Thesis

Based in Changshu, Xinghua Port is China’s most specialized port for the import of pulp. The company is led by a Singaporean family with a strong track record of value creation and was spun off on the Hong Kong stock exchange in February 2018. As a result of a fatal port accident shortly following the spinoff, along with low liquidity and indiscriminate selling by overseas shareholders, Xinghua is selling for a 15% normalized FCF yield (excluding any growth) despite being led by a strong and aligned management team that is growing the business over the long-run. Xinghua was also written up by VI4Life, who presented a wonderful summary of the business.

History and management

On February 2018, Xinghua Port Holdings spun off on the Hong Kong Stock Exchange after being de-listed from Singaporean parent company Pan-United Corporation - a company historically composed of three divisions: 1) shipbuilding and repair in Singapore, 2) concrete in Singapore, and 3) ports in China.

Pan-United was founded in 1958 by Ng Kar Cheong, who was born in China’s Fujian province in 1934. Following Japan’s invasion of China, Kar Cheong’s family fled to Singapore, and Kar Cheong was enrolled in school. Shortly thereafter, the Japanese invaded Singapore and Kar Cheong was pulled from school because the family could not afford to pay the school tuition. In order to earn income for his family, Kar Cheong resorted to selling fried fritters (youtiao) on the street. He was quite successful and his boss rewarded him by offering supplemental income if Kar Cheong would fry the fritters at night. After the war ended, Kar Cheong’s grandmother left China and re-joined the family in Singapore. She urged Kar Cheong to find a better job and taking her advice, he eventually took a job at a hardware store. After accumulating some savings, Kar Cheong purchased a truck in 1957 and became a truck driver.

Kar Cheong’s grandmother insisted that he re-enter the business world and loaned him some money, which he used to found a hardware company called Hiap Soon & Company along with some friends. Business boomed following Singapore’s independence in 1965, and aided by his son Henry, Kar Cheong decided to expand into shipping as he felt that Singapore was a strategic location for shipbuilding and repair.

In 2004, the family spun off the marine business in order to highlight its value. The company was subsequently acquired by Dubai Drydocks World in 2007, yielding a 650% return in 3 years for shareholders from the date of the spinoff and nearly 950% for those shareholders astute enough to purchase shares a few months later following the indiscriminate selling that is typical of most spinoffs.

In the 1990s, the company founded United Cement, which became Singapore’s largest supplier of cement (29% share) and ready-mixed concrete (33% share). Today this remains the core business of Pan-United in Singapore following the spin-off of Xinghua.

In the early 1990s, the Economic Development Board of Singapore introduced Kar Cheong to a project located in Changshu city, in China’s Jiangsu Province. The government was seeking foreign investors to build a coal terminal in place of the cotton field adjacent to the southern bank of the Yangtze River in Changshu. Given his background in shipbuilding, it took Kar Cheong only 30 minutes to realize that the 13-meter water depth, the 6km river width, and proximity to cities such as Shanghai, Nantong, and other coastal cities in the Yangtze River Delta would make Changshu a very attractive port. He was not interested in simply building a coal terminal, however, but rather believed that a multi-purpose port would not only be successful in its own right, but would also be necessary to avoid the risk of focusing on one commodity.

In 1994, following a number of feasibility studies, the Chinese government agreed to his vision and Pan-United shareholders approved the $250 million (SGD) plan to build a port in Changshu. Kar Cheong’s son Patrick (the current Chairman of Xinghua Port) said, “While we didn’t have any experience in developing or operating ports then, we had always been port users. We therefore understood what port users need, and we saw the superior natural attributes this site had for a port.”

In 1997, Xinghua Port commenced operations as Changshu Xinghua Port (CXP) and was granted land use rights for 50 years. Unlike most other ports, which operate a concession, Xinghua “owns” the land under the port (the typical structure of land ownership is a long lease from the government that one day far into the future it will likely opt to renew).

At the time of its founding, CXP invited Westerlund, a Belgian company established in 1903 and specialized in the handling and logistics of pulp and paper products, to establish a joint venture at the port. The resulting JV – called Changshu Westerlund Warehousing Co., or CWW for short, would be 75% owned by Westerlund and 25% by Xinghua. In 2008, Westerlund was acquired by Australian-based infrastructure investor Babcock and Brown. Following the financial crisis, the company had to be restructured and was acquired by Euroports – a Netherlands-based company that until earlier this year was held by Brookfield (40%), Antin (39%), and Arcus (21%). In ­­­­March 2019, R-Logitech acquired the business.

