Interview With Shipping Analyst: 'Few Industries Offer The Potential To Multiply Or Lose Invested Capital As Fast As Shipping'

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Includes: DHT, INSW, SEA, TK, TNK
by: Angel Martin Oro
Summary

Investors and fund managers have been recently adding to the shipping sector (SEA). Why are they seeing value in such a volatile, asset-heavy and cyclical sector?

I interview shipping analyst Joakim Hannisdahl to better understand the sector's fundamental dynamics and its current state.

"With shares underperforming market fundamentals and with a positive outlook, current share pricing appears on average like a bargain" Joakim said.

He's most optimistic on the oil tanker subsegment given its position in the cycle and a positive short-term catalyst on IMO 2020 regulation.

Until recently, the shipping sector was one of the most unknown and obscure equity spaces for me and many other investors in Spain. However, my interest, and that of many others, woke up after the leading Spanish fund manager Francisco García Paramés heavily invested in the sector through his recently-founded asset management firm Cobas. His main investment in the sector was the Teekay Group (NYSE:TK), which as many at Seeking Alpha know, has been a horrible one so far. The most recent data at the close of 2018 show that Paramés’ international fund had a combined position in the group of over 8% of the fund (TGP 4.9% and TK 3.3%, while in previous quarters TK had had the biggest weight). But they are also invested in other names in the shipping sector as you can see in the following table (most notably International Seaways), making the shipping exposure about 28% of their fund:

Note: shipping sector plays are highlighted in bold and italics.

But Cobas AM is not alone in their shipping optimism. Here at Seeking Alpha we have perhaps most notably J Mintzmyer, who is focused on the sector and is very optimistic about the cyclical prospects for many shipping companies, including Teekay, one he has also been long for a while (me too, by the way). Also, other fund managers I track have some exposure to it. Recently, Harris Kupperman (aka Kuppy) from the blog Adventures in Capitalism had a great post titled Great Bargains in Shipping… in which he wrote, “In terms of valuation, there is no question that most US listed shipping stocks are insanely cheap”.

Here I’d also like to point out the recent words from Robert Bugbee, Scorpio’s president for Splash Extra. He said the following: “People at this stage are exhausted with shipping. They’ve been hurt by shipping. But a multi-year bull run in shipping starts off with stocks that are very dislocated because so many people have given up – and what’s causing me great optimism today is just how distressed and how dislocated these stocks have become.” The interviewer also wrote that a “key finance trend in 2018 was the dislocation of US shipping equity value from listed companies’ intrinsic value. Bugbee actually takes this as a positive omen for 2019.

So, given this introduction, why are investors betting on this complex sector? What’s so special about it and what are its drivers? Where in the cycle is the sector found, as well as its different subsegments? I wanted to dig deeper into all these questions to help better understand shipping dynamics. That’s why I interviewed shipping analyst Joakim Hannisdahl, Head of Research at Cleaves Securities, which is a specialized investment bank based in Norway focused primarily on the marine, energy and real estate sectors, with other focus areas including ship broking and ship management. Recently, he has published a very comprehensive report and update on the sector (246-pages long), so the timing of the interview was quite good. Hope you enjoy it.

Q. First of all, please tell us about your background and how you became interested in the shipping sector.

A. There are long historical traditions for shipping in Norway, going all the way back to the Viking era, at least. Even today, Norway exhibits one of the largest shipping clusters in the world. I started my career as a shipping analyst in Nordea Markets in 2011. It was a little bit accidental that I ended up in shipping, although I had already been investing in shipping for many years. Subsequently, I moved to Fearnley Securities where I spent a few years in a similar position. I left Fearnleys and started my own independent research firm, Gersemi Research, which was acquired by Cleaves Securities in 2018.

Q. For readers who may know very little about the shipping sector, it’s important to note that it is not homogeneous at all, as it is formed by a few subsegments. Can you briefly walk us through its different areas?

A. Container shipping is the backbone of the global trade of consumer and manufactured goods, amongst other things. It provides companies with the ability to move goods at a low cost between all parts of the world, both during the production process and to end consumers. Margins in container shipping have been lackluster in the past few years, which is great for the global economy, but not so good for shipping owners.

Dry bulk shipping is another segment which encompasses the transportation of dry bulk goods, including iron ore, coal and grain. China constitutes roughly 50% of the dry bulk trade, and the segment is thus very dependent on Chinese policies.

