CICOF - COSCO Shipping: Still An Overly Discounted Shipping Play

2024-01-16 09:34:52 ET

Summary

• COSCO Shipping came out last week with below-par full-year results.
• H1 2024 is poised to be an improvement, though, helped by elevated rates following Red Sea disruptions.
• Unlike its peers, there’s virtually no optimism in the stock and plenty of safety margin in the balance sheet.
• With a major capital return also in progress, investors get paid very well to sit and wait.

Ongoing disruptions in the Red Sea have, perhaps ironically, re-injected hope into the shipping sector. After months of oversupply concerns, the debate has now shifted toward the prospect of COVID-19-type supply chain disruptions and shortages – a view supported by sharp rises in freight indices in recent weeks. For COSCO Shipping ( CICOF ), another week-on-week rise in the China Containerized Freight Index ((CCFI)), the key rate benchmark for its shipping contracts, is opportune, as upcoming negotiations could see the company lock in these rates for longer. So even in the likely scenario that we see this geopolitical conflict wind down over the next few weeks, elevated rates could support P&L numbers well into H1 2024 – welcome news following COSCO Shipping’s subpar full-year report .

In any case, underwriting any investment solely based on geopolitical predictions is never a wise thing to do. The sector has also rallied strongly on recent rate trends, and thus, a fair bit of rate-driven upside has already been priced into the space – in contrast to the overcapacity and container demand concerns that had been top of mind not so long ago. Relative to many of its re-rated shipping peers, however, COSCO Shipping stands out - not only has the stock lagged the sector rally (flattish since my last coverage ), but it also trades closer to historical trough P/Book valuations than before. This seems unjustified, in my view, and continues to underestimate the company’s net cash value, which, at ~60% of market cap, leaves investors with a lot of safety margin. Plus, management has taken an active interest in returning capital (via dividends and buybacks), and this should help re-rate the stock over time. Investors without liquidity constraints will find the Hong Kong-listed ‘H-shares’ (accessible via CICOF) particularly appealing, given the persistent discount vs their mainland China-listed ‘A-share’ counterparts.

Red Sea Conflict Timely Ahead of Contract Negotiations

After a series of attacks on vessels passing through the Red Sea in the back half of 2023, shipping companies have begun diverting from the Suez Canal through the Cape of Good Hope. As this is a significantly longer route, we're now seeing a reversal of the previous oversupply situation, and, in turn, a sharp rebound in spot rates. Shipping companies over-indexing to the Asia-Europe route have been heavily impacted - the benchmark spot rate gauge, the Shanghai Containerized Freight Index (SCFI), was up in the high-teens percentage again last week and a cumulative +110% since December 2023. Perhaps more importantly, the China Containerized Freight Index ((CCFI)), a gauge for contract rates, has also moved higher; this bodes well for Asian operators like COSCO Shipping locking in these rates into longer-term contracts through next year.

How long the current conflict will last is anyone’s guess. The base case scenario seems to be that this goes on through Q1 and possibly early Q2, given the robust responses by the US/UK in recent weeks. That said, the Houthis aren’t backing down either, and there’s every chance of a prolonged conflict and, by extension, a ‘higher for longer’ rate backdrop prevailing. In any case, shipping companies have a much stronger hand going into negotiations this time around, so expect upside to half-year 2024 results for COSCO Shipping. Of course, longer disruptions and concerns about supply chain instability would present incremental upside into H2 2024 as well, though I wouldn’t underwrite anything too optimistic just yet.

Full-Year Result a Sobering Reminder of Cycle Concerns

While the recent focus has shifted to the geopolitical angle, it’s worth keeping in mind that the industry remains in a very serious oversupply situation. Just last week, for instance, COSCO Shipping released poor full-year 2023 numbers, citing a ~78% net profit decline amid supply/demand imbalances (weak demand combined with excess shipping capacity) and freight rate headwinds. The backdrop may have changed now that ships are being re-routed, but if/when things do normalize, it’s hard not to see spot rates getting hit by another ‘tidal wave’ of new capacity this year (mostly the result of over-ordering through the pandemic).

Liners are unlikely to stay disciplined either, given the industry is moving toward less, not more, consolidation – the dissolution of global alliance 2M (comprising Maersk ( AMKAF ) and MSC Mediterranean Shipping Company) being the highest profile case in point. Plus, there are rising ex-bunker costs (including port tariffs) to contend with and limited room to pass it on; hence, all signs point to an industry back to competing fiercely on cost leadership once the geopolitics die down (in line with COSCO Shipping management’s guidance).

Seeking Shelter in the Balance Sheet

Until the excess capacity situation clears, I wouldn’t be too quick to underwrite a cyclical inflection anytime soon. And alongside the recent rally in spot rates, large-cap shipping stocks have also re-rated, leaving investors with very little (if any) margin of safety. COSCO Shipping stands out in this regard – not only for its valuation (~50% discount to book) but also for its strong net cash balance sheet (~60% of market cap), the result of years of balance sheet repair during the previous upcycle. There’s also largely unrecognized value elsewhere on the COSCO Shipping balance sheet, mainly from financial stakes in less cyclical businesses like ports (61.7% in COSCO SHIPPING Ports ( CSPKF )) and a 71.1% stake in diversified holding company Orient Overseas (International) ( OROVY ), among others.

The market’s refusal to assign value to the cash-rich balance sheet seems unjustified, in my view, given management is now actively returning capital to shareholders via dividends (~9% yield currently) and buybacks (A and H-shares). In essence, investors get paid well to sit and wait for an eventual cycle turn – regardless of whether the market re-rates the stock. Other areas to keep an eye on include the company’s investments into alternative fuels in preparation for an ESG-driven low-carbon future, as well as efforts to smoothen out its earnings cyclicality.

Still an Overly Discounted Shipping Play

Having underperformed its large-cap shipping peers in the recent rally, COSCO Shipping is worth a look. To be clear, this isn’t the highest quality shipping name, as the disappointing Q4 update showed, nor has the broader downcycle bottomed. But at a trough valuation of ~0.6x book and with ~60% of its market cap in net cash, investors don’t need a lot to go right here. Even if the market remains content to ignore the cash value going forward, management’s efforts to actively distribute capital via dividends and buybacks mean shareholders get paid handsomely to wait. Alongside the essentially ‘free’ re-rating optionality if recent disruptions in the Red Sea extend for longer than expected, I continue to like exposure via the discounted H-shares (CICOF) at these levels.

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