Braemar Shipping Services — Awaiting favourable trade winds

Braemar is a broadly based international shipping services group employing 858 people at the end of February 2017. The largest source of income is shipbroking, where the group has a strong position in deep sea oil tankers and the offshore sector. Principal offices are in the UK, Singapore and Australia, supported by a number of strategically placed overseas offices. The group’s non-broking businesses offer a range of technical and logistics services from the UK and regional hubs in Asia Pacific, EMEA and the Americas. Technical services include specialist marine surveys involving site supervision, marine engineering, incident response and adjustment work for the insurance industry. Logistics work ranges from port agency to specialist freight forwarding.

Braemar is trading at a 19% discount to its peer group, or 10% excluding Clarkson, following a very difficult year which has seen profits decline, the rebasing of the dividend and a commensurate fall in the share price. The resilience of the core Shipbroking division in the extended recession for the shipping industry is encouraging, but the development of the diversified Technical and Logistics activities must also be seen to provide sustainable returns in order for the rating gap to close. Certainly the decisive management action in Technical should reverse the lossmaking position in the current year, and we are forecasting cautiously with regard to the shipbroking activities. Our capped DCF valuation based on this view is currently returning a value of 326p per share.

Results for FY17 were slightly better than market expectations that had been reset by the January trading statement. Underlying pre-tax profit fell from £13.4m to an adjusted £3.2m, £0.2m above our estimate. With trading conditions still challenging we raise our current year PBT estimate modestly from £7.7m to £7.8m. Net cash of £7.0m was some £2.0m better than we had anticipated although it benefited from some year end working capital positions which are expected to unwind in FY18. As also indicated in January, the dividend was rebased to 14.0p which provides strong yield support.

Shipbroking profits are sensitive to movements in spot freight rates and the sterling/US dollar exchange rate. Volatile shipping rates will lead to varying gross margins although, with a relatively high proportion of employee remuneration linked to income generated, the impact is lessened. Similarly, with considerable revenues generated in US dollars and the cost base largely in sterling, the business is a beneficiary when the dollar strengthens, and vice versa. There is also a potential vulnerability to the loss of key personnel, who manage the group’s relationships with the oil majors, charterers and leading ship owners. Braemar has countered vagaries of the shipping cycle by developing its Technical and Logistics divisions by acquisition; these businesses are internationally based and tend to reflect the volume of shipping movements and offshore oil and gas work.

Braemar is a leading international shipping services group. Its income is generated in the form of commissions, fees and/or hourly charges for its expertise. It is a purely services business, taking no equity interest in any ship or its cargo; there are no inventories in the group balance sheet. The key drivers to profitability are shipping rates, volumes of seaborne trade and oil and gas activity. Broking services profits can fluctuate with shipping rates, the sterling/dollar exchange rate and the volume of seaborne trade; profitability in the services divisions is subject to the volume of seaborne trade and activity in the oil and gas sector.

The group dates back to 1972, when Seascope Shipping was established as an independent shipbroker; it was admitted to the stock exchange in 1997. Its first acquisitions, Braemar Shipbrokers and Braemar Tankers in 2001, broadened the scope of the broking business. The group has subsequently extended into other types of shipping services.

Today, the group operates through three divisions. The largest, Shipbroking, was significantly extended in 2014 by the merger with ACM Shipping. The two services divisions, Technical and Logistics, were established by a series of acquisitions between 2007 and 2011, in response to the global recession and were aimed at reducing the impact of the shipping cycle.

Shipbrokers act as intermediaries between the various parties involved in the shipping of goods by sea. This usually involves bringing together ship owners and people wishing to transport raw materials, components/assemblies and finished goods from the country in which they are produced to those countries where they are to be consumed; the business also brings together parties wishing to buy or sell ships.

The global market leader, Clarkson, had broking revenue of £234m in 2016. The merger with ACM lifted Braemar towards the number two spot in the market. With revenues of £63m, the division is well under half the size of Clarkson, but is believed to be similar in size to Simpson, Spence & Young, the largest of a number of independent UK-based shipbroking groups. There are also sizeable competitors based in continental Europe, the US and the Far East.

Braemar’s areas of expertise are in deep sea and specialist oil tankers, dry cargoes and offshore oil production/exploration facilities. The majority of group broking revenue is generated in London, but there are key operations in Singapore and Australia and a further 10 strategically placed overseas locations, concentrating on the needs of their local areas.

The main sources of revenue in shipbroking are:

The Technical division comprises five distinct business units offering a comprehensive range of services, operating from three regional hubs in Asia Pacific, EMEA and the Americas.

Cory Brothers provides a comprehensive range of port agency, freight forwarding and logistics services to ship owner, charters and traders from regional hubs around the globe. It is well represented in the UK and continues to invest in geographic expansion, notably the US and Singapore in recent years.

The higher-margin port agency business generates just 23% of divisional revenue profits and over 60% of profits, looking after the needs of ship owners, charterers and traders on a 24-hour basis, with services ranging from the arranging of supplies to crew transfers and customs documentation. In essence, the company organises the docking, unloading, reloading and also arranges the departure of the ship from the port. There is a constant need to update systems and policies and to have the latest technology in place to offer the modern and efficient service required by customers. Cory’s software system offers real-time co-ordination between the customer’s own systems and those of the port being used.

