Monday, February 29, 2016


Analysis: Headwinds and choppy financial waters ahead as Hapag-Lloyd sails into 2016

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My colleague Mike Wackett reported last week that Hapag-Lloyd had announced a preliminary unaudited operating income, or Ebit, of just $20m in the fourth quarter, suggesting “the carrier suffered a net loss” in the last three months of the year.
Just how big is that loss, though? And what kind of risk does Hapag face this year, and next, if it doesn’t manage to return to the black?
These are obvious questions following its latest trading update.
Tidal ebb or flow?
I have written about Hapag since it acquired the container business of CSAV; in fairness, I was not kind with to bankers who structured the merger deal, and I also thought it straightforward to warn retail investors about the perils of investing in its IPO, rather than joining those who have high hopes for what is currently the world’s fourth-largest box line.
Frankly, I doubt the tide is turning, and I find myself inclined to speculate on the possibility of an additional, highly dilutive injection of equity than on any other scenarios, in the wake of last week’s update.
How much money Hapag lost in the fourth quarter is a pretty important detail, because – one big deal and 12 months later – its net debt position rose 10% to €3.3bn in 2015, yet it remains unclear whether it will be able to maintain the level of profitability and cash flows it managed to generate soon after CSAV was consolidated on its books last year.
Trends for profits from the first quarter to these days are revealing. It reported:
  • Ebit of $389m in the nine months to 30 September; net income (NI) of $178m; NI as a percentage of Ebit is 46%;
  • Ebit of $197m in Q1; net income of $144m; NI as a percentage of Ebit is 73%;
  • Ebit of $102m in Q2; net income of $31m; NI as a percentage of Ebit is 30%;
  • Ebit of $90m in Q3; net income of $3m; NI as a percentage of Ebit is 3%.
The way it looks, the synergy package crafted by its bankers was front-loaded – but operational losses are only one part of the problem.
As it said in its IPO prospectus, the market value of its vessels could decrease at a higher rate than anticipated, which may cause Hapag “to recognise losses if any of our vessels are sold or could cause breaches of loan-to-value covenants in any existing financings”.
Tight covenants do not bode well with rising net debts, plunging freight rates and uncertainty surrounding input costs, including bunker fuel prices. According to one of its key covenants, “equity on any testing date shall not be less than the higher of €2.75bn and 30% of the total assets shown in the relevant consolidated financial statements of Hapag-Lloyd”.
One problem is that the book value of its equity is €4.7bn, but the market value of its equity is €1.8bn, while based on its total assets, the level of equity required must be at least €3.2bn. If that valuation gap between book value and market value persists, the accountant will be forced to pay more attention to the fair value of certain assets.
We live in a world where there is so much oversupply and so many surplus ships that there is not even a market for scrap metal. As a side note, its recent acquisition of two modern wide-beam vessels for deployment in South American cabotage trades is not really relevant in the wider coverage I am undertaking here, because they will be restricted to a very specific region that is protected by cabotage regulations.
Globally, however, it is a market where overcapacity dictates a more cautious approach, and I think it possible that Hapag could be forced to record economic losses stemming from asset impairments over the next three years. If net profits shrink or quarterly losses widen, and either results in a permanent damage to the economic value of its assets, Hapag could be in serious trouble, given broader marker conditions and its stretched capital structure.
The most likely write-down candidates that could lead to significant one-off charges into 2017/2018 are goodwill and intangibles, which amount to about 20% of its total assets, but property, plant and equipment – whose combined value is over 50% of total assets – could also bring some nasty surprises.
Not only does its current valuation imply a depressed price-to-book ratio of 0.3x, but its equity is highly illiquid, with only a few thousands stocks changing hands on a daily basis, and a tiny free float does complicate things. All of which means that any additional funding round would have to receive the backing of its existing investors – once again – and unsurprisingly, it could be back to square one for its core shareholders, K├╝hne Maritime, CSAV and the city of Hamburg.
Incidentally, its share price is some 15% off IPO at present.
Currency & leverage
“Future capitalisation measures could lead to substantial dilution of existing shareholders’ interests in the company,” Hapag reminded us in its IPO prospectus.
Hapag only partly benefited from weakness in the US dollar in the first half of the fourth quarter, but overall, exchange rate swings didn’t have a meaningful impact on its performance.
While its reported earnings would benefit from a stronger US dollar, betting on favourable exchange rates is not exactly a viable plan B upon which it could base its forecasts. Its preliminary fourth-quarter Ebitda of €140.4m was based on a 1.115 €/$ exchange rate, and Hapag surely has to hope that euro weakness persists – or currency changes could materially have an impact on its earnings.
However, ECB president Mario Draghi might have different views on monetary policy, and his action could shore up the euro rather than push it down – just as it happened early December, which didn’t help Hapag in the final part of the fourth quarter.
Either way, Hapag might have to count the pennies. At over 4x, its net leverage – as gauged by net debt divided by adjusted operating cash flow, or Ebitda – could become problematic if core profits plunge. It compares with 1.1x for market leader Maersk and over 5x for France’s CMA CGM once NOL is consolidated, but Hapag is left with less cost to cut and less scale than CMA CGM.
In the first nine months of 2015, its net income was 23% and 46% of Ebitda and Ebit, respectively – and that ratio most likely plunged in the fourth quarter. Its quarterly net income averaged $60m in the first nine months, yet Hapag reported only a few millions of profits in the third quarter. Furthermore, in the second half of the year, Ebitda and Ebit fell 31% and 63%, respectively, compared with the first half of 2015, but the Ebit drop (-80%) accelerated quarter-on-quarter at the end of 2015.
If my calculations are correct, Hapag could have actually lost between $50m and $85m in the final quarter, based on the prevailing exchange rate and excluding one-off charges. Which means that its free cash flow might have turned negative in the final stint of 2015, and for the full year, too. If I am right, net debt will continue to rise into the first half of 2016.
Free cash flow was just about in break-even territory in the first nine months of 2015.
The Ebitda margin of 9.4% in 2015 was in line with the company’s guidance, Hapag said, but for the full year its underlying level of cash flow profitability was 70 basis points below that of the first nine months.
It’s worth considering that a drop of one full percentage point means about $20m of lower Ebitda on a quarterly basis. Given the current headwinds, one has to wonder whether widening losses could become the new normal – if so, Lady Luck alone will not help Hapag but fresh funds could do the trick for another year or so before things either turn really bad, or economic recovery brings renewed optimism.,