Oil tankers are also a major shipping segment, where the larger vessels usually carry crude oil and the smaller vessels tend to move oil products such as gasoline and diesel. There are also minor specialized shipping segments, including shipping of gas, chemicals, livestock, etc.

A common trait in shipping is a high degree of business cyclicality and significant volatility on both earnings and share prices. Shipping is asset heavy, which further adds to the balance sheet volatility.

Q. What are the key macro drivers that impact the shipping sector?

A. Shipping is highly dependent on global economic growth in general, and industrialization in particular. The industrialization of China has been a major driver since the early 1990s, with a strong multiplier effect on shipping of commodities like iron ore, coal and oil. There are also important trends that impact shipping from time to time. The focus on clean air in China, India and other areas is at present a significant demand driver for shipping of Liquefied Natural Gas and Liquefied Petroleum Gases (LNG & LPG), substituting domestically produced coal with a cleaner energy source from overseas.

Q. After the sector’s huge underperformance in the last few years and the most recent sell-off, some investors are seeing a big disconnect between stock prices and their fundamentals (strong rates). Is the sector a great opportunity for investors now?

Note: I used SEA ETF as a benchmark for the sector as a whole.

A. I believe so. In broad terms, the last shipping peak cycle in 2014/15 was cut short by a massive amount of capital being deployed, mainly building new vessels. The subsequent increase in shipping capacity killed the cycle in 2015/16. Current pricing of shipping shares indicates a collective recollection of the last cycle, and capital is thus not readily available this time around. This is good news, as the growth in shipping capacity is likely to stay low for the foreseeable future, thus extending the current shipping cycle into the next decade. With shares underperforming market fundamentals and with a positive outlook, current share pricing appears on average like a bargain.

Q. What particular area of the sector are you most optimistic on and why? Any particular companies you would like to highlight?

A. With oil tanker spot earnings booming this winter market and a consequential rise in vessel values, share prices have yet to respond accordingly. Factoring in the recent rise in FFAs (note: Forward Freight Agreements are the most common freight derivative used by ship owners to hedge against freight rates volatility) and time-charter rates, the market sentiment has undoubtedly turned positive during the last six months. Although OPEC reduced quotas in December, oil supply growth is expected to remain positive at 1.4% in 2019. New environmental regulation entering into force in January 2020 will also lead to more vessels leaving the fleet during 2019. We believe oil tanker shares offer the highest return in shipping (see chart below), and highlight DHT Holdings (NYSE:DHT) and Okeanis Eco Tankers as our top picks in the segment.

Source: Cleaves Securities “Shipping update”, 21 January 2019.

Q. However, the market seems focused on the macroeconomic risks. Let’s revise them and see your views on each of these. Firstly, what do you make of the global economic slowdown we are currently going through, particularly in China? Isn’t that going to negatively impact oil tankers and the overall shipping sector?

A. A fair point and cause for concern. It is important to differentiate between the shipping segments: For oil tankers, the main driver is oil supply growth, whereas oil demand growth is more important to set the price where the oil market finds equilibrium. If oil demand is lower than supply, inventories tend to build which can be just as positive for oil tankers. The big short-term risk is of course if OPEC+ reduces oil supply further in response to potentially low oil prices. For dry bulk shipping, Chinese authorities have already started stimulating the economy to counter a lower growth rate. Stimuli tend to be focused on infrastructure spending, which is very coal and iron ore intensive and could thus be positive for shipping. We think clean air policies in China and elsewhere will continue indifferent of economic growth, supporting demand for especially LNG shipping, but also LPG shipping.

Source: “OPEC Cuts? Rates Plunge? Oil Tanker Market to Shrug It All Off”, Bloomberg.

Q. Another potential worry is higher interest rates going forward (i.e. debt becoming more expensive). How will that affect these companies, given their highly levered balance sheets?

A. Higher interest rates are obviously negative for shareholders’ return on equity, but as credit risk premiums are generally high in the industry through the cycle, the relative impact from rising xIBORs is mitigated somewhat (xIBORs: interbank money market rates). A major risk stems from timing of refinancing, where established large cap companies tend to manage this rather well. However, smaller companies with significant balloon payments might find themselves having to accept expensive financing terms if capital remains scarce in the short to medium term.

