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  • Chris Mayer

A Contrarian Buy in Shipping

Updated: Feb 22, 2019


Ideally, I’d love to find ten great stocks I could leave alone for ten years – or longer – or enjoy great returns. But real life isn’t so accommodating. So, while the quest continues, it’s nice to have other arrows in your quiver.


How about investing in cyclicals?


My friend Harris Kupperman, over at Adventures in Capitalism, wrote a good piece about shipping recently. (You can find it here.)


I like the idea of owning a shipper now for all the reasons Harris outlines. The industry has been in a long bear market. The stock charts are like long ski slopes downhill. Nobody’s made any money here in a long time, which is what you want to have when you invest in deeply cyclical industries.


Why is that?


Let’s turn to a book titled Capital Account: A Money Manager’s Reports on a Turbulent Decade (2004). It’s edited by Edward Chancellor and includes letters by Marathon Asset Management, based in London. The sequel is Capital Returns: Investing Through the Capital Cycle and came out in 2016.


Both are good reads and develop Marathon’s idea of the “capital cycle,” which is a framework for thinking about industry cycles. The theory is simple and looks like this:



The basic idea is that, over the long run, a company’s return on capital is what drives the share price. And what drives return on capital is largely a function of the competition in the industry.


Lots of money coming in means rising competition and portends lower returns on capital and lower stock prices. Conversely, money coming out means easing competitive pressure and portends higher returns on capital and higher stock prices. Chancellor fleshes these ideas out in his 44-page introduction in Capital Account, and there are plenty of case studies in the book, but that’s the basic theory.


Obviously, you want to invest at the bottom of the cycle when investors are pessimistic. Shipping seems to qualify. But which shipper? This industry is full of bad actors and over-levered companies. It seems like a risky place to be.


Paraphrasing Jonathan Goldsmith (“the most interesting man in the world”), I don’t always invest in shipping, but when I do, I make sure it has a great balance sheet and trusted insiders with lots of skin in the game.


That brings me to my favorite shipping idea: AP Moller-Maersk (AMKBY). This is a good one if you want some shipping exposure but you’re too afraid of leveraged shippers bleeding cash. I think the odds of losing money with Maersk are pretty low over a 2-3 year period.


Maersk reported earnings this morning and stock dropped about 10%. Maersk, though, had a good year. Revenue was up 26% (8.3% excluding its acquisition of Hamburg Süd). And EBITDA was up 7.8%. It’s the guidance that scared people – and we’ll get to that below. I think the market is giving us a nice entry point.


We own it at Woodlock House, at an average price of ~$6.50. Usual disclaimers apply: I can change my mind, I don’t have to tell you, this isn’t investment advice, etc. See our disclaimers here.


*** Maersk: A Major Transformation is Nearly Complete


Based in Denmark, Maersk is a conglomerate that dates back to 1904. Today, it is the largest container shipping company in the world with about 20% market share. It also owns a terminal business (APM Terminals) as well as oil and gas assets (shares in the oil giant Total and Maersk Drilling). I like that it is family-owned: the Moller-Maersk family owns 53% of the shares.


Maersk is in the midst of a major transformation that is near its conclusion. It’s as if the family went activist on itself. They’ve been selling non-core assets.


They’re going to spin off Maersk Drilling. They may pay a special dividend, or even buy back stock. The total capital coming back to investors could be 20% of its market cap.


There’s a lot of moving parts here, so I’ll just give the high level look in this post.


Valuation Seems Cheap


Maersk generates free cash flow – something most shippers can’t say today. Maersk generated EBITDA of $3.8 billion with $2.9 billion in capex in 2018. Capex requirements are coming down, too. In 2019, capex will fall to $2.2 billion.


So, you’re not buying something that’s bleeding. And Maersk used its free cash flow and proceeds from asset sales to de-lever. Net interest-bearing debt was down to $8.7 billion at the end of Q4. This compares to $12.4 billion at the end of Q3 and $14.3 billion in Q2. The goal was to get down to 2 to 2.5 net debt-to-EBITDA to maintain its investment grade rating. They are there now.


