There are several industries today suffering from the effects of overcapacity: steel producers, automotive assemblers, nitrogen fertilizer and German banks come to mind. It is hard to think of one that is suffering more, or that is more essential to everyday commerce, than container shipping. Container ships move 90% of the volume of cross-border traded merchandise. Countless goods that are produced in one country and sold in another — everything from tinned tomatoes to desktop computers, from shoes and clothing to frozen salmon to children’s toys to furniture to lawnmowers — are necessarily transported on container ships.
The essential nature of this service — essential to global consumption — is what appeals to us. It is clear the industry is in dire straits, brought on by slowing trade growth and excess vessel capacity. Yet goods will continue to be traded in the same vast quantities and so the service of container shipping will continue much as it has in decades past.
The intermodal container industry has many layers in the value chain. At the centre are the shipping lines — companies such as Maersk, MSC, CMA-CGM, Cosco and Hapag-Lloyd — who either directly or through freight forwarder intermediaries serve shippers like Swedish appliance maker Electrolux, Italian pasta maker Barilla, or American shoe designer Nike. The shippers’ sales depend wholly on the shipping lines to move their goods to end markets around the world. The shipping lines are themselves dependent on a host of suppliers. These can range from highly cyclical such as shipyards, to less so such as bunker fuel merchants. Charterers are private ship owners who charter their vessels to the shipping lines. Land side infrastructure like ports and container terminals are essential suppliers as these are where ships are berthed and containers offloaded. Another major supplier to shipping lines is the capital markets — equity investors and financial creditors.
Much as we did with Joy Global and the imperilled coal and mining industry, we’ve looked at container shipping with an eye to finding a high quality supplier that will survive industry stress and emerge stronger for it. One supplier to the carriers that caught our attention for its rational behaviour and relatively favourable economics is the niche of container lessors.
The intermodal container industry was born in the 1950’s and revolutionized the efficiency of global trade. At the heart of the industry is the humble intermodal container — long-lived, standardized, modular steel boxes that can be stacked in layers, transported by sea, road and rail, and easily loaded and offloaded at ports around the world.
Textainer is in the business of owning and managing intermodal containers. After operating for 35 years and having 18% market share, it was until recently1 the largest lessor of containers to the container shipping industry.
Lessors exist for the simple reason that the business of shipping is highly capital intensive, and operators find it appealing to lease containers rather than own them outright. Without a reliable source of containers, shipping lines simply cannot provide their own customers with necessary levels of service. Goods can only be transported on a container ship if they are packed in a container that is available at the point of demand. Being their main line of business, lessors stand ready to buy new containers in response to demand from shipping lines’ customers.
Textainer’s business model in a nutshell:
As a lessor, Textainer funds the purchase of new containers with a mix of equity and debt, and then leases these to customers for an initial 5 year term at a contracted daily rental rate. Leases are triple-net, meaning the lessee is responsible for insurance and maintenance in addition to lease payments. Textainer’s own debt is duration matched to the lease terms. The initial lease period typically accounts for more than half of the expected return over a container’s useful life of 12 years.
Once the lease term is up a container will typically be leased again to the same customer at prevailing market rental rates, otherwise it will be returned to Textainer. Following a second lease period, the container will enter Textainer’s sale inventory, whereby it is sold as a used container, either into the intermodal market or for the numerous uses of end-of-life containers, including storage and temporary or modular housing and offices. The midlife lease will provide about 30% of the expected return, and the end-of-life sale the remaining 15%.
Sounds simple enough, but several points are noteworthy:
In all respects — fleet size, pricing discipline, disposals, credit management, access to funding — Textainer has clear advantages over its smaller competitors and should emerge stronger from a period of industry stress.
We think it is the negativity that surrounds the container shipping industry which is largely to blame for the poor performance in Textainer shares since we first bought into the business.
Recent years have seen two main factors conspire to worsen shipping line profitability. Firstly global trade growth has slowed markedly from a period of many years in which it grew at a multiple of global GDP. 2015 saw growth fall below that figure and 2016 will see virtually no growth at all. And secondly, several years ago, in a tragic prisoners’ dilemma3, the largest carriers began ordering ever larger vessels in an effort to lower costs and outrun falling freight rates. Combined, there is now excess vessel capacity of roughly 30%, leaving freight rates well below cash operating costs and many routes unprofitable.
