INVESTMENT SUMMARY:
Matson, Inc. (“MATX”) is one of the premiere US ocean transportation carriers in the Pacific. ~75% of MATX’s business consists of a duopoly in the Hawaii trade route, a “temporary” monopoly in the Guam trade route and a very profitable niche Transpacific route from China to California. HI and Guam are both protected and regulated by the Jones Act, which gives them both a natural moat. MATX also owns the 9th largest asset-lite freight brokerage in the US, where it provides rail intermodal, highway brokerage and warehousing. Although MATX was founded in 1882, it only recently began to trade independently. On 12/1/2011, Alexander & Baldwin (A&B) announced it would split into two companies, MATX and A&B, a Hawaii-based land company with interests in real estate development, commercial real estate and agriculture (sugar). The separation was recently completed in 6/29/12. During the transition, MATX also gained a new CFO, who was formerly the CFO at Alexander & Baldwin and a Goldman Sachs banker before that.
Based on where MATX has traded post-separation, it is clear that many investors might have preferred the A&B real-estate asset and, subsequently, liquidated its MATX shares. It is also possible that MATX has simply traded down with other international containership peers due to concerns over supply/demand balance and the global macro environment. However, this seems to be unjustified given that 1) only ~13% of MATX’s Ocean Transportation revenue is exposed to international rates and 2) the Jones Act provides invaluable protection/competitive positioning for MATX that other international containership companies do not possess. Furthermore, while MATX seems to be trading in-line with other Jones Act equities, there are several areas poised to potentially expand top-line and margins: 1) core Hawaii end market volume could be at an inflection point based on current leading economic / construction indicators, 2) MATX’s new monopoly and military expansion in Guam and niche (premium-ization of cargo) China lines provide secular price and volume opportunities, and 3) financial distress of a key Jones Act competitor may open an opportunity in another trade lane (Alaska). At current prices, we believe the risk/reward in MATX is extremely attractive with downside to ~$20 based on a conservative asset/liquidation value (not to mention a ~3% dividend yield) and upside to $30 over the next 12 months. MATX is currently poorly covered by analysts who all underestimate a turn in volumes and a recovery in margins.
Given that Hawaii container and automobile volumes are at their lowest point in a decade and overall corporate margins are depressed, we see two main risks to the investment. If the Jones Act were ever repealed or modified, it would have a devastating impact on the outlook and earnings power for MATX and other publicly traded Jones Act companies. We believe that the chances of this happening are remote, but the risk clearly exists. The other uncertainty surrounding MATX revolves around the potential outcomes relating to the deep financial distress of its chief competitor in HI, Horizon Lines. While not completely apparent on the surface level, MATX needs HL (or a competitor with its same demeanor) in order to maintain the current competitive balance in the trade lane. Again, we think this will likely result in a neutral outcome, but the situation is still opaque.
INVESTMENT THESIS:
Well Positioned for a Recovery in the Real-Estate Market and a Beneficiary of Hawaii's Largest Rail Project Ever: The Hawaii trade route counts for ~75% of MATX’s Ocean Transportation revenue and over 50% of its overall sales. MATX has a 2/3s market share of the shipping volume from the US to Hawaii - it is the state’s lifeline. The other player in the duopoly, Horizon Lines, has been in deep financial distress (as a result of several leveraged buy-outs) but has still acted rationale, which has led to a stable pricing environment. Pricing upside exists, but will continue to be somewhat limited by regulatory authorities and MATX is comfortable with its current share. Thus, revenue growth in this trade route will primarily be driven by overall HI container volumes, which is directly correlated to Hawaiian economic activity.
MATX’s container and automobile volumes are currently at their lowest in over a decade. Similar to other parts of the United States, volumes declined from their 05-07 peak due to the financial crisis, the major earthquake in Japan and the downtrend in real estate and construction activity.
