ANALYSIS: With declining returns at Maersk, buying NOL may be one answer

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I warned in August, when Maersk announced its second-quarter results that it was too early to celebrate, and three months later it appears that the company’s executive management team has misjudged the market.

This is more relevant because of the possibility that it will end up owning Singapore container shipping line Neptune Orient Lines. A deal would signal a u-turn in Maersk’s recent strategy, which has focused on – but not managed to deliver – higher returns per unit, particularly in parts of the business where a huge amount of capital is invested.

Maersk Line, which absorbs $20bn of capital (43% of the total), is proof of that, with mildly rising investment but declining ROIC, which fell to 5% in the third quarter from 13.5% a year earlier.

NOL said preliminary talks were underway with Maersk, and France’s CMA CGM, which essentially means that Maersk could be prepared to consolidate NOL’s $2.6bn of net debt in a deal that would be dilutive to earnings, excluding synergies, according to my calculations. This is also implicit in the relative share valuations of both firms.

On October 30, NOL reported net profit of $783m for the first nine months of the year, which came with a one-off gain of $887m from the sale of APL Logistics in the second quarter. In the third quarter alone the company made a $96m loss.

This means a balancing act for group chief executive Nils Andersen, who must consider the risks of embarking on a deal that would likely value NOL’s enterprise at over $5bn, or roughly 15% of Maersk’s market cap, and the peril that declining growth rates pose to Maersk’s dominance in the shipping world.

“We are just following the growth in volumes,” one of his lieutenants argued earlier this year – but the reality is that the executive management was caught out by the weakness in its core container shipping markets. Maersk shareholders would have expected to see better returns on its invested capital, given the relative size of that investment, so a purchase of NOL as the only option for better capital deployment.

Guidance for underlying profits for 2015 indicates that the fourth quarter could be one of the worst in recent memory. Based on expectations for underlying income, and assuming $10bn of quarterly revenue, 2015 net income margin will fall to about 5% in the fourth quarter, yielding a bottom line of just about $500m.

Maersk has a strong balance sheet and, assuming synergies at 5% of NOL’s revenue, net leverage would mildly rise but would remain manageable – but then, what is actually manageable in this environment?

A tough market

Maersk’s cash balances also drew my attention at a time when key financials should raise eyebrows at group level – they are down to $3.2bn from $3.5bn in December 2014, and from $5bn at the end of September 2014.

Maersk Line was “severely impacted by continued low economic growth and significant market imbalances”, the company said on Friday. “Global container demand is expected to have grown by 0-1%, whereas the global container fleet grew by almost 9%.”

Container freight rates declined across all trades except North America, with European trades particularly weak, pushing earnings and returns well below acceptable levels. Maersk is adjusting its strategy accordingly and, sensibly, won’t expand its fleet, having amended its initial plan.

But it needs growth to cope with likely declining pre-tax profit.

As Maersk’s restructuring continues and assets are sold, its top line has plunged by almost 20% a year since 2012. The group has managed to retain a decent level of profitability so far, but it’s less likely, however, to meet generous estimates for sales and operating income in this environment.

In response, management could point to improving margins, but if you took pre-tax profit margin on its revenues in the above chart (EBT divided by sales), 2012 delivered a margin of 12.4%, followed by 13.9% in 2013, when it made some one-off disposals, and 13% in 2014.

So despite all the asset plays, divisional reshufflings and one-off disposals to realise cash, the fact is that margin improved by just 0.6 percentage points over the course of three years – it certainly shows no lack of effort, but the gains are very slight.

And neither do the above numbers lie – the company’s actual EBIT has missed market (and by this I mean financial rather than shipping) expectations every year since 2010. And last year, which was generally healthy for box shipping, it missed it by almost 25%.

With a market cap that amounts to 78%, its enterprise value its capital structure looks safe.

I do not know if NOL is the answer to Maersk’s woes, but perhaps we should prepare for a different Maersk – one which may involve a different-looking management team.

It perhaps could have been worse – and it likely will be for the 4,000 staff that are set to lose their jobs. Admittedly, that is a headline figure and many of those losses will be through natural attrition such as retirement, but there was scant mention of how its management team has performed over the years.

Because here’s the point: you are either a market leader or a market follower, there’s no in-between, and Maersk considers itself (and it is not alone) as the market leader in container shipping. As a result, investors should reasonably expect its senior management to be the best in the business at reading that market. Its latest results would appear to call that into question. Either the market has been so wildly unpredictable as to resist all forecasts or strategy, or the forecasts were wrong and the strategy too inflexible to cope with shifting realities.

In December 2014, I argued that the divestment of APL Logistics by NOL – which indeed occurred one month later – hinged on whether NOL would have managed to find a buyer for its core liner unit. A tie-up with NOL, of course, would likely receive the blessing of investors and Maersk, with its history of large-scale liner takeovers, is an obvious suitor.

Other than NOL, Maersk’s plan B entails relentless cost-cutting – but then shareholders should make sure that, as Mr Andersen said, “the continuous actions taken in all our business units to reduce the cost base” will have a clear focus on unnecessary costs that have weighed on Maersk’s bottom line for a long time now.