Westerlund (now Euroports) was an indispensable JV for CXP, as it was formed only 1-2 years before the massive expansion of the Chinese paper industry. At the time, it was extremely difficult for foreign companies to interface with China, and Westerlund allowed pulp and paper companies to interact with a foreign company that they already trusted and to receive a differentiated service. While the typical Chinese port simply offers stevedoring (loading and unloading of cargo from a ship) and no central point of contact throughout the supply chain, CXP and Westerlund created a port offering the complete package: stevedoring, warehousing, cargo agency, and distribution of goods.

For instance, most ports have no warehouses on site, whereas Xinghua has twenty. In a nutshell, Westerlund gave international customers more comfort in China and to this day there are few companies offering such a service. As more pulp customers (the paper mills) are asking to have the pulp delivered to the mills – as opposed to coordinating to pick it up themselves – having a central point of contact that can coordinate the transport of the entire shipment is more attractive to customers than dealing with a Chinese port, followed by a Chinese trucker to transport the goods from the port, and so forth.

CWW is responsible for the marketing to pulp customers, coordination with the importers, and warehousing of the goods (the warehouses are leased from Xinghua). As the operator of the port, CXP itself performs the handling of the cargo.

In 2005, Pan-United sold a 26% stake in the port to Macquarie International Infrastructure at an implied valuation of HK$1.6 billion (for reference, today’s market cap is half that amount). In 2013, Pan-United repurchased the stake at an implied valuation of HK$1.7 billion.

In 2014, Pan-United acquired 90% of Changshu Changjiang International Port (CCIP), a port adjacent to CXP from the Chinese government for an implied valuation of 666 million RMB ($135m SGD). Now a company owning two ports, Xinghua quickly improved the operations of CCIP – increasing the throughput from 30,000 tonnes to 150,000 tonnes in only six months (today, normalized throughput is 300,000 tonnes). Management improved earnings from a loss of 24 million RMB in the 9 months ended September 2013 to a net income of 13.5 million RMB in the year ended 2017, or around 30 million RMB after adjusting for excess depreciation. In addition, the expanded capacity of the ports allowed Xinghua to optimize the berthing at CXP, which led to incremental earnings of 10-15m at CXP.

Overall, the incremental earnings resulting from the acquisition of CCIP represent a high single digit / low double digit return on equity and capital. The acquisition was expensive but the company felt it was necessary to avoid competition and to placate the Chinese government which had been a supportive partner (and shareholder) for nearly 20 years.

In 2017, in order to highlight the value of the ports, as well as to create autonomy for the different lines of business, Pan-United announced that it would demerge Xinghua Ports. The company began trading in Hong Kong in February 2018. Shortly following the spinoff, the port suffered an accident which resulted in 4 fatalities (discussed in detail later). The Chinese authorities temporarily shut down the port and therefore the figures for 2018 do not represent normalized figures (much of the commentary that follows refers to 2017, when the port was functioning normally).

Xinghua’s Chairman, Patrick Ng, has overseen the development of the ports from scratch since joining his father on the initial diligence trip. CEO Edward Kor Tor Thoon joined Xinghua in 2000 and has been president of the port since then. The Ng family owns the majority of the business and has added to its stake following the spinoff.

Background

Xinghua’s Ports comprise a 1.36 million square meter area with 16 berths and 175,000 square meters of warehouse capacity.

Nearly 80% of the cargo that comes in to Xinghua Port is transshipped to other parts of China (outside of Changshu city) – 70% by barge on the Yangtze River and 30% by truck. In that sense, Xinghua Port is a logistics hub for the hinterland of the Yangtze River Delta. While few ports have the luxury of the land, Xinghua provides ample storage for customers in order to allow them to use the port as a distribution hub. Xinghua is the largest public terminal in Changshu and the only true port in the city.