Container volumes are currently down ~30-40K below their recent peaks and ~2/3s of the decrease (20-25K containers) is due to the continued slowdown in construction activity. While construction activity should remain muted over the near term, there are signs that the current downward cycle has troughed. 2011 was the 4th best year for tourism in Hawaii on record (5% off 2007 peak of 7.6mm visitors) and the University of Hawaii Research Organization (UHERO) indicates that 2012E should show over a 9% improvement in visitor arrivals. Despite threatening global economic clouds, the Hawaii tourism sector has continued to post impressive growth, driven by robust income gains in commodity exporting countries, new airline routes from the US and Asia, and success in tapping non-traditional markets. Additionally, unemployment is currently expected to drop to 5.6% by 2013E, and Hawaii real GDP is expected to turn positive to 1.5% in 2012E after being slightly negative in 2011 and is expected to accelerate to 2.3% in 2013E.
Despite those positive economic indicators, construction activity in Hawaii, the key driver of container volumes, has still lagged, but things are projected to turn around in the next few years. Building permits in HI, a key leading indicator, are forecasted to grow by 50% in 2012E after declining by -22% in 2011 (to be fair, a significant portion of that statistic is being driven by energy tax credits and solar panels). Most importantly, management has indicated that one of the best proxies for construction demand is construction payroll jobs. While construction jobs should continue to be sluggish through 2012E at +0.6%, UHERO expects Hawaii’s construction job count to post several years of strong growth as soon as next year (2013E). Forecasts of a construction recovery in HI have been postponed in past, but the current UHERO forecasts are currently given little credit in consensus forecasts or MATX’s valuation.
Finally, after breaking-ground in 2011, HI’s $5.2bn public transportation rail project was contested as the former governor of HI, Ben Cayetano, came out of retirement to run for mayor of Honolulu with the goal of stopping the rail. He ran against former House Majority leader, Kirk Caldwell, and both were running neck and neck in the polls. However, in the end Caldwell won a decisive victory in early Nov. 2012, which bodes well for the rail project. There are still some federal lawsuits and an archaeological study in progress, but there are folks on both sides that believe they only represent a delay. The FTA is expected to be signing a grant agreement for $1.55bn for the project in the next several weeks (http://www.kitv.com/news/hawaii/Feds-ready-to-give-Honolulu-30-percent-of-rail-project-s-cost/-/8905354/17481652/-/gcsr3n/-/index.html). Furthermore, the archaeological study is ahead of schedule and work is expected to now resume earlier than expected in Q213 vs. Q313 (
http://www.kitv.com/news/hawaii/Rail-project-s-archeological-survey-ahead-of-schedule/-/8905354/17338386/-/m46do8z/-/index.html). The rail project would clearly have a positive impact on construction activity over the next several years.
If HI container volumes were able to get back to pre-real estate bubble levels, it could add as much as $20-$35mm of additional EBITDA.
Guam / China Provide Significant Opportunity: MATX has recently been able to almost double volumes in Guam after the other player in the duopoly, Horizon Lines, exited the market in late 2011 due to financial distress. Thus, MATX is now running a monopoly on the Guam trade route. While MATX has communicated to the market that it expects another competitor to emerge, it is taking actions to postpone this as much as possible. We believe the two most obvious candidates to replace HL, Maersk and APL, have both looked at the Guam opportunity and passed due to the small size of the market and the distance from their current operations. With that said, MATX has been very careful about raising rates (it has not done so in Guam yet this year) and providing very timely service in order to make sure that its customers in Guam remain comfortable with the situation. We believe that this year MATX has been eating extra operating costs to demonstrate its ability to serve the entire trade lane.
In addition to the temporary increase in Guam volumes, the entire Guam route is expecting an uptick in volume due to the 2006 agreement that the US would strategically relocate 8K US marines from Okinawa to Guam over 6-10 years. Studies have estimated that the movement of these troops would require a $27bn infrastructure investment in Guam and could increase the 160K population by an additional +59K. Sell-side analysts have been disappointed that the estimated number of troops has been revised downward to ~5K and that the migration process is still delayed. However, MATX management seems to be content with this turn of events given the HL situation. The gradual increase in troops will continue to make splitting the Guam market unattractive to the larger carriers, thus, extending the time that passes before a competitor enters the market.
