Note: This report was previously shared with members of Value Investor’s Edge.
Costamare (CMRE) is a best-of-breed containership lessor, poised to benefit from the surging charter market. CMRE offers strong corporate governance and proven capital allocation prowess. Insiders are aligned due to a 60% stake owned by the founding family.
The containership sector has been red hot for the last 4-5 months. Although rates could ease a bit from current levels, keep in mind that typical charters usually last for at least a year and the underlying market was already improving before COVID wreaked havoc. We anticipate CMRE will benefit significantly due to a tremendous reduction in counterparty risk combined with higher forward free cash flow due to accretive charter rolls in higher-earning contracts.
COVID Effect on the Containership Market
When the pandemic hit, the rates paid to vessel lessors for their ships started plummeting, as can be seen in the image below. The Harpex is an index that highlights current market conditions for 1-year charters for vessel classes between 700 TEU and 8,500 TEU.
Source: Harpex, 1-year chart
As can be seen in the image above, the Containership leasing sector literally provided a V-shaped recovery. Rates have already skyrocketed around 250% from the lows set during the summer! Even though some could argue the rally has overextended, in historical context, rates are not that extreme. As can be seen below, rates are currently pushing 12-year highs, and to breach historical records they would have to rise another 250%. This is much different than the wild tanker rates we saw earlier in 2020 where rates were at all-time records and contract terms were just 60-80 days.
Source: Harpex Index, 20-year chart
For the last 10 years, rates have remained in the doldrums. Since 2016, they began slowly improving, and then the pandemic happened, sending freight rates downward for a brief pause before rapidly breaking upward into an outstanding recovery (reference the green circled portion of the rates for 2020).
Demand Review: Why Rates are Surging
When the pandemic first hit and lockdowns were issued around the world, retail sales plummeted, reducing container demand, which as mentioned above weighed significantly on charter rates. Retail sales have now recovered significantly, as shown below.
To exemplify the recovery in retail demand, I’ve referenced the “Advance Retail Sales: Retail (Excluding Food Services).” Including food services would have skewed the exemplification, since those goods do not (mostly) travel by containerships and remain severely affected by COVID restrictions.
This recovery has been mostly attributed to the fact that people are spending less money on travel and on services, which is being used to buy durable goods (i.e. appliances), technology products (i.e. desktops, monitors, laptops), and home improvement items.
Additionally, inventory levels remain below pre-pandemic readings, as can be seen in the image below. The pandemic caused significant stress in the worldwide supply chain, which coupled with retailers trying to reduce stocks because of a looming recession led to a decrease in inventory levels in the US. Retailer Inventories have started recovering since June, albeit at a slow pace.
Considering how retail sales have recovered, inventories should (theoretically) be higher than last year levels but are in fact sitting lower. I expect retail sales to remain strong at the very least until mid-2021 (when mass vaccinations start having an effect), at which point money is expected to start flowing back to services (travel, restaurants, etc.). Furthermore, albeit demand for goods may face some headwinds, it shouldn’t fall off a cliff once we get over with mass vaccinations.
Some have been worried by headlines like “China presses shipping line to rein in record freight rates,” or “Chinese authorities say there needs to be a rates ceiling.” Those news refer to the fact that Chinese officials met with liner representatives to try to get them to stop raising freight rates.
The rates the Chinese are referring to are the ones charged by liners to transport goods, not the rates paid to vessel lessors. This is a very important distinction. In fact, I view this as a bullish development for vessel lessors; the only (competitive) way to decrease freight rates is to increase vessel supply, which means hiring more vessels for determined trade routes. The Chinese government and more recently European regulators are essentially going to force liners to hire even more ships to meet demand.
An example of the rates charged by the liner companies to transport goods is the Shanghai Containerized Freight Index, which has been on a tear, as can be seen below.
Source: Shanghai Containerized Freight Index
Supply Side: Limited Growth Allows for Higher Rates
The containership sector was a bit oversupplied for several years, but the total orderbook currently sits at less than 9% of the fleet (per Clarkson’s data), the lowest point in years (to be more concrete we’re talking about the lowest point since at least 1996). Keep in mind that as can be seen below, the current orderbook is focused in the 10k+ TEU and the sub 3k segments, whereas the midsize classes have a virtually non-existent orderbook – there is simply no additional supply on the market for these ships.
