Price Objective S$2.12
Company Description
Yangzijiang Shipbuilding (Holdings) Ltd [Yangzijiang] is the largest privately-owned listed Chinese shipyard. Yangzijiang currently operates three shipyards along the Yangtze River. The group's current core competencies are the construction of 4,800 TEU containerships, and 92,500dwt dry bulk carriers. Yangzijiang has also completed the designs of environmentally friendlier and more fuel-efficient 10,000 TEU containerships as its lead design for the future. Rigbuilding is also a new focus area.
Investment Thesis
We like Yangzijiang as a shipyard that constantly succeeds in improving an already-high productivity level, which sustains its above-industry-average profit margins. The two-year order-book visibility offered by YZJ is also favored, while its high exposure to containership construction is expected to benefit from sustained new orders from mid- 2012. The strong balance sheet could also provide upside merger and acquisition surprises to investors, as the shipyard repositions for the next upturn.
Tweaking up PO to S$2.12 from S$2.08; reiterating Buy
We reiterate our Buy on Yangzijiang (YZJ), driven by
the following potential share price catalysts:
1) rigbuilding order wins surprise in 2H12 (despite skeptical market view);
2) the Street’s FY12E profit upgrade, latest by August 2012, and
3) the return of mega-containership orders in mid-2012.
We now use DCF to better reflect the earnings/cash-flow transition period in FY12-14E. Our new PO is S$2.12.
Aiming to extend our earnings insights to FY12-14E
This report attempts to:
1) reinforce our optimism on YZJ’s earnings visibility in FY12-13E, and
2) present a more realistic picture of its new source of earnings by introducing our FY14 forecast, following YZJ’s ongoing efforts to develop new business in the past 1-2 years.
The Street has surprisingly not raised its earnings forecast for FY12, post YZJ’s recent CNY4bn FY11 net profit, which was spot on with our estimate but beat consensus by 7.8%. Our 26% above-consensus FY12E net profit rests on the recognition of high-margin order backlog, and we expect the strong 1H12 results to force the Street to play catch up with us.
Three potential new earnings sources from FY14E We expect YZJ to benefit from:
1) the potential shipbreaking boom – as 27% of dry bulk carriers globally will be 20 years or older in the next five years, amid low freight rates;
2) the likely maiden rigbuilding contract wins in 2H12 – with YZJ’s chances boosted by the Chinese government’s support and Qatar Investment Corporation’s relationship with offshore players in the Middle East; and
3) rising idle ratio, better freight rates, and lower newbuild prices – which could attract the usually ill disciplined owners to place mega-containership orders from mid-2012.
More corporate actions could still boost FY14 earnings We expect YZJ’s next possible corporate action is to buy the 40% minority interest stake in the new Xinfu yard (involved in mega-containership construction) by 4Q13. We forecast CNY560mn minority interest income from Xinfu yard in FY14.
Expecting earnings upgrade catalysts, latest by Aug 2012 We believe a strong set of results in 1Q12 (in May) and/or in 2Q12 (in August) by YZJ will force the Street’s catch-up with our above-consensus earnings estimates. We are perplexed by the Street’s reluctance to raise its FY12E, following YZJ’s CNY4bn FY11 net profit, which is spot on with our estimate but is above consensus by 7.8%. Our FY12 net profit estimate stays 26% above consensus, due to the expected recognition of high-margin orders.
High-margin contracts should support margins till 2013 YZJ’s high-margin contracts (those secured at high newbuild prices before 2009) are only expected to be fully drawn down by end-2013, even though their proportion of shipbuilding revenue in FY13 will dip below 50%. We expect about 65% of total shipbuilding revenue in FY12 to be backed by high-margin contracts, for which YZJ has collected 40% cash deposits and advance payments, to date.
Yard capacity increases to support more sales from 2014E Ironically, we expect below-consensus profit margins in FY14, due to the complete dominance of low-margin shipbuilding orders, and YZJ’s likely steep learning curve on rigbuilding. This is expected to be mitigated by higher sales, riding on the completion of two large yards under construction till end-2013. These yards are specially built to handle offshore rigs and mega-containerships.
Order backlog likely to be replenished from 2012
YZJ now has nearly two years of order backlog, which is at the lower end of the 2.0 to 2.5 years order backlog of established Asian yards. We expect YZJ to replenish its shipbuilding order book in the coming months via: 1) maiden rigbuilding orders in 2H12, given our bullish industry views, as per Offshore & Marine, 14 December 2011; and 2) the non-consensus expectations for megacontainership orders to return by mid-2012. This will be driven by the increase in competent shipyards’ bargaining power via capacity constraints by mid-2012, the structural push towards lower cost structure, and the trend of low freight rates amid high oil prices. YZJ has 26 options for newbuild 10,000 TEU containerships.
Two years left to buy minority interest in Xinfu yard
YZJ is solely in charge of the ongoing construction and future operation of Jiangsu Xinfu yard. This yard is built with an annual production output of twelve 10,000-TEU containerships. We believe YZJ will try to avoid earnings slippage via minority interest, in line with the recent purchase of the remaining 80% stake in its shipbreaking yard upon the latter turning profitable. If YZJ eventually uses its balance sheet to buy the 40% minority interest stake in Xinfu yard upon achieving operational stability, we will reverse the projected CNY560mn minority interest income from Xinfu yard in FY14E, which equals 15% of profit after tax.
The single biggest risk to our profit forecast
The biggest risk to our profit forecast in FY14 is YZJ’s inability to win rigbuilding orders, and the non-existence of mega-containership orders in 2012. Our sensitivity analysis shows S$1.40 PO, assuming 50% across-the-board lower orders. The implied FY14 P/E is 11.5x, which is slightly above mean forward P/E.
