In choppy waters

Once a well-established player in the shipping industry, Varun Shipping is busy restructuring its debt after defaulting. The company has not reported its financial numbers for the past one year and its stock has not relisted post-restructuring.  It is not the only one sailing through financial stress. The ‘Z’ score, an indication of the probability of a firm going bankrupt, is an alarming 0.25 for Mercator and 1.87 for Shipping Corporation of India (SCI), two of the largest listed shipping companies in India, besides GE Shipping. That’s because the shipping industry is in much dire straits today than it was post the 2008 economic crisis.

A capital intensive business anyway, companies that relied heavily on borrowed funds are facing the maximum impact during the downturn. Varun Shipping has a debt to equity ratio of 4.24x (last reported), Mercator 2x and SCI 1.17x. Compounding the issue is the high cost of capital in India. “This is why they stay high on the global cost curve,” says Captain Vivek Singh Anand, who heads the Indian operations of Japanese ship major NYK Line and is the president of Mumbai and Nhava Sheva Ship Agents Association (Mansa). “A foreign shipper will raise funds at Libor (London Interbank offer rate) plus 1-1.5%, whereas an Indian company will raise funds at Libor plus 5-6%,” he adds. For Indian players, for every dollar earned, 75 cents goes towards covering the capital cost of a capsize dry bulk ship — that leaves little room to accommodate operating costs and make a profit. 

It’s not all gloom and doom though. The debt to equity ratio of Shreyas Shipping and GE Shipping is 0.8x. This is also the reason that despite the downturn, Shreyas’ interest coverage stood at 11x, followed by GE Shipping’s 3.7x. In contrast, Varun Shipping and Mercator haven’t even been able to repay interest. More importantly, not only is GE almost debt free at the net level, it has never reported losses in the last 20 years, and has a consistent dividend paying history. 

The stress though, is reflecting on stock prices, with major shipping companies trading at near half their book value. GE is currently trading at 4x its earnings and offering the highest dividend yield of 4% in the shipping space. Does it then make sense to swim against the tide?

The epicentre
Shipping companies have been struggling for a while. Charter rates are lower than they were after the global economic crisis. During 2008, the Baltic Index, which tracks global shipping rates, fell almost 95% from near 12,000 in May 2008 to 663 in December 2008. In February 2016, the index broke even those lows, plunging to 290-odd. While it has recovered to around 600 currently, it is still well below the 2008 low. “Relative to 2008, when shipping markets were on a rise, tankers as well as dry bulk are well below the peak freight rates,” says Binaifer Jehani, director, Crisil Research. 

While global cues are to blame, the crux of the matter this time around is the China situation. Post the 2008 crisis, the recovery was fast and damage relatively lower because the decline in the developed world — the US, Europe, Japan and others— was offset by Chinese demand. 

This time around, China, which accounts for close to 40% of the global trade, has seen its GDP contract from 7.8% in 2013 to 6.9% in 2015. IMF expects it to fall further to 6.2% by 2017. This downtick is hurting its external trade. During January-May 2016, China’s exports fell 7.3% compared to last year. Similarly, in May 2016, imports fell 0.4%, a 19th straight month of contraction. Imports during January-May 2016 declined 10.3%. Reflecting these worries, IMF in October 2015 reduced its world trade growth estimates by 100 basis points to 3.1%.

“China is sitting on huge capacity. For instance, it has piles of finished steel sitting at the port to be sold. It is reducing its energy consumption, cutting down hugely on the production of steel and other metals, which will ultimately have a bearing on freight rates and world trade. There is a 50% reduction in Chinese thermal coal imports. Its import of iron ore, which is about 60-70% of  global iron ore shipping, has seen significant reduction in imports,” says Navin Kumar, director, bulk shipping research, Drewry Shipping Consultants, an independent maritime advisor.    

