Horizon Lines Inc. HRZ
April 27, 2006 - 9:38am EST by
gatsby892
2006 2007
Price: 13.10 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 440 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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  • Shipping
  • High Barriers to Entry, Moat
  • Oligopoly

Description

HRZ is an overlooked, stable, low-risk, long-term buy worth an easy $16 (25% return) in the near-term and as much as $27 (+110%) longer-term, with downside limited to just $11 (-15%). The free cash flow yield is currently 18.5% and there is a 3.4% cash dividend yield. Furthermore, the Company trades at a 35% discount to its peers on an EV/EBITDA basis, barely above the baseline asset value of its ships and well below a conservative DCF valuation.


The Story:
HRZ is a cargo shipping company (not a tanker stock) operating in 3 US markets (each a rational duopoly or oligopoly) with the impenetrable barriers to entry of the Jones Act (described below). Its cargo is not cyclically volatile commodities or secularly weak autos, but largely perishables and foodstuffs. Volume growth is steady and predictable, pricing is rational and fuel prices are passed through regularly (sometimes even preemptively). Costs are largely fixed, so incremental price and volume increases flow largely unencumbered directly to free cash flow at a very high margin.


Some Details:

An overlooked IPO.
HRZ just went public in September of 2005. The initial IPO range was $16 to $18, but the timing was poor as it followed an endless stream of tanker, shipping, logistics, infrastructure and commodity-related IPOs and sentiment was really waning in those sectors by the time this deal finally came along. The offering was almost pulled, but Castle Harlan (having already made enough money from the offering at nearly any reasonable price) agreed to drop the range to $10 to $12 to get the deal done. The offering priced at just $10 and the beating that many funds took in October in commodity-related names likely kept the focus off of this significantly undervalued stock – but this was in part due to a misperception that HRZ was a similar type of business.

Steady nature of business.
This is not intensely competitive international shipping or a volatile tanker business that is highly influenced by spot rates (as evidenced by the fact that it has been LBO’d at least twice). It is not tied to commodities or low margin cyclical auto shipping – 40% of revenues are foodstuffs & perishables and the rest are largely various everyday consumer products. HRZ is also naturally economically and geographically diversified as it the only carrier serving all 3 of its distinct routes (Hawaii/Guam, Alaska, Puerto Rico). The Company has over 2,000 customers (low concentration risk) and even the all-powerful WMT is just 7% of their total business.

Jones Act protections are a big deal.
This 1920 US legislation requires that any ship delivering goods from one US port to another US port be built in the US, flagged in the US, owned by US citizens and be crewed by at least 75% US officers and crew. The basic premise was to provide for a ready US merchant fleet in case of war and to ensure that the US maintained functional shipbuilding capacity at all times. Ships that cost approximately $55m to build in Asia today cost about $150m to build in the US, but the Jones Act allows the few entitled shippers the necessary protections to earn a healthy return on their higher capital outlays. HRZ is the largest Jones Act shipper with 37% total market share & a #1 or #2 position in each of its markets.

Major CapEx is not imminent.
The useful life of this type of cargo ship is 45 years – not 25, as many investors first assume because of their experience with certain tanker stocks. HRZ trades at such a large discount to its peers primarily because there is a misconception that its ships are significantly older than those of its peers – and therefore will require greater near-term capital outlays to replace. This is based on outdated information from the IPO prospectus which states that HRZ’s ships are 29 years old (which, by the way, is not much older than the peer average of 24 years). However, the Company just recently (Apr. 11) announced that it closed a 5 ship leasing deal that is narrowing its average age to just 20 years once the ships come online in 1H 2007 – the lowest among its peers. This both significantly reduces and delays any large required capital expenditures without impacting the Company’s current cash flows or balance sheet – taking away the largest risk to the story. Furthermore, the 2 oldest ships are just 38 years old and should last until 2013 before needing replacement – and now, as a result of the recent leasing deal, these ships will be used significantly less going forward, further extending their useful lives. In short, HRZ’s fleet replacement strategy is quite practical and amounts to: 1) Don’t spend large sums of money until you have to; 2) Spending money later is better than spending money now; and 3) US ships will be cheaper to build in the future than they are today as technology sharing occurs with Asia (General Dynamics just signed a design sharing agreement with Daewoo earlier this month for its San Diego shipyard that illustrates that this is already slowly beginning to occur).

Declining operating expenses.
The above mentioned leasing deal also serves to lower ongoing maintenance, fuel and drydocking expenses as the new ships are state-of-the-art (diesel vs. steam, for example). These savings are estimated to amount to as much as $3m per ship per year in previously excess operating costs (as well as an additional $3m one-time reduction in drydocking expenses). The Company is also just now beginning to focus on some of its overland (trucking) expenses that occur primarily in the Alaska market (HRZ serves a customer’s entire shipping needs and sometimes some overland movement is required in more remote areas). Although fuel expenses are fairly effectively passed through on the shipping lanes, HRZ has not previously focused on making sure that it is retaining its margins on its overland routes as fuel costs have risen, creating an additional potential opportunity.

