Analysis: will UASC provide some balance as Hapag-Lloyd walks a tightrope?

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The interim results of Hapag-Lloyd were uninspiring, to say the least.

Not only is the world’s fourth-largest box line struggling to cope with a sluggish business cycle, but it is debatable whether the short-term benefits of its acquisition-led strategy outweigh the long-term risks such corporate actions could bring.

Revenues continued to fall in the first half of the year, while front-loaded synergies stemming from previous deal-making seem to have vanished. Hapag booked almost €900m less in turnover than a year earlier, while its underlying profitability shrank at a rather fast clip.

While it so far has bought precious time in a difficult environment – even managing to get away with a fully-priced float at end of 2015 – hefty losses have been the inevitable outcome for investors who committed to its IPO in November. Its quarterly trading update disappointed executives, but those who followed our coverage earlier this year likely knew that bad news had to be expected.

Yet the good news now is that we’ll soon learn more about the acquisition of United Arab Shipping Company (UASC), whose assets, six Triple-E vessels, ought to give a fillip to the German container line – although it’s hard to fathom why growth at any price makes any sense in this market.

Problems

Undoubtedly, Hapag-Lloyd’s financial position has been highly problematic for some time, and the fact that its stock trades in distressed territory, based on price against tangible book value, testifies to that. It could get worse, however, while further deterioration in its equity value would heighten the risk of impairments and write-downs, which could have consequences on existing agreements with its lenders.

Hapag is still walking a tightrope and, arguably, the situation might have soon become untenable had it not opted to engage with UASC this year – understandably, in a low environment for freight rates, urgency is now being felt to complete the deal.

“In this difficult competitive environment, it is very important to complete the transaction with UASC as quickly as possible,” chief executive Habben Jansen told reporters last week, adding that annual net synergies of at least $400m are expected from “2019 onwards.”

Beyond dwindling sales

Based on first-half numbers, and excluding UASC’s figures, which are undisclosed but will be consolidated starting early 2017 if the deal receives the green light from regulators, Hapag’s annualised Ebitda could hit €500-550m in 2016. That implies a forward net leverage of up to 6.6 times, assuming unchanged cash balances on 31 December this year. It reported €3.8bn of gross debt and $473m of cash and cash equivalents at the end of June.

The 17% drop in first-half sales to €3.8bn was more pronounced than the drop in core transport expenses, which came in at €3.2bn, yielding almost €40m of losses at Ebit level. Operational hurdles hurt its cash flow profile, with operating cash flow falling to €203m in H1, down 37.4% from €324m year-on-year.

On the bright side, it burned less cash than in the first half of 2015, once investing and financing cash flows were added to operating cash flow, but Hapag used more debt and invested less than in the previous year. This was in order to shore up its finances as executives arguably paid full attention to working capital management.

For a carrier with such a stretched capital structure, negative working capital can be highly problematic and could even trigger a debt restructuring, also because in Hapag’s case it widened significantly in the first half of the year. This clearly suggests that double or quits was the name of the game for its managers when they came up with the idea of acquiring UASC.

Similarities

Hapag had no choice but to buy cash-strapped Chile’s Compania SudAmericana de Vapores (CSAV) a couple of years ago, yet that tie-up only partly mitigated some structural problems.

The UASC deal now resembles the CSAV transaction, at least judging from the $400m cash call that will ensue once the transaction is completed, as well as the amount of expected synergies.

When the CSAV takeover was announced in 2014, Hapag-Lloyd said it had planned to inject $500m of new equity in the combined entity within a year, while now it expects a cash call of $400m within six months from closing. The level of targeted synergy in the UASC merger is also similar, although the UASC integration may take a bit longer to generate significant cost savings, meaning that Hapag and its advisors might have decided to bet on a rebound in container shipping rates and volumes to justify their projections.

The carrier said last week that, following the purchase of UASC, “Hapag-Lloyd is expected to reach a transport capacity of approximately 1.6 million teu, an annual transport volume of around 10 million teu and revenue of approximately $12bn, putting it ahead of its nearest competitors”.

At a time when everybody blames a glut of shipping capacity for the fall in rates – which might have further to fall, although the bottom “is now in sight”, one shipping expert told me today – Hapag is going for scale. It is bulking up to find an answer to its financial woes in a market where the odds are short that the idled fleet of containerships would grow rapidly in the coming weeks as owners decide to park redundant ships after their time charters expire, as we recently argued.