Three-prong approach to sustain 2H13E and FY14E earnings
YZJ’s efforts to mitigate profit decline from 2H13 and diversify long-term profits are taking shape. The group targets to achieve a long-term revenue contribution of 20% from shipbreaking, 60% from shipbuilding, and 20% from rigbuilding.
1) New shipbreaking business to benefit from BDI collapse We believe YZJ’s recent purchase of the remaining 80% stake in Jingjiang City Dunfeng Ship Dismantle Co. Ltd is timely, as per Yangzijiang Shipbuilding, 11 January 2012. The YTD increase in shipbreaking activities is expected to stay as freight rates for dry bulk carriers remain weak. China, with 30% global market share for shipbreaking of dry bulk carriers in 2011, stands to benefit. We expect ship owners to capitulate in 2012 by sending their old and unprofitable dry bulk carriers to the shipbreaking yards in China, including YZJ’s newly acquired yard. We assume YZJ to deliver only 2% gross profit margin in 2012 as it fine-tunes the operations after achieving full ownership, vs. the group’s guidance of 10-15%.
Demolitions of dry bulk carriers picked up since late 2011
As freight rates drop below cost, we observe the demolition activities for dry bulk carriers have regained momentum since last 2011. There were 2.7mn DWTequivalent of dry bulk carriers sent for shipbreaking in February. This is the fourth highest record month of shipbreaking activities for the global dry bulk carrier fleet, and is 2.3x the average monthly global shipbreaking activities in 2011.
2) Our non-consensus optimism on containership orders
We saw further ingredients for a shipbuilding orders rebound taking shape, since our 2012 outlook report, Offshore & Marine, 14 December 2011. With the structural cost advantage of large containerships (8,000+ TEU) and the persistent high bunker fuel prices, we believe it is a matter of time before the containership owners lose discipline again and place orders for large containerships. We expect this short-term rebound to occur from late 2Q12, as the expected yard capacity and capability constraints will increasingly limit available ship deliveries in 4Q14. We expect this rebound to occur in late 2Q12, and any delay to ignite a stronger rebound subsequently. YZJ is one of the few global builders of 10,000-TEU containerships, and it has given US$2.6bn worth of options and LOIs for 10,000- TEU containership orders to Seaspan and Peter Doyle, respectively.
Four industry indicators improved since late 2011
1) The idle ratio has risen to 4.9% as of end-January, and it should move higher in February and March as leading shipping firms like Maersk pull capacity off the market.
2) The freight rates have rebounded strongly off unsustainable lows and are not expected to fall back to US$500/TEU in 2012, even though our shipping analysts expect part of the recent gains to be pared.
3) The newbuild prices for containerships (8,500-9,100 TEU) have fallen 2% below levels seen in July 2010, when orders first rebounded since the global financial crisis.
4) Order-to-book ratio has fallen to 27%, vs. the average of 24% before the 2003-08 upcycle.
3) Market underestimated YZJ’s rigbuilding preparation
We believe YZJ’s imminent entry into the booming rigbuilding market will be boosted by support from:
1) the Chinese government, via construction funding availability from Chinese banks and difficult-to-get-but-possible tax incentives,
2) the linking up with IOCs and NOCs operating in the Middle East via its marketing and offshore design JV with Qatar Investment Corporation, and
3) the drawing on its own industry-leading shipbuilding capabilities to smoothen the usual steep rigbuilding learning curve. Still, the build-up of the rigbuilding team is slower than expected, and we now expect maiden rigbuilding contracts only in 2H12.
DCF valuation to better reflect fundamentals
We change our PO valuation to DCF, vs. forward P/E previously. We believe the DCF-based PO will better capture YZJ’s transition in FY12-14E, given: 1) the single-year decline in FY14E on recognition of low-margin contracts before productivity on new vessel designs improves further; and 2) the negative free cash flows in FY12-13E, before turning positive again from FY14E. This is due to the delivery of high-margin contracts (with large advance payments) and the lessfavorable payment terms for contracts secured after 2009. We tweak up our PO to S$2.12, implying 9.1x FY12E P/E, 9.0x FY13E P/E, and 11.9x FY14E P/E. We maintain our Buy rating on expected new order catalysts.
Price objective basis & risk
Yangzijiang Shipbuilding (YSHLF)
Our PO is S$2.12, implying 9.1x FY12 P/E, 9.0x FY13 P/E and 11.9x FY14 P/E. This is reasonable, vs the 10x average forward P/E since listing in 2007. We like the coordinated efforts by Yangzijiang Shipbuilding (YZJ) to look ahead and mitigate profit decline from 2H13 and to diversify long-term profits. YZJ targets to achieve a long-term revenue contribution of 20% from shipbreaking, 60% from shipbuilding, and 20% from rigbuilding.
Our PO is based on the DCF valuation methodology, which we believe will better capture the business transition in FY12-14E, given:
1) The single year decline in FY14E on recognition of low-margin contracts before productivity on new vessel designs improves further.
2) The negative free cash flows in FY12-13E, before turning positive again from FY14E. This is due to the delivery of high margin contracts (with large advance payments) and the less favorable payment terms for contracts secured after 2009.
Our DCF valuation model uses a WACC of 8.3%, a risk-free rate of 1.6%, a beta of 1.53, a market risk premium of 7%, a target debt/equity ratio of 40%, and a terminal growth rate of 1%.
Downside risks are:
(1) a sharp plunge in freight rates, which result in high cancellation risk on existing shipbuilding orders,
(2) a steeper-than-expected increase in steel prices, and
(3) an unexpected plunge in the Chinese stock market by more than 70% from current levels, which greatly reduces the collateral value for the financial investments of YZJ.
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