As for the express line from China to Long Beach (CLX-1), management has stated that they continue to expect full utilization despite any moderate changes in demand (has been full for 5 of last 6 years). MATX’s line is a 10-day express service that is 4-7 days faster than its competitors and, as a result, allows MATX to charge a $200-$500 premium to current shipping rates. MATX’s smaller ships allow it to unload freight within 24 hours and provide more efficient routes, such as being able to go into the shallow-water port in Shanghai that larger vessels can not. MATX’s ships also do not “slow steam” like other larger containerships, which gives them better fuel efficiency, but also makes them slower. MATX believes that its timely express service will allow it to trade up to more premium priced garment shipment fares, as it comes closer to competing with air freight. In the near term, Transpacific rates have been steadily increasing as the larger players have made efforts to push price and manage capacity. MATX’s China route is essentially split 50 / 50 between contract and spot rates. The contracted rates reset annually around May. Thus, if the contracted rates reset near the forecasted Transpacific rate levels, it could add an incremental ~$2-$4mm of EBITDA in FY 2013, given its high incremental margin.
Downside is Somewhat Limited Due to Underlying Asset Value: Using industry benchmarks gathered from consultations with several industry players we believe that the replacement cost of the assets is ~$20 per share. This may be conservative as the cost to build a new Jones Act ship is around $200 million per ship before allowable deductions (as shown below MATX has billion dollar enterprise value with well more than 5 ships, a very attractive JV asset and other assets):
Opportunistic Areas for Expansion/M&A Growth: Adding market share in Hawaii and Guam is always challenging as MATX is extremely conscious of creating a situation that would push the respective governments / customers to push for more competitor(s) or even a repeal/modification of the Jones Act. Thus, the other avenue for growth beyond a recovery and improvement in their current end markets is expansion into new routes and acquisition. For instance, management has told investors that the Alaska route could present an opportunity. Alaska is one of the two of the remaining Jones Act trade routes (the other is Puerto Rico, but they are not interested) and it is currently a duopoly, split 60% / 40% between Totem Ocean Trailer Express and Horizon Lines. Management indirectly stated that the poor financial health of HL could allow MATX to enter the market by purchasing its 3 vessels used in that route. MATX management went as detailed to say it could enter the market using its surplus ships, but this option would be less desirable given the increased risk of disrupting the market.
In terms of acquisition opportunities, most of them would lie on the Logistics side of the business. M&A has already been a growth component of its Logistics business as MATX made three acquisitions from 2003-08. Management says it continues to look for small acquisitions (may look to grow its warehousing business). In Ocean Transportation, MATX may also look for acquisition to bolster its international freight forwarding businesses in China.
Margin Expansion Opportunity: Just as MATX’s overall Ocean Transportation volumes are close to a trough, so are its operating margins. While MATX’s most recent segment operating margins are in the ~7-9% range, management believes that it can achieve a 10-12% operating margin in the long-term. Based on MATX’s historical performance, this target not only seems reasonable, but it could still be underestimating MATX’s earnings power. MATX’s operating margins in the Ocean Transportation segment were in-line or even slightly above this range from 2003-2008 and even towards the top of the range in 2010 (a relatively higher equity in earnings from SSAT JV helped somewhat). Despite higher volumes in all three major trade lines (double in Guam) and higher rates in all three trade lanes, sell-side analysts and, to a lesser extent, we are estimating lower margins in our estimates compared to a much less robust 2010 (even if you remove the positive impact of SSAT in 2010).
Similarly, the Logistics segment’s operating margins are at a 10 year low (1-2%) due to the recent loss of a major ocean carrier customer on the Intermodal side and the loss of a full truckload carrier on the Highway side of the business. Management believes it can improve to a long-term Logistics margin of 2-4%. Improving to the mid-point of the Logistics targeted range is worth $5-$10mm of additional EBITDA. While the Logistics margins need to be diligence for any structural deterioration in the business, MATX offers an entry point at trough profitability for both segments.
Even if normalized margins do fall within management’s long-term targets, one can see how much 2013E consensus top-line and margin estimates are still below a Hypothetical Case that assumes 12% Ocean Transportation margins and 3% Logistics margins. A blended Hypothetical Case operating margin is ~9.5%, while 2013E EBIT Margin consensus is currently ~7%.
Structurally Protected from Regulatory and Business Barriers to Entry: The Jones Act allows MATX to operate in its duopoly in Hawaii and its monopoly in Guam. Furthermore, these trade lanes have been historically shared with rationale competitors who have avoided spoiling a market in search of more share. Thus, the current trough in volumes and their resulting low operating margins are simply a point in the cycle. This regulatory barrier to entry allows one to wait for the upturn with less risk of a loss in competitive position in the meantime. Looking into the future, when the cycle gets to a peak, it also reduces the chances of competitors coming in to flood a market.
