COVID-19 is a game-changer for every link in the transport chain, from cargo ships to trucks, trains and air freighters. Amit Mehrotra, the managing director of air freight, surface transportation and shipping at Deutsche Bank (NYSE: DB), is one of the rare professionals who covers the entire gamut.
During a lengthy interview with FreightWaves on Monday, Mehrotra opined on coronavirus consequences for the world's supply chains and explained why he believes some transport companies will see stock valuations "skyrocket" in the crisis aftermath. The following is an edited version of that conversation:
Container imports and globalization
FreightWaves: There have been massive swings in U.S. imports over a short period. What's your view on current volumes? What's still coming in and what's not?
Mehrotra: "We're bracing for a pretty significant leg down in container imports to the U.S. We think there could be a 20%-plus decline in imports through September. What we've seen so far is a supply-chain-driven decline in volumes. I think what's coming is a second wave that is an organic-demand-driven decline in volumes.
"We haven't really seen the fallout yet from the financial turmoil a lot of people are finding themselves in. The bottom line is we're going to have 20%, 25%, 30% unemployment in this country. What's coming is the real ‘air pocket' in demand. It's not going to zero — people are still going to need essential items: food, beverages, personal care, dry goods. But they won't need that sweater and that new pair of shoes, and a significant chunk of the economy is retail apparel."
How important are U.S. container imports to land-transport volumes, whether trucking or intermodal rail?
"It's very important for land transport. It's undeniable. There is more of a lag with trucking than with intermodal; with trucking loads, there is a 65% correlation [with port imports] on a one-month lag basis. Every trucking executive will tell you that port imports are a very big absorber of capacity."
Do you think this crisis will cause global supply chains to diversify away from China, or for there to be some deglobalization and nearshoring — or both?
"Both. There are going to be huge implications for how freight moves globally. I was talking to the head of supply chain at one of the world's largest retailers, which serves 100 million households in the U.S. — 70% of U.S. households. And he said that 80% of their supply chain still comes from China and they don't believe it makes sense anymore.
"Diversification of supply chains away from China to countries like India and Vietnam will very obviously be a long-term implication of this, but I also think there will be more nearshoring. I cover Kansas City Southern (NYSE: KSU), which has a lot of exposure to Mexico, and they are seeing this trend. We were already seeing it [before coronavirus] as wage inflation rose in China."
Transport stock upside ahead?
How do you think the coronavirus is going to affect transport stocks in the medium term? What are the bellwethers you're looking at with regards to the shape of any recovery curve?
"I want to say this very clearly: My personal belief is that I hope we find a vaccine and everybody is healthy and this is over as soon as possible. But purely in the context of assessing stocks, I don't really care about the shape of the recovery.
"I think the slope of the recovery is irrelevant as long as it's positive. If it turns out that the slope of the curve is negative, equity values in the near term have a big leg to go down, but I think the bottom is in.
"I was probably the most bullish transportation analyst out there last year and obviously the coronavirus derailed that to some extent, but the underlying premise of my bullish view is wholly intact. My view is that what's going to happen over the next 12-18 months will be very positive for equity valuations.
"What I believe you're going to have for equity valuations is a perfect storm: one, very low interest rates; two, low capital intensity because everybody's cutting CAPEX; and three, accelerating growth expectations. I know this could be considered a perverse argument but for better or worse, 2021 growth looks better today than it did three months ago, because 2020 is down in absolute terms [due to the coronavirus].
"We're talking about a 20%, 25%, 30% negative GDP print in the second quarter. It's completely unprecedented. Anytime you have such a disproportionate decline in GDP, it's typically followed by a significant release in pent-up demand.
"As an example, Europe is maybe one month ahead of the U.S. in terms of coronavirus impact. XPO Logistics (NYSE: XPO) has said that in Europe, its volumes in the last week of April were 23% above volumes in the first week of April. If we can get that type of sequential improvement, transport equities are going to skyrocket, not necessarily because earnings expectations are going up but because people are going to capitalize earnings expectations in the midterm at much higher multiples.
"In general, equity values are much more levered to the multiples you place on earnings than the actual earnings themselves. If you earn $10 per share and grow earnings to $11, then all else equal, your stock price goes up 10%. But if your multiple goes from 10 times to 12 times, you see a disproportionate uplift on the entirety of your earnings.
"Multiples are a function of forward growth. If there is growth on the horizon, people are always willing to capitalize today's earnings at a higher multiple because of that dynamic. That's the way cyclical investing works. If you are earning $10 today and that represents a cyclical low and you expect to earn $13 at some point in the future, whether it's next year or the year after, people are willing to capitalize that $10 at a higher multiple.
"The opposite is also true. If you get that $13 tomorrow and people see $10 on the horizon, they're probably going to de-rate that stock [give it a lower multiple]. Solely from a financial stock analyst point of view, you don't actually want there to be a V-shaped recovery because it risks de-rating the stocks more quickly than you otherwise would. My hope is that we have a recovery and it's a slow and steady recovery so that the cycle can be more elongated."
Higher risk premium for transport players
Another issue for transport stocks, regardless of mode, involves risk. The risk of the coronavirus was not factored into the equation previously due to a failure of imagination, but we can't "unremember" it now, so it will be factored in going forward.
