Description

Overview 

Hapag-Lloyd (HLAG GY) is a leading global liner shipping company with ~250 ships and 12 million TEUs capacity. Pre-COVID, this was a highly competitive, MSD ROIC business; HLAG’s ambitious long term financial target is to earn ROIC>WACC. 

Of course everything has changed since March 2020. Spot freight rates were up 10x at the late 2021 peak as constrained supply could not keep up with surging demand for goods. HLAG’s ROIC has surged to >100% and the business is gushing cash; HLAG is now sitting on $6.9B in net cash vs. LT target of <3x leverage. 

HLAG reported a beat-and-raise 1Q22 on sequential growth to record levels, shares are up ~7x from pre-crisis and have been making all-time highs. However, leading indicators suggest the cycle has already peaked, mid-term supply/demand dynamics look bad, and HLAG trades at a huge premium to peers or cyclically-adjusted long term multiples. 

Industry Supply Set to Expand

The pandemic drove a well-documented logistics crisis, driven by a lack of available workforce, shortages of various parts and supplies, and a massive shift in demand from services to goods that accelerated in 2021 with fiscal stimulus. Congestion in ports particularly impacted sea freight rates and capacity. 

Focusing on supply side first, the marine freight capacity shortage could unwind over coming quarters from a combination of (1) new supply of ships entering the market, and (2) release of effective capacity currently restrained by port congestion and bottlenecks.

On (1), shipbuilding orders have surged to levels not reached since the Great Recession, with the current order book equal to 25% of the world fleet base. 

On (2), according to Drewry (via ZIM), real effective capacity was 17% below potential in 2021 and could remain ~15% below in 2022. Clearly the release of effective capacity is very difficult to predict and will depend on COVID restrictions etc. especially in China. But there are positive signs on the West Coast US ports and the eventual release of this excess capacity will be the equivalent to ~2 above-average years of new shipping capacity additions. 

Demand Normalizing…or Worse

The unwinding of the pandemic-era shift in demand from services to goods is already starting to affect freight volumes. HLAG reported flat volumes Y/Y in 1Q22 with declines in the Transpacific and Atlantic corridors. This followed (8%) volume decline in 4Q21.  Market leader Maersk reported a 7% decline last quarter. 

While volumes have been affected by congestion and capacity constraints, this does not fully explain the recent trends. Global trade contracted 3% Y/Y in March and 5.6% in the EU. US imports of goods declined by $4.5B in April. 

Likewise the recent jump in US retailer inventories (ex-auto) and disastrous 1Q earnings reports suggest that retailers speculated on demand and over-ordered in recent quarters, which could further dent shipment volumes in the rest of 2022. 

Although it is difficult to handicap the impact of China’s zero COVID policy, in the near term it is reducing shipment volumes further and could help relieve congestion in the West. There is risk of another bottleneck in Asia limiting throughput, but the current environment seems much less conducive to another massive supply squeeze given the combination of weakening underlying demand and new vessel supply starting to come on line in the coming quarters. Of course, the potential for a full-blown global recession in 2022 poses materially greater risk to trade volumes and rates. 

Summary: Supply/Demand Outlook

The following chart from HLAG provides an optimistic view of the supply/demand balance in 2022-2023. Demand is shown to grow at +3% in 2022. This is despite HLAG revising down its internal company volume guidance to flat Y/Y in 2022, and a rapidly deteriorating goods trade environment. Meanwhile supply growth is expected to reach +8% in 2023, but as discussed, if effective capacity returns to potential due to easing bottlenecks this could be much higher… even 15% or 20%? 

Just as the pandemic created an unprecedented supply shortage, the reverse could take hold as it unwinds. The response to excess capacity would be plunging rates, blank sailings, and idled and scrapped fleets. From a longer term perspective, the prior cycle saw a multiyear period of persistent overcapacity depressed rates as supply outstripped demand, leading to record-low freight rates beginning in 2015 that were not recovered until the pandemic and a steady stream of large carrier bankruptcies or near-bankruptcies (e.g. Hanjin, HMM). The industry has consolidated and HLAG is flush with cash and not a bankruptcy risk, but in the end it is still largely a cylical, commodity business. 

Rates & Earnings Outlook

Marine freight spot rates have fallen 30%+ from the highs, as measured by the WCI composite. But they remain c. +20% Y/Y and, combined with the phasing effect of longer term contracted rates, this has allowed HLAG to continue to report rising average rates. Likewise it produced an earnings beat in 1Q22 and raised guidance, with 2Q22 likely to show continued strength. 

However, this looks to be mostly the timing effect of contracted rates at the peak of a cycle. HLAG’s realized rates should follow spot rates with a lag. 

Container spot rates remain extremely elevated but have rolled over. Meanwhile, there has been no real let-up in fuel and other cost inflation, not least of all vessel charter rates (which are locked in for multiple years and will be slower to adjust on the downside). Over half of HLAG’s fleet is chartered and amortization of right-to-use assets nearly doubled Y/Y in 1Q22. This does not matter at current freight rates, but could within a few quarters. 

Valuation

HLAG has outperformed its peers since the start of 2021, in some cases dramatically. 

This may reflect the small free float (only 4% of shares) but it trades ~EUR 14 MM/day and borrow is available. 

HLAG currently trades at  <5x EV/EBITDA at the midpoint of its raised 2022 guidance and <7x consensus P/E (6x net of cash). This represents a 100-200%+ premium to peers. 

Pre-crisis, HLAG traded closer to ~7-7.5x EBITDA on average.  At 2023 consensus numbers, the current multiple balloons to 11x EBITDA and ~15x P/E. Current consensus calls for a “soft landing” step-down in EBITDA to EUR 6.5B in 2023 from raised 2022 guidance of EUR 13.6-15.5B. 

While HLAG will continue to massively over-earn in the short term, given the discussed supply/demand dynamics I suspect 2023-24 numbers could start to look more like 2020, with downside risk. On 2020 earnings the multiple would expand to 26x EBITDA or ~70x earnings, and on the pre-crisis (2019) base it reaches >35x EBITDA or >200x P/E.

Catalyst

-Continued decline in freight rates and flow-through to contracted rates

-Volume pressures

-Medium term supply release from bottlenecks easing and and new shipbuilding

-Potential global recession / contraction in goods trade