INVESTMENT RISKS:
If the Jones Act Were Ever to Be Repealed or Meaningful Modified, MATX Would be in Serious Trouble..: There is no secret that MATX’s business model heavily depends on the Jones Act remaining in its current form. I would argue that all of MATX’s revenue is directly or indirectly influenced by the Jones Act. The HI route requires ships to be US-owned, US-crewed, US-built and US-flagged, whereas the Guam route requires them to be US-flagged and US-crewed, but not US-built. While the China line does not technically benefit from the Jones Act, its economic viability is made possible since it acts as an extension of the HI and Guam routes, which spreads its costs to the latter two. While it would be very difficult to repeal the Jones Act due to its function in maintaining economic and wartime interests to the US, there is no shortage of its critics. They argue that the Jones Act is simple protectionism that also results in far higher shipping costs of moving cargo between US ports. On June 25, 2010, Senators John McCain and Jim Risch introduced the Open America's Waters Act, a bill to repeal the Jones Act. Sen. McCain said the Jones Act restricts shipping and raises costs to consumers in Hawaii, Alaska, Puerto Rico and Guam, but the bill died. HI’s Senator, Dan Inouye is a big supporter of the Jones Act, but there is some speculation as to what may happen after he leaves his position (Age: 88).
Planned Ship Additions Over the Next Five Years is a Large Burden on True FCF: The management team has told its investors that it plans on purchasing 2 more containerships for $200mm each over the next 5 years. Management has also stated that it would continue to make similar investments every 5 years in order to manage the average age of their fleet, which is in-line with its historical purchasing patterns over the previous decade (MATX purchased 4 containerships between 2003-06). Furthermore, even if you bullishly assume that the next 2 ships MATX acquires will simply be to increase their fleet size to 11 vs. 9 ships in order to meet increased volume demand (and not to replace current ships), MATX would still need to purchase and simultaneously retire a containership every ~2.5 years in order to maintain the current average age of its fleet (analysis does not include the 3 barges in operation). That being said, it is clear that the purchases are not absolutely necessary during the timeframe given. By comparison, HL’s average fleet age is ~35 years compared to MATX’s 19 years, so MATX is clearly taking these actions to provide capacity flexibility and to avoid a similar situation that HL is in right now. If MATX were hypothetically put into a capitally constrained position for a period of time, it seems like these investments could be postponed.
A cost of $200mm/ship every 2.5 years averages out to ~$80mm of replacement CapEx / year in addition to management’s long-term maintenance CapEx of $40-$50mm / year. In a hypothetical “normalized” environment where volumes are at average historical levels and margins are within management’s long-term margin guidance (Ocean Transportation: 10-12%, Logistics: 2-4%), operating cash flow is projected to be ~$160mm/year. Calculating FCF / share with only maintenance CapEx results in a strong $2.67/share and including expansion CapEx, reduces the amount to $1.53/share (assumes tax break from CCF). Furthermore, as a Jones Act company MATX has the ability to contribute earnings before taxes to a Capital Construction Fund. If these funds are withdrawn for investment in vessels and certain related equipment, they do not give rise to a tax liability, but reduce the depreciable bases of the assets for income tax purposes. If one assumes a 38.5% corporate tax rate and that a vessel is purchased with funds from the CCF, the upfront cost is only $123mm ($200mm x (1-38.5% tax-rate)), or $49mm a year, but its important to note that MATX would have a relatively smaller depreciable base for tax purposes in the future.
M&A Risk Exists in Both Ocean Transportation and Logistics: While there is always the chance MATX could partake in some type of meaningful M&A transaction on the Ocean Transportation side, the options seem limited to bolt-on acquisitions given the opportunities available. The bigger threat is the expansion of its Logistics segment given the very fragmented nature of the industry. MATX is the 9th largest US brokerage, so there are clearly acquisition opportunities to expand. Given the current relative contributions of the two businesses, it is intuitive that the investor base would be displeased with any transformational acquisitions on the Logistics side of the business. To be fair though, management has not given any indication so far that they would be looking to make any substantial acquisitions post-separation.
