2023-07-21 14:35:32 ET
Summary
- Coming off the COVID-driven highs, the shipping industry is now stuck in a downcycle.
- COSCO SHIPPING is exposed to the same industry headwinds but has shown surprising resilience.
- With the H-shares now priced below net cash, the market has likely penalized the stock too harshly.
In the context of softer-than-expected freight rates from the Chinese liners last quarter, COSCO SHIPPING's ( OTCPK:CICOF ) strong preliminary Q2 result came as a surprise. To be clear, the industry isn't yet out of the woods, with further pressure on the horizon from new deliveries coming on stream. But the resilience of the P&L, albeit helped to a large extent by cost discipline, is a timely rebuttal against cyclical fears. Positioning in names with exposure to more demand resilience (i.e., less US/Europe, more Asia) and a defensive cost structure makes sense here; COSCO SHIPPING, with its concentration in the Trans-Pacific and Asian routes, fits the bill nicely.
Perhaps the most compelling part of the COSCO SHIPPING thesis, though, is the equity valuation, which has moved below net cash for the Hong Kong-listed shares (i.e., the H-shares accessible in the US via CICOF). But with the company still profitable and its core shipping business showing signs of resilience, the setup here strikes me as a classic 'heads I win, tails I don't lose much' scenario. Further expansion of the mainland China-Hong Kong 'Stock Connect' scheme presents a potential upside catalyst (note COSCO SHIPPING H-shares trade at a wide discount to the mainland-listed A-shares for liquidity reasons), along with incremental shareholder return announcements.
Resilient Q2 Result Defies Industry Headwinds
Earlier this month, COSCO SHIPPING posted surprisingly resilient preliminary half-year numbers, with H1 2023 EBIT at RMB24.7bn (down 74.1% YoY) and net profit to shareholders of RMB16.6bn (down 74.4% YoY). Despite the steep headline YoY declines, parsing out the implied Q2 numbers makes for interesting reading - the implied Q2 EBIT of RMB15.4bn is up 66% QoQ, while implied core earnings of RMB9.4bn equates to a +32% QoQ increase. In contrast, the China Containerized Freight Index was down in the low teens percentage sequentially. While this means COSCO SHIPPING likely suffered a weaker top-line in Q2, it also suggests a defensive cost structure and that management has been effectively taking out costs - positive indications for the company's through-cycle earnings power.
In a broader global context, shipping peers like Zim ( ZIM ) have been guiding to significantly lower revenue and profitability numbers for the full year (2023 EBITDA range down to $1.2bn-$1.6bn from $1.8bn-$2.2bn prior), validating the case for Q1 being 'peak earnings' for the industry. But there is an important divergence between the EU/US and Asian routes, with the stabilizing volumes and more resilient freight rates for the latter supporting a more benign earnings outcome. Companies like COSCO SHIPPING, with good cost control and a healthy balance sheet, are particularly well placed to come out ahead of this downcycle. Adding to the defensiveness is COSCO's net interest income from the >RMB150bn net cash balance for 2023e (~100% of the H-share market cap) and equity investments in key ports; these counter-cyclical earnings streams should cushion against volatility in the core shipping P&L.
Industry Outlook Still Bleak, but There Are Encouraging Signs of Resilience
Following a cyclical upswing through the pandemic-affected years, spot freight rates for container shipping have normalized significantly lower this year amid the unwinding of port congestions globally. Also contributing is the ongoing inventory destocking cycle, as liners realign inventory with reduced demand, along with the 'tidal wave' of new vessel capacity scheduled to come on stream in H2 2023 and 2024. No surprise, then, that freight indices have been down across the board globally since the Jan 2022 peak.
The silver lining, however, has been the relative resilience of the Shanghai Containerized Freight Index, which tracks spot rates for Shanghai container exports, at the 1k level (currently at ~967). A key contributor has been renewed discipline in Asian routes, where container liners have, for instance, been imposing 'general rate increases' ((GRI)) for Trans-Pacific routes in April and June. Building on the success of previous GRI s, the carriers successfully pushed for a third round of surcharges this month ahead of contract negotiations; assuming recent discipline holds, further rounds of GRI implementations could be on the cards as well, keeping rates well-supported throughout the year.
Liners aren't out of the woods just yet, though - sustained 'higher for longer' interest rates in the US/EU and inflationary pressures remain key headwinds, while in China, deteriorating manufacturing and export growth (per consecutive months of contractionary PMIs) are further weighing on global demand. Hence, picking defensive spots through the downcycle makes a lot of sense. Given the resilience shown by Asia-North America trade thus far, both on rates and import volumes , COSCO SHIPPING's higher Transpacific route exposure screens favorably. Additional upside drivers to a potential oversupply situation include increased slow steaming (i.e., reducing cargo ship speeds to save on fuel consumption), as well as a concerted pullback on fleet expansion in favor of capacity replacement. Either way, the pessimism embedded in COSCO SHIPPING's current equity price (market cap below net cash) means that even after factoring in the record levels of new vessel capacity additions from H2 2023, investors could still come out ahead here.
Unfairly Penalized and Priced Below Net Cash
With the global macro environment taking a turn for the worse and driving freight rates lower in recent months, shipping stocks have understandably taken a beating. Yet, COSCO SHIPPING has bucked the trend with a surprisingly positive set of preliminary Q2 results on the back of effective cost cuts and a more resilient pricing backdrop in its key Trans-Pacific and Asian routes.
While the stock has bounced in the aftermath, the market is still pricing the H-shares (accessible to US investors via CICOF) below net cash, presenting investors with a deeply discounted opportunity. So even with H2 potentially seeing more pricing pressure amid a wave of new capacity globally, investors should still come out ahead. Key near-term catalysts include signs of demand resilience or COSCO SHIPPING's cost discipline allowing it to further defend margins through the downcycle. Investors also get additional cushion from the low-double-digit H-share discount (vs. equivalent A-shares), which should narrow as regulation eventually allows expanded mainland inflows to Hong Kong, as well as a solid mid-single-digit forward dividend yield.
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COSCO SHIPPING: Unfairly Penalized And Priced Below Net Cash