By Paul Choi
Oversupply has kept dry-bulk shippers in the brig, and it will take some time before they are squared away. Strong demand for the dry-bulk trade continues to be fully offset by available capacity in the existing world fleet. Despite record-breaking scrapping rates and elevated slippage rates, oversupply is expected to keep a lid on freight rates for all of 2012. When the Baltic Dry Index -- which measures shipping demand vs. supply -- reached a 25-year low Feb. 3, some industry participants called for a bottom. However, we think headwinds will weigh heavily for some time, and we would delay investment in this market until the order book trims down and the rate of new orders weakens. We think this is likely to occur in late 2012, at the earliest, or early 2013.
Despite the near-term pains anticipated in dry-bulk shipping, we think many of the companies we cover are fairly valued to slightly undervalued. Initial first-quarter earnings reports have reaffirmed our view that 2012 will be difficult for ship owners and, as a result, our dry-bulk shippers have traded lower. We think Eagle Bulk Shipping (EGLE) and Genco Shipping & Trading (GNK) are the most exposed to a prolonged weak period in shipping. Conversely, Diana Shipping (DSX) and Navios Maritime Holdings (NM) are our two favorite picks to weather an extended downturn.
China Still Fueling Demand, but So Is India
Chinese demand for iron ore and coal continues to be the biggest driver in the dry-bulk trade. According to the World Steel Association, Chinese steel production increased 8.9% to 694.5 million tons in 2011, increasing its share of world steel production to 45.5% in 2011 from 44.7% in 2010. Despite the recent slowdown, we're optimistic that China's appetite for iron ore and coal remains firm longer term, with a growing population leading to increased housing and infrastructure projects. In 2011, the emerging economy imported 687 million metric tons of iron ore, up 11% year over year, and increased coal imports used in steelmaking and power generation by an estimated 13% year over year. China accounts for 60% of iron ore consumption worldwide and is responsible for 35% of the global dry-bulk shipping trade.
India has also become a major dry-bulk consumer since it has taken initial steps to industrialize and urbanize. To keep pace with expanding steel and electricity production, India coal imports have increased 25% compounded annually since 2006. According to the Central Electricity Authority of India, elevated demand levels should continue, since 65% of new power generation is projected to be coal-fired. The country now imports more coal per year than the United Kingdom, Italy, France, and Germany combined.
We expect China will remain the dominant steel producer and consumer worldwide, with India the fourth-largest (behind the United States and Japan), and we expect these countries will fuel demand growth over the long run. The global steel and iron ore trade reached a record 1.1 billion metric tons in 2011, increasing imports for the 10th consecutive year, and we think the demand for dry-bulk commodities will remain healthy in 2012 despite a slowing Chinese economy.
2012 Deliveries Signal Oversupply
Ship scrapping is on pace to reach an all-time high for the second consecutive year, and slippage rates are expected to remain elevated in 2012. While these trends are positive for ship owners, we think higher scrapping and slippage rates are not enough to mitigate oversupply.
We think the 100 million deadweight tons, net of delivery delays and order cancellations, that are still scheduled to enter the global dry-bulk fleet in 2012 will carry forward the oversupply issues that have plagued the industry. While we're encouraged to see the global order book materially trim down to 28% of the existing world fleet (fleet stood at 627 million DWT as of February 2012), compared with 45% a year ago (fleet as of February 2011 was 545 million DWT), we're still concerned about the scheduled 19% supply growth rate. However, we like that scrapping rates are on pace to mint an all-time high for the second consecutive year. As of February, the market had scrapped 4.0 million DWT compared with 2.4 million DWT in the comparable prior-year period and 22.3 million DWT for 2011. Scrapping in 2010 amounted to 5.9 million DWT. After accounting for new highs in scrapping, we estimate the vessel supply growth to be around 15%. Still, given our expectations of 6%-8% growth in demand for dry-bulk trade, we estimate net oversupply of 7%-9% will keep a lid on freight rates for all of 2012.
Dry-Bulk Fleet and Order Book
Source: RS Platou Economic Research, Morningstar Equity Research.