Out of business 
With the slump in the dragon’s fortunes, the biggest issue before shipping companies, especially those in the bulk segment, is capacity utilisation. In the last two years, globally, the number of inactive vessels has shot up from 42 at the end of 2015 to 327 ships currently. In terms of tonnage, it has moved up from 2.83 million deadweight tonne (DWT) by the end of 2015 to 19.3 million DWT. There is, thus, huge supply pressure, which is unlikely to alleviate soon. 

“At current rates, almost half of the industry capacity is idle. Companies are not even able to recover the cost. For instance, operating cost for a dry bulk carrier is a little over $5,000 per day, if we add the capital cost, this comes to around $15,000 per day. As against this, the present ruling rates are somewhere in the range of $5,000-$6,000 a day,” adds Kumar. 

Within the sector, dry bulk, which accounts for close to 50% of the global sea-borne trade, is seeing the most pain, with all-time low freight rates. Dry bulk deals with commodities like iron ore, coal, fertilisers and others. “The current dry bulk freight rates (and BDI levels) are unsustainable, with vessels running below operating costs. The situation is particularly bad for larger vessels such as Panamax and Capesize vessels,” says Jehani. 

Keep waiting
What makes matters worse is that most industry watchers feel it will be a long-winded recovery, with a lot hinging on China. “The world is going through a recession; there is literally no demand, and on top of that, there are supply concerns. Recovery should start once China starts to stablise. However, that may not happen immediately,” says Anand.

The IMF though, is hopeful. According to its April report, world trade growth is projected to grow at 3.8% in 2017 compared with 3.1% in 2016, largely driven by imports from emerging and developing nations. 

Crude oil prices hold the other key. Anand feels that if crude oil price recovers to around $70 a barrel by the end of next year, other commodities, too, will start recovering, leading to improvement in day rates.  “But that is still about 18-24 months away,” he adds.  

Whether it is going to be 24 months, 36 months or even longer, companies are in for a tough time. And even if there is a recovery, this time it may be different. In the earlier cycle, the multiplier of trade growth to GDP growth was in the region 1.8-2x, which has now shrunk. “The GDP to trade multiplier for container shipping has been close to 1 in the past three years. This is the new normal,” says Peter Sand, chief shipping analyst at BIMCO, one of the largest international shipping advisories, adding that companies have to adapt to this level as the glory days of the past are unlikely to repeat anytime soon. 

“This is not the beginning of a swift recovery. If the dry bulk ship owners strictly don’t expand their fleet for the coming years, and expectations of a 2% demand growth comes through, the industry will become profitable in 2019,” he adds.  

Jehani is of a similar view. “The dry bulk recovery is unlikely to be steep, rather the dry bulk freight rates would improve only gradually, driven by easing oversupply situation in medium to long-term,” she says.

Saving grace
Amid the global chaos, a few things have been working in favour of Indian companies. The wet cargo or tanker segment (about 60% of India’s external trade comprises of these) has been relatively stable. For instance, the Baltic Dry Index fell 76% from its peak in August 2015 to its low in February 2016. However, during this period, Baltic Dirty Tanker Index (rates for wet cargo like oil, petro-chemicals) remained flat. 

“In the energy market, it is largely a supply issue. As such, the demand has not fallen, which is why volumes haven’t either in the tanker segment. In fact, there is more demand as a result of the lower oil price. Many countries are building strategic reserves. India is creating 40 million barrels of strategic oil reserves and has achieved about 10 million barrels so far. Besides, there is growing demand for LPG from emerging and developing nations, helping shippers and bringing stability in day rates,” says Kumar.

Within the country too, energy demand has been growing with a spurt in consumption of both petrol and diesel. Imports, thus, have been rising. Last fiscal, India imported 202 million tonne of crude oil as against 189 million tonne in FY15.  

Similarly, the demand for LPG is in double digits fueled by household consumption and demand from the auto sector. In FY16, India imported close to half of its 19.55 million tonne consumption of LPG. Besides, India’s LNG imports jumped more than 43% to 2,082 million metric standard cubic meter (mmscm) in May 2016. 

