Signs that the global shipping industry has hit the bottom of its current cycle provides a good case for opportunistic investing in cargo vessels, Mercer says.
Investing in ‘distressed shipping’ is a variation of the current capital scarcity theme, Mercer says: now the small number of the banks which have been consistent suppliers of debt to the shipping industry – such as RBS, Lloyds TSB and HSH Norbank – have been forced to exit and focus on domestic businesses, investors with “fresh capital” can buy vessels at attractive prices.
“With the majority of shipping banks largely withdrawn from current ship lending as they tackle their own balance sheets, lack of capital has seen the valuation of second-hand vessels falling to very low historical levels,” the consultant writes in a research note, The ship’s in for opportunistic returns.
Specialist ‘distressed shipping’ investment managers tell Mercer that internal rates of return between 15 and 25-plus per cent can be achieved in the current environment.
The return drivers are income and capital appreciation: the charter rates paid to vessels generate income and can provide unlevered yields of between 14-17 per cent in the next few years, Mercer writes. And as the shipping cycle turns upwards valuations of shipping vessels, capital appreciation will come into play.
As such, shipping investments chart return profiles similar to private equity but can throw off significant yields.
The shipping industry has a history of generating volatile returns, primarily due to the “boom and bust nature” of maritime freight rates, the consultant writes. These rates are directly linked to the cyclicality of global trade – and there are signs that the shipping industry has hit the bottom of its current cycle.
Ships are the major transporters of merchandise and commodities, including crude oil and iron ore, and transport almost 90 per cent of global trade, generating a total global revenue of more than US$600 billion each year.
There are three main vessel categories: cargo and dry bulk, which transport commodities such as iron ore; tankers and wet bulk, which ship crude oil; and containerships, which carry manufactured goods. Each of these sectors has distinct supply and demand dynamics, which are strongly cyclical and drive the investment returns for direct investors in the industry.
In the five years to 2008, shippers enjoyed large charter rate increases and the strong appreciation of vessel valuations as the growing global economy drove demand for further shipping capacity. Plentiful and cheap debt enabled the industry to expand. But this didn’t last.
Global trade volumes were undercut by the financial crisis. The containership sector was hit first, and dry bulk trade slowed as demand for raw materials from China dropped off. And by May 2009, shipping rates for crude oil, product and chemical tankers had fallen 95 per cent.
These sharp declines came as ship owners were neared the expiry dates for covenant repayments on loans they had taken on in previous years. As refinancing risks loomed, banks put pressure on borrowers, putting downward pressure on the value of their vessels.
The ups and downs of global trade must be taken on board when investing in shipping, Mercer reminds. The value of a ship is calculated from the expected future cash flows it can generate, and this future income is reflected in the charter rates it commands. This means a ship’s purchase price is directly linked to its charter rates at the time of acquisition.
Surging charter rates in the five years preceding the crisis increased the future expected cashflows of ships and consequently drove up asset prices. But as charter rates declined, ships bought at those high valuations have underperformed as investments.
But lower charter rates now provide an investment opportunity. “Vessels purchased at today’s asset prices and chartered at current charter rates can be profitable and therefore appropriately matched and able to generate operating profit,” Mercer writes.
The consultant reckons that income from current charter rates can “generate acceptable profit margins”.
But the private equity-like play is truly opportunistic, and high returns depend on the partial recovery of prices paid for vessels. And since valuations are driven by demand for shipping transport, a prolonged economic downturn, sluggish international trade or lower consumption of crude oil stand as the greatest risks for investors.