Cosco - Challenging years ahead

In a recent meeting with management, it was highlighted that the average revenue per vessel repaired has declined by 30-35% y-y because shipping companies are cutting back on repairs and servicing. As at 1Q09, close to 60% of repairs at the group’s six shipyards was for bulk carriers, while 15-18% was for container ships, and the rest for chemical and other tankers and specialised vessels. Management is of the view that a sustained improvement in Baltic Dry Index (BDI) levels will lead to increased ship repair revenue per vessel, particularly for bulk ships, which account for most of the vessels repaired at its six key shipyards.

As for the progress of its US$7bn shipbuilding orderbook, the group delivered its first bulk ship (57,000 dwt), the MV APG KV, to its owner on 28 April, 2009 from the COSCO Guangdong yard, according to management. This came almost two years after the group announced its first bulk carrier newbuild contract on 11 July, 2007. To date, shipbuilding contracts account for US$4.5bn, offshore for US$2bn and conversion for US$0.5bn of the group’s gross orderbook of US$7bn.

Since December last year, the group has reported five of its bulk ship orders cancelled and another 26 rescheduled from six months to three years. Management is of the view that there could be more delivery rescheduling since ship owners are still requesting the postponement of ship deliveries.

Management expects revenue from its 12 remaining bulk ships to be adversely affected by weak bulk charter rates, once a number of vessels come up for renewal at today’s lower prices. An estimated 35% y-y decline in revenue is likely, according to management, with three to four of its ships making losses on short voyage charters.

In FY08, group turnover from shipping rose by 24% y-y to S$257.4mn, while shipbuilding EBIT increased by 26% y-y to S$174mn, accounting for 38% of the group’s total EBIT. However, with more than half of its ships up for charter renewal in 1H09F, the group will be hard put to shore up earnings, given the significantly lower freight rates relative to previous charters.

Cosco’s 1Q09 net profit of S$33.2mn was below our estimate of S$46mn, based on lower ship repair, shipbuilding and shipping earnings. The group sales were flat at S$714mn, against our estimate of S$865mn, with ship repair accounting for 20% of revenue, conversion and offshore for 51% and newbuildings for 29%. The group’s 1Q09 EBIT declined by 59% y-y to S$61.8mn, below our estimate of S$85mn, with EBIT margin contracting by 12.2pp y-y to 8.7% (no divisional EBIT breakdown given).

Management highlighted that while ship repair continued to be profitable, the number of ships repaired for the quarter was down by 60% y-y, which means just 24 ships were repaired, according to our estimates from 1Q08 numbers (no detailed numbers given for 1Q09). Ship repair revenue stood at S$173mn for the quarter, with bulk ships forming 59% and containerships 18% of total vessels repaired.

Shipping revenue fell by 22% y-y to S$46.2mn, based on lower charter hire rates, but with EBIT margin remaining at 40%, shipping contributed an estimated S$18.5mn or for 30% of group EBIT, based on our estimates.

With continued execution delays, shipbuilding barely broke even in the quarter, according to management. In FY08, the group made S$171mn in provisions, mostly in 4Q08, with some S$89mn for ongoing construction contracts. These included provisions for steel prices, higher ancillary outsourcing and contracting costs, tighter pre-delivery inspection procedures imposed by shipowners facing the current unfavourable market conditions and higher operational and development costs for shipyards expansion.

We have revised our FY09-10F earnings forecasts downward by 25-35% to account for lower margins for the group’s shipyard business. We have lowered FY09F and FY10F EBIT margin to 9.0% and 9.1%, from 15.2% and 15.3%, respectively (versus 1Q09 EBIT margin of 8.7%).

With the earnings revisions, our SOTP price target for Cosco Corp (method unchanged) stands at S$0.70 (previously S$0.63). The marginal increase is mainly on an update in the market valuation of the group’s fleet of 12 ships (from US$23mn/vessel previously to US$28mn, based on DryShip’s recent sale of a 1995 Panamax drybulk carrier for US$30.8mn). Our shipyard valuation remains DCF-based, with a 12% WACC.

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