If something cannot go on forever, then it will not. There are increasingly signs the destructive forces of capitalism will prevail and restore the industry to profitability. Several smaller carriers have failed and some medium size players have been acquired. Most recently and dominating headlines, the two Korean carriers Hyundai Merchant Marine and Hanjin Shipping have entered talks with creditors with the former likely to conclude a successful restructuring and the latter heading toward liquidation.
In the coming wave of carrier restructuring, we are fairly confident that Textainer will not be too adversely affected. Barring outright liquidations, it is our understanding that in restructuring it is other suppliers who typically bear the brunt of the workout with creditors. Charter ship owners, for example, simply have their ships returned, where they struggle to find new charters. As the cost of leasing containers is such a small part of carrier operating expenses, it is not seen as a line item where meaningful reductions are achievable. Crucially, the lessors have considerable leverage in the sense that were they to repossess their containers, this would cause havoc with the surviving operations of the carrier, not least because the containers would frequently contain their own customers’ (relatively valuable4) merchandise.
Industry fundamentals have indeed spilled over into the market for leasing containers. Daily lease rates are a function of demand for containers, new container prices and funding costs. New container prices are in turn a function of steel prices (being the primary input) and container manufacturer profit margins (which are historically low). Daily rental rates are therefore depressed because of weak trade growth, low steel prices, low manufacturer margins and low interest rates.
The most visible impact on Textainer is in the form of expiring leases which were contracted at higher rates rolling over into new leases closer to market rates, leading to falling leasing revenues. However, as Textainer has been a consistent buyer of new containers over the years, its lease book is evenly spread meaning only 8% of its container fleet will off-hire in 2016, and 7% in 2017.
Furthermore, the fat years’ trading gains made on the sale of used containers above book value are being reversed in the down-cycle lean years. Textainer recognises impairments as used container prices have fallen along with new container prices, and end-of-life containers are moved to sale inventory. These impairments are non-cash in nature, and due to the staggered lease book Textainer remains highly cash generative. This fact is overshadowed by the decline in accounting earnings and management’s decision to cut the dividend commensurately.
Importantly, there is no connection between the overcapacity of container ships and the demand/supply balance of actual containers. Indeed, there is simply no excess supply of containers. When compared to the actual shipping industry, the container lessors are far more rational. Lead times for new containers are only a few months, versus several years for new ships. This makes the global container fleet far more responsive to actual demand conditions. Hence new container production has been declining for several years, with 2016 marking the first year in some time that end-of-life containers withdrawn from the market will equal or even exceed new additions.
We think Textainer is deeply discounted and that we will be well rewarded for remaining an owner and continuing to add to our holdings during this time. The current share price is valuing Textainer’s container fleet below replacement cost even at today’s historically low new container prices — last seen in the period 1999-2002. New containers purchased in that timeframe went on to become Textainer’s best performing assets. We see multiple avenues for why new container prices and daily lease rates will recover in the future. We think the best use of Textainer’s cash flow today is in buying cheap containers, which is precisely what they are doing.
Textainer has been a consolidator in the past, and it has also recently acquired fleets of containers from smaller financial players looking to exit. We have no doubt there will be further consolidation among the lessors. It is highly likely Textainer will be a participant and a prime beneficiary of the coming period of industry stress.
A company called Trencor owns 48% of Textainer, a major reason for its low liquidity, the company’s reticence to repurchase shares, and something of a deal breaker to a potential acquirer. Do you think Trencor would sell its stake at these prices, given their intimate knowledge of the business?
The answer is no. Trencor management has gone as far to suggest they would contribute further capital to Textainer in the event of a large acquisition. We are inclined to see ourselves in Trencor’s shoes, as long term shareholders with limited opportunity to exit, and looking to increase our investment as the cycle deteriorates.
We look forward to writing to you again.
1 The second and third largest players, Triton and TAL merged in July 2016 to form the largest lessor with 25% market share.
2 One TEU equals one 20 foot equivalent unit. Since Textainer has many 40’ containers, its fleet size is approximately 2 million containers.
3 In hindsight, all carriers would be better off today had none of them invested in very large container ships. Instead, Maersk made the first move, whereupon others soon followed.
4 A container load of Nike shoes would have a sales value of around USD150,000