2023-11-14 13:11:10 ET
Summary
- ZIM Integrated Shipping's most recent EBIT guidance, provided in July, estimated full year EBIT of -$100 million to -$500 million, suggesting a $139 million second-half EBIT loss at its guidance midpoint.
- For many reasons, particularly interest related to ZIM's addition of many long-term container ship leases, its underlying net losses are increasing at a faster rate than ZIM's EBIT trends imply.
- ZIM's cash levels are deteriorating faster than its net loss trend, partly because the tax credits it reports only become relevant when ZIM again has offsetting taxable income.
- Therefore pre-tax loss rather than net loss is a more relevant starting point for analyzing or projecting cash flows.
- ZIM's cash balances are also negatively impacted by down payments on some of the new long-term leases.
Introduction
ZIM Integrated Shipping ( ZIM ) provided updated guidance for its 2023 annual Earnings before Interest and Taxes (EBIT) in July. Earnings were then released in mid-August. I examine this information to determine what the remaining EBIT amount would need to be to meet the midpoint of its guidance. I then estimate ZIM's earnings and cash flow for the remainder of the year based upon the company hitting the midpoint of its EBIT guidance. This analysis is particularly relevant now with ZIM's Q3 earnings scheduled to be released on Wednesday, November 15.
Both ZIM's business profile and industry fundamentals are rapidly changing. In particular, ZIM used to have many short-term ship leases but has now committed to many long-term leases. This substantially changes ZIM's risk profile, a factor I strongly suspect is not fully understood by the market. Lease accounting is also deceptively complex. As a result, by necessity, I will devote a fair amount of this article to lease accounting issues which is a necessary first step to understanding my cash flow conclusions.
ZIM's EBIT Guidance
The following table shows the three scenarios within ZIM's full-year EBIT guidance. I provide estimates of the EBIT losses for the remainder of the year at the high, low, and midpoint of its estimated $100 million to $500 million EBIT loss. I chose the midpoint of this range, a $300 million EBIT loss as my base case:
ZIM's EBIT loss would need to be a total of $139 million for the remainder of the year, or an average of $70 million for the remaining two quarters to match the midpoint of company guidance (my base case). ZIM's EBIT loss in Q2 alone was $147 million, and would have been $168 million except for a $21 million "adjustment") so the company's performance would need to improve considerably to meet this target.
However, the company did highlight in its June 30 earnings release that " the expected redelivery of certain vessels sold and leased back by the Company in 2018 negatively impacted net loss by a non-cash after tax amount of $51 million ." This would amount to a pre-tax loss of about $60 million. Without this impact, the EBIT loss would have been about $90 million, only a bit worse than the negative $70 million run rate needed for the company to meet its full year guidance.
Estimating Pre-tax Loss Using ZIM's EBIT Guidance and My Projected Net Interest Expense
This table begins with the EBITs reported by ZIM in the first two quarters of 2023 and my calculation of the EBITs for the remaining two quarters of the year which would allow ZIM to meet the midpoint of its annual guidance (negative $300 million). I then include the actual results or my estimates of future interest income/expense to arrive at pre-tax quarterly loss figures.
It should be noted that in Q2, ZIM positively adjusted EBIT by $21 million for a "Capital loss (gain), beyond the ordinary course of business" as disclosed in its earnings press release , but it was an expense nonetheless, so I needed to subtract it at the end to reconcile the figures to ZIM's Q2 pre-tax loss.
I am projecting a continued trend of modest interest income decreases for the remainder of the year, consistent with market expectations of continued losses and cash decreases.
Obviously, the important figure above is the interest expense line, which is rapidly growing. Interest expense increased by $46.8 million, almost 50%, from Q1 of '23 to Q2! I find this figure absolutely astounding considering debt did not increase by much in the quarter.
As a result, I created the following table, estimating the average debt outstanding in each of the past six quarters (by averaging each quarter's starting and ending debt) and estimating the interest rate on each quarter's debt utilizing the quarter's interest expense:
ZIM only discloses the interest rate on its debt, including lease liabilities, once per year. At December 31, 2021, the reported interest rate on the lease liabilities was 5%, while at December 31, 2022, it was 7.7%, reasonably consistent with my above estimates. (There was only a small amount of other debt outstanding on those two dates.)
