Horizon Lines HRZ
December 04, 2006 - 1:09pm EST by
gatsby892
2006 2007
Price: 28.40 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 955 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Ignore the stock price chart and look at the fundamentals. HRZ offers compelling upside of more than 60% to our $45 price target.  Shares have more than doubled since our April VIC write-up (read that first for background), but a number of significant unforeseen (and still woefully underappreciated) developments have dramatically raised the investment’s upside potential over the last 7 months.  We are “re-posting” with this updated analysis and a new valuation to account for these recent developments.
 
 
What Has Changed Since the April Write-Up:
 
EDGE Cost Savings Initiative
In late July, HRZ announced that they had hired Celerant Consulting to implement the Company’s first major cost savings initiative since its last in-depth operational review under CSX ownership in 1999.  Management is targeting annual savings of $40m per year beginning in 2008 primarily in the areas of order to cash management (36%), asset productivity (30%) and port operations (20%).  This figure is quite substantial relative to the Company’s estimated $163m of EBITDA for this year (2006), but it is quite reasonable when compared to the nearly $1 billion of targeted operating costs – equating to just 4% savings.  In fact, a number of early wins have given management the confidence to relay to us in recent conversations that they now expect to exceed their targets.  The DCF impact of just achieving management’s initial estimates is approximately $11 per share.  Looked at another way, at the current average forward multiple of HRZ’s peer group (8.2x), this incremental $40m of EBITDA represents $330m of value (or roughly $10 per share).
 
 
Tonnage Tax Election
Towards the end of October, HRZ surprised investors by informing them that it was electing to pay a tonnage tax in lieu of corporate income taxes, a decision that permanently decreases the Company’s effective cash tax rate from 38% to just 20%.  The tonnage tax election was created as part of the American Jobs Creation Act of 2004, with the intention of providing a sustained corporate tax incentive for certain operators of US flag vessels.  Once made, the election remains effective for all subsequent years (no annual test must be met) and the law includes no sunset provision.  The impact of this permanent benefit adds approximately $5 to $7 to the Company’s DCF value, depending on your other operating assumptions.
 
 
TP1 Expansion
At the time of our initial write-up, HRZ had disclosed very little about the magnitude of the impact that the new ship leasing deal and the expanded TP1 agreement would have, other than to signify that it would be substantial.  Analysts estimated at the time that these arrangements could lead to perhaps as much as 10-15% upside to their EBITDA estimates over time (yet not one of them updated their models to reflect this).  Now that the Company has released a more detailed financial impact analysis, we know that these initial estimates were quite conservative.  Even after accounting for all incremental leasing expense and one-time fleet rationalization costs, the TP1 expansion should begin contributing meaningfully to HRZ’s EBITDA beginning in 2009 (with a ramp to $30m by 2012).  Management estimates the average annual impact during the first 10 years (including the drag from the initial investment / rationalization period) to be approximately $28m in incremental EBITDA, equivalent to roughly 17% of the Company’s full year 2006E EBITDA.  We estimate that this benefit adds approximately $6 per share to HRZ’s DCF value.
 
 
Non-Replacement of Spare Vessels
As a direct result of the increased efficiency and higher utilization from the combination of the recent leasing deal and the subsequent fleet rationalization, HRZ will actually have 4 ships comprising a “bullpen” of spare vessels (the Consumer, Challenger, Crusader and Discovery, representing a total of nearly 6,000 TEUs of dormant capacity).  The Company’s guidance (and the Street’s models) assumes that these ships are never put back into productive operation, but that HRZ continues to bear the full costs of maintaining, certifying and securing them.  For conservatism, we have made the same assumption, even though we think it likely that at least some portion of this bullpen will be put into a revenue generating role at some point.  Despite whether that occurs or not, certainly having spare vessels on hand in a ready state will increase overall active capacity utilization during periods of routine maintenance or regularly scheduled drydock.  This capacity will also serve as a significant competitive barrier to entry for anyone looking to challenge HRZ’s market share – effectively allowing rates (and therefore margins) to remain higher throughout each of the tradelanes as a result.
 
