Abaci's Common Sense Investing

I started studying the shipping shares around mid this year after concluding whilst industrials had been my favorite, there were just too many odds against them, e.g. higher costs, weak bargaining power with customers, RMB appreciation, over competition, changing government policies, to name a few. I figured the shipping industry is a good proxy for industrials as all goods get on board in the end. Although shippers don’t fare much better in market perception and faced similar issues, they larger size will ensure they sail through the adversaries.

I did not then and won’t now try to analyze the shipping industry in terms of market demand and supply, or to study and predict the freight index; because this to me is no different than guessing the HSI or how your hedge fund will perform in the coming quarter. It’s just too darn imprecise that I shouldn’t bother trying. Having said that, I don’t really need that much precision to like China COSCO and OOIL. First, some positives on the industry over the long run.

• "Made in China" phenomenon is a tide which can’t be turned. Take a look at the cover of OOIL interim report and you’ll have a very good visual of the reality. The industrials are suffering right now but once the consolidation is over the winners will grow healthily. Low tech assembly type operations will fade but more high tech upstream components will be made in China. There’s little chance China will output less than does now.
• Growth in China consumption market.
• Capital intensive nature and fact that most shippers are state owned enterprises will help lower competition.
• Cost of vessels will get lower because China ship makers are catching up in producing heavy vessels.
• Cost of operation, a.k.a. oil price, seems to have stabilized and if not, due to the oligopoly structure, this higher cost will eventually be passed on to consumers.

Negatives? People are afraid that over-expansion of fleet and slow down of world economy will drive down freight. Interim results confirmed freight and margin deterioration, e.g. CSCL (2866) reported 96% drop in profit. As usual when evaluating negative factors, people turn over bearish and sold down all shipping shares, which now trade at 3-6 times historical P/E. Profits will definitely go down this year but the low share prices should provide enough cushion. And I don't expect the problem of over capacity and USD70+ a barrel oil price to stay on indefinitely. World economy is another matter which should be left alone for the economists to figure.

If you believe in the long term prospect of the industry, next let's look at the major players on market and some operating parameters I got from the latest 2006 interim reports.

(Turnover, Capacity, Shipping volume)
(HKD, TEU, TEU)
COSCO 16.6b---381k--- 2.4m
CSCL 14b---- 371k--- 1.85m
OOIL 20.3b--- ?**--- 2.65m

* Shipping division only.
** If anyone could find out this out please let me know. Thks.

China COSCO operates two businesses, container shipping and via its 51% subsidiary COSCO Pacific (1199) container leasing and port/terminal operation. The parent company of China COSCO separately operates a dry bulk fleet and I think at some in time it will be injected into COSCO. Perhaps you should also know that the biggest customers of COSCO Pacific are China COSCO and its parent company which together contributed about 1/2 of its turnover.

CSCL is a pure container shipping play and hence a perfect benchmark.

OOIL is a shipper plus a terminal operator in North America and Taiwan, which you should have at least heard about its recent giant disposal. Besides, it holds the Wall Street Plaza in New York and some real estate development projects in Shanghai which will go on sale starting 2008.

If you agree the size of the three shippers is similar with CSCL behind in shipping volume and turnover whereas OOIL seems to be better managed, you’d surprised by difference in their market value.

At close of Dec 15 2006 and in HKD:

COSCO CSCL OOIL
Market value 27.4b--- 12.5b--- 30.6b
Less:
Terminals 20.2b*--- n/a--- 15.1b**
Properties n/a--- n/a--- 9.5b***

Shipping only 7.2b--- 12.5b--- 6b

* 51% of market value of COSCO Pacific.
** sum of (1) 13.1b increase in market value since July 25 2006 when disposal of North America terminals was first announced. This is comparable to expected disposal gain of 15.4b stated in subsequent circular and is at a ~30% discount to expected sales proceed of 18.8b. I assume this reflects the completion risk; and (2) value of remaining terminal assets at 1.5x book value of ~1.32b, i.e. 1.98b (for reference both China Merchant and COSCO Pacific are trading well over 2x book value).
*** 2x of book value of 4.75b (not unreasonable at all when valuation of many Chinese property companies have gone ballistic, just look at Chinese Overseas & R&F)

So here we have a scenario where similar sized shippers facing similar problems have gotten very different market value, by as much as over 100%. Of course you could argue that companies which are not focused in their principal business deserve a discount. But the discrepancy here is too large to ignore. I'd say the shares of China COSCO and OOIL are clearly undervalued, even within the shipping industry itself. Having said this, CSCL is not a bad bet either if you, like myself, believe in the long term future of the shipping industry. It offers 100% exposure and maximum upside as it doesn't have other businesses to tangle with. China COSCO and OOIL, on the other hand, have lower valuation of fleets, offers more downside protection, but their bundle of other businesses are more fairly priced, e.g. COSCO Pacific is trading at 15x p/e already and OOIL share price has a large cash component now, which will cap future appreciation potential.

DISCLOSURE: I hold both 1919 and 316 at time of writing.

p.s. btw if anyone knows how to do a table properly please tell me. thks.

# posted by Abacus1 : 2:02 PM