Description
Main Points (please note that Price and Market Cap are in Euros)
· Royal Nedlloyd’s P&O Nedlloyd operates the world’s third largest container shipping company.
· NYLN shares are trading at a 10% discount to book value, at 3.2x and 2.6x 2004 earnings and free cash flow, respectively. Current yield is 3.35%.
· World container shipping has grown, and continues to grow, at rates in excess of world trade growth, as the logistical advantages of containerized transportation lead to a gain in market share.
· Containerized shipping is, and will continue to be, a direct beneficiary of China and India’s increasing market share in global manufacturing.
· Container shipping shares will benefit as investors who do not traditionally invest shipping stocks will look to the shares as a way to directly participate in the India and China themes, without having to take-on the risks of direct investments in those emerging markets.
· NLYN is looking to divest itself of its 50% holding in Martinair (cargo and passenger airline), which could yield Eur4 per NLYN share and would be distributed to shareholders.
Description
Royal Nedlloyd (Bloomberg symbol: NLYN NA) is a holding company that owns a 50% interest in container shipping company P&O Nedlloyd (partner is P&O) and a 50% interest in Dutch cargo and passenger airline Martinair (partner is KLM; given that Martinair represents only 18% of NLYN’s book value, and a fraction of that in terms of earnings contribution, I’ll focus the discussion on the container shipping business). P&O Nedlloyd (PONL) is the third largest container ship operator in the world behind Maersk-Sealand and MSC. PONL is currently reaping the benefits of both a) a strong (and strengthening) container shipping market, and b) an operational turnaround resulting from a major cost cutting program initiated in 2001. As a result, 2004 EPS are expected to jump to Eur9.20 from breakeven in 2003. Consequently, NLYN’s should generate free cash flow per share of Eur11.27, and book value should jump to Eur41 by year-end 2004.
The Container Shipping Market
After two weak years (due to the combination of the world economic slowdown and excess capacity) the container shipping market turned around in 2003 as demand outstripped supply. In the first half of 2003, US West Coast ports handled a 20% increase in container volumes over the prior year. Far East to Europe traffic increased 25% in the same period.
Historically, long-term demand growth for container shipping has been 7-9%. A rule of thumb used by shipping economists asserts that container demand grows approximately 2.5x to 3x global GDP growth. Demand growth has been particularly strong in 2002 and 2003 thanks to the growth in the Asian market, driven primarily by China. Continued strength in China would likely result in demand growth being at the upper end of historical ranges over the next several years. Importantly, a growing Chinese economy not only implies more containers leaving China for export markets, but also results in an increased level of imports from other Asian economies to China. Indeed the fastest growing segment of the container market has been the inter-Asian trade.
As 350 million Chinese will be “urbanized” over the next decade, one of China’s great challenges will be to find ways to employ this population. Given the current wage differential with developed western economies, it is clear that China (and western capital) will focus on stimulating domestic manufacturing in China (India will also benefit from the same trend). As this process unfolds, an increasing portion of the worlds manufactured goods will be transported, via containers, to end markets.
These trends, combined with the current rebound in economic activity in the rest of the world form a solid underpinning for container shipping demand growth over the next several years.
The all-important ‘left-hand side of the equation’ in shipping economics/profitability is supply. As ships are relatively inexpensive to build and easily financed, historically, there have been low barriers to entry and shipping companies were often rather small in size (no economies of scale) and leveraged. Whenever business got strong, excessive vessel newbuild orders would wipe out any excess returns the industry could temporarily generate. Often, and similarly to other cyclical industries, the lag time between newbuild orders and their delivery, would result in the new capacity coming online just when the cycle turned negative, and thereby crushing profitability.
Although one should always be careful not to say, “this time will be different”, there are a number of factors that, if nothing else, will mitigate the strong natural tendencies for this industry to shoot itself in the foot. I will list a few:
· China and India’s secular growth.
· The world’s shipyards are full. Today, shipyards are taking orders for vessels to be delivered late in the second half of 2006. This is due to the fact that all sectors of shipping (oil tankers, dry-bulk carriers, LNG vessels, refined product carriers) are experiencing strong markets, and are scrambling to increase capacity to meet demand.
· Consolidation within the industry is leading to an increased level of competitor rationality.