The majority of the cargo in the port is imported pulp, steel, and logs. The main export is steel, a result of China’s overcapacity in steel. In 2017, Xinghua’s two ports handled 4.7m tonnes of pulp, 3.2m tonnes of steel, 2.4 million cubic meters of logs, 1m of other cargo, and 125,000 TEUs (twenty-foot equivalent units) of containers, for a total of 13m tonnes handled (with capacity of 17.5 million). The average fee for pulp (RMB/tonne) was 47, for steel 26, and the overall average was 51. In 2018, the volumes declined as a result of the fatalities and the resulting disruption.

As a background on pulp: pulp is made by mechanically or chemically separating fiber from wood. Wood is made up of fibers called cellulose, and the cellulose fibers are stuck together with a natural “glue” called lignin. In the mechanical process, machines can grind wood into pulp. The chemical process is more common and uses chemicals to separate the lignin from the cellulose fibers. Long fiber pulp (also known as softwood pulp) refers to pulp made from conifers (mostly pine trees) and provides strength to its products, while short fiber pulp (also known as hardwood pulp) refers to pulp made from eucalyptus trees, which are the most abundant source of paper, and provides softness so is generally used for specialty paper, packaging papers, tissues, etc.

Given that it represents the greatest volumes as well as the highest fees, pulp is Xinghua’s most important cargo. Due to low forest coverage, the government’s ban on deforestation for pulp production, and the country’s increasing demand for pulp (tissue paper, packaging paper, adult diapers, etc.), Chinese pulp imports have increased significantly. In 2018, China imported 24.8 million tonnes of pulp compared to 7.9 million tonnes in 2005 and 3.3 million tonnes in 2000.

The growth is expected to continue, particularly as China has recently enacted bans/quotas against the import of recycled paper given the significant amount of garbage that is mixed into it. The ban has resulted in an increased demand for pulp to compensate for the shortage of used paper.

Globally, pulp is primarily transported by break bulk (90%) as opposed to container shipping (10%). A 40-foot container holds a maximum of 26 tonnes of pulp. In order to transport 50,000 tonnes, two thousand 40-foot containers are required – in contrast to break bulk where all 50,000 tonnes can go on one ship. Although containers are cheaper from the perspective of the shipper, they are more expensive from the receiver’s perspective because the receiver faces container handling charges, costs to pick up and return the containers to the port (trucking), and so forth. The relative affordability can fluctuate depending on the supply/demand dynamics in containers or break-bulk shipping. Xinghua is able to receive both types of ships, but the majority of its volumes are in break bulk.

Contracts range between 1 and 5 years, with the contracts for pulp tending to range between 3-5 years. The contracts have annual escalators for inflation, minimum wage increases, fuel price increases, etc. but both parties (the port and the shipper or the end customer) have the flexibility to cancel the agreements.

Competition

While China has over 2,000 ports, Xinghua is differentiated based on its location and

relationship with Euroports.

Location

The map below shows Xinghua Port’s location and its neighboring ports – Shanghai, Taicang, Nantong, and Zhangjiagang. Nantong is on the north side of the Yangtze River and is therefore not considered a competitor. Shanghai is the world’s busiest container port but primarily serves the Shanghai region – a different area than Xinghua’s.

Xinghua’s ports in Changshu have an advantaged location on the Yangtze River. Along with Zhangjiagang (further upstream) and Taicang (downstream between Changshu and Shanghai), Changshu forms part of the complex of river ports known as “Suzhou Port.” The location of these three ports is attractive given that they serve the hinterland of the Yangtze River Delta, an area responsible for 20% of China’s GDP and 33% of its imports and exports – and still experiencing rapid growth.

One of Xinghua’s primary advantages is that it has a draft of 13.3 meters. Upstream past Changshu, the draft is 10.5 meters and further up the river it is only 9 meters – severely limiting the size of ships that can go upstream. Changshu can accept the same large ships carrying break bulk cargo that go to Shanghai, but upstream past Changshu, the majority of the goods must be transshipped on smaller ships or barges to the various river ports up the Yangtze River. Nanjing (see below) is the absolute limit for ocean ships (but smaller than those arriving in Changshu). Although it is downstream, Taicang has a draft of 12.5 meters, also smaller than Xinghua.

In contrast to Xinghua’s focus on break bulk cargo, Zhangjiagang handles mainly coal and iron ore bulk cargo and Taicang focuses on containers. Bulk cargo and container shipping are much higher volumes compared to break bulk cargo, which is cargo that must be loaded and unloaded individually (out of pallets, bags, drums, etc.).

