Global Liner Shipping Sector

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1 Global Equity Research Global Liner Shipping Sector Connections Series Liner alliances: Size matters but not enough Figure 1: Caught between a rock and a hard place The shipping alliance's 'Catch 22' that stem from large vessel sizes Alliances drive cost and capital benefits and encourage large vessel orders The Credit Suisse Connections Series leverages our exceptional breadth of macro and micro research to deliver incisive cross-sector and cross-border thematic insights for our clients. and result in lower freight rates that drive cost and capital savings Research Analysts Timothy Ross timothy.ross@credit-suisse.com Neil Glynn, CFA neil.glynn@credit-suisse.com Christopher Siow christopher.siow@credit-suisse.com Source: Credit Suisse but lead to excess capacity Alliances won't save the shipping universe: The scale at the individual vessel or liner company level is demonstrably rewarded in terms of operating and capital cost so alliances that emphasise scale benefits are a natural ambition. However, with pricing co-ordination prohibited, they fail as a cure-all for the industries' capacity-led woes, exacerbated by alliance led large vessel orders. but they are the best available option: That said, they have driven marked reductions in opex and capex and could lead to capacity co-ordination that better deals with the large format vessel deliveries that are, especially, expected to sustain pressure on Asia-Europe rates. Vessel selection has been the key benefit, with ports likely as the source of liner gains. You won't beat them, so join them: With 82% of the world's capacity currently within one of the four major alliances, we expect few independent operators to thrive. Maersk Line (NEUTRAL, TP DKK15,800) should retain its cost leadership, profitability and returns as weak rates ensure it preserves its targeted 5% EBIT margin gap to the industry. However, ML cost emulation and alliance benefits should see improved returns sector-wide. Elsewhere in our coverage, the best combination of improvement in and absolute level of returns are generated by OOIL (OUTPERFORM, TP HK$60) and NOL (recently upgraded to OUTPERFORM, TP SG$1.20) DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 Focus charts Figure 2: Most of the world is in an alliance Alliance market share by trade lane Transpacific Asia-EU Transatlantic Figure 3: but these do nothing for rate stability Asia-EU spot rates vs YoY % chg. 3,500 3,000 2,500 2,000 1,500 1, Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec M G6 CYKHE Ocean 3 Others Rates (US$/FEU) YoY % chg. Source: Alphaliner Figure 4: Scale, however, is rewarded Scale (TEU slots) vs EBIT margin (2H14) 3,000,000 ML Source: Drewry Figure 5: so alliances should see returns move to ML's Liner industry vs Maersk Line ROIC 2 2,500,000 2,000,000 1,500,000 CMA 15% 1 5% 1,000, ,000 HPL EMC HJS MOL NOL OOIL NYK K-Line COSCO CSCL WHL % -1-15% 2007A 2008A 2009A 2010A 2011A 2012A 2013A 2014A 2015E 2016E Maersk Line Industry Source: Company data Source: Company data, Credit Suisse estimates Figure 6: Liner sector valuation comparison table ( as at 15 April 2015) Liner Reuters Share price Last Close Mkt cap Target Up/Down FY15E Name Code currency Price (US$ mn) Rating price side (%) PE EV/EBITDA PB ROE Div yield K-Line 9107.T JPY OP % NOL NEPS.SI SGD OP % NYK 9101.T JPY OP % OOIL 0316.HK HKD OP % Maersk MAERSKb.C DKK N % EMC 2603.TW TWD N % MOL 9104.T JPY UP 390-3% WHL 2615.TW TWD UP % CSCL 2866.HK HKD N.R. N.R. NA Cn COSCO 1919.HK HKD N.R. N.R. NA YMM 2609.TW TWD N.R. N.R. NA HMM KS KRW N.R. N.R. NA HJS KS KRW N.R. N.R. NA Source: the BLOOMBERG PROFESSIONAL service, Company data, Credit Suisse estimates for covered companies Global Liner Shipping Sector 2