"It's such a great point and I've been thinking about this a lot. I don't think a lot of people talk about the price of risk.
"When you think about the valuation of a company, the cost of capital is extremely important as a reference point. When we talk about a company creating value over time, we are talking about generating returns above the cost of capital.
"One of the biggest components of calculating your weighted average cost of capital [WACC] is the price of risk — your equity risk premium. I think it's totally logical and fair to say that the equity risk premium has structurally risen in the post-pandemic world. That's very clear.
"But if your risk premium goes up 100 basis points because of coronavirus and at the same time your interest rates go down 100 basis points, that doesn't impact your cost of capital.
"Also, when you look at the levers that drive returns above the weighted average cost of capital, it's obviously your margins, and the CAPEX intensity dictates how much of your margins is dropped down to free cash flow. Ultimately all you're doing is discounting your free cash flow. When you look at that, you find the biggest lever to that number is growth and as I mentioned before, one of the impacts of the coronavirus is that growth expectations for next year have actually improved."
What you're saying is that the outbreak will cause the equity risk premium to rise but the effect on WACC would be offset by lower interest rates and at the same time, growth prospects would increase off a lower base, so net-net, a positive?
Ocean shipping stock valuations
I'd like to bring this theoretical discussion over to concrete examples. Let's talk about ocean shipping stocks, starting with tanker stocks, because there's a lot of talk now that they're not being properly priced in the market in terms of the fundamental value of the tanker companies. In fact, you recently wrote an open letter to the management of Euronav(NYSE: EURN) addressing the stock-valuation issue.
"The letter I wrote definitely came from a place of some frustration, but what I was really trying to get across was the question of: Why should a shipping company be public? The answer is that the public equity markets can be a very efficient avenue for capital if the value of your stock is above net asset value [NAV; the market-adjusted value of the fleet and other assets minus debt and other liabilities]. If your stock is above your NAV, that provides you a perpetual capital base to fund accretive growth. I believe the entire 100% reason for a shipping company to be public is to manage the business so that one day its stock is valued above NAV.
"But what if you're a well-managed company with an incredibly responsible capital allocation and you've done everything right, like Euronav has, and the market is still treating your stock like crap? What benefit are you getting from being public? It costs $5 million to $10 million [a year] for these companies to be public. That's money going right out the door.
"So, you pay out dividends and what you're trying to do with dividends is decouple the stock price from NAV and value the company based on the dividend. There's no other reason to give dividends. But what if that doesn't work?
"I believe Plan B is to take your debt down to zero, which brings your breakeven way down. With no debt, your breakeven is OPEX, so [for a company like Euronav] $8,000-$9,000 a day [per very large crude carrier], which means you'd be able to pay dividends on a more sustainable basis.
"And after all that, if a company like Euronav still doesn't get credit, I think it should just buy back the whole thing and go home [i.e., privatize]."
But this all goes back to the question of whether these tanker stocks are working properly right now. Why are stocks like Euronav's trading where they are when these tanker companies are churning out piles of cash?
"It's a fair question. First, I'd say we haven't really seen all the money yet. You saw some of it in the first-quarter results, but we still really haven't seen the deleveraging of the balance sheets we will over the next three to four months.
"I also feel investors are understandably saying that these rates are unsustainable because there's a lot of [oil] inventory being stocked and we're going to see the biggest destocking cycle of our lifetimes, during which tanker demand will go toward zero, although it won't go all the way to zero because you'll still have to move some oil.
"But I do think the magnitudes of the cash flows have been completely underappreciated. These companies are trading at a 20-30% discount to NAV, but that NAV is reflecting a capital structure that's probably understated by $400 million-$600 million. Because that debt is going to be paid down in the second and third quarters, these companies are not really trading at a 20-30% discount to NAV, they're trading at a 40-50% discount to NAV when you look at it from a pro forma perspective. I do think there is a real dislocation here."
Looking at the overall field of U.S.-listed ocean shipping companies, there are so many of them now with extremely low valuations versus NAV, many lower than Euronav's, and with market caps that are minuscule, in most cases much lower than Euronav's.
"It doesn't do the industry any good [to have so many micro-cap companies listed] because all it does is fragment the capital base.
"We made the decision to stop covering any company with a market cap under $500 million that doesn't trade more than $5-10 million in volume per day. It's no coincidence that every stock I cover in shipping is the largest company within its segment, whether it's Euronav (in crude tankers), Scorpio Tankers (NYSE: STNG) (in product tankers) or Star Bulk (NYSE: SBLK) (in dry bulk).
"I'm going to cover each vertical and the biggest guy in each vertical. I'm going to go with the one I think has a sustainable model, and that can evolve from being a company into being a platform to consolidate the sector."
But consolidation — and the idea that the public ocean-shipping arena needs to evolve into one with fewer, larger players with much higher market caps — has been talked about for years. It hasn't happened yet. Do you really think it's possible to finally turn this around post-coronavirus and for public markets to become more consolidated?
"To be quite honest, I would say the odds are against it. But I still think it is possible — I am still hopeful." Click for more FreightWaves/American Shipper articles by Greg Miller