The Containerized Shipping Megatrend for 2013

Further to the December '12 post, I will try to address 2 aspects in Logistics mega-trends for January 2013

Starting with the first one will be Containerized Shipping and this will be followed up with my take on HR by mid-Jan '13

Containerized Shipping

As mentioned earlier as well, the Baltic Dry Freight Index continues to be at an all-time low [adjusting for Inflation] and there is too much capacity floating around with a glut of ships all over the place. The root cause of this has been over-optimistic volume forecasts with unrealistic growth projections for perpetuity.

For starters, people tend to forget the base effect i.e. a 10% Growth over a base of 50 million is relatively difficult compared to the Growth of 10% over 10 million and a growth of 10% over 1 billion is far more difficult than any of the earlier bases. The underlying fact is that executives are by and large emotional themselves and have a tendency to 'escalate level of commitment' for their own projections and 'ideas about reality'. A simple math calculation of compound interest done at high school level says that Amount = Double The Principal [i.e. Interest Earned = Principal Amount itself] works on the formula

Amount = Double The Principal with Formula R% x N-Years = 70

So if the rate of interest is 10%, one doubles the principal in 7 years 70 / 7 at which point the new principal becomes twice the original principal at the beginning of the iteration.

Why is this so critical for container shipping companies??? Simply because this formula works on the debt required to build new ships [on which they pay interest] and also the volume projections made work on the same base effect principal. Compounding to the woes are the twists and turns in economic cycles [a crash happened in 1987, a crash happened in 2000-2001, 2008-2009] but it is unfortunate that executives of top notch class failed to take these aspects into account. [read self-fulfilling prophecies and disparate incentives that promote short-term gains over long-term losses!] The relentless quest for volume growth has had a spiraling effect on the wages required to be paid that will continue to grow at the rate of inflation.

Last but not the least, the fact that opportunities exist for other players to enter the market and make money will invite competition to the extent that the basic economic principle of 'Marginal Revenue' = 'Marginal Cost' over the long run is satisfied. When one adjusts for all these factors, it is pretty clear that growth rates beyond 3% to 4% on a Compound Aggregate Basis are simply not possible in the containerized shipping industry[now the distribution of this 2% to 4% can be skewed in terms of highly negative in some geographies and double digit growth in certain geographies. And if one feels that this is pessimistic, one should look at beer consumption growth projections for the next 2 decades that are largely made at 2% CAGR per annum!!!]

Base Freight Rates will continue to hold at current levels unless capacities in the market don't go down and with so much more delivery still pending of so-called mother vessels, it would be unrealistic to assume any meaningful growth in Base Freight rates for 2013 through 2016. Peak Season Surcharges, Bunker Adjustment Factors, Currency Adjustment Factors will continue to fluctuate / surge. The first and foremost activity that shipping companies should work towards is keeping aside a reserve fund to deal with the fluctuations of oil prices and hedge themselves in such a way that the price shocks don't bleed the balance sheets adversely [one must recall that the likes of Goldman Sachs predicted oil prices at 200 dollars a barrel in 2008 and locked in prices from a lot of airlines when crude was boiling at 125+ dollars a barrel only to see oil prices collapse all the way to sub-60 levels] Range for Nymex Crude for 2013 is expected to be USD 65 / barrel on the downside and USD 145 / barrel on the upside. Shipping companies that have analysts with sound economic and technical analysis skills would do well to lock in 'Cost Prices' to firms in such a way that external shocks won't matter.

On the currency front, there are a lot of headwinds regarding the Euro [it is destined to fall; detailed outlook can be seen on the other blog http://niftyparadox.blogspot.com] and it is just a matter of time. Sudden shocks in currency exchange prices and overnight devaluation of peripheral European countries and a sudden surge in value of German currency remain high probability risks for international markets at large. This is extremely critical for shipping companies that have to deal with daily collections in over 300 countries on a daily basis. Whilst a lot of corporations already have a daily sweeping mechanism in place for consolidating daily collections, parking them in low risk countries and hedging risks of fluctuations will be very critical. The SnP, Fitch and Moody's ratings have no bearing on the real life scenarios. The risk of bank runs continues to remain high across a lot of peripheral European countries, Latin American, West African countries.

Again only economically, financially and technically sound treasury departments will be the only ones who can help mitigate risks whilst mediocre executives with high focus on local optimization and ignorance of global optimization will impact balance sheets adversely [not only treasury but lackluster leadership, lack of vision and herd mentality of leaders themselves has contributed to the downfall of shipping industry today]

On the wages front, cost per employee will continue to surge at 8% to 10% per annum on a global scale thanks to rampant money printing policies of developed economies and the growth in emerging nations where there is a steady tendency for wages to grow towards parity with their developed countries' counterparts. At the end of the day, employees also have to take care of their families in their respective countries and cope with inflation to just maintain their existing lifestyles. Whilst migrating work to Asia has been pretty successful and will continue to be, one should not go over-board with this and focus on getting more productivity and efficiency in place with existing projects.

Should the expected economic crisis in peripheral Europe erupt as expected, one may also see a huge competitive advantage to have shared service centers within peripheral Europe as they may end up being cheaper than their Asian counterparts should that crisis take place. The question is not whether this collapse will come [it is bound to come] but the question is whether it will be in 2013 or towards 2016 [when one can expect a repeat of the Great Depression of 1929 yet again in the new millennium. One can trace economics as far as it gets and one will find a major crisis economic every century of high magnitude and 1 major catastrophe every decade]. It is sad that a lot of leaders are made to let go off when decisions fail but the underlying assumptions behind business models are not revisited to prepare revised strategies. Knee-jerk reactions to impress the financial stream on the stock markets and severing employees and hiring people randomly never really solve problems.