Maersk funded that pay down in part with the proceeds from selling shares of the French oil giant Total. Maersk got these shares when it sold Maersk Oil.


Maersk received shares worth $5.6 billion in March of last year. They sold $3 billion in 2018. And they sold another $1 billion worth of shares in 2019. And it retains 27.9 million shares with a value of about $1.6 billion. I expect we’ll see these remaining shares sold by the end of Q2.


Maersk still owns Maersk Drilling, which it will spin out to shareholders in April of 2019. Maersk Drilling ended the year with $3.8 billion in book value and net debt of $1.1 billion.


Looking ahead, Maersk’s guidance calls for $5 billion in EBITDA in 2019. It could generate over $2 billion in free cash flow in 2019 from transportation assets alone. Stripping out the energy assets leaves the stock trading for ~10x free cash flow. Seems cheap to me for a company somewhere around the bottom of its cycle.


Lots of catalysts


A Maersk shareholder has a lot to look forward to in 2019.


The first is the spinoff of Maersk Drilling in April, which has one of the youngest fleets in the industry. This is a business that expects to generate ~400 million in EBITDA in 2019. (It did $1.3 billion in 2016 – so plenty of upside when this cycle turns, too).


In any case, the spinoff simplifies the Maersk story and could be a catalyst for unlocking value.


We could also see a special dividend around mid-year. Maersk has a history of paying special dividends. Last time it did so shares rallied 20% following the pay out of a 10% special dividend in 2015 (related to the sale of Danske bank). Maybe we’ll see a similar replay again in 2019.


Further, while 2018 results were strong, the market hit the shares today on weak guidance for the year ahead. On the call, CEO Søren Skou laid down a scary outlook:


“Our guidance is very much focused on a number of uncertainties that we see. We see clearly, a global economic growth that is declining. We see weaknesses, in particular, China and Europe. We expect demand to decline to 1% to 3% [growth] this year from 3.7%, 3.8% last year. And as a result of that, on top of that, we have quite some uncertainty as to what happens with fuel prices. They have gone up quite a lot in the last months or so. And then finally, we will be, as an industry, implementing IMO 2020 towards the end of the year, which will, all things equal, also mean a significant increase in fuel prices.


“In terms of trade war, of course, we also are concerned about continued higher level of tensions on the trade agenda. U.S. China negotiations are ongoing, and we have no insights to how likely it is the deal will be landed, even if the price is positive right now. But we don't believe that China U.S. deals will be the last we have heard about trade tensions in 2019 because there's also clearly an outstanding discussion between Europe and the U.S. and that's real the background for our guidance for 2019.”


But the way I look at it, he’s set the bar low. I think his guidance is beatable.


And besides, you want to buy when people are pessimistic. That’s the case now. Even so, in absolute terms, their guidance is not terrible. As thing stand, we’re still looking at over $2 billion in free cash flow in 2019.


Still, There Are Risks


Of course, this is still shipping. And so, you are at the mercy of freight rates, volumes, bunker fuel and exchange rates. Maersk helpfully provides the sensitivity of its business to these various factors.


But again, we’re bobbing around somewhere near the bottom of the waterfall. After years of too much supply, the supply-demand balance for ships seems benign for the next year or two. Net supply growth is near historic lows.


There are the looming IMO 2020 fuel regulations, which worry people too. And who knows how the trade wars will go. However, anything that makes life difficult for shippers falls disproportionately on the weaker competitors. Maersk is the largest and among the best financed. It’s used the weakness in the industry to get stronger. (Acquiring competitor Hamburg Süd is one example). I like its position.


There is an acronym I’ve long used to summary four key things I look for in an investment: CODE. Let’s see how Maersk stacks up.


C is for “cheap.” Maersk trades at cyclical lows. (You can see this on price-to-book, for example.) Also, backing out energy assets, Maersk trades for ~10x free cash flow, based on estimated 2019 numbers.