Cory’s freight forwarding/logistics operation supports its customers following the landing of goods in port. Services range from arranging customs clearance and warehousing to the onward transport of the goods by air, road, sea, express courier or by hand. The business has a global contact base offering experience in handling a comprehensive range of goods, including support for businesses as diverse as the inter-continental oil, automotive, nuclear, renewables and recycling industries.

During the early years of this century, the global shipping market grew as world trade expanded, driven by growth in emerging markets and the associated increased flow of raw materials and finished goods that stemmed from the shift in manufacturing capacity to low-cost territories. There was a minor dip in the volume of seaborne trade in 2009, but it was quickly reversed. Steady growth resumed this decade but, as was the case with industrial output, this was at lower rates than experienced prior to the financial crisis. In 2018 seaborne trade is expected to grow at just 2%.

There were shipping capacity shortages for several years up to 2009 which drove a growing order book for new ships, with lead times running several years into the future. The global recession effectively applied a two-year brake on the rate of growth in seaborne trade. Previously ordered new capacity continued to come on stream creating surplus capacity, with a direct impact on shipping rates and on the value of ships. Shipbrokers, who are remunerated by virtue of the cost of shipping movements, saw their income sharply reduced. The pace of new shipping orders has slowed considerably but the earlier than planned retirement of a number of older vessels has so far failed to materialise to a sufficient extent to rectify the oversupply situation. Instead, steaming at slower speeds has mopped up some of the excess capacity. In recent months the trade stance of the incoming US administration has created new uncertainties over future global trade flows. The combination is serving to further extend the shipping cycle with shipping capacity in most sectors remaining significantly above demand.

The unfavourable combination of weaker freight rates and slower trading volume development led to increased consolidation in shipbroking. The larger broking houses, which have major research teams, have taken an increasing share of the market. The Braemar/ACM merger was just one of three major shipbroking deals announced in that period; the pooling of resources to enable fixed-cost reduction and to be able to advise customers more effectively is a natural response to the challenges and uncertainties.

There are four key elements to Braemar’s ongoing business strategy:

The downturn in the oil and gas industry severely impaired performance of the Technical division during FY17, which saw a significant reversal in operating performance. Both the core Shipbroking activity and Logistics proved more resilient although conditions across most segments were far from favourable. Overall revenues declined 12% to £139.8m in FY17, with underlying pre-tax profits falling from £13.4m to £3.2m. Underlying EPS of 8.73p were ahead of our much reduced expectations of 8.0p for the year, but represented a 75% decline on FY16. The executive management reaction to the Technical division’s issues was decisive and should rapidly return the operations to profit, although the challenging market conditions and continuing uncertainty predicate against undue optimism over the timing and strength of any recovery. As a result the full year dividend was reduced by 46% to 14.0p in line with indications from January, which is seen as a sustainable base from which to rebuild.

Exceptional items totalled £3.8m, broadly in line with management indications. These included both restructuring costs of £3.0m and gains from the Baltic Exchange share disposal of £1.7m, as well as continuing costs relating directly to the ACM merger. There was a £2.1m decrease in net cash from £9.2m to £7.1m.

In the absence of any acquired growth, Braemar’s shipbroking operation was resilient in the face of much tougher market conditions, notably in declining tanker and offshore rates. All segments remained profitable with continued expansion and strengthening of the teams, as well as prior year restructuring benefits also helping to mitigate the trading conditions. Underlying operating profits fell to £7.9m from £9.7m in the prior year, on an 11% fall in revenues; a creditable margin of 12.5%.

The performance of the largest department, deep sea tankers, experienced an unwinding of the favourable conditions seen in FY16 as tonnage expanded and the beneficial effects of lower oil prices wore off, lowering freight rates. Demand for oil was met increasingly from high local stocks levels reducing the demand for shipping of cargoes. Fleet growth was lower than expected as deliveries slipped, but asset values also continued to decline steadily for both new and used assets. The lengthening of average journeys also continues to be a positive although, but as stocking levels are consumed both crude and product tanker rates should see some recovery. The tanker market contributed 63% of divisional revenues, up from 62% the previous year.

In dry bulk cargo (up from 14% to 16% of revenues) freight rates hit an all-time low early in FY17, but recovered to two-year highs by December 2016. An optimised structure was put in place during H117 and key hires were made to strengthen the department. There are continuing signs of an improvement in dry bulk trade, although the fleet development leaves the supply demand balance uncertain which remains crucial to prospects.

Offshore (6% of revenues) remained particularly challenging due to very low activity levels in the sector as markets remain subdued. A profitable outcome was nevertheless achieved, and conditions while more stable are unlikely to recover sharply, although Braemar has retained an experienced core team to respond when the situation does improve.

A higher volume of demolition and second-hand vessels transactions in the Sale and Purchase operation (down from 18% to 15% of revenues), was offset by reduced average values. Tanker activity also remained subdued.