Leaders in corporations that plan for this entire turbulence in the period 2013-2016 will stand out and receive accolades or else, we can continue to see the same lackluster performances that leave bad leaders with golden parachutes and lower rung employees struggling to get things in order.

Now towards the sides that can make things better [if the reading so far sounds depressing, I would strongly encourage readers to read HBR's  'Alusauf Aluminum Hillside Project Case - just costs 6 dollars that has a far more depressing background and shows how a corporation in a bleeding industry can turn things around in depressed markets as well]

In 2011-2012, one has seen a lot of shipping corporations trying to delay sailing and create artificial demand as well as lower bunker expenses / operating costs. Pointers to cope with shocks on bunker prices have already been mentioned above. The other thing that is going to make a significant difference to shipping corporations is application of analytics. The moment the word 'analytics' surfaces, one thinks of doctorates crunching numbers and some nerds developing algorithms or a battery of consultants from the BIG 5 doling out their services @ 200 hours per consultant per week; the reality is a far cry away from that. Most of the data that the industry needs is already present in their own computers and most of the people required to do the analysis are also employed with the shipping companies themselves. All that the corporations need is to identify those high-sparked employees who fit the bill, hone their skills in analytics with simple regression models, decision sciences [usually takes about 40 hours of classwork and 120 hours of assignments over a 3 month period] and then put them into internal projects [just as leaders did for shared service centers setups] and within a year or 2, get the desired results in place.

It is actually a shame that the same shipping companies that have been dealing with the Walmarts, Targets and Tescos for decades now have not absorbed even 50% of the analytic capabilities that these clients use for operations. Analytics will help corporations optimize the demand-supply much better and in the current economic climate, artificial demand and supply won't solve the problem. The lesser the demand-supply imbalance, the more loyal will customers be. Time definite deliveries, guaranteed space allocation and higher utilization of vessels and equipment will go a long way to help carriers arrest the rot in the balance sheets. Analytics will go a very long way to work things out. There will also be opportunities in certain geographies for domestic transportation via sea and such opportunities must be exploited.

Now that containerized shipping has become a commodity, opportunities must be exploited for direct shipments, online bookings and transparent freight rates [the days of keeping some obnoxious freight rate as the list price and then segregating internal pricing depending on class of customer are passé] Barring the VIP/VVIP clients, regardless of geography, customers by and large know the prevailing prices. It will be difficult for the shipping companies to directly engage with shippers due to complexity and sheer volume of workload, but steps towards direct bookings and minimizing the number of hands involved in the chain of one transaction will go a long way towards economic sustainability.

Last but not the least, the shipping consortium needs to seriously ensure that old ships are taken out of the available capacity in the market and also try to cancel out new orders that have not yet begun as it will take at least a decade to get rid of existing debts on vessels already taken over the last 5 years. It is very unfair that some shipping corporations have ships over 25 years old still plying on prime routes and competing with expensive ships with modern equipment. Also existing debt on ships needs to be restructured with interest rates no greater than 6%

Any major upside for the shipping industry as a whole can only come towards the latter part of this decade. Turbulence, consolidation and more uncertainty will prevail for 2013-2016. The players who get their act in order during this period are the ones that will emerge with success.

I frequently get questioned regarding assignment of Earnings Percentage and PE multiples and that Im extremely pessimistic with estimates for the shipping and logistics industry as a whole. Lets quell this out

PE Multiple = Price to Earnings Multiple
Higher The PE Multiple, Lower the Earnings Growth and greater the over-valuation of stock prices [A High PE Multiple in the short run can help generate a better valuation but it will impact the earnings potential of investors which is the reciprocal of Price to Earnings]

A simple metric i.e. utilization of 20' Containers has remained stagnant at about 5 per year. In other words, 1 20' container, on average is utilized 5 times in a period of 50 weeks giving it 5 Earning Cycles per year. For the business to be sustainable, it has to generate 20% Gross Margins to just break even of all operational expenses and all overheads. For it to generate 15% net profit after all expenses except tax, it has to have a gross margin of 35% Ask any top notch shipping executive as to whether it is possible to have 6 times asset utilization of containers in a year with gross margins of 35% - if that were indeed the case, we would not have had the Baltic Dry Freight Index at such pathetic levels in the first place!!!

15% net profit is what is the most reasonable estimate in this industry for players who get it right and a PE multiple of 5.5 [8 at best] is the fair one for those having lower cost structures and operational efficiencies. A section from Private Equity / Venture Capitalists can always argue against this valuation. That is a different financial aspect together and it is critical to remember that LBOs do not improve Return on Asset in any form. It is just the leverage of deployed capital that amplifies Return on Investment [and amplifies both gains as well as losses]. Moreover, the gains made by 1 PE/LBO player is dependent on the assumption that there is somebody on the other side willing to pay a higher valuation! [In the end, somebody will be sitting with an overvalued lame duck]

The next article will deal with HR issues, skill gaps etc. for the shipping industry. Comments, criticism, questions are more than welcome [Comments are moderated for decorum purposes only]