Each week we screen thousands of corporate bond listings to find what we believe is currently the best corporate bond for investors needing or seeking higher yields with the least amount of risk possible relative to its projected return. This week, we look at short 4 year Yankee bonds (in US dollars) from a company returning to profitably, Hapag-LLoyd, a maritime service operating out of Hamburg Germany. Although the over 7.8% yields currently indicated with this bond only carries a B rating from Standard & Poor's, the following review shows why we see these 55 month high yield notes are a good bet to increase cash flow and preserve wealth. We think that as the European difficulties subside, this debt instrument offers sound diversification into the German economy and makes for a good addition to our high yielding foreign and global fixed income investments.
Assessing the Yield Curve
Although we have communicated it many times previously, it bears repeating that wealth preservation by achieving returns that can outpace moderately rising inflation is one of the biggest concerns among our clients and other fixed income investors.
A look at the issuer
Hapag-Lloyd AG was formed on September 1 1970, as a result of the merger of Hamburg-Amerikanische Packetfahrt-Actien-Gesellschaft (Hapag) and North German Lloyd (NDL). But the origins of these shipping lines go back much further, as Hapag was founded in Hamburg in 1847 by local merchants and NDL in Bremen in 1857. In 2005, Hapag-Lloyd acquired the British-Canadian container line CP Ships, thereby becoming one of the leading liner shipping companies of the world. In addition to this, Hapag-Lloyd Holding AG (the parent company of the Hapag-Lloyd Group) operates a cruise ship line, Hapag-Lloyd cruises. The Group currently employs a staff of about 6,900 at 300 locations in 114 countries. The owners of Hapag-Lloyd are the Albert Ballin consortium (77.96%, consisting of the City of Hamburg, Kühne Maritime, Signal Iduna, HSH Nordbank, M.M.Warburg Bank and HanseMerkur) and the TUI AG (22.04%).
Hapag-Lloyd is Germany's largest container liner shipping company and is considered the 6th largest shipping company worldwide with over 146 ships owned, leased or chartered. For the second consecutive year, Hapag-Lloyd captured Alcoa's ocean carrier of the year award for best-in-class export and import container service for North America. This is in addition to four consecutive years of the Global Carrier of the Year awards from Hellmann Worldwide Logisitcs, the 2012 Carrier of the year from Röhlig Logistics and Gebrüder Weiss Transport and Logistics, and a wide array of other prestigious Carrier, Excellence, and Environmental Achievement awards.
In order to utilize the medium-term expansion opportunities resulting from market growth and realize economies of scale in its ship operations, between July 2012 and November 2013 Hapag-Lloyd will launch a total of ten new very large container vessels into service, each with a capacity of 13,200 TEU. In December, Hapag-Lloyd opened negotiations to merge with Hamburg Süd, the 12 largest shipping company, which currently has no debt and also has the same Port headquarters of Hamburg Germany. The Port city of Hamburg holds close to 37 percent of Hapag-Lloyd. Hamburg-Süd, which was founded in 1871, had sales of 4.75 billion euros in 2011, and combined with Hapag-Lloyd the two lines together would have capacity only less than A.P. Moeller-Maersk A/S (OTCPK:AMKBF), CMA CGM SA, and Mediterranean Shipping Co. While Hamburg Süd focuses on North-South trade, Hapag-Lloyd mainly operates on East-West lanes such as Asia to Europe, and Westend Brokers Research analyst Klaus Kraenzle recently commented that the merger would be "a good step, potentially giving Germany one global shipping player."
We like companies that are profitable
In the most recent 9 month of 2012 report, Hapag-Lloyd's posted positive operating earnings before interest and taxes (EBIT adjusted) of €86.6 million ($112.44 million), EBITDA of €164.1 million ($213.1 million), and after-tax earnings of €45.6 million ($59.2 million). Average freight rates and revenues were substantially higher than the same period last year as Hapag-Lloyd was able to increase freight rates, revenue and results in the third quarter, although the market environment remains challenging. The average freight rate rose year over year by 8%, and the earnings (EBIT adjusted) margins increased from 2.4% to 4.9%. The rate increases initiated by Hapag-Lloyd in the first quarter and implemented in the second quarter had a tangible effect, and transport volume in the third quarter amounted to revenues that were 15% higher than in the same period last year and more than made up for the operating losses incurred in the first half of the year. In short, earnings before interest and taxes more than doubled from €36.7 million ($47.7 million) in the first 9 months of 2011 to €86.6 million ($112.5 million) in the first nine months of 2012.
Interest Coverage Ratios
Global demand for container transport services was actually substantially weaker than expected in the third quarter of 2012 - which is traditionally the peak season for container shipping due to sluggish growth in the world economy. Furthermore, bunker prices remain comparatively high, exacerbating the industry's cost position. Yet, in spite of these negative factors, Hapag-Lloyd anticipates achieving positive operating results again for the full financial year 2012 and expects the liquidity situation to remain adequate despite the effects of higher investments in newbuilds and the ship portfolio on net debt. All of its planned ship and container investments are funded through long-term loan agreements. Interest cost for the nine months were €33.5 million ($43.5 million) indicating nearly 5:1 coverage ratio against EBITDA and about 2.5:1 when measured against adjusted EBIT. While Hapag-Lloyd uses adjusted EBIT - earnings before interest and taxes adjusted for special items - as the key parameter for the internal management of its operating activities, EBITDA is an important indicator of the achievement of sustainable company results and gross cash flows.
