Stay away for now; long road to a sustainable recovery. Dry bulk shipping appears to have the worst outlook amongst different sub-sectors within the transport sector. In our view, the sector is likely to undergo more pain before a structural recovery can take place. We think stock prices are likely to see further correction as ship prices fall. Difficulty in obtaining ship financing and depressed
returns could force owners with high leverage to sell their ships and this will weigh down on second hand ship prices. Within OSK's regional coverage, we have Sell on Thoresen Thai Agencies (TTA) (TP: THB12.30), Precious Shipping (PSL) (TP: THB11.85) and Maybulk (TP: RM1.46).

This is not a typical downcycle. In our analysis of past boom/bust cycles since 1985, we noted that: (1) there are four major cycles with peaks in May 1989, Oct 1992, Nov 2000, and Jun 2008; (2) in the past three cycles before the peak in 2008, on average, the BDI took 2.5 years from trough to peak and 2.6 years from peak to trough; (3) the 2003-08 boom is the longest, taking 6.6 years from trough to peak. While the current downcycle is now tracking 4.2 years, we believe a structural pickup is not yet visible as fleet growth remains aggressive.

Other takeaways in this note: (1) We believe the market will struggle to reach demand supply equilibrium in the near term. Fleet capacity growth of 9.7% in 2012 does not bode well for freight rates and Chinese demand is growing but at a slower pace. (2) Share prices and the Baltic Dry Index (BDI) have stopped moving in tandem since 2010. (3) Cash level is declining. A prolonged downturn
could lead to more bankruptcies for highly leveraged ship owners.

Sell TTA, Maybulk and PSL; ports may be safer bets. We see downside to share prices as they are trading at a premium to charter-free net asset value (NAV). In our view, ports are safer bets for exposure in the transport sector. We have a Neutral rating on HPH Trust (TP: US$0.78). Key risks to our call are: (1) slower-than-expected fleet growth; (2) swift rebound in global trade.

Bulk shipping is primarily focused on the movement of iron ore, coal, grain, and minor bulks like sugar, forestry products, and building materials. Shipping is a cyclical business as ship owners tend to overinvest in good times, leading to excess capacity when demand declines. Based on our observation of the Baltic Dry Index (BDI) from 1985, we noted that the industry has undergone four major cycles. The highest reading on the BDI was 11,793 in May 2008.

In previous boom/bust cycles, we observed that the longest upcycle was 6.6 years from the bottom in Nov 2001 to the peak in Jun 2008. In other upcycles, the average upcycle lasted for 2.5 years. In the past three downcycles (excluding the present downcycle), the dry bulk shipping market took 3.4 years (May 1989 to Oct 1992), 3.3 years (Apr 1995 to Aug 1998) and 1.0 year (Nov 2000 to Nov 2001) respectively before hitting a bottom, suggesting an average peak-to-trough period of 2.6 years.

While the current downcycle is now tracking 4.2 years, longer than the average peak-to-trough period of 2.6 years, we believe a structural pickup is not yet visible. If history is any indication, we think the dry bulk shipping market could bounce along the bottom for another one to two years before a structural recovery can take place.

Previous dry bulk upcycle underpinned by China's industrialisation needs. China dry bulk shipping demand has consistently surprised on the upside. The long upcycle from late 2001 to mid 2008 was largely fuelled by growing demand for raw materials from China. China's industrial steel production grew >15% YoY for 72 consecutive months from Aug 2002 to Jul 2008 before the demand was derailed by the global financial crisis.

China's GDP is projected to grow at a slower pace. China's GDP growth is expected to slow down over the next two years. Our economist is projecting +8.1% growth in 2012 and +7.9% growth in 2013, with some downside risks.

High thermal coal inventories in China and drought in the US affecting demand. Near term demand for dry bulk shipping remains weak given: (1) high thermal coal inventories in China; and (2) weaker food exports from the US due to low corn production arising from the drought. Thermal coal inventories in China rose to record levels in June as electricity production dropped. While inventory levels have declined 12% from peak (Qinhuangdao: 23% from peak), we think China is unlikely to resume coal imports aggressively due to lower electricity demand.

Prices are still drifting downwards. The value of second hand ships continues to decline on depressed freight rates. In the past 12 months, the prices for five-year old Panamax, Handymax and Handysize have fallen 22%, 13% and 30% respectively. Prices for handymax ships appear to be the most resilient.

High ratio of second hand ship prices to newbuild prices points to potential downside. Prior to the upcycle that started in 2003, prices of five-year old and ten-year old vessels were 65% and 55% of newbuild prices respectively. Today, the ratios of five-year old Panamax, Handysize and Handymax to newbuild prices are between 70% and 90%, suggesting more downside to second hand ship prices should the ratio revert to historical average.

