Thursday, September 12, 2013

Regional transport stocks: Dry bulkers, ports and airlines to ride upturn in demand, says Credit Suisse’s Ross

Written by Kang Wan Chern  
Monday, 09 September 2013 12:56
Timothy Ross, head of transport research in Asia-Pacific for Credit Suisse, believes now is the time to pick up selected stocks in the regional transport sector as consumption in the US and China improves and exports begin to pick up once again. “We have seen signs that the West has probably been through the worst and China looks like it is starting to lift off the bottom. [So], we expect transport stocks in the shipping, ports and aviation sectors that are leveraged to those economies to outperform over the next six to 18 months,” Ross tells The Edge Singapore during a recent interview.

Growth in the US and China has indeed shown signs of gaining momentum in the past quarter. In 2Q2013, US GDP increased 2.5% from the same period last year, up from the initial estimate of 1.7% and compared with a 1.1% y-o-y rise in 1Q2013, according to official US data. The better-than-expected data is due to higher exports and a 1.8% y-o-y increase in personal consumption. Meanwhile, manufacturing activity in China as monitored by the HSBC Purchasing Managers’ Index (PMI) hit 50.1 in August, up from an 11-month low of 47.7 in July and ending a three-month period of deterioration. Though modest for now, manufacturing activity in China is expected to rise further in the months ahead as Beijing takes steps to rebalance the economy, says HSBC.

In that light, Ross suggests buying into shares in selected shipping plays, particularly in the dry bulk sector. This is because structural changes are taking place in China, which will drive imports of iron ore and coal once again. “In the regional transport sector, we are most sanguine on dry bulk,” says Ross, who has covered the transport sector as both an investment banker at UBS and a sell-side analyst at Credit Suisse for two decades.

Iron ore and coal are two of the most frequently moved seaborne commodities, so a rise in demand from China will help soak up additional capacity and set the stage for freight rates to rise from current levels. Indeed, the Baltic Dry Index — a measure of global rates to move dry commodities — is up more than 60% year-to-date, closing Sept 5 at a 52-week high of 1,125. Meanwhile, a higher frequency of old vessels being sent for scrapping and a slowdown in newbuild deliveries over the past few quarters is also helping to ease a vessel glut that has stunted the industry for years.

“Higher prices of scrapped steel and restrictions in financing have stopped significant ordering in the past few years, and that bodes well for the dry bulk outlook in the next two years,” says Ross. “Even if the banks opened up their coffers today and gave shipyards as much money as they needed to go ahead and build dry bulk carriers, the yards would not be able to deliver the ships for at least 18 months. That adds stability to cash flows and longevity to investments, meaning you can stay invested in dry bulk for a longer period now. The dry bulk business is getting better.”

Based on his estimates, demand to move seaborne dry bulk commodities should grow 6% y-o-y this year, overtaking an expected 5% rise in vessel supply over the same period. The gap between demand and supply is expected to widen even more next year. That is because dry bulk shipping is a bet on growth in the emerging markets, where iron ore is needed for steel mills and coal, to generate power. “These commodities are the cornerstones for industrialisation, demand for which is likely to continue to grow,” says Ross. “Emerging markets are still growing much faster than developed markets.”

With anticipation for more commodity shipments to China in the coming quarters running high, Ross notes that value is beginning to return to dry bulk shipping. His top pick in the sector is Hong Kong-listed dry bulk vessel operator Pacific Basin Shipping, which operates the world’s largest fleet of Handysize and Handymax dry bulk carriers. For the six months to June 30, Pacific Basin’s revenue rose 11% y-o-y to US$766.8 million ($979.4 million) and earnings rose 325%, owing to the discontinuation of its underperforming roll-on/roll-off business and higher contributions from the dry bulk business. Recently, the company also added three Handymax vessels to its fleet for a total of US$68.6 million.

In the dry bulk sector, Ross is also recommending Japan-listed shipping groups Mitsui OSK Lines and NYK Group, both of which run extensive dry bulk operations.

Things aren’t looking as rosy in the container shipping sector, though. For one thing, excess capacity continues to undermine the industry’s efforts to raise freight rates to more sustainable levels, with several recent attempts to hike rates in the Asia-Europe and Transpacific trade lanes failing to be fully implemented or held. The Shanghai Containerised Freight Index — a gauge of spot pricing on major trade routes out of Asia — is down 18% y-o-y, weighed down by an 11% y-o-y decline in Asia-Europe rates and a 28% drop in Transpacific rates over the period.