3 Liner alliances: Size matters but not enough Whilst shipping alliances have been a feature of the liner landscape even before the abolition of the conference system in 2008, the decision by CMA CGM and MSC to form an alliance based primarily around their Asia-EU services in December 2011 sparked a relationship revolution that has seen 16 of the world's 17 largest container shipping companies divide the globe's largest liner trades up into four broadly equal shares in an effort to shore up their clearly pressured profitability. We list these in Appendix I. Revenue beyond control With regulators expressly prohibiting any form of co-operation on sales and pricing, alliances have had little appreciable impact on rate stability. This is despite the >9 market share concentration on three of the world's four major trades that the four major alliances now represent. Volatility may have become less extreme, but there is no denying that the downward pressure evident on rates in most markets has been in no way mitigated by either organic or alliance-centred consolidation. Better capacity management could balance supply and demand more effectively, although this is likely insufficient to address the oversupply looming on Asia-Europe trades as large format vessels deliver. Only levers are capital and costs As airline-like joint ventures are verboten, alliances are only effectual in reducing capital commitment and aiding costs through more efficient use of equipment and pooled purchasing. It is clear to us that scale has a direct read through to profitability (in EBIT margin terms) and this permeates both individual companies and goes down even to vessel sizes. The desire for the scale that alliances represent is a logical aspiration in this context especially when any form of pricing collusion is unattainable. The unfortunate corollary is that alliances seem to perpetuate the escalation of capacity; alone few single carriers can afford to finance a strong of 20,000 TEU vessels, however, ordering in pairs or trios alliance members are essentially adding 1% to global capacity every time an order is placed. United we stand? Despite the unfortunate influence on aggregate capacity that seems to stem from alliance participation they do represent an acceleration of the consolidation that has been a feature of this industry for the last 15 years. During this time the world's top-ten players have moved from controlling 5 of industry capacity to closer to 7 at present, largely without any M&A. Including alliance partners, the four major groups constitute 82% of the world's TEU slots, which are opening up significant operating cost reductions for them. The most significant is vessel selection and the bunker savings associated with this. ML has identified US$350 mn in alliance-based savings, while Japanese players expect to realise US$ mn a year in direct and indirect savings from their memberships. Key conclusion: Alliances, as good as it gets? We see alliances as imperfect, but they are the only available option for returns improvement to the liner sector, and we arrange our stock preferences around those players with the greatest leverage to changing ROICs. Having driven its returns into double digit territory in 2014, aided by an industry-leading EBIT margin of >9, we see ML as well placed to optimise returns from a position of strength. The key area of concern is Asia-Europe where the delivery of large format vessels (all of which belong to alliance members) could swell capacity and pressure rates. For this reason, we like carriers such as NOL and OOIL, whose rising returns are more insulated from this trade and where cost cuts driven by internal processes and alliance membership are bearing fruit. K-Line (OUTPERFORM) is also less exposed to this trade and leverage to a likely rebound in Transpacific contract rates. Most of the world's liner capacity is operated by alliance members As pricing co-operation is ruled out by regulators the aims of alliance centre round capital management and cost efficiency Although imperfect, organic and alliance-led consolidation has led and is leading to major savings with Maersk Line the high water mark for sector returns and margins Global Liner Shipping Sector 3

4 Revenue beyond control Fragmentation of industry ownership and universal market access are generally accepted features of the transport industry, with the liner segment as no different. With few barriers to entry, players have difficulty retaining any form of pricing power, which only tends to exert itself during (increasingly rare) periods of supply shortages. With the industry featuring a TEU-weighted average age of less than nine years and oversupplied by both the liquidity excesses of the mid-noughties and 2010, as well as the ease with which large format vessels appear to attract funding now more than ever, the control of the top line seems further from liner players' grasp than ever before. Figure 7: Alliance market share by trade lane 10 9 Oversupply and ownership fragmentation have accounted for the liner sector's poor revenue track record and even the recent emergence of alliances have failed to alter this Transpacific Asia-EU Transatlantic 2M G6 CYKHE Ocean 3 Others Source: Alphaliner This despite the control that the major alliance exert on the three major east-west trade lanes, where they jointly account for >9 of the capacity operated, are yet prohibited from co-operating on sales efforts or pricing. despite their control, of 82% of the world's capacity Figure 8: Asia-EU spot rates vs YoY % chg. Figure 9: Transpacific spot rates vs YoY % chg. 3, , ,000 2, ,600 2,400 2, ,000 1, ,000 1, , ,600 1,400 1, Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec ,000 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14-4 Rates (US$/FEU) YoY % chg. Rates (USD/FEU) YoY % chg. Source: Drewry Source: Drewry Some participants feel that there has been a reduction in freight rate volatility since alliances kicked off in earnest, however the facts (especially on Asia-EU) provide only a lukewarm support for this assertion. Variance around the mean on Asia-EU freight rates Global Liner Shipping Sector 4

5 has fallen from 33% four years ago to 28% over the last two years and on the Transpacific from the US West Coast from 16% to 9%. Average rates, meanwhile, have fallen 24% over the last three years on Asia-EU, 14% on Transatlantic and 17% on Transpacific lanes, confirming that alliance membership has provided neither stability nor insulation. Figure 10: The alliance 'Catch 22' Alliances drive cost and capital benefits that stem from large vessel sizes and encourage large vessel orders In many respects, alliances contribute to rate weakness whilst seeking the scale benefits they enjoy from large vessels and result in lower freight rates that drive cost and capital savings but lead to excess capacity Source: Credit Suisse Meantime, the other driver of revenue (volume) has been insipid to say the least. While the comparative cost of shipping goods by sea versus air might have driven some modal shift over this period, the volumes would not have been great and there is no suggestion that liner alliances have had any influence on the volumes of goods transported by sea. These have largely been a reflection of Western consumption patterns and economic growth, given that the secular layer of growth that the containerisation of previously break-bulk goods had provided has largely been exhausted. Rates have been impacted by oversupply and volumes by weak consumption, with alliances exerting a demonstrable lack of control Figure 11: Asia-EU TEU volumes vs YoY % chg. Figure 12: Transpacific TEU volumes vs YoY % chg. 1,500, ,550, ,400,000 1,300,000 1,200,000 1,100,000 1,000, , ,450,000 1,350,000 1,250,000 1,150,000 1,050, , , ,000 Jun-11 Jan-12 Aug-12 Mar-13 Oct-13 May-14 Dec ,000 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14-2 Volumes Series2 Volumes YoY % chg. Source: Container Trade Statistics Source: Container Trade Statistics According to Container Trade Statistics, volumes have risen 7% annually for the last two years on Asia-Europe, 4% on Transpacific and down 1% across the Atlantic. The spike apparent in February reflects (1) the change in Chinese New Year and (2) the low base caused by last year's winter conditions, especially in the US...although 2015's numbers YTD give some reason for optimism Global Liner Shipping Sector 5