Source: Danaos Corporation’s Q3 earnings presentation, slide 18
Throughout 2018-2020, a significant amount of mid-sized containership vessels were scrapped. In fact, even during 2020, there were 16 vessels demolished from the 3-6k TEU range. This tightened the supply even further right before the massive demand growth this past summer and fall. Per the latest Clarkson’s data, the global containership fleet saw 2.5% growth this year, whereas trailing demand fell by around 2%. This is expected to improve further going into 2021, with fleet growth expected at 3.2% and demand projected to grow by 5.1%.
Current Financial Position
CMRE has strong financial footing, with no significant debt maturities until 2024. The current portion of long-term debt stands at $211M, and current finance lease liabilities stand at $17M, whereas long-term debt (net of current portion) sits at 1,206M, and finance lease liabilities (net of current portion) stand at $120M.
The company finished the quarter with cash and cash equivalents of $149M, $7M in current restricted cash and an additional $40M in non-current restricted cash. Total liquidity was $210M.
Furthermore, the company has 6 unencumbered vessels, which in case of necessity could either be re-levered or sold. These ships are listed below:
Source: CMRE’s Q3 earnings release, page 14.
Additionally, CMRE has a significant amount of preferred equity:
As can be seen above, the preferred equities carry a significantly higher cost than the bank debt CMRE has been able to secure. Management likes the preferred as a source of perpetual equity, since in CMRE’s case the issuances do not have “step-up options.” Even though at a steep price, the preferred equities provide a lot of optionality. Ideally I’d like to see some preferred repurchases and with the improving backdrop and rock-bottom interest rates, perhaps they could refinance some of these in 2021 closer to 7.0%.
Charter Book Structure
CMRE has a significant charter book, with contracted revenues of “approximately $2.1B as of October 27th.”
Source: CMRE’s Q3 earnings presentation, slide 10.
Vessel lessors charter books have been heavily discounted for years due to the weak financial position of their counterparties, but surprisingly, COVID has solved this problem. Liners were able to cope outstandingly well with the pandemic, rationalizing supply via blank sailings (cancelling scheduled sailings), which provided support to freight rates. Low fuel prices provided additional upside to liner earnings.
For instance, Maersk’s Q2 EBITDA was up 26% y/y, whereas CMA CGM’s was up 26.3% for the same period. Hapag Lloyd’s Q3 EBITDA was up 22.5% vs. the same period last year. Not only did liners not suffer any negative effects from the pandemic, but they outright benefitted from it. Therefore, liners are in a stronger position now than they were in the past, warranting a smaller discount for CMRE’s charter book.
Alongside Q3 earnings, CMRE announced that it had sold the “Zagora,” a 1995-built 1,162 TEU vessel and the “Singapore Express,” a 2000-built 4,890 TEU. Both vessels were sold for scrapping, the first for around $2M for green recycling and the second for around $7.3M.
Additionally, CMRE announced it had acquired 3x vessels:
- JPO Scorpius: 2007-built 2,572 TEU vessel
- One 2006-built 5,600 TEU vessel
- One 2011-built 4,200 TEU vessel
These acquisitions will be initially funded with equity. The Scorpius has already been delivered; the 20011-built is expected to be delivered at some point during Q4, and the 2006-built will be delivered in 2021.
The newbuild program has continued developing steadily, with CMRE taking delivery of 2x 12,690 TEU vessels fixed on 10-year charters with Yang Ming.
Vessel valuations in the mid-sized containership segment remain subdued, with some vessels being valued $1M-2M above scrap. CMRE is in an adequate financial position to take advantage of this situation, which has been demonstrated by the 3x aforementioned acquisitions.
Q3-20 Rolls and Other Near-term Exposure
Throughout Q3, CMRE secured 8x contract extensions and chartered 5x vessels in “new contracts.” The charter terms for the “Guanghzou,” the “Ningbo,” the “Venetiko,” and the “Trader” were not disclosed. The Artemisio was rolled at an slightly lower rate, whereas the “Akritas” and the “Kortia” were rolled at $9k lower rates (they came off above-market charters). The Prosper and the Messini were rolled in stronger contracts.
To exemplify how strong current rates are, we can look at the “Ensenada,” a 2001-built 5,576 TEU, which was chartered for a period of 7 to 9 months at $21,500. Considering the vessel’s age and that it was coming from a $8,700/day charter, this was an outstanding fix which perfectly illustrates current strength.