The fleet utilisation in the segment is also better at roughly 88% compared with the bulk segment. Experts now feel this segment could also come under pressure because of higher supply.  

“For crude oil tankers, as well as oil product tankers, 2015 was a brilliant year with solid earnings. 2016 is where the tide is turning against the sector. The fleet growth of crude oil tankers is expected to rise from 2.4% last calendar to 4.3% this year. 2017 is likely to see an even higher fleet growth rate. That is too much for the market to absorb. Therefore, lower freight rates for the full year will follow,” says Sand.

Jehani concurs, adding that the segment will have to face the impact of Brexit too. “The Baltic Dirty Tanker Index is rising marginally only due to softening global crude oil demand. Going forward, growth in freight rates are expected to mellow down, while product tankers would continue to remain strained,” she says.

Volume game
Besides the stable wet cargo rates, Indian companies have been able to clock higher volumes, helping them partly offset the negative impact caused by falling day rates. In the quarter ended March 2016, bulk cargo volume grew 8.5% year-on-year, followed by containers at 6.6% at major Indian ports. 

To put it in perspective, in the March 2016 quarter, the Baltic Dry Index, on an average, was down 42% compared to same quarter previous year. Despite the huge correction, SCI, GE Shipping and Mercator reported only an 8.5% drop in their revenue. 

While higher volume is helping protect the topline, companies have had to take a hit on profitability because of lower realisation. In case of SCI, which has higher exposure to the bulk segment (71% of revenue), the impact has been higher. The EBIT margin of the bulk segment halved to 6% in Q4FY16 as against 12% in Q4FY15. 

On the contrary, GE’s bets to diversify and shift to long-term contracts have worked well though. It currently has about 32 vessels, out of which only 28% or nine vessels are deployed in the bulk segment, which is the most hit. “GE Shipping is far more efficient and well diversified. Compared to SCI and Mercator, GE has lower bunker cost and it’s almost debt free, having flexibility in terms of leveraging its assets,” says Bharat Chhoda, senior analyst with ICICI Securities. 

Bunker costs, which include basic operating costs such as fuel and other direct expenses, are the lowest for GE at less than 10% compared to 11% for SCI and 16% for Mercator. Also, within dry bulk, GE has ramped up long-term contracts from 5% in Q4FY15 to 37% in Q4FY16. This has helped the company reduce its dependence on spot price volatility and correction in the dry bulk segment.

On the contrary, Varun Shipping vanished into the oblivion because of ill-timed expansion. “Varun Shipping is nowhere today because the company diversified into the offshore segment, buying expansive assets through huge borrowing, which later on could not be serviced as a result of falling rates. In fact, to service those bad assets, it had to sell some of the cash-generating assets in the gas business,” says Chhoda. 

Shreyas Shipping which provides connectivity between the Indian ports where only Indian shippers are allowed to operate has been able to grow as it derives 40% of its revenues from coastal shipping. With a market-share of 60% in coastal shipping, Shreyas actually went ahead with expansion last year. During Q1FY14, despite all the major shipping companies showing decline in their revenues, Shreyas reported a 25% growth in revenue backed by 29% volume growth. That apart, Shreyas makes close to 60% of its revenues from exim trade, where it provides transhipments (90% market share) and end-to-end connectivity to shippers, where rates have been relatively better. Exim has also helped in protecting realisations. 

The other big differentiator which saved the day for both GE Shipping and Shreyas is interest cost. Even in the worst quarter (Q4FY16) for shipping companies, Shreyas and GE Shipping made a net profit margin of 6-7%. Unable to cover their interest cost, Mercator and SCI ended up with losses. 

Despite their relatively better performance, worries linger. “While GE Shipping and Shreyas are well placed, even these strong players will face challenging times in the coming two years because there is huge pricing pressure in the international market and threat of higher supply. That is why while both these companies are trading at attractive valuations and offering good dividend yield, one will have to be really patient investing in these companies,” ends Chhoda.