6 Airlines show the way forward but liner revenue solution tantalisingly out of reach By contrast, we highlight the airline industry's hugely positive experience of revenue/profit sharing joint ventures that have transformed pricing dynamics on Transatlantic since demand recovery commenced in The three Transatlantic airline joint ventures (oneworld's joint business agreement, and both SkyTeam and Star's JVs) crucially involve price as well as schedule co-ordination and have been instrumental in structurally improving the returns of the key players in a concentrated market. These JV benefits have risen above traditional codeshare agreements that have contributed little demonstrable assistance to carrier pricing and returns historically. We highlight that while the structure of the Transatlantic air travel market resembles that of the East-West lanes for the liners in terms of alliance concentration, airlines have enjoyed continued year on year pricing growth on these routes, in contrast to prolonged East-West liner pricing weakness despite the advent of 'modern' alliances at the beginning of but the clear success of alliances in managing airline industry revenues stands in stark contrast to the shipping peer group Figure 13: EU-US air travel market mirrors E-W liner trades with JVs dominating. Figure 14: but Transatlantic pricing differs dramatically from the liner experience 25% Other 21% oneworld JBA 26% 2 15% 1 5% -5% STAR JV 26% SkyTeam JV (incl DL-VS JV) 27% -1 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 Air France KLM IAG Lufthansa Source: Diio Mi 2014 data Source: Company data European carrier quarterly Transatlantic unit revenues/rask YoY at constant currency This is because alliance members are expressly forbidden from any form of pricing cooperation by the world's regulators including those in the EU (the European Commission), the Federal Maritime Commission (in the US) and the Chinese Ministry of Commerce. This prohibition means that member sales teams have to work independently of each other to fill the slots that each partner contributes (or has purchased from other alliance members). It also accounts for the apparent ineffectiveness of de facto consolidation via the alliance process to provide any form of price stabilisation. At the G6 for example, there are up to six sales forces selling an identical product (given that each alliance partner might have slots on the same vessel that by definition all depart and arrive at the same time) whose only point of differentiation is price. The root cause of this is the absence of any pricing collaboration, and price being the only point of alliance member differentiation. Global Liner Shipping Sector 6

7 Only levers are capital and costs With freight rates down double digits and volumes flat to up mid-single digits, it is apparent to us that if liner alliances were formed to address the revenue line then they have been sovereignly unsuccessful. However, we do not believe this to be the basis for their foundation, not least because of the regulatory response to anything that resembles the cartel-like conference regimes that were abolished in Rather, alliances have been designed around the scale benefits that are clear in terms of reducing both operating costs and capital expenditure of their constituents and these are clearly visible in the charts that follow. Combining purchased services and vessel orders should allow alliance members to leverage the benefits of scale that are observable at the individual company level. With all carriers for which we produce research (and a number that we do not) having produced numbers to end-december, we have compared EBIT margin against size, with a linear relationship evident. Wan Hai Lines is the only real outlier in our universe, where its tight cost control and intense focus on short sea markets still see it generating operating margins approaching those of the industry-leading Maersk Line. Benefits obvious as size increases Figure 15: Scale (TEU slots) vs EBIT margin (2H14) 3,000,000 2,500,000 ML with the benefits of scale clear in terms of operating margins 2,000,000 1,500,000 CMA 1,000, ,000 HPL EMC HJS MOL NOL OOIL NYK K-Line COSCO CSCL Source: Company data, Credit Suisse WHL Scale related cost savings are a function of both what can be achieved ashore and by the fleet at sea. Administration and operations control, as well as sales force require little change in size whether one operates a 1 mn TEU company or one of Maersk's size. However, scale economies are clear at sea as well, with an 18,000 TEU vessel close to US$250/TEU (or a third) less expensive to operate. The incremental benefit of vessel size diminishes steadily after about 6,000TEUs, but there is still a US$20,000 per voyage saving when operating an 18,000 TEU vessel relative to one of 16,000. Administration and crewing costs are obvious areas of opex savings Global Liner Shipping Sector 7

8 Figure 16: Operating cost/teu vs vessel size (TEU, 000s) 750 as are the at-sea benefits of operating larger ships Source: Clarksons, Credit Suisse based on 14,000 mile round trip, seven port calls, 9 headhaul, 6 backhaul loadings The industry's largest ships of 20,000 TEUs cost around US$160 mn apiece and a minimum of ten are required to operate a full string on the only trade-lane that can accommodate them (Asia-EU). With such large sums involved, there are also capital gains evident in the scale of vessels ordered. Looking at transactions announced over the past 18 months, slot costs fall as the size of vessel increases. Figure 17: Capital cost/teu (US$) vs vessel size (TEUs) 15,000 14,000 Capital expenditure is another area where size confers savings.with 20,000 TEU vessels around 2 cheaper/slot than those half their size 13,000 12,000 11,000 10,000 9,000 8,000 7,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 Source: Company data, Credit Suisse estimates Moreover, with access to the US$1.1 bn in debt financing that a string of vessels represent (assuming 7 LTV), it is only large and stable businesses that can attract banking support. As part of a virtuous cycle, because of the size of the facilities, shipping lines within the 'circle of trust' are also able to negotiate cheaper funding costs than those that are more marginal in their credit quality. Japanese liner companies, Evergreen Marine Corporation (EMC) and Orient Overseas international (OOIL), have blended average interest rates between 1-2% as compared with their Korean counterparts that fund closer to 5%. Meanwhile, funding costs also favour those players trusted enough to borrow large Global Liner Shipping Sector 8

