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Introduction
Three years ago, I published an article on shipping stock Danaos (DAC), calling it the cheapest stock in the market. It was trading at less than 2x EPS after it had been forced to issue shares as part of a settlement with banks that held its debt. The stock almost doubled, Covid hit, and the stock halved as investors feared a reprise of the Great Depression. Then consumers unable to spend on services shifted their spending to goods, governments enacted fiscal stimulus, and lease rates for the company’s container ships went through the roof. Earnings exploded, and the stock followed, up more than 10x.
Today, I present to you another stock in the shipping sector that is at less than 2x this year’s earnings. ZIM Integrated Shipping Services (NYSE:ZIM) is an Israeli company that provides container shipping services. It both owns and leases vessels from others. Curiously, Danaos has an equity stake in the company, though it has been selling down its position.
Company background
ZIM is a 75-year old Israeli company that IPO’d in the US market in 2021. It focuses on two major areas – Asia to the US East Coast, and intra Asia. However, it services almost all the major global shipping routes. The company owns some container ships, but mostly leases them from others. This provides it a high degree of flexibility depending on demand. However, it also clouds the company’s long term future as the ship owners may be able to extract higher rates over time if tight conditions persist.
The company is a comparatively small player in an industry dominated by Maersk, MSC and Cosco. It could thus become an acquisition candidate for one of the larger players.
Financial overview and outlook
The company’s recent quarterly results were very good. In the three months ending March 31, 2022, the company’s revenue of $3.7 billion was up 113% YoY, primarily due to a doubling of freight rates. Operating income tripled to $2.2 billion at a 60% margin. Net income of $1.7 billion resulted in diluted EPS of $14 in the quarter. Free cash flow of $1.5 billion lagged net income by a bit due to higher working capital. However, I believe this number is overstated since it does not include vessels acquired through capital leases, so the actual number is a good deal lower. The company capitalized on increased demand and higher prices for its services.
The consensus estimate is for the company to earn $44 per share this year and $14 next year as conditions normalize. I believe these estimates are achievable, but there could be a significant variance depending on market conditions. The company’s guidance of approximately $6.5 billion in operating income this year would equate to a little above $40 per share.
The company has $780 million of net cash. With 120.5 million diluted shares, its market cap is $5.7 billion and Enterprise Value is $4.9 billion. I would regard the net cash position to be prudent in the current environment.
The company’s dividend policy is to pay out 20% of net income on a quarterly basis, while paying out 30-50% on an annual basis, with a true up in the fourth quarter. The first quarter dividend of $2.85 per share was paid on June 8, 2022, to holders of shares as of May 31, 2022.
Valuation: Fair value of $70 for the stock
I believe a 5x multiple on next year’s earnings of $14 per share is reasonable. This would result in a $70 target price for the stock, offering 45% upside from the current $48 price. I would add that the company could end up paying upwards of $10 in dividends as well over the next year.
There is considerable uncertainty on where earnings will come in and much depends on where global economies are headed and what impact monetary tightening will have. It is virtually certain that demand will decrease and so will the company’s earnings. But what if they decline by only 50% over the next year? In a bull case, earnings will come in at $20 per share and a similar multiple would result in a $100 stock price, offering 100% upside.
In a bear case, the company’s revenue and earnings will miss estimates, with only $8 of EPS, resulting in a $40 stock price for 17% downside. The company’s book value currently stands at $35 per share, but I don’t think this is a particularly useful figure since the company has a mix of owned and leased assets.
External ratings
Seeking Alpha’s quant ratings on the company are mixed, with an overall rating of 3.49, between a hold and a buy. It garners an A+ for valuation, but a surprising F for growth, with this being almost all due to forward growth projections being negative. I believe this is unnecessarily harsh, ignoring the recent high growth over the prior year.
Not surprisingly, the sell side is more positive on the company, with a rating of 3.85, close to a buy. The average price target is $80.
Share price history
The stock has only been public since the beginning of 2021. It has had a nice gain since then, vastly outperforming the S&P 500. It peaked at $85 in March of this year and is down 40% since then.
Why did ZIM stock dip?
There is evidence that Central bank tightening and inflation is having some impact on consumer behavior. Spending is slowing down and retailers have excess inventory. There is some push-back against the sky-high freight rates that are being charged in the market. Freight rates are coming down, although still high by historical measures. Investors focused on reversion to the mean will sell the stock, believing that there is a lot more fundamental downside to come. If estimates are going to go down, the stock should follow. However, I believe that we are not going back to the pre-Covid average for commodity prices or shipping rates. There is just too much money that was created that is sloshing around. Even the Fed’s objective is not to get the price level back to what it was at that time – it is simply to not have it increase much further from where it is now.
Risks are high
The biggest risk here is that the company’s earnings will come in lower than expected due to macroeconomic, competitive, or execution factors. As a small player in a fragmented industry, the company has little control over supply and demand. It could also face labor shortages and higher costs that it is unable to pass on.
A rapid increase in interest rates could prompt equity investors to pay lower multiples. I believe that longer term interest rates are unlikely to increase much more from where they are now.
Shareholders depend on a company’s management being good stewards of their capital. There is a risk that the company will make an overpriced acquisition of either another company or assets. This risk can be lessened by management returning cash to shareholders rather than hoarding it at the company level.
Conclusion
An investment in ZIM offers the opportunity to generate a good return, capitalizing on a continuation of the shipping boom. The stock’s risk is offset by its cheap valuation and upside potential.
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