The Technical division was severely affected by the slowdown in exploration and production activity in the oil and gas sector. Revenues fell by 21% to £42.9m, incurring an underlying operating loss of £2.9m (FY16 profit £5.2m). The drop in oil prices led to a combination of reduced drilling activity, onerous debt levels incurred by producers and the lack of replenishment of maturing, long-term contracts, which in turn led to sharp falls in demand for construction and support vessels.

Braemar spent the year implementing a realignment of the division in response to the deterioration in performance after installing a new management team. £2.8m of the exceptional restructuring charges were incurred by the division which is expected to provide £6m of annualised saving in the current year, which should return the division to profitability.

The workforce at Offshore located in Asia Pacific has been scaled appropriately to meet lower levels of demand. Braemar Engineering, the consulting engineering activity, was refocused following the completion of a three-year support contract for LNG vessels in Nigeria and the more general downturn in the sector. Braemar Marine (formerly SA) has also responded to lower levels of activity for its specialist hull and machinery damage surveying and marine consultancy services.

Whilst Adjusting remained profitable in a challenging market, staff utilisation rates are being optimised by positioning staff to match project locations. The environmental consultancy and incident response business, Braemar Response, experienced routine workloads during the year with no significant project work. It also reset its cost base and refocused activities, closing its operation in West and Central Africa.

Logistics proved to be the most resilient division during FY17, following the weak performance in FY16. Revenues were marginally lower at £33.9m (FY16 £34.1m) and an underlying operating profit of £1.3m was generated. Cory Brothers’ Ship Agency business achieved strong business development and improved performance during the year despite the challenging environment. It is continuing to try and expand its US and European presence, while maintaining the strong UK position. The divisional outcome was achieved despite a difficult market for the smaller specialist Freight Forwarding activity due to a lack of projects and price competition. The activity has undergone a detailed performance review and a business improvement programme is now in train.

Braemar underperformed its peers significantly over the last year, as the impact of the oil and gas downturn on Technical took hold. Year to date the shares have performed well, despite confirmation of the rebasing of the dividend. Not surprisingly, Braemar continues to trade at a P/E discount to Clarkson, the market leader and the only other listed shipbroker. On a calendar year 2018 basis this currently stand at 37%, a reflection of the stronger anticipated growth for Clarkson, in addition to the greater recent resilience of its earnings. Braemar trades on a 19% P/E discount to the entire peer group in 2018, or 10% excluding Clarkson. The high dividend yield remains supportive.

If the company can resume growth and markets start to display evidence of sustained recovery we would expect the discounts to the peers to diminish. A rating in line with Clarkson requires a longer track record of growth and stability to be established. In this regard Braemar’s strong position in the tanker market, above average exposure to South-East Asia and ability to develop its non-broking interests are all supportive to the medium-term outlook. The cash-generative nature of the business and the above average dividend yield remain important positive factors in assessing the shares.

We also now consider a capped DCF value for Braemar. For this we utilise a six-year forecast period and then cap the cash flow growth at zero in the terminal value, adjusting the working capital and capex cash movements to reflect the zero growth scenario. We use a calculated WACC of 9.0%. As we are not currently forecasting substantial recovery in the shipping cycle over the forecast period, this returns a value of 326p (in bold in table below), only 4% above the current share price. Sensitivity to higher terminal growth and WACC is reflected in the table below.

The outlook statement indicates that a considerable amount of uncertainty persists in FY18, with depressed markets having the potential for recovery, but the timing and strength of any such movement being far from predictable. However, the self-help actions undertaken by management should see Technical swing back to moderately healthy profitability in the current year. In addition, Logistics should see continued development through its Port Agency business, aided by an improved performance from the refocused specialist Freight Forwarding activity. In the core Shipbroking business the length of the cycles to date in various segments leads to caution when it comes to predicting improving trading conditions. As a result, we have taken a cautious stance with respect to both volume growth and trading margins in the current year, despite signs of improvements such as Dry Bulk rates. Overall, we are forecasting a further moderate decline in underlying Shipbroking operating profit contribution.

The medium- to long-term outlook will be determined by global trade development as well as a recovery in the oil and gas markets. Both areas appear relatively stable at low levels at present, and Braemar’s operations appear positioned to respond to any improvements. However, given some of the recent uncertainties in the macro outlook that have been introduced by Brexit, the European elections, the new Trump administration, and North Korea, we feel it is appropriate to stay relatively cautious at present. An acceleration in demolition work would be encouraging for prospects on rates, as well as for the Sale and Purchase business.

Net cash of £7.1m at the year-end was some £2.1m better than we had been forecasting, with an outflow of only £2.1m during the year despite the challenging environment and associated restructuring charges. The position was strengthened by the disposal of Braemar’s shares in the Baltic Exchange, and also benefited from some year-end working capital positions. The former will not recur this year and the latter is likely to unwind in FY18. Nevertheless, we expect broadly neutral cash flow for the current year as profitability recovers, and the dividend payments reflect the sharply reduced FY17 final dividend payment and rebalancing of the interim for FY18.

The group’s £30m facility with HSBC, comprising a £15m RCF and a £15m accordion facility, combined with the strong cash position enables management to seek further bolt-on acquisitions, having rebased the income to investors to sustainable levels.