9 United we stand? With size evidently rewarded at the individual carrier level, logic follows that increased scale confers even greater savings. Indeed there has been creeping consolidation over the past 15 years, initially spurred by M&A, but over the last decade it has been more the big getting bigger as their large orderbooks deliver. Today the world's top-ten liner companies account for 68% of the container market, almost 2 more than it did at the turn of the century as they leverage their better banking relationships and superior operating economics to build out their fleets. Figure 18: Market share world top ten container shipping companies (TEUs) 7 The big get bigger 65% Top-ten liner companies account for ~7 of total capacity...up almost 2 in the last 15 years 6 M&A driven 55% 5 45% Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Source: Alphaliner The same top-ten players also all belong to one of the four major alliance groupings (listed in Appendix II), which essentially control just about all of the capacity operated on the principal East-West trade lanes, which when combined account for 45% of global cellular capacity as measured by TEUs. The four alliances account for >8 of total TEU slots. Figure 19: Alliance market share by trade lane Alliance Transpacific Asia-EU Transatlantic 2M 16% 35% 33% G6 31% 19% 47% CYKHE 36% 23% 7% Ocean 3 13% 21% 5% Others 4% 2% 8% Total while the four major alliances account for 82% of total TEU slots and over 9 market share on the major East- West trade lanes Source: Alphaliner Their most heavily plied routes are the Transpacific lanes, although vessel sizes are smaller reflecting the capabilities of US infrastructure and the absence of transhipment ports once vessels depart Asia and commence their 14 day transit to the US West Coast. Figure 20: Alliance weekly sailings by trade lane Alliance Transpacific Asia-EU Transatlantic 2M G CYKHE Ocean Total Source: Company data Global Liner Shipping Sector 9

10 Arms race escalates One of the corollaries of alliance membership has been the co-ordination of ordering patterns, especially where these are concentrated around large format vessels. With at least ten (and, in this slow steaming age, ideally eleven) vessels required for a standard string (or loop) on Asia-Europe trades, there are few individual companies that have the balance sheet capacity or strategic desire to fund the full amount alone. As a consequence, alliance members tend to hunt in packs, placing orders in combination with yards to spread the capital and financing costs and risks. Recent examples include China Shipping Container Lines (CSCL) and United Arab Shipping Corporation's (UASC) collaborative orders of ten 18,400 vessels (five each), and MOL and OOIL's combined orders for ten sister vessels at Samsung Heavy Industries. Figure 21: Alliance vessel orders (TEU) and delivery dates 500, ,000 Alliances have been indirectly responsible for accelerating orders for large format vessels and account for >98 of the global orderbook and 10 of the ULCS' on order 400, , , , , , ,000 50, M G6 CYKHE Ocean 3 Source: Company data, Lloyd's list, Alphaliner As each alliance has placed orders for large vessels, it has placed pressure on others to follow to ensure unit cost parity. However with each successive order, the stakes in the game are raised; the world's total cellular capacity today is 18.6 mn TEUs, so every string's worth of ULCS' ordered adds 1% to global capacity. While Maersk has stated that even at 7 utilisation its 18,000 TEU vessels are more efficient than the 14,000 TEU vessels that they were mixed with while awaiting delivery of enough ships to run a dedicated 18K loop, there is increased pressure on vessel operators to fill their behemoths to generate the at-sea cost savings that the vessels boast. While we detail ULCS orders by operator and by alliance in Appendix III, alliance members account for 91% of orders outstanding with shipyards and all (either directly or through financing partners) of the ULCS' on order. OOIL signed a deal with SHI that will allow the G6 to run a full string and COSCO is expected to formalise an order for 11 x 19,000 TEU vessels next month, which have yet to find their way into Alphaliner's orderbook data. With collusion on pricing 'off the table', the only hope for the Asia-Europe routes where these ships will be deployed, is that alliance partners constrain their use. Irrespective of this, we see the forces of gravity on Asia-Europe rates likely to persist for some time as that lane in particular remains over-supplied. Every string's worth of ULCS grows global capacity 1%...and they are all destined for the Asia-Europe service Part of the over-supply on Asia-EU stems from the reduced pool of smaller vessels that can be cascaded onto other trades as large format vessels deliver and thereby 'share the pain'. Since the alliance 'big bang' at the start of 2012, the pool of vessels small enough to transfer off the Asia-EU lanes (or cascade) into other trade lanes has fallen by almost two-thirds. Global Liner Shipping Sector 10

11 Figure 22: Sub 10,000 TEU vessels deployed on Asia-EU trades down 58% in last three years where the pool of cascadable vessels has shrunk by ~6 over the past three years Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Source: Alphaliner In the last year alone, cascadable vessel numbers have fallen by over a third, with less than 130 that could possibly be employed on any other trade. This significantly reduces the risk of overcapacity spreading to North-South, Transpacific and Intra-Asia trades, but does see overcapacity concentrated on Asia-Europe. Ports pay the price Seeing port calls increasingly rationalised by alliance members, ports face the probability of squeezed margins for the business that they retain as alliances look to joint bargaining to secure volume-related discounts. Equally pressing, capacity constraints at ports are also likely to intensify in the near term at least. According to Maersk Line's CEO, Soren Skou, "Since 2007, the ship size in the Asia Europe trade has effectively doubled. We used to have 6,500 TEUs being the workhouse, now it is 13,000 TEU ships, which are the workhorses. Our point is simply that port productivity has not doubled since then. While there has been improvement in productivity, we are spending more time in port because of bigger ships". This is illustrated in the chart below that shows how vessel scale has been achieved through depth and beam rather than length: A 19,000 TEU vessel is the same length as a 16,000 TEU vessel and only 32% larger than a 7,400 TEU post panamax ship, despite carrying 16 more boxes. According to a recent Drewry report (Who will pay for a port productivity revolution?, 22 March 2015) daily berth moves for a 19,000 TEU vessel are only 2 higher than for a 13,0000 TEU vessel, despite being nearly 5 larger. and the hope is that alliance coordination will limit vessel use to constrain the otherwise rampant capacity growth on Asia-EU Liner company gains could be port company losses as vessel scale benefits work against port operators Global Liner Shipping Sector 11