The interest rate increasing from the reported 7.7% at 12/31 to my estimate of the rate approaching 12% at 6/30 was quite surprising to me, particularly considering that lease labilities go on the books at a fixed rate for the life of the lease.
There are multiple factors involved. Part of the reason is that although the net lease lability has only been gradually increasing, there are major additions and subtractions each quarter. I created a second table demonstrating this. I utilized the reported lease liabilities at the end of each quarter as well as the quarterly lease principal payments. I then used that data to calculate the gross lease addition amounts:
Although the lease liabilities are set at fixed interest rates for the terms of the individual leases, the rapid turnover of the historically short-term leases (average of two years or so) partly explains the rapid increase in the rates. Obviously, the new leases are at much higher rates simply due to the increase in interest rates over the past year or so.
Another factor is that ZIM is now adding much longer term leases which would have higher interest rates than a short term obligation would. Finally, ZIM might be utilizing a higher risk premium on its obligations this year, as it has transitioned into an environment where it will likely be losing money, rather than earning a profit, for the foreseeable future.
Lease Accounting and Interest Expense
I know many ZIM investors do not consider lease interest expense to be a real expense but rather just some sort of esoteric accounting rule that can be ignored. Although there is a small element of truth to that, it does generally represent real cash going out the door.
There are two elements to the lease expense which is recorded on ZIM's income statement (not including operating expenses). In addition to the interest expense, there is depreciation expense on the leases.
The "Right-of-Use" asset put on the books for the leased ships is a discounted value, using the same discount rate as the associated lease liability. In fact, the initial amounts put on the books for both the asset and the liability are identical, with the exception that any upfront payment on a lease reduces the initial liability amount.
The "right-of use" asset is then depreciated over the life of the lease on a straight-line basis. A higher discount/interest rate causes the annual depreciation expense reported to be lower but the annual interest expense to be higher. Over the life of the lease, the total of the depreciation and interest expense will equal the total lease payments actually made.
If, for example, ZIM were to make the unlikely decision that a 0% interest rate were appropriate, the interest expense would be zero but the depreciation expense would be much higher due to the initial asset value going on the books at the full amount of the total lease payments, not the lower discounted amount. The end result over the life of the lease is that the lease payment expense would be the same irrespective of the interest rate assigned to the leases. The only artificial result is the allocation of the lease payments to depreciation vs. interest; the total expense is a real number.
There is one minor quirk in the timing of the lease expenses, however. Just like a mortgage has its interest expense front-loaded in the payments, so are ZIM's lease interest expenses. As a result, the sum of the interest and depreciation expenses will be higher than average over the early years of a lease and lower than average in the latter years, basically front-loading the expenses. The result is that the accounting expense for a particular lease in the early years is higher than the economic expense (with the situation reversing in the latter years).
Normally, this would be an irrelevant rounding error. With new leases regularly being added and old leases approaching termination, the result would be a minimal net quarterly impact on ZIM's economic vs. GAAP income/loss. However, ZIM has recently entered into a number of long term leases for large ships and will soon be adding many more. I therefore expect that ZIM's GAAP results will be somewhat worse than its underlying economics for at least the next couple of years due to this surge in new leases. Most investors won't understand this. Of course, ZIM's current dividend policy is based upon GAAP earnings, not a possibly higher "economic earnings" figure.
Lease Accounting and Cash Flow
The lease accounting rules, in conjunction with the imputed interest rate ZIM has determined is appropriate, does not impact cash flow. It does impact how ZIM allocates lease payments though. The actual lease payment is a fixed, contractual amount. The interest expense is calculated based upon the lease interest rate. The principal payment on the lease is the "plug" on the cash flow statement, determined by subtracting the interest payment from the lease payment. The financing activity section of the June 30 cash flow statement helps to demonstrate this:
For the first six months of the year, the total repayment of the lease liabilities and (other) borrowings was $861.4 million while the cash interest paid was an additional $182.7 million, or a total of $1,044.1 million. Although a small portion of this is for ZIM's non-lease debt, likely well in excess of 95% of it is related to the lease liabilities. (We do not have a specific breakdown.)