Opportunities for fleet rationalization.
Prior to the ship leasing deal mentioned above, HRZ was utilizing 60% of the capacity on 5 of its Hawaii/Guam route ships to serve a transpacific shipping route (“TP1” – further described below) that is exempt from the Jones Act (because it does not involve shipping between 2 US ports – ie, from Guam to Asia to the US). This capacity amounts to nearly 20% of the entire Company’s 16 ship capacity that was dedicated to a route that could be using ships that cost close to one-third of the price of HRZ’s Jones Act fleet (just $56m each vs. an estimated $150m if built in the US). The new leasing deal (for the 5 non-Jones Act ships) allows the Company to free up the vessels that were previously serving that route to now use ships that cost significantly less, effectively tripling the ROA on 20% of the Company’s total capacity (beginning in late 2007). This is in addition to the many benefits noted above regarding reduced capital outlay, ongoing maintenance & fuel savings, etc.

Shift to higher margin business.
Because capacity utilization is already about 90% in all 3 trades (prior to the leasing deal, which will free up some capacity for increased TP1 business), the focus is largely on overall expense reduction and on upgrading the quality and margin opportunity of the existing business. For instance, HRZ is actively shifting the mix of its container fleet to have a greater concentration of refrigerated units (a 30% increase in the last 18 months) as it shifts away from any lower margin or somewhat cyclical products to much higher margin staple products. The Company has also increased the focus on its logistics services business and even recently won a couple of contracts to manage a number of ships for the US military. Although these are typically lower gross margin businesses than the Company’s core Jones Act shipping, they are additional revenues on top of a highly fixed cost expense structure, which means a high incremental operating margin and therefore overall accretion. They are also extremely low risk (cost-plus contracts) and tend to have very high renewal rates. Over the years, HRZ has gotten creative in finding ways to increase its margin (which is improving, but still well below its peers). One of these is the addition of seafood backhauls from Alaska. Instead of returning to the northwestern US with empty containers, HRZ now gets paid for the return trip by filling the containers with one of Alaska’s primary exports (fish) – another highly accretive decision.

Expansion of TP1 route.
Another of HRZ’s creative revenue/margin enhancement strategies has been to form an alliance with Maersk (global shipper) whereby, HRZ uses Maersk’s containers to deliver its goods from the US West Coast to Hawaii and Guam. But instead of just leaving the empty containers in Guam or having to haul them back to the US empty (where Maersk can’t really use them because its traffic typically flows just one-way from Asia to the US), HRZ continues a short way to Asia where it allows Maersk to refill the empty containers (on a fully bought take-or-pay basis) before it returns to the US with the Asian cargo in tow. Again, this is lower gross margin business than the core Jones Act routes, but it is an engine for growth and generates strong incremental cash flow on top of the Company’s relatively fixed cost infrastructure. Also, as discussed earlier, HRZ is now going to commit substantially less expensive assets (for the same revenue generation ability – actually, more, since the ships are larger) to this business going forward as a result of the recent leasing agreement. Although the Maersk deal expires in 2007, the expectation is that not only will it be renewed (it is quite convenient and lucrative for both parties), but that it will be expanded to fill the additional capacity coming onto the TP1 route as a result of the larger size of the leased ships relative to the ships currently being used. Analysts estimate that this incremental Maersk hauling should be 10-15% accretive to EBITDA beginning in mid-2007 – and this accretion is not yet in any of their models because the Company has yet to announce that the agreement has been formally extended.

Other potential high value options.
Given the escalating costs (primarily fuel-related) of overland trucking as a delivery method as well as the increasing congestion of an aging interstate transportation network, there has been some discussion of the possibility of opening a route to deliver cargo by ship between New York and Florida. This could be an additional lucrative growth opportunity for HRZ.


Valuation:

Downside protection.

1. The Company’s estimated FCF (after all maintenance capital expenditures, drydocking expenses, etc.) is projected to be between $75m and $85m for each of the next 5 years (and growing steadily thereafter), implying a FCF yield of roughly 18.5%. Even though HRZ’s plan is to delay any additional capital expenditures as long as possible, this FCF yield does not tell the whole story as it does not account for any eventual replacement of Jones Act compliant ships (built in the US as opposed to leasing, life extension, foreign-built ships, etc.). However, even accounting for the full value of this today (assume a conservative $150m per ship divided by a 45 year life equals $3.3m per year times the remaining 11 fully Jones Act compliant ships equals roughly $35m per year), still leaves roughly $45m in unencumbered FCF per year for a sustainable FCF yield of 10% (which we think is very rich given the stable, recurring, non-competitive nature of this business). Note: all EBITDA and FCF figures used herein are before the impact of the recently announced leasing transaction, which will increase ship rental expense, but overall should be accretive to EBITDA and FCF as revenue capacity increases and operating expenses are substantially reduced.

2. Prior to the lease deal (which is on market terms), HRZ had 16 Jones Act ships with an average age of 29 years. This implies a 16 year remaining useful life per ship or 36% of the total ship value. At a $150m replacement cost per ship (all of these were US ships), that implies a value of $54m per ship times 16 ships equals $864m, just 6% shy of yesterday’s enterprise value, before taking into account any value for the profitable ongoing operations of the business (contracts, relationships, infrastructure, etc.). This implies a floor market capitalization of $375m or just over $11 per share (bringing into perspective just how absurdly low the $10 IPO value was). This floor value is only about 15% below yesterday’s closing price.

