Orient Overseas (International) Ltd. Initiation Report – Still good value based on key fundamentals and potential takeover

14th March 2017, Hong Kong - The share price of Orient Overseas (International) Ltd. (OOIL) has risen 35% and outperformed the Hang Seng Index by 27% year-to-date. We believe this is mainly driven by market speculation that OOIL could be a potential takeover target on top of the recent improvement in container shipping volume and freight rates in the spot market.

Fair value: HK$50

Rating: Outperform

OOIL is indeed an attractive takeover target given its strong business model. The key “push factors” for OOIL’s shareholders to sell would be the rising capital costs needed to grow due to the industry’s continued vessel upsizing, persistent sector overcapacity as some of the weak carriers continue to be supported by their governments, excess capacity may not be removed from the industry even when carriers go bankrupt and profit margins tend to be razor-thin. However, we believe this is more likely to happen in the longer term, mainly due to near term constraints faced by the major potential acquirers as most of them are in the midst of integrating with another carrier. Moreover, OOIL has historically been astute in timing its asset sales and we believe that any proposed takeover or merger offer will only be considered if the valuation is highly attractive to OOIL’s shareholders. Recall that OOIL sold its Terminals division for US$2.4B in November 2006 and its OODL property division for US$2.2B in January 2010. OOIL’s current market capitalization is only US$3.5B.

Therefore, it would be more pragmatic to focus on the key fundamental drivers for now and we still view OOIL attractively valued even after its recent rally upon weighing its positive drivers against its downside risks. OOIL remains one of the most competitive container shipping companies globally.

Chart: Orient Overseas (International) Limited - Crucial Perspective Scorecard (Full marks = 100 points)

Orient Overseas (International) Ltd. initiation Report: Crucial Perspective Scorecard

Chart: Orient Overseas (International) Limited - Financial Summary

Orient Overseas (International) Ltd. initiation Report: Financial Summary

Key Positive Drivers for Orient Overseas (International) Ltd. 

+ Continuous fall in unit cost per lifting excluding fuel, notwithstanding OOIL’s already lean cost structure, is impressive and this is expected to continue

In the last 3 years, OOIL’s unit cost per lifting excluding bunker fuel cost has fallen by 13% which is impressive given OOIL’s already lean cost structure prior to this. Management targets to drive unit costs lower which will sustain its competitive advantage versus sector peers and help mitigate the earnings impact on OOIL should freight rates remain low.

Chart: OOIL unit cost per lifting excluding bunker fuel cost (2013 to 2016)

Orient Overseas (International) Ltd. initiation Report: Bunker

+ Strategy of maximizing its vessel size on each major trade lane helps

One of OOIL’s differentiating strategy is to operate the largest possible ship size on each of its major trade lanes. On paper, OOIL ranks the 9th largest container shipping operator globally. However, OOIL ranks 6th globally in terms of the average vessel size that it deploys for its entire operating fleet and 3rd globally if we consider only its owned vessel fleet. If we take into account the newbuild vessel deliveries going forward, OOIL will operate the 5th largest average vessel size globally for its entire operating fleet and 2nd largest average vessel size if we consider only its owned vessel fleet by 2019. This enables OOIL to have one of the most competitive cost structures in the global container shipping industry.

+ OCEAN Alliance membership will strengthen OOIL’s market position globally, particularly on the East-West trade lanes

If we take into account alliances, the three carrier alliances – 2M, OCEAN and THE alliances will control 75% (or 77% including Hyundai Merchant Marine) of the global container shipping capacity with 32% (or 35% including its vessel sharing agreement with Hyundai Merchant Marine), 26% and 17% market shares respectively.

Their dominance is even more pronounced on the two major trade lanes Asia-Europe and Transpacific. On the Asia-Europe trade, 2M, OCEAN and THE will have 40% (including its vessel sharing agreement with HMM), 35% and 23% share of the market, raising their total market share to 98%.

On the Transpacific trade, OCEAN, THE and 2M will have 41%, 29% and 19% share of the total market, raising their total market share to 89% (source: Alphaliner). We believe that carriers that are not part of the above 3 alliances are likely to be crowded out of the market over time.

When the implementation of OCEAN and THE alliances are in place from 1st April 2017 (in addition to 2M alliance), we expect improved coordination in capacity deployment among the carriers which should help reduce excess capacity allocation on routes where demand is soft. This should help support and stabilize freight rates.

 + OCEAN Alliance will be a highly competitive liner grouping

The OCEAN Alliance will have the largest number of weekly service offerings on the Far East-US West and East Coasts and Far East-Mediterranean trade lanes among the three carrier alliances and tie with 2M Alliance in first place for the Far East-North Europe trade lane - a big improvement for OOIL which derives only 16% of its total revenue from the Asia-Europe trade. OCEAN will also have the fastest transit times per route for the Far East-US West and East Coasts and Far East-Europe trade lanes. The OCEAN Alliance will also have a significant lead ahead of 2M and THE alliances in terms of the number of port pairs it serves for in the Transpacific and Asia-Mediterranean trade lanes (source: OOIL, Alphaliner).

