Analysis: K Line looks good on paper, but will Q2 results reveal underlying damage?

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“If you believe everything you read, do not read” – Japanese proverb.

This week I took a deep dive into the financials of K Line, a sizeable shipping company that operates in Japan and Asia, but also boasts some meaningful exposure to the US and European markets. I was impressed by some of the statements I read – less so by certain figures and projections.

As it says in its 2015 annual reports, the group has made a continuous effort to enhance safety on navigation and cargo operations as a “world-class shipping business company that remains trusted, relied on and wanted by the society.”

It goes on, noting that “K Line has been recognised as an outstanding company that exhibits a highest score of transparency in the disclosure of climate-related information and climate performance in a survey conducted in 2014 by CDP, an international non-profit organisation that promotes projects in conjunction with institutional investors”.

I was left wondering how investors would feel if they found out that, during the process of becoming an operational benchmark for the shipping industry in Japan and elsewhere, K Line managers will have to tweak down medium-term forecasts for budget, growth and earnings.

On 1 October, shareholders had to digest the announcement of unexpected economic losses – yet I have bigger concerns about some of its mid-term projections.

1 October

The group issued a press release on 1 October that caught investors by surprise with the news that K Line would post a loss following a revaluation of investment securities. Essentially, some securities it held on its balance sheet turned out to be worth much less than book value, according to mark-to-market accounting rules. It’s unclear whether short- and mid-term forecasts will be amended, and it would be nice to know what lies ahead, really. Yet K Line “will make a prompt announcement when it becomes necessary to disclose a revised forecast”, it said.

The losses stand at about ¥8bn, which equates to $66m, which is not much as a percentage of its total current assets, but is enough to doubt K Line’s ability to meet forecasts for its net income, which came in at $214m last year and is expected to be over $200m at the end of this year. Net income was $83m in the first quarter, so its annual projections could still be safe even assuming the business doesn’t generate any profit in the second quarter. This is relevant because K Line is trying to get one message across to the financial community – it represents a solid investment that combines growth and yield.

The risk is that poor earnings management will ultimately impact its dividend policy, which in 2014 saw the company pay out 30% of its consolidated net profit to shareholders. The group has been intent on consolidating “a stable profit base”, it says, in order to secure cash flow from operating activities, but the odds are short that management may find it more difficult to deliver on its promises if more bad news is contained in its second-quarter results, due on 30 October.

K Line has a mixed track record. It grew revenue by almost 22% last year but missed its targets for Ebitda and income, and although its free cash flow profile has improved a lot over the years, its balance sheet still carries a significant debt load.

All these elements seem to be fairly reflected in a valuation that currently puts its stock on forward P/E and EV/Ebitda multiples of 11 times and five times, respectively – at least until we assume that it will be able to accelerate in the second half of the year, meeting forecasts for its core earnings.

K Line has a plan

The good news is that K Line has a plan – the bad news is that its plan is a bit vague, to put it mildly. The group endeavours to “increase its corporate value, fulfil its society mission and achieve sustained growth towards the next 100 years that will start from its 100^th anniversary in 2019.”

In typical Japanese corporate fashion, management has crafted and made public a financial plan aimed at 2019, when K Line expects to have almost doubled its Ebit from ¥48bn ($384m) to ¥85bn ($680m). Most of the rise in its Ebit line will be driven by “large eco-friendly ships”, the “addition of stable revenue” and “cost reductions”, which will only be partly offset by “market fluctuations” and other “one-time causes”, according to management.

If you struggle to quantify all these elements, you have my sympathy, although market analysts remain bullish on its prospects. According to Thomson Reuters, K Line is covered by 19 analysts, and 16 of them have either a hold or an outperform recommendation on the stock. Consensus estimates suggest that capital appreciation for shareholders could be up to 20%, but the most bullish analysts have pencilled price targets that imply capital gains of up to 50% in future. In all this, downside appears to be limited to 5%, according to the brokers.

My quick take?

K Line may have to pay more attention to its capital structure if one-off charges hit its economic performance, although it is no worse off than any of its larger domestic rivals. I distinctly remember, when I took my first look into the financials of the three main Japanese shipping firms earlier this year for The Loadstar, that K Line, the smallest player in the market, seemed to stand out for its recent performance and financial solidness. Now, unfortunately, we’ll have to wait for second-quarter results to determine the real extent of the damage.

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