12 Figure 23: Vessel length vs vessel capacity 1,400 1,200 1,000 Vessel sizes have grown, but not length, meaning more dredging and extended reach cranes are now needed Capacity Length Source: Clarksons, Indexed from 100 (first generation container vessel) Effectively, ports have not invested in the terminal infrastructure required to unload ships at the same pace that shipping companies have grown the size of their vessels. Labour issues aside, alliances and vessel sizes are the root cause for the extra time that vessels are spending either queuing at harbour mouths or alongside being worked. Port congestion as was observable last summer (pretty much universally) and was especially troubling on the West Coast of the US, could however, absorb some of the additional ULCS capacity. Changes in sailing patterns and large vessels have also driven cargo spikes at ports, especially those that specialise in transhipment. Alliance partners are increasingly looking to harmonise their sailing schedules to avoid additional time alongside, however the increased volumes of boxes to be loaded and discharged, often from different terminals, have introduced complexities that port systems are not capable of handling. Because throughput volume growth is not changing (its arrival is merely being compressed into fewer hours of the week) ports have little incentive to invest in additional infrastructure, especially as alliances are likely to put pressure on ASPs. We certainly see a recurrence of 2014's bottle-necks as likely during this year's peak shipping period (June to September), with agencies such as the FMC requiring alliance members to formally outline their plans for combatting congestion. Indeed, FMC chairman Richard Lidinsky commented recently that 'much of the port congestion troubles that just took place on the west coast reportedly resulted from alliance cargo, stowed to reflect new alliance ties, rather than previous stowage practices, so it had to be directed to a specific terminal or trucker, thus exacerbating the overall problem at the root of alliance formation are the increasing number of mega ships of such size that they cannot today, and very likely not tomorrow, call [at] US ports. Where are the savings? Real life examples Up to this point our discussion has been academic yes size drives savings and big players have better EBIT margins, so alliances that enhance scale should result in even more savings. But where is the proof? We polled the liner companies under our coverage (Appendix I) on the value that they have derived from alliance membership and where they saw further benefits arising. Vessel (and especially fuel) efficiency was cited as the most compelling reason to ally with other players, with members: and this has contributed to terminal congestion Alliance-led cargo spikes are also to blame, with vessel arrivals bunched to enhance connectivity, but instead putting pressure on port systems and infrastructure We surveyed the liner companies under our coverage on their views of alliance benefits Global Liner Shipping Sector 12

13 Selecting the most economical vessels for each trade lane; Reducing overall costs through buying cheaper slots on these scale-efficient vessels; and, Generating bunker savings from efficient network configuration. Port call consolidation is another area of cost reduction, which reduces voyage length and is increasingly beginning to play a role, although port user agreements (that govern tariffs) are generally signed at the individual liner level. Consolidating alliances in common terminals and negotiating volume discounts are pools of savings yet to be tapped, although regulatory scrutiny may delay decision making or render liners less ambitious on procurement. and most responses listed vessel selection as the leading contributor to cost savings Figure 24: Liner industry unit costs (US$/TEU) vs YoY % chg. 1,400 1,350 1,300 1,250 1,200 1,150 1,100 1,050 1, E 2016E 25% 2 15% 1 5% -5% -1-15% -2 Sector unit costs began to head down in 2013 as alliance benefits began to bite; bunker should provide an assist, but is muted by USD impact Industry average YoY % chg Source: Company data, Credit Suisse estimates Having been stationary in 2012, the impact of larger vessels and alliance membership has had a palpable effect on industry unit costs since alliances began to gather steam. In USD terms, industry costs/teu handled have fallen close to 11% in the last two years, most of which were not bunker-related and are actually understated because of the strengthening of the USD against most of the world's currencies over this period. We expect another 7% drop in the next two years (again muted by FX), which includes the assumption that Brent prices return to ~US$100/bbl, implying bunker of US$600/t vs closer to US$300/t at present. In terms of changes in costs structure, the greatest improvers in the year ahead, relative to 2013, are those with some of the highest cost structures or where structural reforms are being implemented. Neptune Orient Lines (NOL) has assiduously rid itself of inefficient older vessels financed on expensive legacy charters and only partially replaced these with new, balance sheet-funded assets while chopping out large swathes of unneeded management. Consequently its unit costs are expected to drop the most in the sector (15%) over the two-year period. The other leader is Mitsui OSK Lines (MOL), which is also expected to see a sharp reduction in unit costs (14%) as it finally executes the changes to its cost structure in 2015 that its peers implemented over the two prior years. It remains, however, the highest cost producer in our segment and vulnerable to the returns of the bunker 'dividend' that has recently been a feature of bunker adjustment factors. In local currency terms, unit savings have been better with the best performers being those that have shed older legacy assets and replaced these with younger vessels Global Liner Shipping Sector 13