MATX’s Operating Leverage in its China Trade Lane Offers Some Volatility Due to Transpacific Rates: While the China line business is not a large top-line contributor (~12% of Ocean Transportation revenue), it does have a meaningful impact on earnings due to its high operating leverage (~90%) as it essentially acts as an add-on to the already existing HI and Guam lines (picks up goods from China for the otherwise empty ride back to the west coast). At this point, management is confident that the China line can remain at close to 100% utilization due to its small, niche position in the market. As a result, pricing will drive revenues in the medium-tern. While its express service is priced at a $200-$500/container premium to other competitors, MATX’s China line is still dependent on the Transpacific market rate. MATX is in the process of attempting to secularly increase its rates by attracting more premium cargo away from the airline freight carriers, but, in the grande scheme of things, MATX is a price taker and subject to the greater market dynamics and the large carriers operating in the Pacific. Recently, Transpacific rates have been improving but they depend on a continued rational carrier management of industry capacity. Based on history, there is no guarantee that this will continue.
VARIANT VIEW:
MATX is Subject to the Market Carrier Rates in the Pacific: It is clear that over the last several months, MATX share price has declined along with other international containership carriers over concerns of a global slowdown. However, MATX should be evaluated differently than the others as its end markets are narrower and its Jones Act status creates a much more favorable competitive environment. As MATX is clearly correlated to the HI / Guam economy, its share price should not be as closely linked to concerns over the global macro economy or international shipping spot rates. Almost 90% of the sales in its Ocean Transportation segment come from Jones Act trade lanes where it operates as either a monopoly (Guam) or duopoly (Hawaii). In those two trade lanes, its rates have proven to be consistently steady over time. Furthermore, while its China line is subject to changes in the Transpacific rate, the line’s demand relies on US demand for goods manufactured in China and generally operates at close to full utilization, so the cyclical swings would not be as dramatic compared to bigger Transpacific containership companies.
Hawaii Container Volumes Will Be Muted in the “Near Term”: The consensus view is that a construction rebound will fail to occur in 2013 and Hawaii container volumes will be essentially flat, as MATX 2013E consensus revenue growth is only 2%. However, based on a number of independent 3rd party economic forecasts, there is a solid chance that a construction turnaround in HI could begin in 2013/14 for the reasons listed above, including the positive recent developments relating to the $5.2bn rail project in HI. Given where consensus is, any of the leading indicators playing out in 2013/14 would result in upside to the shares.
CapEx Ear-Marked for New Ships are for Replacement Purposes: It seems like most, if not all, sell-side analysts are combing over the public announcement from MATX that it will purchase 2 new vessels over the next 5 years. Analysts are essentially chalking these capital expenditures up as maintenance, and that MATX will not earn a “return” on these investments. However, given managements comments that they believe MATX’s volumes are currently at trough levels and the relatively manageable age of their fleet (compared to HL), I believe they are giving themselves the optionality of putting these new vessels into their active fleet. MATX currently operates 9 active ships in their fleet, but, if one recalls, MATX historically operated with 11 vessels. In addition to the added volume from Guam (new monopoly and potential for military troops) and Hawaii (increase in container volumes), there could be some other opportunities. It is possible that MATX could be positioning themselves to take on HL’s Alaska trade route (if they leave it) and there are some that believe a potential end game in Hawaii is HL or a their successor operating with less market share. Even if these upside scenarios that require the 2 vessels do not materialize, I do not believe these cases are built into MATX’s shares, limiting any downside.
MATX’s Margin Targets Will Take A Long Time To Achieve: Many analysts believe that MATX’s stated margin goals are optimistic as evidenced by the fact that consensus margin estimates don’t seem to move at all from 2012E to 2013E. However, we believe that sell-side analysts are under-estimating the inherent incremental margins that will result from higher volumes.
VALUATION:
We have a Target Price for MATX of $30.00 over the next twelve months which equates to 8x our 2013E EBITDA estimate. One can get to much higher long term prices ($34 - $40/share) based on using a “normalized” set of financial statements or assuming a sum of the parts methodology ascribing an appropriate multiple for the logistics business and the terminal JV at normalized levels.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.