HPGLY - Hapag-Lloyd: Valuation Seems Too High

2023-03-27 02:41:12 ET

Summary

• I expect profitability to be much lower in 2023 due to a drop in freight rates.
• While the container shipping industry has volume growth potential and possibly more limited supply growth than was feared, the next two years are expected to be challenging ones.
• Hapag-Lloyd is currently trading at 8.8x NTM forward EBITDA and close to 12x 2-year forward EBITDA, making it significantly overvalued compared to its comps.

Investment thesis

I think Hapag-Lloyd (HPGLY) should be considered a sell. Profitability in 2022 was exceptionally high, but I anticipate that in 2023, due to the recent precipitous drop in freight rates, profitability will be much lower. Although I believe the stock is supported by management's plans to increase capital returns to shareholders, I think the current valuation is excessive given the company's potentially bleak earnings outlook. As such, I recommend that existing positions be liquidated or substantially reduced in size to protect against the revaluation.

4Q22 results

Given the summary release in late January, most of the 4Q22 results were already public knowledge. Similar to AP Moller - Maersk's huge sequential EBITDA decline of 39% in 4Q22, HPGLY EBITDA fell 33% q/q in 4Q22. However, volume was down only 1.2% year over year, which I attribute to HPGLY end of voyage accounting and trade lane mix. The annual increase in freight rates was 1.9%, while the quarterly decrease was 15.5%, with the largest quarterly declines on intra-Asia and TP and relatively stable rates on Atlantic and African lanes. It seems that all unit costs, right down to EBIT, have gone up by another 4% over the past quarter. At the end of FY22, the company had accumulated net cash of $13.4 billion. The range of expected group EBITDA for 2023 is $4.3-6.5 billion, with EBIT coming in at $2.1-4.3 billion. Assumptions underlying guidance include a moderate uptick in volumes, a precipitous drop in freight rates as congestion in the supply chain eases, and cost-cutting measures that are partially offset by inflationary pressures.

From an industry standpoint, I felt that both the results and the outlook were better than I expected. These findings seem to point to a more optimistic future, with volume growth potential and possibly more limited supply growth than was feared. However, while this may be a positive development for the sector as a whole, I do not think it justifies the HPGLY current high valuation when compared to history and comps.

My outlook

Most investors, in my opinion, view the container shipping industry with skepticism over the next few years. This is understandable, given the expected supply situation. In my opinion, the next two years (FY23 and FY24) will be challenging ones with little room for improvement because the narrative will be terrible, and the current valuation doesn't help matters (below). As 2023 progresses, I have serious doubts as to whether demand will increase faster than supply, resulting in a larger than expected rebound in freight rates. Until such time as such evidence becomes available, I have a very pessimistic outlook on the sector as a whole.

Valuation

HPGLY is currently trading at 8.8x NTM forward EBITDA and close to 12x 2-year forward EBITDA (it previously traded at 7x 2-year forward). With current earnings expectations, I believe these valuations are simply unsustainable. However, I believe that the expected dividend of EUR63/share is what is supporting the stock at its current valuation. This equates to a dividend yield of about 21%. Even after adjusting for dividends, the stock trades above 7x forward EBITDA (8.8x * 0.89), indicating that it is still overvalued.

First, we examine HPGLY vs comps, which indicate that it is significantly overvalued in terms of expected EBITDA growth. While the dividend yield is higher than most comps, it is a one-time payment that is not sustainable, and thus should not be used to justify the current valuation.

Next, how much is HPGLY worth if it trades down to where the closest competitor, Maersk, is today? In my base case (shown below), the downside could be as much as 50% if it trades at 3x forward EBITDA at $4.7 billion EBITDA in FY23. I like to remind readers that HPGLY is still 2.4x the level of FY19 EBITDA at $4.7 billion EBITDA. In my opinion, this is still a rather high EBITDA. In the worst-case scenario, assuming HPGLY has grown 10% per year since FY19, FY23 EBITDA would be around $2.8 billion. Attaching at 3x forward EBITDA to $2.8 billion would result in an EV of $2.8 billion and a market cap of $16 billion, implying a share price of $89, a 70% drop.

Other highlights

One of the most important things to keep in mind is that management anticipates demand will stay low until the destocking cycle has been completely finished. Although there may be some relief from scrapping and capacity control measures that are likely to be implemented, the supply of new vessels will put pressure on freight rates. Management also discussed data suggesting that actual supply growth may be significantly lower than anticipated (I am dubious as of now, but we will see). This is primarily attributable to slippage in the orderbook, which is caused by shipyards running behind schedule. The orderbook currently accounts for approximately 28% of the total fleet operating today. On account of the weak market dynamics, freight rates as such have dropped by a significant amount from their peak levels. Management was also positive about the possibility that freight rates will have to increase from their current levels. Given the phasing of contracts, management mentioned that profits would most likely be front-loaded in 2023.

Conclusion

I recommend that HPGLY be considered a sell. While dividends pay out to shareholders may support the stock, I believe the current valuation is excessive given the company's potentially bleak earnings outlook. Existing positions should be liquidated or substantially reduced in size to protect against the revaluation. HPGLY's current valuation is unsustainable, trading at 8.8x NTM forward EBITDA and close to 12x 2-year forward EBITDA. The downside could be as much as 50% if it trades at 3x forward EBITDA at consensus $4.7 billion EBITDA in FY23. While the container shipping industry may have a more optimistic future, I have a very pessimistic outlook on the sector as a whole. Therefore, until such time as evidence becomes available to the contrary, I remain skeptical about the sector's rebound in freight rates.

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