Q. And lastly regarding the risks the market perceives, we have the trade war between US and China. How important has this issue been for the shipping sector?

A. Extremely important for all shipping segments, but we believe the biggest immediate impact would be on container shipping, dry bulk and LNG. The US-Sino negotiations are working against a 1st of March deadline. A deal would most likely lead to an immediate rally in shipping shares. A failure to reach a deal would likely cause a rout. The risk-averse investors should await more information before buying shipping shares.

Q. The shipping sector, as some investors have experienced recently, is quite difficult and may be a big money-loser full of mines. What advice would you give investors to successfully navigate it through the cycles?

A. As in all cyclical industries, it is very difficult to pinpoint the inflection points. My best advice is to pay close attention to the cycle. Don’t get greedy. It is better to invest after the trough and divest before the peak than to get caught in a market sell-off which could see individual shares decline 90-100%. When contemplating an investment at what one believes is trough levels, make sure the companies you are considering have a strong enough balance sheet to last longer than you might think is necessary. It often takes much more time for the cyclical expansion to kick in than initially thought. Shipping investments are notoriously volatile. Create your own strategy and stick with it as long as the assumptions behind it are unchanged. Make sure you don’t invest money you cannot afford to lose.

Q. Beyond balance sheet strength, what are the key aspects you look for when picking the right shipping stocks? How important is the valuation part in such a volatile and cyclical sector like this, and what are your preferred valuation tools or multiples?

A. As an investor, you should ask yourself if you would rather buy a vessel or buy a company that owns a vessel. Are the company’s shares implicitly pricing a vessel at a discount? What value does the existing company add to the vessel beyond its steel value? Surprisingly often, the answer is close to zero or even negative due to bad corporate governance which is unfortunately flagrant in the industry.

For most investors, it is easier to buy shares than vessels. A natural question then is if a company is trading below the value of its fleet less any capital sources senior to equity (Net Asset Value). NAV is a pivotal tool in the toolbox of a shipping investor, but one also needs to have a view on the forward NAV: Will the company’s fleet appreciate in value in concert with an expanding cycle, or will values depreciate in a cyclical contraction? Also, will operational cash flow be positive and add to forward NAV? Will the company be able to pay dividends? Returning capital directly through dividends or indirectly through a rising NAV is arguably the two primary ways a shipping company can return value to its shareholders.

EV/EBITDA is also an important way to assess the profitability of shipping companies across different capital structures.

Q. Many investors have suffered from their exposure in the Teekay Group, including Spanish asset manager Cobas. Do you have any views on the Teekay group?

A. Within the Teekay group, we only cover Teekay Tankers (TNK). We had a SELL recommendation on the company until mid-2018, when we correctly identified the cyclical trough in the oil tanker segment. We have since May 2018 recommended to BUY the share as we believe the balance sheet was shored up by then and with expectations of improving earnings ahead. We are 30% ahead of consensus on TNK’s EBITDA for 4Q18E (see our target price in the chart below).

Source: Cleaves Securities, 10 February 2019.

Q. A reader might wonder: is Joakim just another analyst chasing prices and providing no real value to investors in his recommendations? To answer that, can you share with us your historical track-record on your work?

A. During my many years as a shipping equity analyst, I have developed a healthy skepticism towards the underlying motivations of analysts in general. This was one of my major motivations for starting Gersemi Research, which revenue stream stemmed from investors rather than the companies we covered. Although acquired by Cleaves Securities, which has a strong track record within corporate finance, our integrity remains our strongest currency when offering advice to both investors and corporate clients.

I rightfully foresaw the 2016 cyclical contraction in LPG shipping already in early 2014, the collapse of dry bulk shares in 2015 and oil tankers 2016. I also faced strong criticism from companies and peers in 2015 for maintaining a view that the LNG shipping cycle would not turn until 2018/19. In general, my econometric approach has performed very well with my recommendations outperforming our shipping share index by 320% and analysts’ recommendations by 282% since 2014.

Q. Finally, anything else investors should know about the shipping sector?

A. As a highly cyclical business centered around mean reversion, the risks are inherently high and the returns are close to zero in the long run. Either invest in companies with a superior industrial platform or make sure you are able to play the zero-sum cycle better than the average investor. Few industries offer the potential to multiply or lose invested capital as fast as shipping. Good luck!

Disclosure: I am/we are long TK, COBAS INTERNACIONAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.