Relationship with Euroports

Xinghua’s strength lies in pulp imports. It is the largest pulp terminal in China and accounts for 7% of the world’s pulp imports. According to Chinese government statistics, Qingdao Port is the largest importer of pulp in China, but half of the pulp it handles (2.6 of the 5.2 million) arrives via containers. Therefore, in terms of actual pulp handling, Xinghua is China’s largest importer. Handling pulp requires particular care because the material is quite sensitive to damage and requires an environment free of contamination. Pulp cannot be exposed to water, plastic, or dirt so the berths and quays where pulp arrives must be separated from polluting commodities such as coal, grains, or any other dust. Special equipment and specialized labor is required for discharging pulp. Xinghua and Euroports offer this specialization and as a result, Changshu is the leading importer of pulp into China.

The cost of transportation is very small relative to the value of the product, so shippers and customers are unlikely to take risks with inexperienced ports. In 2017, compared to pulp’s cost of around $1,000 per tonne, the handling fee at Xinghua was $7/tonne – less than 1% of the value of the product. Today, pulp prices have declined significantly, and a slightly higher handling fee (that includes storage income) means that the cost has increased to greater than 1% of the product. Customers are reluctant to alter their logistics to lesser ports for a marginal savings, despite the “volume-driven” nature and price reductions offered by nearby ports (particularly Taicang). As the head of pulp logistics at one of Xinghua’s large customers told me, “We were paying a premium due to their standards in China. We wouldn’t take the risk [to change].”

Pulp shipped from South America can travel two months before arriving in China, which occasionally results in some bales being damaged during the journey. Euroports has a “pulp hospital” at the port and helps repair, clean, and re-bundle the pulp. They also conduct brightness reversion tests for the paper mills, the customers of the pulp, who wish to ensure the quality of pulp following a long voyage.

China imported 24.8 million tonnes of pulp in 2018, headed to the three main river regions of China: the Bohai Rim in the north near Qingdao and Tianjin, the Yangtze River in the center and east, and the south near Guangzhou and Shenzhen. Around 10 million went to the north, 8 million to the Yangtze River, and 6 million to the south. Of the 8 million headed to the Yangtze River, Changshu imported 4.7 million, a resounding market share.

In 2017, Xinghua imported 2.4 million of the 14 million logs that entered China (the company was China’s 5th largest importer of logs). What is interesting is that there are no saw mills in Changshu but rather the logs are being transported deeper into China. In 2018, following the port stoppage as a result of the fatalities, Xinghua shifted from logs to higher-margin pulp and hence reduced its logs import by half.

Growth

The import of pulp is expected to continue in China at a high single digit rate as a result of a ban on deforestation and quotas on the import of recycled paper, alongside increased consumption per capita of paper products.

In 2017, before the accident, the utilization of the port was 76% at CXP and 52% at CCIP. More recently, in the first half of 2019, the berth utilization was 53% for CXP and 33% for CCIP. Therefore, the port has ample capacity to increase revenues without large incremental spending. Furthermore, even as volumes grow, the port can change the mix of cargo. For instance, as more pulp is imported into China, the company will shift volumes from lower margin cargo and replace them with pulp.

The company aims to complement its organic growth with M&A along the Yangtze River. Management believes there are many distressed ports that have been volume-driven as opposed to profit-driven and have been operated quite poorly. A good example is the loss-making CCIP which CXP acquired in 2014 (and discussed above).

Capital allocation

Xinghua plans to utilize its free cash flow by paying dividends and considering M&A if the opportunity presents itself. Earlier this year, the company renegotiated with its lenders to significantly delay the amortization of its debt. The company will amortize an average of under 30m RMB per year through 2025; only until 2026 will there be a large maturity of 400m RMB.

The dividend yield is currently 4.5% which means the largest part of cash flow over the following years will be to build up cash against the debt and also likely to be used for M&A. Management believes there are many distressed ports along the Yangtze that have been operated poorly.

Insiders own over 70% of the business and our interests are aligned (they have historically treated shareholders very well). Following the spinoff last year, Chairman Patrick Ng was actively purchasing shares for his own account, and he has been doing the same over the past few weeks.

Valuation and accounting

The market capitalization of Xinghua Ports is approximately HK$814m. Ports are capital-intensive businesses, particularly during their formation. Once they have been established, maintenance capex is quite low. Therefore, there is excess depreciation that should be accounted for when considering the free cash flow generated by the port.

