Description
Introduction
I am recommending China Cosco as a short with 50%+ upside. The company currently trades at 2x+ 2009 book value even though it is loss-making (losing more than 1.7bn USD in 4Q08 and 400mm in 1Q09 - this relative to a current book value of 7.3bn USD) and will continue to generate losses (or, at best, sub-optimal ROEs) for years to come. The company's current valuation is also significantly in excess of the replacement cost of its fleet based on recent second-hand transacted ship prices.
Description
China Cosco is the largest operator of bulk ships in the world, with 212 owned vessels and 221 chartered vessels, giving it a total dry bulk capacity of 34mm deadweight tons (DWT). It has the greatest exposure to Capesize and Panamax carriers, which transport iron-ore and coal (versus the smaller Handymax and Handysize carriers, which transport soft commodities such as grain, a more stable source of demand). Apart from its bulk shipping operations, China Cosco is also the sixth largest container operator globally with 140 vessels. Additionally, the company has 51% stake in Cosco Pacific, a publicly-listed port operator and provider of container leasing services.
China Cosco's dry bulk operations have historically accounted for ~90% of its earnings. Hence, for the purposes of this write-up, I will focus on the dry bulk operations. I would be happy to address any of the other business segments in the discussion thread.
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75% of China Cosco's owned and chartered dry bulk fleet operate on spot rates and the remaining are on 3-5 year long-term contracts. 2007 was a truly extraordinary year for the fleet, as spot rates (as represented by the Baltic Dry Index, or BDI) skyrocketed to as high as 11,000. Some context is necessary here - if you pull up the BDI on Bloomberg and look at the 20-year chart, 2007 sticks out even more dramatically than 1999 does on a long-term chart of the NASDAQ. The BDI is an index that, since 1989, has had an average value of 2,300. It has fallen as low as 700. Compared to a commodity such as oil, supply is not nearly as constrained and demand can be relatively fleeting. 11,000 is many, many standard deviations above the trend-line.
It is no surprise then that, at 11,000, the operating leverage in the bulk-shipping business model caused China Cosco to literally mint money. Net margins in 2007 were greater than 17%, and return on equity was up near 50%... Amid the euphoria, however, the company leased vessels from other ship-owners at very aggressive rates (5,000-6,000), expecting that the BDI would stay above that level for quite some time to come. The company locked itself into paying these super-normal rates for anywhere between 3 to 10 years. Of course, with the onset of the economic crisis in 2008, the BDI nosedived to below 2,000; it has since recovered to 3,500, but is still far below the charter rates that management entered into.
The BDI breakeven point for China Cosco's owned fleet is 1,300, versus 5,000 for its chartered fleet (remember, the company has 221 chartered vessels to 212 owned). The blended break-even BDI for the company is around 3,200 versus average BDI of 2,160 for 2009 year-to-date. Current spot BDI is 3,500 due to strong iron-ore imports into China ahead of the iron-ore negotiations - but rates are unlikely to be sustained at these high levels for the remainder of the year, and, more importantly, for the next few years, as massive new supply of bulk ships gets delivered (more on this below).
Investment Thesis
The short thesis is simple. China Cosco is operating at both a cash and accounting loss, and will continue to do so over the next few years if BDI stays at current levels. It is likely, moreover, that BDI falls to an even lower level due to impending massive new supply. Consider this fact: the new supply being added in 2009 and 2010 is equal to 76.2mm DWT - 33% of the existing world fleet. Said differently, China Cosco (as noted above) is currently the largest bulk shipper in the world with capacity of 34mm DWT. There is enough supply coming online this year and next to create more than two additional companies the size of the number one player, all while demand has fallen off significantly. A commoditized business like this in the throes of a depressed earnings cycle should not trade at 2x book.
China Cosco's cash burn has already turned its healthy net cash position in 2008 to a net debt position in 1Q09. Its net debt/equity ratio is expected to continue to increase to 90% of equity by 2010 through a combination of operating cash burn, capex commitments for new vessels, and operating lease commitments that management has entered into.
I believe China Cosco is only worth 4 HKD per share based on 1.1x 2010 book value. This is also quite close to my 3.70 HKD valuation of China Cosco's fleet based on second-hand ship prices (see below). Further, it is important to note that I have been generous in my asset valuation in that I did not include 12bn USD of off-balance-sheet lease liabilities.
Simple Economics of Cosco's Fleet
(Based on BDI of 2,300, all figures USD)
For its owned fleet...
Blended revenue per day = $16,400
Cash cost per day = $9,200
Cash operating profit per day = $7,200
For its chartered fleet...
Blended revenue per day = $16,400
Cash cost per day = $40,000 (due to long-term charters entered into in 2007/early 2008 when BDI was much higher)
Cash operating loss per day = $23,600 (loss)
The owned/chartered ratio by tonnage is 42/48 so you can see that the company is generating a cash loss at these rates. I have a model that breaks this down into further granularity but cannot post it to VIC; I would be happy to post it online to a file-sharing site for interested members.
Alternative Valuation - Asset Value of China Cosco
Value of owned bulk fleet = $5.7bn USD (based on second-hand transacted prices)
Value of container fleet = $1.5bn USD (based on second-hand transacted prices)
Value of new-builds = $2.9bn USD (based on second-hand prices)
Total value of fleet (USD) = $10.1bn
Total value of fleet (HKD) = 78bn
Less net debt = (HKD 2.4bn)
Less capex commitments = (HKD 34bn)
Less minority interests = (HKD 14bn)
Subtotal (HKD) = 27.6bn
Add 51% stake in Cosco Pacific = HKD 10bn (based on 51% of current market cap)
Total = HKD 37.6bn (or ~HKD 3.7 per share)
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Either an asset-based replacement-cost valuation or a simple 1x 2010 book value yields a fair value of below HKD 4.0 per share versus a current share price of HKD 9.15 per share.
Catalyst
- Flood of new supply leading to drop in BDI.
- Continued operating losses/mediocre ROEs at best.