O is for “owners.” I like companies where the insiders have a lot of skin in the game. Here we have the Moller-Maersk family, which owns 53% of the stock. I think they’ve been good stewards of capital during difficult times.


I also like their focus cash flow and returns. In the most recent quarter, they introduced a new metric to report. Here’s the CEO on the call:


“And then we're introducing the new metric, cash return on invested capital to really demonstrate that we are moving forward in a very, very strong capital discipline and with the aim of generating real cash returns. Our long-term return on invested capital target of 8.5% stands, but it becomes 7.5% when we include the effects of IFRS 16. [IFRS has to do with the treatment of leases].”


Now a 7.5% cash return on invested capital doesn’t sound like much. But it was 0.8% in 2018. So, a move to 7.5% - should they achieve it – would have a dramatic effect on their valuation. (Think of it this way; their target is 9x better than what they did in 2018).


D is for “disclosures.” I’m looking for good public disclosures and a business I can understand. Maersk checks the boxes here. In fact, I rate their quarterly disclosures among the best of any company I follow. See all that you get on their website here.


E is for “excellent financial condition.” I like companies with strong balance sheets. Maersk certainly qualifies with its investment grade balance sheet. Its even more impressive if you’ve spent any time looking at shippers. Maersk stands out in its financial strength.


In summary, I think the risk to the downside here is fairly low. We own a well-financed conglomerate with hard to replace assets in shipping and logistics. We have lots of catalysts on the horizon in the form of a spinoff, possible special dividends and/or buybacks. We own a firm managed by a family with a lot of skin in the game (they own about half the shares). And we’re picking these assets up near the bottom of a shipping cycle.


I like our odds.


*** 100-Baggers in Cyclical Companies?


Many of my value-minded friends have an objection to owning cyclicals. My own work on 100-baggers seems to argue you shouldn’t ignore cyclicals. Just a casual glance at the list of 100-baggers yields the following:


Chevron

Exxon-Mobil

Halliburton

Occidental Petroleum

Vulcan Materials

EQT Corp

Helmerich & Payne

Cabot Corporation


Among many others… oil and gas firms, oilfield services, materials, etc. There were also plenty of railroad stocks among the 100-baggers. There were no shippers (unless I missed it), but that may be because my study only includes US-listed stocks and the biggest shippers are listed overseas. I also had a market cap cutoff, so micro-cap shippers that hit it big would be missed.


Peter Lynch didn’t shy away from cyclicals. He has a whole chapter on them in Beating the Street: “The Cyclicals: What goes around comes around.” He talks about owning Phelps Dodge (copper mining, smelting) and General Motors.


(John Neff is another one of those star money managers that seem extinct today. He compiled a great record running Windsor for thirty years. In his book John Neff on Investing, you can read about how he owned homebuilders, airlines and oil and gas firms. I could keep pulling things from my library, but it could take awhile as I have a lot of books...)


So, there you go. I think I would prefer not own cyclicals. But there are times and circumstances when you may find some compelling opportunities. I don’t mind taking a piece of the portfolio to invest in these.


*** Mailbag


A reader writes in about position sizing:


“On sizing, you may want to speak with Cameron Hight of Alphacution. His business is helping sizing decisions.


"In my experience as a manager of long short PMs, on average they are not adding value in their sizing. Very few are able to beat a machine on that. Too much emotion. Too much sizing to “conviction” (my least favorite word).


"They would be better off equal weighting. So my mantra has become every position is a medium unless there is a reason to make it a large or a small. Then we test whether the reasons work.”


I like this e-mail because he challenges the presumption that betting big on your favorites is the way to go. That may not be true for everyone. If position-sizing is a skill, we shouldn't expect everyone to be good at it. You might be better off just equal-weighting, as his experience seems to show. I also like the idea of testing it somehow. This is something I will watch in my own fund.


Thanks for reading. Send me mail at: info [at] woodlockhousefamilycapital.com.


***

Published: February 21, 2019

Please see our disclaimers.


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