· Several Asian industry participants, having barely survived the Asia crisis of the late nineties, and the weak container markets of 2001 and 2002, are focused on de-levering, rather than growing their balance sheets.
These factors result in a tight supply/demand balance for the next several years:
Container Shipping Demand/Supply Growth*
Demand Growth Supply Growth
2003 9.6% 7.0%
2004 8.7% 6.5%
2005 7-9%** 6.7%
2006 NA 4.2%
*According to Clarksons and Fearnleys
** Historical range
As a result of this tight balance, container-shipping rates have been rising, and are expected to continue to rise in both 2004 and 2005. In the first half of 2003, average rates have increased by between 10 and 20% on different routes.
Given that the container market is still relatively fragmented, most companies have joined “alliances” which allow them to, a) offer a more extensive route menu to their client base (better service), b) gain better information on client needs and plans (informational advantage compared to the perfectly competitive alternative), and c) gain pricing power. This latter point is important, because it significantly reduces the number of players competing on price, and provides a vehicle for collusion.
Container Cos. mTEU Mkt Share Cumulative
Maersk Sealand 773 12% 12%
MSC 482 7% 19%
P&O Nedlloyd 407 6% 26%
Evergreen 344 5% 31%
Hanjin 286 4% 36%
APL 269 4% 40%
COSCO 256 4% 44%
CMA CGM 205 3% 47%
CP Ships 200 3% 50%
NYK 195 3% 53%
K-Line 189 3% 56%
OOCL 182 3% 59%
MOL 170 3% 61%
CSCL 169 3% 64%
Hapag Lloyd 155 2% 66%
Yang Ming 147 2% 69%
HMM 132 2% 71%
Zim Israel 132 2% 73%
Wan Hai 90 1% 74%
PIL 79 1% 75%
Top 20 4,861 75%
Total Market 6,442
Alliances mTEU Mkt Share
Grand 939 15%
Cosco/K-line/YM 879 14%
Maersk 773 12%
New World 570 9%
United 380 6%
Evergreen 344 5%
60%
Additionally, in the container market, shipping companies generally negotiate longer-term (1 year) contracts with their larger clients. Contracts are generally renegotiated either in May or October. For large container shipping companies, these contracts represent over 50% of annual volumes. This is the case for PONL.
This market structure leads to two important results for investors. First, near term (one-to-two year) visibility of sales and profitability, as the different alliances “signal” to the marketplace what they expect to charge in the next round of yearly contract renegotiations. Second, the swings in profitability, as rates move up and then down in a cycle, are smoothed out thanks to the longer-term contracts. (This is very different from the oil tanker market, for example, where most voyages are negotiated on a spot basis, and therefore there is no way of knowing what next weeks’ or months’ rates will be, let alone next year’s.)
On this note, a number of rate increases have already been agreed to, or signaled for, next year. Here are a few of the more notable announcements:
· Rates were increased, effective September 2003 between Japan and the Middle East ($150/TEU) and India ($150/TEU). Obviously these rate increases were not captured in Q3 2003 numbers.
· In October 2003, the rate for routes between Europe and S. America were raised by $300. Similarly, this will only begin to show up in Q4 2003 performance.
· The Transpacific Stabilization Agreement (an association of 14 global carriers) agreed to a guideline rate increase of 20% for all shipments from the West Coast to Asia for 2004-5 contracting period, beginning in May 2004.
Given the nature and timing of contract negotiations, the announced rate increases for the 2004 renegotiation periods imply that 2005 rates will, on average be higher than in 2004.
P&O Nedlloyd (PONL)
PONL is part of the Grand Alliance, which controls approximately 15% of the container market capacity. Importantly, PONL has significant (45%) exposure Asia.
PONL Trades Volume%
Europe-Far East 32%
Pacific 13%
Atlantic 13%
North-South Cross 42%
The significant exposure to the Asia-Europe route, is a positive for PONL if the US $ continues to weaken relative to the Euro. Other things being equal, a strengthening Euro will cause Asia-to-Europe exports to grow relatively to Asian exports to the US.
The momentum of the container shipping markets, and the earnings power of PONL’s assets were demonstrated in Q3, as NLYN’s earnings jumped to Eur0.98 per share vs. a loss of Eur0.23 in Q2. As mentioned, NLYN’s Q3 numbers did not reflect the September/October rate increases. These will begin to show up in Q4, as voyages begun under the old rates are completed and new cargoes are picked up at the new rates.