14 Figure 25: Unit costs changes (US$000s/TEU): 2013 vs 2015E However, the greatest gainers still retain the highest absolute unit costs, suggesting further gains are possible CSCL WHL COSCO EMC OOIL Maersk NOL K-Line NYK MOL E Source: Company data, Credit Suisse estimates Three years in, G6 is yet to meaningfully help Hapag-Lloyd earnings Hapag-Lloyd, one of the early movers in the global alliance development with the launch of G6 in 2012, has provided reasonable colour on alliance benefits over recent years. However, we highlight that the new HL management confirmed disappointing contributions from G6 with FY14 results underwhelming benefits were attributed by new CEO Rolf Habben Jansen to teething problems in integrating schedules when the alliance expanded from an initial AE offering to a full EW co-operation from 2013, and we consider it natural that an alliance of six carriers with varying strategies and interests will encounter challenges in executing a common strategy seamlessly given varying ambitions and interests. G6 launched in 2012 and has been expanding to a full East-West service but losses at Hapag-Lloyd highlight it is not a silver bullet to secure profitability Figure 26: G6 heralded an industry-wide change, suggesting first mover advantage Figure 27: G6 benefits are numerous Source: Hapag-Lloyd investor presentation 2014 Source: Hapag-Lloyd 2014 results presentation In our view, G6 operational opportunities and resultant efficiency initiatives are highly attractive at the headline level. Global Liner Shipping Sector 14

15 Figure 28: G6 designed to leverage vessel size benefits Figure 29:.and promote network efficiency and flexibility Source: Hapag-Lloyd investor presentation 2013 Source: Company data, Credit Suisse estimates In particular, Hapag-Lloyd data illustrates bunker savings coming through as G6 allows HL to adopt larger and larger vessels. Figure 30: Larger vessels, which G6 facilitates, helping bunker consumption in combination with slow steaming Figure 31: though ex-fuel costs present a more mixed story at the headline level 1 15% 1 15% 9% 8% 1 9% 8% 1 7% 6% 5% 7% 6% 5% 5% 5% 4% 3% -5% 4% 3% -5% 2% 1% -1 2% 1% A 2012A 2013A 2014A -15% 2011A 2012A 2013A 2014A -15% Average vessel size growth yoy (LHS) Average vessel size growth yoy (LHS) Bunker consumption growth yoy (RHS) Direct ex-fuel unit cost growth yoy (RHS) Source: Company data Source: Company data (Note: 2014A declines ex-us WC port disruption) But clearly G6 cannot help freight rates as per the terms of the alliance structure and regulatory approvals, and thus far rate weakness has outweighed progress on HL's cost base. Global Liner Shipping Sector 15

16 Figure 32: G6 clearly not helping rates. 15% Figure 33:.and difficult to detect in HL earnings given continued downward rate pressure 1, % % A 2013A 2014A AE yoy rate growth TA yoy rate growth TP yoy rate growth (200) 2010A 2011A 2012A 2013A 2014A EBITDA ( m) Underlying EBIT ( m) Source: Company data 2M has joined the party, aiming to make the strongest stronger Source: Company data Global market leader Maersk Line (ML) and number two player MSC launched 2M in January 2015, following the Chinese regulator's (MOFCOM) veto of the planned P3 alliance that was to also include CMA CGM. ML is the only carrier globally to have publicly confirmed a financial benefit objective; highlighting a US$350 mn estimate at Investor Day 2014 (US$250 mn in 2015 after phase in costs) as E-W average vessel sizes rise from 9,500 TEU to 11,500 TEU to be filled by two sales teams. Maersk sees the alliance movement as the way forward and has picked the most powerful partner Figure 34: 2M kicked off on E-W trades in 1Q15 Figure 35: It aims to generate US$350 mn in savings for ML (likely % of its EW opex) Source: AP Moller Maersk Investor Day 2014 Source: AP Moller Maersk Investor Day 2014 ML has an excellent track record in reducing unit costs, albeit in part due to utilisation improvements via slow steaming and fleet size management with the reduction of its charter fleet. Improved port access will clearly improve the product, without a commensurate increase in capacity/cost, however the extent of benefit to earnings from selling a better product remains to be seen. We note that ML abandoned Daily Maersk, its premium daily service launched in 2011 with guaranteed delivery times offered for higher prices, as uneconomical given the price sensitivity of customers on highly commoditised E-W trades and the additional cost required to run Daily Maersk with required reliability. Unit cost benefits more digestible than service quality in a commodity business Global Liner Shipping Sector 16

17 Figure 36: Industry-low unit costs and industry-high quality to be supplemented. Figure 37:.for a market leader going from strength to strength under disciplined, returns focused management 4,000 15% 3,000 2,000 1,000 - (1,000) (2,000) (3,000) 2007A 2009A 2011A 2013A 2015E 2017E 1 5% -5% -1-15% -2 NOPAT ($m) (LHS) Net margin (%) (RHS) Source: AP Moller Maersk Investor Day 2014 Source: Company data, Credit Suisse estimates ML's EBIT margin was 9% in 2014 compared to an industry average of 3% on our calculations (per Maersk). While we model expansion to 12% by 2016E (prudently modelling stability thereafter), it seems unlikely that it can protect this margin gap to the sector over the long run as struggling competitors improve profitability via alliances. Indeed, ML targets a 5% EBIT margin gap, partially in recognition of global industry improvement potential (see Appendix IV for our sector EBIT margin forecasts). We highlighted in Further value creation requires ML heroics on 27 February 2015 that a mid-teen EBIT margin may be required to unlock significant future value in AP Moller Maersk as a group, with Maersk Oil under pressure and much of the obvious portfolio streamlining activity completed. 2M should clearly help ML margins, but alliances may help peers close the 9 point EBIT margin gap Global Liner Shipping Sector 17

