HLAGF - Hapag-Lloyd AG: Beware A Prolonged Container Shipping Downturn

2023-05-23 11:53:24 ET

Summary

• Hapag-Lloyd posted surprisingly strong results despite a challenging industry backdrop.
• But with the supply/demand balance poised to get worse before it gets better, it may be too early to underwrite an investment here.
• At the current premium to book value, Hapag-Lloyd remains exposed to more downside.

The record-high container rates in recent years, a symptom of the pandemic-driven tightening of global logistics supply chains, have started to unwind, and container shipping operator Hapag-Lloyd ( OTCPK:HLAGF ) is fully exposed to a downturn. 2022 was one of the strongest years on record for the company, but the market is normalizing lower, and 2023 is shaping up to be a far more challenging year for earnings. Since I last outlined the risk of a downcycle in my prior coverage here and here , the stock price has declined significantly – but not enough, in my view. While freight rates are already well below their 2022 highs, most of the 2023 capacity is only set to hit the market in H2, with an even bigger wave of new builds expected to come on stream in 2024/2025. Alongside weakening global PMIs (contractionary in the US, EU, and China), the industry appears set for significant downside ahead.

With many operators already running routes below costs and with a large percentage of costs being variable, there will come a point when economic incentives move the supply/demand back into balance. Pending concrete signs of capacity withdrawals, however, I wouldn’t suggest an investment in Hapag-Lloyd anytime soon. Too much optimism is priced into the stock at the current premium to book, leaving ample room for further de-rating.

Outperforming the Industry in Q1, but for How Much Longer?

Hapag-Lloyd defied a very challenging demand backdrop in Q1 to deliver flattish sequential volume growth (down 5% YoY), well above the low-single-digit percentage increase for its container shipping peers. Some of the delta was due to better route economics, given the company’s relatively large exposure to the more resilient Transatlantic and Latin America routes. But there was also an accounting influence in the results, which will reverse in future quarters – as Hapag-Lloyd accounts for revenue based on an end-of-voyage recognition vs. the proportion-of-voyage policy used by many of its peers, some of the negative rate impacts will only flow through the P&L next quarter. So even though average freight rates for Hapag-Lloyd were only down 24% (vs. >30% QoQ for peers), the Q1 outperformance should normalize in the coming quarters.

Profitability was another strong point, with EBIT coming in at EUR1.7bn and margins at >30% vs. ~20% for key peer A.P. Møller - Mærsk ( OTCPK:AMKAF ) and high-teens percentage for overseas peers like COSCO SHIPPING ( OTCPK:CICOY ). The Q1 EBIT only contributes to ~60% of the company’s EUR2-4bn guidance for the full-year (unchanged), however; by comparison, AP Møller – Mærsk has pegged its guidance range at a wider $2-$5bn, and the Q1 EBIT already accounts for >70% of the midpoint. With some of the Q1 benefits set to reverse in Q2 and beyond, the company remains exposed to potential downward revisions, in my view.

Near-Term Outlook Clouded by Worsening Industry Dynamics

In line with the pessimistic industry view, Hapag-Lloyd management noted a limited demand uplift in its trade lanes thus far. Yet, they also remain optimistic about an eventual inventory destocking cycle driving a return of YoY volume growth. Meaningful destocking has yet to materialize, however, with order data instead pointing to an influx of capacity in H2 2023 and later in 2024/2025, Even with a temporary offset from increased scrapping and slow steaming, all signs point to elevated supply through the rest of the year, if not longer. Further skewing the supply/demand balance is the deteriorating state of demand, with leading PMI indicators in the US, EU, and China all signaling an industrial contraction ahead.

While freight rates have already declined in reaction to the skewed supply/demand balance, it remains early days. Hapag-Lloyd noted its transpacific contracts are still being finalized at above spot rates, but many other routes are already running below costs. A sizeable percentage of shipping costs is sunk, whether or not they go on a voyage, so liners would likely run at sub-par economics as long as they can sustain rates above marginal costs. And with Hapag-Lloyd’s EBIT margin running above peers in Q1 (largely due to its different accounting recognition and route mix), it is likely most exposed to future downside. Hence, I think the market’s selloff post-Q1 was justified; from here, expect continued downward revisions to quarterly earnings alongside spot rates.

Sustainability Challenges Weigh on Mid to Long-Term Economics

Given the interconnectedness of container shipping within global supply chains, its environmental profile is increasingly coming under the microscope via scope-3 emissions regulations (i.e., indirect emissions from industries’ supply chains). More stringent regulations in Europe mean Hapag-Lloyd faces an undue capex/opex burden to successfully comply with its decarbonization objectives, particularly at this early stage of the 'green' cost curve. Dual-fuel vessels, for instance, can entail up to a 20% higher capex outlay relative to standard vessels. On the opex side, green fuels are also increasingly more expensive than conventional fuel options (e.g., the widening VLSFO/HSFO spread), leaving the company exposed on the P&L and balance sheet.

In a cyclical industry where operators have shown limited pricing power, it remains to be seen if companies can successfully pass on the higher costs to their corporate and end-market consumers. To make matters worse, the industry is entering a potentially severe downturn; pending visibility into the impact of the 2023/2024/2025 capacity influx on industry economics, recommending a mid to long-term investment here is challenging. And with regulatory challenges only set to intensify ahead of the 2050 net-zero target (or earlier), which the leading shipping companies have already committed to, I see more downside than upside to the equity outlook.

Beware a Prolonged Container Shipping Downturn

Hapag-Lloyd has long been a best-in-class operator, operationally and on the shareholder value creation front (e.g., the ROIC>WACC mid to long-term target). But like all the other container shipping players, the company is ultimately at the mercy of the cycle. The COVID-driven logistics shortages globally, for instance, drove record earnings through 2022. But with every boom comes a bust, and the market has now begun to normalize lower, with spot rates falling well below last year’s highs.

Q1 conference calls suggest some players are already loss-making on some routes, though none have suggested withdrawing capacity. Yet, a huge wave of supply is coming online in H2 and another wave in 2024/2025, so we likely aren’t anywhere near the bottom of this cycle. Pending a meaningful upturn in container demand (unlikely anytime soon, given PMIs are <50 for all the major economies, including China), Q1 was likely the 2023 peak. With management teams still optimistic, expect more downward revisions from here. At the current premium to book, Hapag-Lloyd stock screens too richly and will be very vulnerable in a prolonged downturn scenario.

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