That suggests that container liner revenues — including those of Singapore-listed Neptune Orient Lines (NOL) — could remain soft in the coming quarters. Even though NOL managed to turn a profit of US$41 million in 1H2013 from losses of US$371 million a year ago by cutting some US$240 million in costs and netting proceeds from the sale of its Alexandra Road headquarters, the liner continues to underperform because of an inability to raise rates in key Transpacific routes.

As such, Ross is advising investors to stay away from the sector for now. “Liners will still see a lot of pain over the next 12 months as mounting debt levels raise ownership costs and large capital expenditure programmes needing to be funded. At the same time, freight rates have proven to be insensitive to the liners’ attempts to raise them,” says Ross. “Even though private consumption in the US is improving and container volumes are likely to tick up, the problem for container shipping is overcapacity. In 1H2013, industry demand grew between 1.5% and 2% but net capacity grew 5%. It’s incredibly hard to see how anyone can make any money with those dynamics.”

Meanwhile, Ross believes a better way to play rising consumption in the West is by buying selected port stocks in the region. His top pick for ports is Singapore-listed Hutchison Port Holdings Trust (HPHT), owing to the trust’s direct exposure to rising Chinese manufacturing and exports. Hutchison holds controlling stakes in some of the region’s busiest deep-water container ports, including Hong Kong International Terminals, Asia Container Terminals and Cosco-HIT Terminals at Hong Kong’s Kwai Tsing Port, as well as Yantian International Container Terminals in China’s Shenzhen Port.

Based on Ross’ calculations, HPHT’s profits should rise more than 9% for every 5% rise in throughput volumes next year. In July this year, throughput at China’s ports rose more than 8% y-o-y, led by ports in Guangzhou, Ningbo and Zhousan. “We think that the port industry is a much more probable beneficiary of any pick-up in volumes, with those servicing the mainland best placed to capture accelerating manufacturing and export activity,” Ross writes in an Aug 19 report.

Investors may also want to take a closer look at Shanghai International Port Group or Cosco Pacific, the container terminal arm of China Cosco Holdings. Cosco Pacific recently saw its earnings rise more than 200% y-o-y in 1H2013 after it sold its stake in container maker China International Marine Container Group to its parent. China Cosco is restructuring assets in a bid to turn a profit, having posted a loss in FY2012 for the third year running that may result in its shares being delisted from the Shanghai Stock Exchange. (See Ross's top transport picks table.)

Ross also expects a handful of airlines to benefit from the improvement in export activity, “especially as they have defended their load factors through more active capacity management than their liner cousins”, he notes in his report. Indeed, not only have most Asian airlines either matched or exceeded revenue expectations with better fares and passenger mix, following the recent earnings reporting season, but improving trade volumes in China in July are likely to give air freight earnings a boost in the quarters ahead.

On top of that, Ross also expects selected full-service airlines to benefit from a rise in corporate travel as business activity in the region gains more momentum. “For airlines, where we are most positive is in the area of business travel. We see the pick-up in stock exchange turnover and higher cash flows in the region as a leading indicator that business travel will improve,” says Ross.

His top pick in the aviation sector is Hong Kong-listed Cathay Pacific Airways, which recently saw “significant yield improvements from a better mix of travellers”, he says. On the cargo front, the airline is expected to benefit from its relationship with China through Air China Cargo, a 2011 joint venture between Cathay Pacific and Air China. Meanwhile, Cathay Pacific’s revenues could also receive a boost from its relationship with international freight forwarder DHL through its subsidiary, Air Hong Kong.

Separately, Ross is also positive on Singapore Airlines because of its recovering passenger yields and cargo business. “The decline in SIA’s yields narrowed sharply in the recent quarter because of a better passenger mix and we expect the cargo business to perform better as well,” he says.

Ross warns, however, that the time horizon for investing in the sector is fairly sh ort. “Liners and airlines tend to be more volatile, so you wouldn’t want to hold them for much more than six months,” he says. On the other hand, the outlook for the dry bulk and port sectors is looking more stable over the longer term. “The less volatile the cash flows, the longer you might want to stay invested.”

Publish date: 09/09/13

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