eurosis (Nasdaq:Different) is a Greek-operated Marshall Flag subsidiary that operates container ships (intermediate volume and feeder). The company has seen its prices rise and fall in line with container leasing rates between 2020 and 2022.
in August I wrote a bearish recommendation on ESEA, on the grounds that its industry was cyclical and overinvested, and that the company’s management was not good at allocating capital. Since then, the stock has fallen nearly 28%.
In this review with 3Q22 data, I find that the container market has already collapsed, and ESEA has not changed course. Ahead developments remain dire, with plenty of supply hitting the market, increasing ESEA’s depreciation expenditures. ESEA is still highly overrated.
Note: Unless otherwise noted, all information has been obtained from ESEA filings with the SEC.
cyclical commodity industryThe container industry has all of the profit-destroying characteristics: massive fixed assets, high exit barriers, and a commodity product. This leads to a classic industrial cycle of undersupply, and prices rise very quickly, as a lot of new supplies start to build up (with lead times of about three years), after which prices collapse again and the market swells in supply. This symptom is slowly stopped and the cycle starts again.
Management is not good at allocating capital: The only way to win in this type of industry is to play the cycle in the opposite direction from a capital allocation perspective. Management has to accumulate cash without investing at the top of the cycle and then buy capacity from nervous competitors at the bottom.
Unfortunately ESEA management has not. As if they didn’t understand their own industry, or perhaps thinking that ‘this time is different’, the company invested heavily in the previous cycle (2003-2007), only to sell those vessels with huge losses in value during the downward cycle (2008-2020) . This time, they rushed to order new ships (9 in all, for $350 million) and buy used ones at prices approaching record prices. I can say with almost certainty that massive downside losses await ahead.
Family relationships are not very clear: ESEA is controlled by the family of its founders. This is generally a good sign. However, ESEA has many business relationships with other companies of the founder’s family. She has been buying and selling ships for the family (at market prices but always at bad timing). And most of all, to pay a family business a huge administrative bill. This service can easily be outsourced, allowing for better cost control.
The latest developments
The price has already collapsed: the New Contex container index Already back to near unprofitable prices that were pre-COVID. Prices appear to have at least temporarily stabilized around $15K for the Nutrition class, and around $19K for the Medium class. I don’t plan on predicting future rates, but these will likely not go below $10k per day (as they were before COVID) given the inflation the world has seen.
ESEA has two years of profitable contracts, then the market the pricesA significant portion of ESEA’s currently operating fleet is already chartered at record high rates, averaging $30,000 per day per vessel. The contracts mature in stages in 2023 and 2024.
These charters provide the profitability of the current operating line through 2024. The new vessels will probably be chartered at rates closer to current rates (since the cycle is already back up), except for two that are chartered at very good rates of $48k through 2026. After 2024 Most of the ships will be chartered at rates close to current rates.
An explosion in consumption and interest costs in the future: With ESEA starting to take delivery of 9 new boats in 2023 and 2024, it will start depreciating them. With an average depreciation life of 25 years, and a cost of $350 million, I would expect $14 million in additional annual depreciation expense by 2025.
Since ESEA is not generating the cash to pay for those ships, it will have to increase its debt levels. ESEA still has to pay $287 million, and has made about $100 million in CFO TTM. Assuming the same level of CFO in 2023 and 70% of that in 2024, the company would have to increase debt by $100 million to pay for the new ships, reaching net debt minus cash of $190 million by the end of 2024.
ESEA borrowing rate (Reported in the last 20 years for FY21, it could have changed now) LIBOR was +3.5%. The company’s interest in average debt in Q3 ’22 shows an actual interest of 5% (less than expected as LIBOR was already over 4% in that period due to hedges against $60m).
Given a very easy rate of 5% over the long term, the company is expected to pay $10 million in interest by 2024.
As I explained in the August report, ESEA had a fairly consistent average operating cost of $10,000 per day, including dry-docking expenses.
By the end of 2024, the company will have vessels with a total value of $600 million being depreciated at a cumulative rate of $25 million annually. That works out to about $1 million per vessel or another $2.8k per day. This is different from the market losing the value of the ship. According to the information in Investor Show from NovemberA 2,500 TEU vessel loses $20 million in value in the first 10 years of operation, from the original price of $40 million, which means it loses value faster at the start of operations.
Finally, the $10 million interest fee adds up to a thousand dollars a day per vessel. All of this means that ESEA needs an average post-2024 rental rate of $14K per day just to break even. Given that amortization is not on an accrual basis, the company can set aside $25 million to pay off the debt annually in this case. In order to pay off her main debts, she has to earn more.
Finally, with a current market cap of $140 million, prices would have to rise another $1.5k per day on average for the company to generate $14 million in after-tax profit. This means that the profitable aircraft leasing rate is at least $15.5k per day on average.
Prices are already close to those levels, and supply has not yet fully reached the market. According to ESEA, in 2022 the feeder fleet will increase by 6%, and it is expected to grow by another 8.5% in 2023 and 5% in 2024. For intermediate vessels, the rates increase to 10% in 2023 and 10% in 2024.
ESEA operates in a junk industry and has a less than stellar management team. It has consistently operated at a loss, destroying hundreds of millions of shareholder value. In this new cycle, the company has repeated the bad decisions that slashed profitability and destroyed value in the 2010s.
With that in mind, claiming a 10% return on ESEA’s current market cap is quite generous. One can demand the same return on the higher quality companies in the current market.
However, this return will be difficult to achieve in the long term given ESEA’s growing expenses, and the fragile state of the container market. Therefore, today’s investment in ESEA does not guarantee even a very low required return for a very poor quality company. In my opinion, ESEA is clearly prohibited.