This alone proves that the 2004 analyst consensus estimate of Eur2.46 is ridiculous. Simply annualizing the Q3 number, before rate increase, would yield an EPS estimate of Eur3.92. If one assumes that the average 2004 rate will be 7.5% greater than Q3 2003 (ie. $1,447/TEU vs $1,346/TEU), then the leverage resulting from PONL’s transportation of 940,000 TEU per quarter will show how quickly NLYN’s earnings can rise:
940k TEU * $101 = $94.9million
NLYN’s share = $47.5 million
Eur 38.3million (at Eur/$ 1.24)
= an additional Eur1.80 per share, per quarter on a pre-tax basis
Given the fixed cost nature of PONL, one can therefore quite easily see NLYN earn over Eur10 per share in 2004.
On the cost side for 2004, taking into account the combination of a) the increase in certain variable costs such as vessel time chartering costs and potentially higher bunker (fuel) costs, and b) further cost reductions resulting from PONL’s ongoing cost cutting program (new internal cargo systems, moving of 2,000 back-office staff to shared service centers in India an China, etc.) should result in overall costs being flat over 2003.
Given these assumptions, an EPS estimate of Eur9.20 for 2004 seems achievable.
Valuation
Based on EPS Eur9.20 for 2004, NLYN is trading at 3.2x earnings. Given depreciation of approximately Eur110 million, expected working capital increase of Eur46 million and maintenance capital expenditure of Eur20 million, 2004 free cash flow per share should be Eur11.27. Therefore NLYN is trading at 2.6x free cash flow.
If this were a leveraged oil tanker company, trading its vessels on the spot market and with absolutely no visibility into next years earnings, not to mention 2005, then 2.6x FCF would still be considered remarkably cheap. But this is not a tanker company, and as discussed above, approximately 50% of NLYN’s business is fixed on a 1-year basis, with price increases already being announced for the next round of price negotiations in May and October 2004. Additionally, given the supply/demand balance, and the fact that no additional new vessels can be delivered before the second half of 2006, it is likely that 2005 earnings and cash flows will be at least as strong as 2004’s
NLYN’s 2003 year-end book value (on a pro-forma basis, that is, consolidating its holdings of PONL and Martinair) is Eur32.75 per share, and, after paying out a Eur1 dividend for 2003, should grow to Eur41 per share by year-end 2004. Net debt to cap is only 26% percent for NLYN on such a consolidated basis. By year-end 2005, NLYN will have generated sufficient cash to fund its newbuilding program and pay down all its debt. Even if NLYN shares were to maintain their current discount to book value, an investor in the shares would gain 25% over the next twelve months and pocket a 3.35% dividend to boot.
Additionally, management is working on, and expects to close a sale of its Martinair stake within the next twelve months. Management has even indicated that they expect to receive Eur100mln (Eur4.69 per share). This price would equate to approximately 4x sales, 2.5x Ebitda, and Martinair represents only approximately 5% of 2004 EPS.
If the market does not re-rate NLYN shares, then clearly NLYN is a prime take-over candidate. P&O (NLYN’s partner in PONL) has already indicated that they are looking to sell their stake. Indeed, a large part of the balance sheet clean-up and cost cutting measures can be viewed as a precursor to an eventual sale. The Dutch press has already speculated that CP Ships (NYSE: TEU; mkt cap $1.8bln) would be an interested buyer. PONL’s exposure to Asia and Europe would clearly be attractive to any player looking to add exposure to Asia, and NLYN is relatively small compared to the larger conglomerates included in the Top 20 container shipping companies listed above. NLYN would be a willing seller, but not below book.
Catalyst
Catalysts
· Positive analyst earnings estimate revisions. Current consensus for 2004 is Eur2.46. Simply annualizing Q3 2003 would already yield Eur3.92, and this would not include the rate increases that went into effect in the fall, nor does it account for additional rate increases announced for 2004.
· 2004 earnings and cash flow will add nearly Eur10 to book value by 2004
· Potential sale of part (or all) of P&O Nedlloyd
· Imminent sale of Martinair could generate EUR4 per share in cash, which will be distributed to shareholders.