18 Alliances, as good as it gets? The liner industry's problem is that it has too many young ships; there is limited appetite to remove capacity via scrapping and few players have the desire or balance sheet capability to execute meaningful acquisitions that might see capacity utilised in a more optimal fashion. Despite a small spurt of M&A in 2014 (at both Hapag Lloyd and Hamburg Sud) we see this as unlikely to move the needle, moving forward, unless amalgamation takes place within alliance ranks, given the minnow-like dimensions of those independent operators that might contemplate a transaction. Moreover, M&A might drive more efficient vessel use, but it does not change the number of TEU slots available, all of which have a tendency to seep back into active use, irrespective of who owns them. So it appears that alliances are all that the sector has got to work with and we do perceive them as having a net positive impact on the key measure of sector profitability return on invested capital. Maersk Line and Wan Hai Lines' ROICs are now covering their cost of capital, but these are the only liners to do so globally, using publicly available information. ML is also generating attractive levels of free cash flow (albeit absorbed somewhat by sister company Maersk Oil within the APMM group), which it is investing selectively to grow margins and returns. While enjoying excellent momentum, the business's trajectory does beg the question of how long can returns continue to improve in a straight line in such a volatile industry. 2M and global consolidation provides us with comfort that it should continue to improve, however, we consider it natural that the pace of improvement should moderate from here. Globally, the picture has been different, with returns having been in a downward channel since 2004 reflecting the dual effects of over-investment and declining freight rates (the brief rebound in 2010 excepted). Some pick-up was observed in 2014 as industry profitability edged higher and we expect evident improvements in the next two years, although never to a level that exceeds cost of capital. With the absence of a large scale roll-up or inter-alliance 'marriage', M&A is unlikely to have a measurable impact on the liner sector Only two shipping companies in our universe cover their WACC although ROICs both at ML and globally are trending higher Figure 38: Maersk Line ROIC vs FCF 2007A-2018E 2 15% 1 5% -5% -1 4,000 3,000 2,000 1, ,000-2,000 Figure 39: Liner industry ROIC % 2007A 2009A 2011A 2013A 2015E 2017E ROIC (LHS) FCF ($m) (RHS) -3, E Source: Company data, Credit Suisse estimates Source: Bloomberg, Company data, Credit Suisse estimates More recent gains in ROIC can be attributable to alliances (in our view) as well as to the falling costs of bunker especially in 2015E. The reduction in capital investment and lower opex lift both the denominator and numerator of the ROIC equation, respectively, and should more than offset the negative effect on rates (especially on the Asia-EU lanes) that we expect the large format vessels for which alliances are responsible to exert. Capital and opex gains offsetting rate volatility Global Liner Shipping Sector 18

19 Of the listed companies that we follow, only MOL has seen its return stagnate and that has been a reflection of its aggressive capital plans, with all of its peer group enjoying a lift. While some of the greatest changes in ROIC between last year and what we expect for 2015 have occurred at lower quality companies such as CSCL, COSCO or Evergreen Marine Corporation, the industry leaders remain the likes of Maersk, Wan Hail and OOIL. Figure 40: Liner company returns on invested capital (2013 vs 2015E) with all of our universe expected to see a pick-up in returns between E CSCL MOL NYK NOL K-Line EMC COSCO OOIL Maersk WHL E Source: the BLOOMBERG PROFESSIONAL service, Company data, Credit Suisse estimates Global Liner Shipping Sector 19

20 Appendices Appendix I Liner survey questions (1) How much cost saving have you made since you joined/started xyz alliance abc years ago? (2) How much more cost do you think you can remove in the next two years a consequence of being an alliance member? (3) What are the greatest areas of potential cost saving? (4) How much capacity have you avoided adding since the commencement of the alliance? (5) How do you plan capacity addition with your alliance partners? (6) What impact on utilisation have alliances had as multiple sales teams sell into one vessel, and is there further to go? (7) Are you experiencing any inflationary pressure from ports/terminals/inland transportation? Can inflationary pressure from supply chain be more easily dealt with as an alliance member? (8) Will being part of an alliance lower the amount of capital you need to invest over the next two years? (9) If yes, by how much (US$ mn or %)? (10) Do you believe that there is a level of consolidation (either fewer players accounting for more capacity because of their financial muscle or M&A-driven) at which more rational pricing might prevail? (11) Why have alliances not helped pricing thus far/what has been the key driver of continued pricing weakness despite consolidation and more restrained capacity growth? (12) Do you see parallels with airline alliance and where could you see these similarities deepen? Respondents: Mitsui OSK Line Nippon Yusen Kabushiki Kaisha Orient Overseas International Line Neptune Orient Lines Kawasaki Kisen Kaisha Evergreen Marine Hapag Lloyd Global Liner Shipping Sector 20

21 Appendix II Alliance members 2M Maersk Line Mediterranean Shipping Company G6 Neptune Orient Lines Hyundai Merchant Marine Mitsui OSK Lines Hapag Lloyd Nippon Yusen Kaisha Orient Overseas Container Line CYKHE COSCO Container Lines Yang Ming Marine Kawasaki Kisen Kaisha Hanjin Shipping Evergreen Marine Ocean 3 CMA CGM China Shipping Container Lines United Arab Shipping Company Source: Company data Global Liner Shipping Sector 21