Where we do differ from the Street analysts is in how we handle the replacement capex for these four ships.  Given that these spare vessels will no longer incur wear from daily operations and that the Company’s long-term guidance includes no revenues from them, it stands to reason that HRZ would not choose to incur the $150m per ship to replace these four once they would have reached the end of their useful lives (45 years, on average).  This assumption has a substantially beneficial economic impact due to the fact that these ships are also among the oldest in the fleet (and therefore the soonest to be replaced).  As a result, we estimate that HRZ will not need to replace even one Jones Act vessel until the Navigator and the Trader reach 45 years of age in 2017.  The impact of this reality adds approximately $6.50 per share to the Street’s DCF models.
 
 
Removal of Castle Harlan Overhang
After the October 2005 IPO (and at the time of our initial write-up), Castle Harlan owned approximately 39% of HRZ and the Stockwell Fund an additional 9%.  This had the result of creating a large overhang on the shares as the market anticipated pressure from an eventual monetization of their positions.  The size of their aggregate stake also dramatically reduced the available liquidity, effectively increasing the discount the market placed on the shares (by virtue of a lower multiple).  This has all changed in the last 6 months, however, as three secondary offerings have reduced Castle Harlan and Stockwell’s combined ownership to less than 1%.  Significantly, not one member of the management team sold a single share during any of these offerings and the group has maintained its ownership of approximately 11%.
 
Liquidity has also dramatically improved (by a factor of 11.3x) since our initial write-up and the stock now trades nearly $11m per day versus just $940k per day back in April.
 
 
Multiple Parity / Premium
At the time of our initial write-up, we acknowledged a number of market concerns that were leading to the (albeit unwarranted) discount that HRZ was receiving versus the other major public Jones Act shippers (ALEX, KEX, ACLI).  In our valuation analysis, we initially assumed that some discount may persist due to the Company’s limited public operating history at the time.  However, we strongly believe that HRZ actually deserves a premium to its peers based on superior EBITDA growth (a CAGR of 17.4% from 2006-2008 vs. just 10.5% and 11.5% for KEX and ALEX, respectively); its higher financial leverage (strong free cash flow benefits will quickly accrue to equity holders through high cost debt reduction); its healthy capital position (no major expenditures required until 2017); and its advantageous tax status as a result of its recent tonnage tax election.
 
 
The Valuation:
 
Street analysts have continued to grossly underestimated Horizon’s EBITDA and FCF generating ability.  Initially, they overlooked the extensive extraordinary and non-recurring items that impacted historical results (IPO expenses, Castle Harlan management fees, etc.) and currently, they are neglecting to include the significant future benefits of the TP1 and EDGE initiatives.  Only Goldman (in its recent Nov. 21 report) has begun to include any portion of the value associated with these programs (and even they stated that they would not attribute the full benefits of TP1 until the Maersk deal is officially announced – which actually occurred just this morning).  Our calculations of the Street consensus estimates versus an adjusted EBITDA are below:
 
Adj. EBITDA Overview
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2006
2007
2008
2009
2010
2011
2012
Core Operations
 
Est. Date
 
 
 
 
 
 
 
 
 
JP Morgan
 
10/31/2006
 
$163
$177
$188
 
 
 
 
 
Caris & Co.
 
10/31/2006
 
  166
  183
 
 
 
 
 
 
Goldman (pre 11/21)
7/30/2006
 
  162
  173
  184
 
 
 
 
 
Deutsche
 
3/7/2006
 
  160
  168
 
 
 
 
 
 
UBS
 
 
11/7/2005
 
  162
 
 
 
 
 
 
 
 
Consensus Estimate
 
 
 $163
$175
$186
$195
$205
$215
$226
 
 
 
% Growth
 
 
 
 
7.9%
6.1%
5.0%
5.0%
5.0%
5.0%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
TP1 Expansion (mgmt. guidance)
 
   -  
 (15)
  (2)
  11
  18
  24
  30
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Edge Cost Savings Initiative (mgmt.)
   -  
  13
  40
  40
  40
  40
  40
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Adj. EBITDA
 
 
 
$163
$173
$224
$246
$263
$279
$296
 
% Growth
 
 
 
 
6.7%
29.2%
10.0%
6.8%
6.2%
6.0%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
DCF
Our discounted cash flow analysis yields a value of $51 per share for HRZ using what we believe to be very reasonable assumptions.  Key drivers include growth in both revenues and costs of just 3% per year (including annual inflation in the prices paid per new ship), achievement of management’s stated TP1 and EDGE program guidance, a 20% cash tax rate, and the non-replacement of the 4 spare vessels discussed above.  Conservatively, we have not grown the size of the potential cost savings by any inflation factor after 2008, despite the fact that our model assumes that overall operating costs continue to escalate at 3% per year.
 