The market value of Xinghua’s properties was appraised to be 1.8 billion RMB at October 31, 2017. Adding the valuation surplus to the net PP&E yields an adjusted equity value of approximately 1.6 billion RMB, or HK$1.85 billion. Transaction valuations involving the port have averaged around HK$1.7 billion.

In 2017, Xinghua generated revenue of roughly of 480 million RMB. The majority comprised stevedoring income, which are fees charged to load and unload cargo. Around 10% of revenues were income from storage. The major expenses are employees (of which there are 473) and subcontractors (30% of revenues) and freight, fuel, and consumables (10% of revenues). As all ports face such costs, an increase in costs can be passed through to higher fees for customers.

Adjusted for listing expenses, Xinghua earned 107m RMB in profit in 2017, of which 97m are attributable to equity holders and the remaining 10m are attributable to minority interests (portions of CXP and CCIP that are owned by the Chinese government). Depreciation is around 50m annually, and maintenance capex is 10-15m. Free cash flow was therefore around 134m RMB, or HK$154m. Following the port accident, the company is willingly increasing its expenditure related to safety. Therefore, HK$120m before the prospects of any growth is a conservative assumption of free cash flow in light of this.

The market cap of the company is HK$814 million and net debt is around HK$455 million (paying fixed interest rates of around 5.5%) The FCF yield is thus around 15% and the unlevered free cash flow yield (adding back 30m of interest costs, tax-adjusted) is more than 10%. These figures are very attractive for China’s most important pulp terminal.

Accident

In March 2018 (shortly following the spinoff), Xinghua suffered an accident at its CCIP port that quite regrettably led to the fatalities of four subcontractors. During a cargo unloading operation that the company had been doing for 10 years, a hopper collapsed and crushed the workers underneath it. While investigating the incident, the Chinese government shut down the CCIP port for 5.5 months (and CXP was shut for 20 days), which greatly affected the company’s 2018 results. In addition to the loss of revenues, the company faced an increase in costs (both opex and capex) in order to ensure the safety of its employees. Since then, Chairman Patrick Ng flew from Singapore to China on his own volition (putting himself in danger of imprisonment by the Chinese authorities) and stationed himself in Changshu in order to improve the safety culture at the port. Since another serious accident at the port could be fatal for the business, it is vital that safety is a value of all employees at the port – and I believe it has become so under Patrick’s leadership.

Risks

There are five primary risks with an investment in Xinghua Port Holdings.

The first is the involvement of the Chinese government. On one hand, the government has been an important partner in Changshu’s development and has benefited from its partial ownership of CXP and CCIP. On the other hand, government policy has the ability to direct the growth of industries in China. For instance, if the Chinese government decides that the paper mills should be in a different part of China, the demand for pulp going through Xinghua’s ports could be affected.

Furthermore, another accident at the port could lead the Chinese authorities to shut down the port again. It is difficult to find another port accident outside of China that has resulted in such an extended work stoppage as that of CXP and CCIP in 2018, but the Chinese are getting very serious about safety. Thus, Xinghua faces concentration risk in that its only assets – two adjacent ports – are located in the same Chinese city under the jurisdiction of one local government.

The second risk is the relationship with Euroports, which has actively marketed the terminal to pulp customers globally. In their contract, Xinghua has a clause allowing it to market to pulp customers that Euroports does not have a relationship with. If this relationship deteriorates in the future, the value of the port could diminish.

The third risk is if another foreign company tries to emulate Euroports by providing service and a specialized terminal at another port in China. Alexander Global Logistics is attempting to emulate Euroports in Qingdao in the north, but that is unlikely to affect pulp volumes in the Yangtze River Delta.

The fourth risk has to do with leverage. Although the port is highly cash generative, Xinghua carries debt on its balance sheet – and it is always a risk to rely on the kindness of strangers. The mitigating factor is that the debt has recently been refinanced as discussed earlier.

The final risk is a macroeconomic slowdown in China and a depreciation of the RMB which would make the import of pulp more expensive. However, this risk is mitigated by the long-term trend of wealth growth in China and the associated relationship with increased consumption of tissue (whether for toilet paper, paper towels, adult diapers, and so forth).