Daily Rates by Vessel Class
Source: RS Platou Economic Research, Morningstar Equity Research.
Ship Financing Remains Scarce
In 2012, we've seen several companies restructure or seek restructuring with depressed shipping rates, forcing owners to examine their liquidity position. It appears that ship financing has become more difficult with banks attempting to minimize their shipping loan portfolios. Western European banks, the traditional financiers to the shipping market, face very difficult market conditions. We think the sovereign debt crisis, stagnant economies, and increasing default rates have led to scarcity of funds for financing vessel acquisitions and tougher covenants. Still, we think lenders are willing to work with better-capitalized ship owners that have the balance sheet strength or solidly locked-in charter coverage for additional financing opportunities. Moreover, we think 2012 will entail several more restructurings and some industry consolidation, as independent ship owners struggle to deal with depressed shipping rates.
Baltic Dry Index
The BDI gives a pretty accurate picture of the dry-bulk market's dire straits. We saw market weakness intensify in the beginning of 2012 on the back of a flood of new-build deliveries hitting the water in January. Owners with orders nearing delivery at year-end were motivated to take the ships the following year; this "January effect" allows owners to market their ships as being younger by one year. Deliveries in January this year totaled 12 million DWT, a monthly record. With the additional impact of the Asian New Year, which commenced two weeks earlier than usual, and weather-related issues in Brazil temporarily reducing iron ore exports, the BDI reached a 25-year low of 647 points on Feb. 3 as very little business was conducted between Christmas and the end of the Asian New Year. We think the index attracted some investor attention as a result, but industry fundamentals show continued muted pricing, in our opinion. The BDI has slightly recovered since, thanks to a pickup in iron ore fixtures and the South American grain season getting under way.
Little Upside in the Near Term
We anticipate both emerging and advanced economies will drive decent demand growth for dry-bulk cargo, but we see very little upside for the dry-bulk shippers we cover during the next 12 months. We think the industry is lacking a material catalyst for dry-bulk shipping stocks, and we don't expect an improvement in rates anytime soon. This is largely in part because the order book still represents 28% of the existing fleet, and we believe the overhang will take at least two years to alleviate. Though the BDI remains at historically low levels, we doubt any improvement in rates will be enough to generate meaningful cash flow generation from any of our ship owners. By our estimates, dry-bulk trade growth for 2012 is projected at 6%, but fleet growth, although past its peak, is expected to remain elevated. We believe 2012 will be another challenging year for the dry-bulk market, with supply/demand fundamentals coming more in balance from 2013 onward.
We reiterate our very high uncertainty rating for the industry and require a wide margin of safety in our discounted cash flow analysis before recommending investment. We project additional pull-downs in freight rates from 2011 averages for all asset classes and generally predict softer cash flow generation for most of these ship owners, with declines in EBITDA margins and operating margins during the next two years. Beginning in 2013, however, we predict high-single-digit growth rates as we see freight rates returning to somewhat normalized levels; in fact, we think capital expenditures will be needed to fuel growth from that point. We think Diana Shipping and Navios Maritime Holdings are best positioned to handle additional weakness in the dry-bulk shipping because of their stronger balance sheets, ample liquidity, and solidly locked-in contract base.
Conversely, we think Genco Shipping & Trading and Eagle Bulk Shipping are the most sensitive to fluctuating freight rates, as many of their contracts have rolled off in 2011 and a larger portion of their fleets is now subject to the spot market. Additionally, Eagle is operating under amended credit agreements and is in discussions with its lenders on a longer-term restructuring solution, which we think will be necessary to remain viable beyond 2013. After coming off a mixed first quarter, Excel Maritime Carriers (EXM) is operating under a favorable restructuring of its $1.4 billion syndicated credit facility that provides flexibility in 2012. The company and its lenders reached a principal agreement to defer up to $100 million of installments, which were scheduled for payment during the next three quarters, and to amend a handful of covenants through Dec. 31, 2013. Furthermore, Excel has secured 67% of its 2012 available days (100% of its 2012 Capesize fleet) on fixed-rate charters, which we think insulates it in 2012.
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