3. HRZ is currently paying a 3.4% cash dividend yield.

4. Management owns 11% of the Company and Castle Harlan owns an additional 37%, making for extremely aligned interests with all the right people.


Fair value estimate.

1. At just 5.7x 2006 consensus EBITDA, HRZ trades at a ridiculous 35% discount to its peers (KEX currently trades at 9.7x and ALEX at 8.0x 2006 consensus estimates). There are reasons why a discount might be appropriate (higher leverage, shorter public operating history, smaller publicly traded float), but there are also reasons why an equivalent or even premium multiple could be warranted (rapidly closing the margin gap with peers, de-levering creates value for the equity, now has the youngest fleet, TP1 expansion, etc.). We believe that the size of the current discount is irrational and is largely due to a lack of understanding of the Company’s business model, a misperception about the near-term capital expenditures required and the fact that the story is just not known at all (one of the analysts covering the stock told us that we were the first call he had gotten on the name this year!). If HRZ’s discount were to be eliminated as investors’ misperceptions are cleared up, the shares would trade at $27, more than double the current level (assuming the midpoint of the current peer range). Taking a conservative 10% haircut to the lowest peer multiple yields a $20 stock price (55% upside). Even accounting for an occasional stumble, we see no reason at all that the stock should not currently be trading at least in the $16 range (a 20% discount to the lowest peer multiple) and believe that the shares will reach that level within the next quarter or two as the Company begins to build a public earnings track record.

2. Using a DCF, we derive a fair value of least $20 per share with conservative operating assumptions – just 4% revenue growth (well below the 8.7% increases of the past 5 years or the 5.5% – 6.5% GDP growth in each of HRZ’s 3 trade zones); modest ongoing margin expansion from cargo mix and SG&A leverage; and benefits from deleveraging as a result of robust FCF generation. Expansion of the TP1 route as well as any accretion from the recent leasing deal are both upside to this valuation. Should pricing and volume increases remain even close to historical levels, that would create additional value as well. This valuation also assumes that each ship is replaced at a full cost of $150m upon turning 45 – any improvements to this strategy (such as further leasing deals or lower cost US built ships) would also create additional upside.


Risks:

High leverage.
Analysts talk a lot about the high leverage here, but a lot of that was really the legacy capital structure under the Castle Harlan LBO. Pro forma for the debt reduction from the IPO, HRZ has a Net Debt / 2006 EBITDA ratio of just 3.0x. Although this is a bit higher than its peers (ALEX & KEX are each at about 0.9x), we think that it is perfectly acceptable, especially given the nature of the business. The leverage drops to just 1.8x in 2008 assuming that the $80m of FCF generation per year goes towards debt paydown and that the EBITDA expands slightly to $180m (both as expected by consensus estimates).

Massive future capex requirements.
We believe this fear is largely exaggerated at this point as we discuss in detail above.

Repeal of Jones Act.
This legislation has been in place since 1920. Both political parties espoused their support for it during the last Presidential election. Post 9/11, in a political climate where Bush could not even get the Dubai port deal approved, we think the likelihood of any adverse changes to the Jones Act are extremely remote.

Shift in competitive landscape.
The Jones Act obviously makes it impossible for lower cost foreign competition to come in. And importantly, HRZ has an average 22 year relationship with its 10 largest clients (as long as 40 years with some of them). But even though competition is severely restricted, it is still a market and the dynamics could shift (although rational economics should prevail over the long-term). In the late 1990s, the Puerto Rican state-owned carrier (Navieras) launched a price war to increase its market share and gain scale. Its irrational actions hurt everyone involved (hence the lower margins for HRZ back around 2000-2001), but the carrier eventually went bankrupt. Its exit from the market in 2002 reduced capacity by 15% and allowed for substantial price increases over the subsequent years (prices are now finally just below where they were pre-Navieras).

Economic slowdown.
HRZ’s business is tied to consumption and so could be hurt by a downturn in GDP. However, it is important to note that the Company’s risk is diversified across 3 very different economies (each with distinctly different drivers) and that the GDP growth of all 3 of its trade zones has historically been above US GDP growth. Also, it is not just GDP growth that is the driver, but the growth of imports and exports, which could remain relatively robust even if sectors such as real estate, oil or tourism were to temporarily suffer. We believe that our conservative operating forecasts mitigate this risk.

Catalyst

1. With an 18.5% FCF yield, each quarter of in-line earnings is in itself a positive catalyst as management builds a public track record and the business de-levers. The next earnings release is before the market opens this Friday, April 28.

2. An announcement of a renewal and/or extension of the Maersk TP1 agreement will provide upside (estimated 10-15% accretion that is not currently in Street projections).

3. The 5 new ships come online in 1H 2007 and will begin contributing to revenues and lower operating (and drydock) expenses towards the back half of next year and beyond.
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