22 Appendix III Ultra large container ship orders by alliance Alliance No. of Vessels Size (TEUs) Delivery 2M Maersk Line 5 18, , Mediterranean Shipping Company 6 18, , , , , Total ,870 G6 Mitsui OSK Lines 6 20, Nippon Yusen Kaisha 4 14, , Orient Overseas Container Line 6 20, Total 20 68,150 CYKHE COSCO Container Lines 5 14, ,000 Evergreen Marine 12 14, , , Kawasaki Kisen Kaisha (K-Line) 5 14, , Yang Ming Marine 7 14, , Total ,500 Ocean 3 CMA CGM 6 18, , United Arab Shipping Company 5 18, , , , Total ,200 Source: Company data, various media including Lloyds List, Journal of Commerce, Reuters and Tradewinds Global Liner Shipping Sector 22

23 Global Liner Shipping Sector 23 Appendix IV Liner EBIT margins Company 2007A 2008A 2009A 2010A 2011A 2012A 2013A 2014A 2015E 2016E NOL 7.6% 2.5% -10.1% 5.9% -4.1% -1.9% -1.9% -0.9% 2.9% 2.9% OOIL 9.9% % 15.2% 2.9% 4.5% 1.6% 4.9% 9.4% 9.7% NYK 7.8% % 6.3% -1.3% 0.9% % 3.8% 3.9% K Line 9.7% 5.8% -6.2% 5.9% -4.2% 1.3% 2.4% 3.9% % ML 3.1% 3.4% -9.8% 11.7% % % 11.9% 12.3% EMC 7.1% 2.2% % -4.7% -0.8% -3.7% 1.1% 4.4% 4.4% Wan Hai 10.4% 2.7% -0.2% 14.4% -0.5% 4.5% 3.7% 8.1% 10.7% 9.8% MOL % 1.6% % % 1.2% 2.8% 3.4% CSCL % -32.3% 12.2% -9.7% -0.9% -8.2% -0.8% 0.5% 2.8% COSCO 20.3% 10.6% -10.1% 7.6% -11.8% -8.5% -7.5% 3.8% 7.4% 8.7% YMM 4.3% 0.5% -19.5% 11.7% -8.9% -2.8% -8.2% -0.1% 5.2% 6.1% HMM % -8.3% % -6.3% % 3.1% 3. HJS 6.6% -5.4% -1.1% -2.4% % 4.6% Industry EBIT margin % -1.4% 5.9% 0.1% -1.5% -0.2% 3.2% 5.7% 6.3% Source: the BLOOMBERG PROFESSIONAL service, Company data, Credit Suisse estimates for covered companies

24 Companies Mentioned (Price as of 15-Apr-2015) AP Moller Maersk (MAERSKb.CO, Dkr ) China COSCO Holdings (1919.HK, HK$5.79) China Shipping Container Lines Company Ltd (2866.HK, HK$3.64) Evergreen Marine (2603.TW, NT$23.15) Hanjin Shipping ( KS, W8,580) Hyundai Marine ( KS, W9,720) Kawasaki Kisen Kaisha Ltd. (9107.T, 312) Kuehne + Nagel (KNIN.VX, SFr142.6) Mitsui O.S.K. Lines Ltd (9104.T, 402) Neptune Orient Lines (NEPS.SI, S$1.08) Nippon Yusen Kabushiki Kaisha (9101.T, 348) Orient Overseas International (0316.HK, HK$52.45) Samsung Heavy Industries ( KS, W20,000) Wan Hai Lines (2615.TW, NT$37.2) Yang Ming Marine Transport (2609.TW, NT$17.75) Important Global Disclosures Disclosure Appendix Timothy Ross and Neil Glynn, CFA, each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. 3-Year Price and Rating History for Samsung Heavy Industries ( KS) KS Closing Price Target Price Date (W) (W) Rating 27-Apr-12 39,400 46,400 O 30-Jan-13 38,050 44, Oct-13 39,750 44,000 N 27-Jan-14 34,250 39, Mar-14 32,150 39,000 O 25-Apr-14 28,500 28,000 N 20-Oct-14 25,050 26,000 * Asterisk signifies initiation or assumption of coverage. O U T PERFO RM N EU T RA L The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts stock rating are defined as follows: Outperform (O) : The stock s total return is expected to outperform the relevant benchmark*over the next 12 months. Neutral (N) : The stock s total return is expected to be in line with the relevant benchmark* over the next 12 months. Underperform (U) : The stock s total return is expected to underperform the relevant benchmark* over the next 12 months. *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractiv e, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ratings are based on a stock s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin Ame rican and non-japan Asia stocks, ratings are based on a stock s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock s absolute total return potential to its current share price and (2) the relative attr activeness of a stock s total return potential within an analyst s coverage universe. For Australian and New Zealand stocks, 12 -month rolling yield is incorporated in the absolute total return calculation and a 15% and a 7.5% threshold replace the 10-15% level in the Outperform and Underperform stock rating definitions, respectively. The 15% and 7.5% thresholds replace the % and % levels in the Neutral stock rating definition, respectively. Prior to 10th December 2012, Japanese ratings were base d on a stock s total return relative to the average total return of the relevant country or regional benchmark. Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Global Liner Shipping Sector 24

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