This $1,044.1 million figure is a real cash outflow, but if ZIM had decided a lower imputed interest rate, or even a 0% rate was appropriate, then the interest payment would have been recorded as a much lower figure but the principal payment would have gone up by the same amount; the total cash paid would still be $1,044.1 million, "no matter how you slice it."
Investors need to keep in mind that principal payments on debt are not expense items, just cash flow items. As can be seen above, they are not even operating cash flow items, but rather financing ones. Interestingly, ZIM categorizes interest payments as financing cash flows as well; most companies consider interest payments as operating cash flow subtractions.
It is worth noting that although ZIM reported $237.2 million of gross interest expense in the first half of the year, interest payments were only $182.7 million. These figures will rarely be exactly the same due to timing differences between accruing the interest expense and actually paying it. However, this is an unusually large difference. I believe this is mainly due to the large number of ships which were delivered in Q2 for which interest has begun to accrue but some of the associated lease payments had likely not yet been made.
Ship Deliveries and Lease Renewals Continue
There seems to be a misconception among some ZIM investors that its fleet may be shrinking due to expiration of some leases and the early termination of others. In actuality, it is growing. The table below is from ZIM's 2022 annual report:
As the chart indicates, at December 31, the total leased ship capacity scheduled to mature in 2023 was 90,833 TEU's (15,548+75,285), only 16.5% of ZIM's total capacity at year-end 2022. ZIM has contracted for many new build ships. Henrik Alex, in his recent Seeking Alpha article, put together an excellent chart and some explanatory comments on this subject:
Mr. Alex makes a number of significant observations:
- "Please note that year-to-date, the company has only taken delivery of four out of a total of 42 publicly-disclosed newbuilds chartered on long-term contracts from various lessors between 2020 and 2022.";
- "In addition, ZIM has recently taken delivery of four 12,000 TEU newbuilds from Seaspan, but the company has not disclosed the terms of these leases.";
- "Please note that the newbuild vessels are of substantially larger average size than the company's existing fleet."; and
- "While ZIM has a total of 47 vessels with lease expirations in 2023 and 2024, even when assuming zero extensions, the company's total capacity is going to increase substantially at the worst possible time..."
This means that the fixed costs, mainly depreciation and interest expense, will increase dramatically the next few quarters. In fact, the lease liability which ZIM will report as these ships are delivered will greatly understate the total future payment obligations correctly reported by Mr. Alex simply due to the discounting impact of ZIM's accounting.
For example, Mr. Alex correctly calculates the total lease liability for the 10 15,000 TEU ships will result in total added lease payments of over $2 billion during the next decade or so. However, due to present valuing/discounting, the figure which will go on the balance sheet will be roughly half of that, with the remainder to be reflected in future hugely increased annual lease interest expense.
Putting the Cash Flow Pieces Together
Utilizing the figures I've provided above, and conservatively estimating possible lease down payments at $50 million per quarter, I show that ZIM's cash balance could easily decrease by roughly $250 million to $300 million per quarter in the remaining two quarters of this year, including the one already completed but not yet reported:
I believe my figures are quite conservative, and therefore the above figures may be close to "best case" scenarios. I started with the midpoint of the revised EBIT guidance ZIM provided in July. ZIM provided quite a large $400 million range for the remainder of the year. As a result, ZIM's EBIT could average as low as -$170 million/quarter or as high as +$30 million/ quarter. I expect that the actual EBIT about to be reported for Q3 will be below the -$70 million midpoint due to weak container rates in Q3.
EBIT can rapidly improve based upon possible increases in shipping rates. The largely unrecognized issue by many ZIM investors (even professional analysts!!) is the impact on interest expense the huge commitments ZIM has made for long term large liner leases will have. Interest expense increased by almost 50% from Q1 to Q2 and it will likely continue to experience large increases in each of the upcoming quarters. I therefore think my rough estimate of an increase in interest expense of only $25 million per quarter is likely quite conservative. Increased interest expense will be a long term drag on ZIM's performance.
My estimate of only $50 million per quarter for lease down payments may be conservatives as well. As a result, although my base cases for the next two quarters is about $252 million to $280 of cash usage in each of the remaining two quarters of 2023, I would not be at all surprised if the actual result is closer to $350 million.
For further details see:
ZIM Integrated Shipping: What Its Current EBIT Guidance Means For Net Income And Cash Flow