debts when they come due. In terms of liquidity, close on 40% of PB’s current market cap is accounted for by cash.
Target Returns, Time Horizon & Conclusion
We think Pacific Basin Shipping is a great way to play Asia’s regional expansion and a recovery in the global shipping market, for those who have the patience.
We don’t know how long PB will trade at current levels, but we are certain that it is just a question of time when (and not if) the next big move will be to the upside.
We believe that this is an “easy” 2-bagger trade from current levels, at least until it gets to $4.50 where it will start attracting attention of institutions, which will ultimately likely push it past $8.
As with all our trade recommendations, we are investing in this trade alert. But we won’t overstay our welcome.
As soon as Pacific Basin starts attracting attention from institutions we will be quietly offloading and finding something else that mainstream institutions wouldn’t dare touch. That is just the way we invest.
Founder & Editor In Chief, Capitalist Exploits Independent Investment Research
Founder & Managing Partner, Asymmetric Opportunities Fund
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