We like companies with lower debt to cash ratio
Total debt for Hapag at the end of 9m 2012 stood at €2.345 billion ($3.046 billion), while cash and cash equivalents totaled €579 million ($752 million), giving it a modest four to one debt to cash ratio.
We like companies that have good balance sheets
The equity ratio for the Hapag-Lloyd Group as of September 30, 2012, amounted to around 46%, while cash and cash equivalents accounted for around 8% of the balance sheets total. At the end of 9M 2012, a total of 49 direct and indirect subsidiaries and five equity-accounted investees belonged to the group of consolidated companies of Hapag-Lloyd Holding AG. The equity-accounted investees include two strategic holdings in container terminals in Hamburg and Montreal. Hapag-Lloyd has a balanced fleet structure, owning approximately 50% of its fleet.
While comparisons may be made between Hapag-LLoyd and either DryShips, Inc. (NASDAQ:DRYS) or Eagle Bulk Shipping (NASDAQ:EGLE), our analysis revealed that both DryShips and Eagle Bulk Shipping have much weaker balance sheets and far too high a debt ratio to give us any confidence that either might be suitable for our clients. Excel Maritime Carriers, Ltd. (NYSE:EXM) appears to have an even higher possibility of default or bankruptcy. Should that occur, we think it might be a good thing for the stronger, more entrenched companies such as Moeller-Maersk and Hapag-Lloyd.
We like higher yields
Hapag-Lloyd has two outstanding bond issuances, a €480 million (equivalent to $623.5 million) note maturing in 2015 and a $250 million (US dollar) note maturing in 2017. The functional currency used by the international container liner shipping industry - and therefore also the Hapag-Lloyd subgroup - is the US dollar. Payment flows in currencies other than the US dollar are hedged to the US dollar as appropriate. Although trading at a slight premium, we think the 4½ year Yankee bond, couponed at 9.75% and currently indicating a yield to maturity of about 7.84%, offers the better opportunity.
Economists from the International Monetary Fund believed that the risks for the global economy increased further in the third quarter of 2012, and in its rating update on September 28 2012, the international rating agency Standard & Poor's downgraded its issuer rating for Hapag-Lloyd Holding AG from BB- to B+. Moody's followed suit a month later from B1 to B2, while the outlook ("negative") from both remained unchanged. The downgrading of Hapag-Lloyd Holding AG's rating and that of the bonds issued could result in less favourable conditions for raising new funds in the medium term and could adversely affect the trading price of its bonds. More recently, however, China showed its first acceleration in eight quarters and the IMF now expects global economic growth to rise from 3.2% last year to 3.5% this year.
The default risk is Hapag-Lloyd's ability to perform. The Hapag-Lloyd Group's prime objective is long-term profitable growth, and increasing global demand for container transport forms the basis for this planned organic growth. Based on current forecasts (IHS Global Insight, October 2012), the volume of global container transport should grow by 4.4% to 131.9 million TEU in 2013. Selling services at viable prices is still more important to Hapag-Lloyd than purely quantitative growth in volume, and the main influencing factors are transport volume, freight rate, the US dollar exchange rate against the euro, and operating costs including bunker price. Last week, A.P. Moeller-Maersk beat annual profit forecasts and predicted its container shipping business would benefit from a pickup in world trade this year, helping to overshadow a warning on falling earnings at its oil business. We see this as boding well for Hapag-Lloyd's future profits, and considering its historical, recent and forecasted levels of performance, its fair cash position, reasonable balance sheet and the sound cash flow to service its interest bearing debt, it is our opinion that the financial default risk for this relatively short term bond is minimal relative to its more favorable return potential.
Moreover, it is our opinion that diversification into other forms often serves to reduce risk. Our strategy here, as with other Yankee bonds, is to focus on unique or required services that can be seen as adding key economic value to the society it's associated with. Hapag-Lloyd's container shipping business is a basic necessity for international commerce, and it is highly regarded as one of the industry's best operators.
The cost of shipping is directly affected by trends in the international market and prices, as well as by the exchange rate of the Euro. Fluctuations in the price of bunker fuel are also is unpredictable, but fuel and currency hedges and an expanded globally diversified fleet offering better economies of scale should help alleviate some of these uncertainties.
We believe that these Hapag-Lloyd bonds have similar risks and maturities to other European Yankee bonds we have reviewed, such as the 7.4% yielding bonds from Ferrexpo,the 10.5% yields from Myria Agro, or the 7.58% yielding bonds from Georigan Railway.
Summary and Conclusion
It is our opinion that Hapag-Lloyd has positioned itself well for the future as a global leader in shipping container services. Along with its fair cash position, earnings have rebounded and interest expense coverage ratios have risen, resulting in a significantly improving bottom line. As a result, we believe these Hapag-Lloyd bonds offer an excellent yield relative to the financial risks that we can identify, and have chosen them for addition to our Foreign and World Fixed Income holdings.
Issuer: Hapag-Lloyd AG
Yield to Maturity: ~7.84%
Disclosure: Durig Capital and certain clients may have positions in Hapag-Lloyd 2017 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.