Peer Multiples
Taking the 8.2x average forward (2007) EBITDA multiple of HRZ’s peer group (ALEX, KEX, ACLI) and applying it to HRZ’s 2008 Adj. EBITDA estimate from the table above (the first year of benefit from the initiatives currently underway), would yield a $41 share price, implying nearly 50% upside from the recent closing price.  Using ACLI’s current 2007 multiple of 9.1x would yield a share price of $47 (nearly 70% upside from current levels).
 
FCF Yield
We expect HRZ to generate at least $125m in FCF in 2008 (with a healthy growth rate thereafter), implying a 13.5% FCF yield at current prices.  Given the growth and stability of this cash flow stream, the rapid benefits of deleveraging, the advantageous tax election status and the minimal capital expenditure requirements over the foreseeable future, we believe that HRZ shares warrant an 8% yield (or a 12.5x multiple).  This would imply a per share valuation of roughly $46 – more than 65% upside from current levels.
 
 
The Catalysts:
 
Signing of the Maersk deal
The benefits of the TP1 expansion are reliant on the extension and modification of a series of contracts with Maersk.  The Company just this morning announced that the necessary contracts have been revised and extended through 2010, with options to renew through at least 2012.  We confirmed with the Company this morning that the renewed agreements allow for the capacity increases contemplated in the Company’s TP1 guidance.  This is a significant event that we believe is not yet being suitably appreciated by the Street as evidenced by this morning’s very modest reaction.
 
Analyst upgrades
Quite strangely, most analysts have acknowledged the substantial increases in EBITDA that lie ahead for Horizon primarily as a result of the EDGE program and the TP1 expansion, yet they have chosen not to update their models yet.  This stems partially from the fact that they typically look out just one full year for their estimates (and the benefits first begin to accrue in 2008) and from the fact that the Maersk deal had not yet been officially announced until this morning.  As we enter 2007 and they roll their estimates forward to 2008 (and now that the Company has formally announced the TP1 expansion), we expect to see dramatic upside revisions and subsequent upgrades.  These should provide built-in positive catalysts over the next few quarters.  Goldman, for instance, stated in its most recent research report (Nov. 21) that it’s $33 price target (or $38 assuming non-replacement of just the 3 oldest vessels) would increase by approximately $7 per share assuming management’s stated TP1/EDGE goals were reached and that they “would revise our TP1 revenue estimates once this extension is signed.”
 
Delivery of remaining ships
HRZ just announced that it has already taken delivery of the first of its new ships, the Hunter.  It expects to receive 2 more during the first quarter of 2007 and the final 2 ships during the second quarter.  We expect each of these announcements to be viewed as positives by the market as they will allow for the realization of the financial upside described herein.
 
Upside potential for 4 surplus Jones Act vessels
Current guidance includes no revenues from these ships, yet 100% of the costs necessary to maintain them in a ready status.  As per management, potential upside opportunities include:
·   Coastwise service or additional Jones Act route.  We believe that the opportunity for a coastwise service could be significant and we have urged management to focus on exploring this alternative.  Given the escalating costs of overland transportation, the chronic shortage of drivers in the trucking industry, the deteriorating condition and costly congestion of interstate highways (especially on the east coast) and the continued growth of interstate commerce, opening a north/south coastal corridor could provide a strong value proposition to HRZ’s existing customers.  Even quite small share shifts from trucking to shipping could create substantial economic benefits for HRZ’s relatively fixed cost infrastructure.
·   Relief vessels during routine drydock periods
·   Spare capacity for peak volume surges
·   Charter possibilities

Catalyst

1. Signing of the Maersk deal.
2. Analyst upgrades.
3. Delivery of remaining ships.
4. Upside potential for 4 surplus Jones Act vessels (Coastwise service or additional Jones Act route; Relief vessels during routine drydock periods; Spare capacity for peak volume surges; Charter possibilities).
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