Another very interesting fix was the “York,” which saw its charter extended by a period of between 20.5 and 23 months at $21,250. Considering that it’s a 2000-built 6,648 TEU, this isn’t bad at all! The new rate is almost a double from the previous $11,500, which is the cherry on top.
Per their conference call commentary, CMRE has 14 additional ships coming off charter over the next six months. Per their earnings release, they have 16x vessels coming off-charter before Q1 end, but keep in mind that “charter terms and expiration dates are based on the earliest date charters could expire,” so some of these charters could be extended at the previously chartered rates.
It’s relevant to note that each and every one of the highlighted vessels will be chartered (given current conditions persist) at a higher rate. Keep in mind that a charter can be agreed upon “three, four, five, six months in advance, assuming that the charter wants the ships,” so most of this exposure should be already covered at very strong rates. We are talking about rate increases of between $2k and $15k per vessel, which isn’t negligible.
Source: CMRE’s Q3 earnings release, page 17
Once the 16x highlighted rates have been re-negotiated, we should be looking at quarterly EPS of around $0.35. Admittedly, we don’t know exactly when that’s going to happen, because CMRE does not disclose the potential extensions at lower rates.
CMRE does not have a fixed dividend policy, but since going public in 2010, they have been paying a quarterly dividend. In fact, when the firm went public, the company instituted a quarterly $0.25 dividend, which steadily rose to a peak of $0.29/quarter in 2016. Though, after those steady raises, the dividend was axed in 2016 due to poor conditions in the sector and a high-profile bankruptcy by major Korean liner Hanjin Shipping, which weighed on CMRE’s performance.
The Containership market has remained subdued since then, but once charter renewals start kicking in the company will be a literal cash-flow machine (and keep in mind that these charters are for periods of 1-2 years, some deals even longer yet). The founding family holds around 60% of common shares, so their interests are aligned with ours as investors in the common stock.
Common share repurchases could be an option, but CMRE has never repurchased any common shares, and per their tone on the podcast conducted by J Mintzmyer for Value Investor’s Edge members, it seems they will stick to dividend payments.
Source: J Mintzmyer’s interview with CMRE’s management for Value Investor’s Edge: Costamare on the Surging Containership Markets (Podcast Transcript)
With financial performance set to improve, and considering the generous dividends paid during “good years” (i.e. 2011-2016 period) I expect management will hike the dividend in the near to medium term; I don’t know if they’ll decide to do it alongside Q4 earnings, but throughout 2021 they should certainly do it. The company currently yields around 5.4%.
For Q4, I expect the company to report EPS of between $0.25 and $0.27, and once all the aforementioned charter rolls have been conducted, we should be easily looking at quarterly EPS of around $0.35, which suggests a run-rate annual EPS of approximately $1.40.
CMRE is one of the best managed equities in the containership market, where we can invest alongside the founding family, which holds a 60% stake in the company. Even though the potential upside in the name is not as huge as some other riskier players (i.e. GSL, NMCI, DAC, or CPLP) the downside is significantly more limited than the other peers mentioned. CMRE has historically traded at a steep premium to peers due to its higher-quality structure, and every other major containership name is setting fresh 52w highs while CMRE still trades at a 30% discount.
Earnings should see continued upside throughout 2021 as vessels are re-chartered at significantly higher rates. Overall, once mass vaccinations are underway, demand for goods may face some normalization headwinds, but considering that retailer inventories are sitting at lower than average levels and that the economic recovery may give more breathing room to some industries, the potential downside appears limited.
I’d like to see some preferred repurchases; it seems outrageous for CMRE to pay 8.5% for financing in current market conditions (especially with interest rates hovering around 0%). Even though I acknowledge the attractiveness of perpetual financing, does CMRE need to have more than $300M of this kind of instruments outstanding? For income-seeking investors, the preferred equities look like a decent way to make a strong 8.5% yield.
I expect CMRE to hike the dividend in 2021. The potential hike is anyone’s guess, and they may take it conservatively, but if they passed along even half of the earnings improvements, they could easily afford a 50% payout hike. Management has been quite conservative in the past so we might see steps of smaller raises first.
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Disclosure: I am/we are long CMRE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for educational and informational purposes and should not be considered investment advice.I am not a financial advisor.
This article was first published in Value Investor’s Edge, and J Mintzmyer provided initial feedback.