Research Report: Pacific Basin Shipping (2343:HK) highly leveraged to Handysize recovery

Pacific Basin Shipping (2343:HK) Fair value: HK$2.10
Pacific Basin Shipping (2343:HK) Rating: Outperform

16 October 2017, Hong Kong – We initiate coverage on Pacific Basin Shipping (2343:HK) with Outperform rating and price target of HK$2.10. We also analyse the updates from Pacific Basin Shipping’s 3Q17 briefing where CEO Mats Berglund discussed Pacific Basin Shipping’s 3Q17 operations.

IMPROVING GLOBAL INDUSTRY DEMAND-SUPPLY BALANCE WILL SUPPORT HANDYSIZE RATE RECOVERY WHICH IS THE KEY POSITIVE CATALYST FOR PACIFIC BASIN SHIPPING

Pacific Basin Shipping (2343:HK) is trading at 1.0x Price/Book which is near the upper end of its average valuation range in the past 10 years during the global dry bulk shipping industry downturn. Investors will need to see a stronger improvement in profitability, in order for the stock to re-rate further.

As the world’s largest Handysize operator, Pacific Basin Shipping’s share price has historically had a positive correlation with the Baltic Handysize Index. Further improvement in spot market freight rates in the Handysize segment will be the most important positive catalyst for the stock.

Given our forecasts that the global Handysize and Handymax shipping industry’s demand and supply balance will improve in the next two years as net capacity growth slows based on the existing vessel orders, this should help drive further recovery in freight rates and Pacific Basin Shipping’s earnings from 2018 which underpins our Outperform rating with a price target of HK$2.10.

Chart: Pacific Basin Shipping share price versus Baltic Handysize Index (2007 to 2017)

Chart: Pacific Basin Shipping share price versus Baltic Handysize Index (2007 to 2017)

 

Chart: Pacific Basin Shipping Price/Book valuation since listing (2004 to 2017)

Chart: Pacific Basin Shipping Price/Book valuation since listing (2004 to 2017)

 

GLOBAL HANDYSIZE & HANDYMAX MARKET WILL IMPROVE IN 2018 AND 2019 AS CAPACITY GROWTH DROPS

On a combined basis, we expect the Handymax and Handysize segments’ net capacity to grow 5% y/y this year, in line with our projected minor bulks shipping demand growth of 5%. We expect the industry demand-supply balance to improve from 2018. We forecast net capacity growth to decelerate to 2% in 2018 and 1% in 2019 versus our projected minor bulks shipping demand growth of 4% and 3% respectively, supporting freight rate recovery in the smaller vessel segments in the longer term. This will be highly positive for Pacific Basin Shipping’s earnings.

Chart: Global grains and minor bulks shipping demand versus Handymax and Handysize segments capacity growth (2000 to 2019)

Chart: Global grains and minor bulks shipping demand versus Handymax and Handysize segments capacity growth (2000 to 2019)

 

3Q17 KEY BRIEFING TAKEAWAYS AND CRUCIAL PERSPECTIVE VERDICT

GREATER EARNINGS LEVERAGE TO SPOT FREIGHT RATES FROM 2018 GIVEN LIMITED COVERAGE RATIO SO FAR

70% of Pacific Basin Shipping’s contracted days are covered at $8,890/day for the Handysize segment and 79% are covered at $10,600/day for the Supramax segment in 4Q17. Pacific Basin Shipping has so far covered 14% of its contracted days at $7,690/day for the Handysize segment and 32% of its contracted days at $9,640/day for the Supramax segment for 2018.

Crucial Perspective verdict:

Due to Pacific Basin Shipping’s high coverage ratio in 4Q17, a further increase (or decrease) in spot market freight rates will have a limited impact on its earnings in 4Q17. Pacific Basin Shipping’s earnings will be more leveraged to the spot market freight rates from 2018 given its limited coverage ratio so far.

Pacific Basin Shipping’s coverage ratio for the year ahead (2018) is lower for the Handysize segment but higher for the Supramax segment compared to its coverage ratio for the year ahead (2017) during the same time last year. During Pacific Basin Shipping’s 3Q16 management briefing, it had 18% of its contracted days at $9,480/day for the Handysize segment and 27% of its contracted days at $11,410/day for 2017.

This likely reflects management’s greater optimism on spot market freight rates in the Handysize segment and continued caution on spot market freight rates in the Supramax segment in 2018. Note that Pacific Basin Shipping’s covered freight rates are also lower than the covered rates locked in a year ago.