+ Expect greater capacity discipline in the global container shipping industry this year notwithstanding the sizeable scheduled newbuild vessel deliveries

On paper, 2017 and 2018 look like another two challenging years for the global container shipping sector given the sizeable scheduled newbuild vessel deliveries this and next year, pointing to another 2 years of industry oversupply before we see any glimpse of sector recovery from 2019.

However, we believe that after incurring huge losses in 2016, the liners will be more determined to implement disciplined capacity management this year, at least until they start making money again and the ambition to increase market share returns.

Chart: Global container shipping demand and supply growth, containership idle fleet ratio and freight rate movement (2007 to 2020)

Orient Overseas (International) Ltd. initiation Report: Global Container

For more details, please refer to our sector report: "Global container shipping outlook: Capacity discipline is needed to lift freight rates; increased industry concentration helps (8 March 2017)"

+ More favourable Transpacific contract rates

The Transpacific route region is the most important revenue contributor for OOIL, accounting for 37% of its total revenue. We expect OOIL to lock in higher contract rates on the Transpacific trade this year given the container shipping industry’s rising market concentration and more disciplined capacity management. In addition, following Hanjin Shipping’s bankruptcy, shippers are also more concerned about the risk of cargo transport disruptions and are likely to be more willing to pay more for service reliability and sustainability.

+ Efficiency gains and earnings upside from the Long Beach Container Terminal project

The Long Beach Container Terminal (LBCT) will be the most automated and environmentally friendly container terminal in the United States, significantly improving the turnaround time of OOIL’s vessels and could boost revenue from third-party liner customers in the longer term. Phase 2 of this project will be completed towards the end of 2017 and following its final completion in 2020/2021, LBCT is expected to add around 1% to OOIL’s EBIT.

+ More defensive against the risk of higher fuel prices and potential asset impairment charges should freight rates and resale vessel prices remain depressed

The average age of OOIL’s owned containership fleet is 8 years versus the sector average of 11 years. Its young and more fuel efficient vessel fleet help to mitigate the impact of higher fuel prices and potential asset write-downs to some extent compared to carriers who operate older vessel fleets should freight rates and resale vessel prices remain depressed.

+ Value could be unlocked from selling its non-core property investments

Based on their current market valuations, OOIL’s remaining stake in Hui Xian REIT and its Wall Street Plaza are worth around HK$675m and HK$1.7B or HK$1.1 and HK$2.7 per OOIL share respectively.

Key Downside Risks for Orient Overseas (International) Ltd. 

+ Capacity and revenue exposure to the Asia-Europe trade will increase as OOIL takes delivery of the ultra-large containerships

OOIL is scheduled to take delivery of five 20,000 teu newbuild vessels this year which could be challenging to fill at profitable freight rates on the Asia-Europe trade, unless demand picks up.

+ Industry recovery is fragile

A marked improvement in freight rates could potentially drive operators, ship lessors and investors to order newbuild vessels again, prolonging the global container shipping industry’s downturn. It could also drive the reinstatement of idle ship capacity which could dampen freight rates again.

Globally, 6.5% of the global shipping capacity is laying idle as the operators have withdrawn services to cut losses and returned chartered-in vessels when their leases expire.

Our concern is that once freight rates return to more profitable levels, the operators are likely to reinstate their idle owned capacity. Fortunately, only 21% of the global idle vessel fleet belong to the operators. 79% of the global idle vessel fleet belong to non-operator owners who are finding it challenging to lease these vessels out even at low time-charter rates. However, if freight rates improve meaningfully, some operators may also be tempted to charter in some of the idle vessels given the low ship charter rates.

Reinstating these “ghost ships” without a corresponding rise in container shipping demand could worsen the industry oversupply again.

+ Protectionism could negatively impact trade flows

Growing protectionism and a more inward-looking United States could potentially negatively impact OOIL’s Transpacific route revenue and the throughput growth prospects of its Long Beach Container Terminal.

+ Potential asset disposal losses

Resale containership prices have fallen markedly. While OOIL is not required to mark to market its vessel fleet under the accounting rules, it could potentially book disposal losses when it sells some of its older vessels if freight rates and resale vessel prices remain persistently low.

 

Earnings Outlook for Orient Overseas (International) Ltd. 

We forecast OOIL’s revenue to grow 11% per annum, reaching by US$7.2B by 2019. We expect OOIL to turn profitable this year, delivering a net profit of US$137m in 2017 versus US$219m net loss in 2016. We expect 2019 to be a much more profitable year for OOIL as the global container shipping industry demand and supply balance becomes more favourable, enabling OOIL to earn a net profit of US$258m.

 

Valuations for Orient Overseas (International) Ltd.

We value OOIL at HK$50 which is based on 0.9x P/B, assuming ROE of 4% and 0% long-term growth. This is also in line with our estimated “liquidation” value assessment of HK$50 per share for OOIL.