Order book still high. Order book-to-fleet ratio is moving towards more normalised level (now at ~24%).The ratio of order book-to-fleet hit a high of 79% in Oct 2008 when bullish sentiment in the shipping sector drove record new orders. Given the prevailing weakness in the market, we expect the ratio to show gradual decline as more vessels are delivered. We
estimate the ratio of order book-to-total fleet to fall from 24% currently to 18% by end-2012 and 13% by end-2013. Shipyards are expected to struggle in the next two years as we believe ship owners will hold back from placing more new orders due to unattractive return on investment.

Ship scrapping could hit 40m DWT in 2012. In the overlay of two charts between monthly demolition and Baltic Dry Index (BDI), we found that any recovery in the BDI has to be supported by a strong pickup in vessel demolition. The industry scrapped 23m DWT in 2011 and 18m YTD Jul 2012. Industry captains are expecting the scrapping to hit 30-40m in 2012, which will help support the soft freight rates. Indian buyers have been the most aggressive with 29% market share of tonnage bought for scrapping YTD.

...and slippage is set to remain elevated at ~28%. YTD Jul 2012, the dry bulk sector added 67.8m DWT of new ships with another 68.3m DWT scheduled to be delivered from Aug to Dec 2012. Slippage ratio has decreased over the past three years, from 40% in 2009 to 36% in 2010 and 28% in 2011 as financing situation improves post the global financial crisis. We estimate that 100m DWT of new ships will be delivered in 2012 compared to a total of 139m DWT scheduled for delivery in 2012. This implies a slippage ratio of 28%.

Historical data suggests that the sustainable growth rate of global dry bulk capacity is around 5.0% per annum in the long run. Based on our model, we forecast the global fleet to expand 9.7% and 3.0% in 2012 and 2013 respectively.

Our assumptions are premised on:

Current freight rates are barely profitable. We estimate that a 5-year old Supramax vessel will need to be chartered out for US$9,500/day to breakeven. Current rates for one-year time charter are between US$9,500 per day and US$10,000 per day, which are slightly above the breakeven point.

Multiple factors keeping freight rates soft. We believe dry bulk freight rates are likely to remain soft due to a combination of lower/negative growth coming out of Europe, slower than expected recovery in the United States, lower shipping demand from China and excess capacity in the market. A pickup in the BDI in Jul-Oct 2011 to above 2,000 points was shortlived as the rally was sparked by sudden increase in reconstruction demand from Japan post the earthquake.

Share prices and BDI no longer move in tandem. Share prices used to trade closely to movement in the BDI but this has no longer be the case. During the dry bulk upswing in 2003-2008, stocks prices had positive correlation as high as 95% before the relationship
broke down post the global financial crisis.

Depleting cash level across the board. Figure 22 and Figure 23 suggest that the ratio of total cash to total assets is slowly declining while the ratio of total debt to total assets is rising. If freight rates remain under pressure for another 12 months, we believe companies with high leverage on their balance sheet may be forced to sell their ships at lower prices or more bankruptcies could emerge. See Figure 26 for net debt-to-shareholders' equity and total debtto- total equity ratios.

YTD, the best performing bulk carriers are Pacific Basin (+14% YTD), Maybulk (+4% YTD) and U-Ming (+3% YTD) and the worst performers are STX Pan Ocean (-34% YTD), China Shipping Development (-33% YTD) and Thoresen Thai Agencies (-20% YTD). All the stocks outperformed the Baltic Dry Index (BDI) which fell 59% YTD.

Not time to bargain hunt yet. Investors have consistently asked if this is the right time to move back into the dry bulk shipping sector. Not in our view. We see potential downside risk to share prices as dry bulk continues its search for the bottom. Ship prices are still drifting downwards and share prices could follow as charter free NAV declines. With the lack of earnings visibility, we think the best way to value shipping stocks is using fleet value or book value. We value TTA and PSL using fleet value (with adjustment for cash and other investments) and Maybulk at 0.8x P/B.

Sell TTA, PSL and MBC. Across OSK's regional coverage, we have Sell ratings on TTA (TP: THB12.30), PSL (TP: THB11.85) and Maybulk (TP: RM1.46). In terms of balance sheet strength (as of FY11), Maybulk has the strongest balance sheet with a net cash position followed by Precious (17% net gearing) and TTA (31% net gearing). Sector profitability will stay under pressure on continued glut of dry bulk carriers and the sector demand supply dynamics may not come back into a balanced situation in the next six months.

Which stock appears the most attractive? On one-year forward P/B valuation, Pacific Basin (2343 HK) (Not Rated) appears most attractive with a one-year forward P/B of 0.66x. While TTA appears attractive at 0.49x, a big part of the value resides in Mermaid Maritime, which is the oil and gas division listed in SGX and trading at significant discount to book value (FY12F P/B: 0.42x).

Source: OSK