AVERAGE DAILY EARNINGS IMPROVED Y/Y AND CONTINUED TO OUTPERFORM THE MARKET IN 3Q17

Pacific Basin Shipping’s average daily earnings continue to beat the market’s spot freight rates. In 3Q17, Pacific Basin Shipping’s Handysize average daily time charter equivalent (TCE) was $8,130/day, 15% higher y/y and 16% higher than the market index rate. Similarly, in 3Q17, Pacific Basin Shipping’s Supramax average daily time charter equivalent (TCE) was $9,350/day, 27% higher y/y.

Crucial Perspective verdict:

Pacific Basin Shipping’s consistent outperformance versus the market in recent years notwithstanding the challenging industry conditions is impressive. However, note that Pacific Basin Shipping’s 16% outperformance has narrowed in 3Q17 compared to its 20% premium versus the Handysize market index rate in 1H17. Similarly, in the Supramax segment, Pacific Basin Shipping’s outperformance was only 3% versus its 11% premium versus the Supramax market index rate in 1H17.

Chart: Outperformance of Pacific Basin Shipping’s Daily Time Charter Equivalent (TCE) versus the Market Rate Index (9M2014 to 9M2017)

Chart: Outperformance of Pacific Basin Shipping’s Daily Time Charter Equivalent (TCE) versus the Market Rate Index (9M2014 to 9M2017)

 

OWNED VESSEL FLEET HAS TRIPLED IN THE PAST FIVE YEARS AND IS UNLIKELY TO EXPAND SIGNIFICANTLY NEAR TERM

Pacific Basin Shipping has grown its owned vessel fleet to 106 vessels in 3Q17 (from 36 vessels in 3Q12) and is unlikely to grow its vessel fleet much more aggressively from its current levels near term unless they yield attractive returns. Pacific Basin Shipping has a total dry bulk vessel fleet of 264 ships, including 106 owned and 158 chartered-in vessels. The average age of its core fleet is 7.3 years old.

Chart: Pacific Basin Shipping vessel fleet (3Q17 versus 3Q12)

Chart: Pacific Basin Shipping vessel fleet (3Q17 versus 3Q12)

Crucial Perspective verdict:

Pacific Basin Shipping’s counter-cyclical investments in vessels at the bottom of the cycle is strategic. We expect Pacific Basin Shipping to unlock value via asset disposals when vessel values increase, providing significant upside to earnings during the industry upturn. Management’s guidance that Pacific Basin Shipping is unlikely to increase its owned vessel fleet much more aggressively from the current size is a pragmatic move, in case the current industry recovery proves short-lived. Pacific Basin Shipping’s average net book value was $15.6m (9.4 years) for Handysize and $22.8m (6.3 years) for Supramax as at June 2017.

 

EXITS TOWAGE BUSINESS FOLLOWING THE SALE OF ITS LAST TUG

Pacific Basin Shipping has finally sold its last tug. Management expects limited impact on Pacific Basin Shipping’s book value and financial results in 2H17.

Crucial Perspective verdict:

It was a sound decision to exit the Towage business and focus solely on Dry bulk shipping. Pacific Basin Shipping is the world’s largest Handysize operator and well-positioned to leverage on the minor bulks shipping sector recovery. Pacific Basin Shipping’s well-diversified cargo mix, 60% and 40% business exposure to the Pacific and Atlantic respectively, large client base of 500 customers helps to reduce its product and counterparty risks.

Chart: Pacific Basin Shipping cargo mix (1H17)

Chart: Pacific Basin Shipping cargo breakdown by commodity type

 

KEY DOWNSIDE RISKS FOR PACIFIC BASIN SHIPPING

  • The global dry bulk shipping sector has lower barriers to entry compared to the other shipping segments and a sharp improvement in freight rates could drive an influx of investments into building new vessels.
  • Existing vessels could also increase their sailing speeds which raises the effective capacity in the market. If all the dry bulk ships in the world increase their sailing speeds by 1 knot, the global shipping capacity will increase by around 6.7% on average on a full year basis.
  • There could be potential dilution if Pacific Basin Shipping issues more shares again to fund its vessel acquisitions and/or to strengthen its balance sheet.

 

Note: Stocks with upside of more than 10% based on our fair value 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.

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“Belt and Road” Initiative’s impact on global dry bulk shipping and other BDI updates

Global Dry Bulk Shipping Outlook – Is the current Baltic Dry Index (BDI) rally sustainable?

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