 

Chart: Orient Overseas (International) Limited – Gordon growth valuation model

Orient Overseas (International) Ltd. initiation Report: Gordon Valuation

 

Chart: Orient Overseas (International) Limited – Estimated “liquidation” value

Orient Overseas (International) Ltd. initiation Report: Liquidation value

Stock Catalysts for Orient Overseas (International) Ltd. 

OOIL’s share price has risen 35% and outperformed the Hang Seng Index by 27% year-to-date. We believe this is mainly driven by market speculation that OOIL could be a potential takeover target on top of the recent improvement in container shipping volume and freight rates in the spot market.

OOIL is indeed an attractive takeover target given its strong business model. The key “push factors” for OOIL’s shareholders to sell would be the rising capital costs needed to grow due to the industry’s continued vessel upsizing, persistent industry overcapacity as some of the weak carriers continue to be supported by their governments, excess capacity may not be removed from the industry even when carriers go bankrupt and profit margins tend to be razor-thin. However, we believe this is more likely to happen in the longer term, mainly due to near term constraints faced by the major potential acquirers:

 + COSCO Shipping (member of OCEAN Alliance)

The world’s fourth largest liner COSCO Shipping is still in the midst of streamlining its operations after absorbing China Shipping Container Lines’ (CSCL) capacity. Given its high leverage, COSCO Shipping is unlikely to finance the acquisition of OOIL with cash. COSCO Shipping may be interested in a share swap agreement with OOIL but OOIL’s shareholders are unlikely to agree, in our view, given that OOIL’s current valuations (0.8x P/B) are less than half of COSCO Shipping’s (2.2x P/B). It is probably easier for COSCO Shipping to secure financing to order new containerships to be built in the Chinese state-owned shipyards than to acquire OOIL. Moreover, it may potentially be politically sensitive to sell OOIL to a Chinese state-owned enterprise at present, in our view.

 + CMA CGM (member of OCEAN Alliance)

The world’s third largest liner CMA CGM is still digesting its acquisition of Neptune Orient Lines and OOIL may not add significant value to its network since it already owns APL.

+ Evergreen Marine (member of OCEAN Alliance)

The world’s 7th largest liner (as its global ranking is expected to fall after Hapag Lloyd’s merger with UASC raises its ranking to the world’s 5th largest and the 3 Japanese carriers’ integration of their container shipping lines into 3J raises its ranking to the world’s 6th largest) Evergreen has traditionally preferred to grow organically through vessel acquisitions.

+ Maersk (member of 2M Alliance)

We believe the world’s largest liner Maersk may be interested but it needs time to integrate Hamburg Sud first. However, Maersk is known to drive a tough bargain and a share swap agreement may not necessarily be acceptable to OOIL’s shareholders either as Maersk (1.1x P/B) is trading at a 37% valuation premium to OOIL (0.8x P/B).

+ Hapag Lloyd (member of THE Alliance)

Hapag Lloyd also needs time to integrate with United Arab Shipping Co. (UASC) first and it may be financially challenging to acquire OOIL.

 + 3J (members of THE Alliance)

Meanwhile, the three Japanese carriers K-Line, MOL and NYK are integrating their container shipping business segments into a single entity (3J) and are unlikely to consider any external acquisitions until 3J is launched in July 2017 and begins operations from April 2018, in our view.

Moreover, OOIL has historically been astute in timing its asset sales and we believe that any proposed takeover or merger offer will only be considered if the valuation is highly attractive to OOIL’s shareholders. Recall that OOIL sold its Terminals division for US$2.4B in November 2006 and its OODL property division for US$2.2B in January 2010. OOIL’s current market capitalization is only US$3.5B.

Therefore, it would be more pragmatic to focus on the key fundamental drivers for now and we still view OOIL attractively valued following its recent rally upon weighing its positive drivers against the downside risks. OOIL remains one of the most competitive container shipping companies globally.

CRUCIAL PERSPECTIVE FORECASTS

 

Chart: Orient Overseas (International) Limited - Profit & Loss Statement

Orient Overseas (International) Ltd. initiation Report: Profit & Loss

Chart: Orient Overseas (International) Limited – Balance Sheet

Orient Overseas (International) Ltd. initiation Report: Balance Sheet

Chart: Orient Overseas (International) Limited – Cash Flow Statement

Orient Overseas (International) Ltd. initiation Report: Cash flow

Note: Stocks with upside of more than 10% based on our fair value (versus the closing share price on the date of our report) are assigned an Outperform rating. Stocks with downside of more than 10% based on our fair value are assigned an Underperform rating. Stocks with upside or downside of less than 10% based on our fair value are assigned an In-line rating. These are Crucial Perspective’s proprietary rating classifications and by no means serve as investment recommendations.

Related Articles:

Global container shipping outlook: Capacity discipline is needed to lift freight rates; increased industry concentration helps (8 March 2017)

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