Braemar Shipping Services — Update 20 May 2016

Braemar is a broadly based international shipping services group. The largest source of income is shipbroking, where the group has a strong position in deep sea oil tankers and the offshore sectors, with principal offices 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 offices across the UK and several overseas locations, especially in the Asia Pacific region. Technical services include specialist marine surveys involving site supervision, marine engineering, incident response and adjustment work for the insurance industry. Logistics work ranges from ship agency to freight forwarding.

Braemar’s prospective rating is almost 30% below that of Clarkson on the basis of prospective 2016 calendar earnings, falling to a 16% discount on the basis of 2017 estimates. It is also rated at a discount to other members of its peer group. We believe that this discount reflects market fears that the strength of the tanker market may not be sustainable, while the ultimate recovery of other segments of the broking industry will be less beneficial to Braemar than to Clarkson. Our estimates do suggest much slower immediate earnings growth at Braemar compared to the remainder of the peer group. Nevertheless, Braemar’s strong position in the tanker market, its above average exposure to South-East Asia and action taken to develop further its non-broking interests all point positively to the medium-term potential. The reduction in risk stemming from the diversification policy, the cash-generative nature of the business and the well above average (1.3x covered) dividend yield are all important positive factors in assessing the shares.

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 service 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 £240m in 2015. The merger with ACM lifted Braemar towards the number two spot in the market. With revenues of £71m, the division is well under half the size of Clarkson, but is believed now to be close in size to Simpson, Spence & Young, 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 businesses, offering a comprehensive range of services from 37 offices based in 20 different countries.

Cory Brothers provides ship agency, freight forwarding and logistics services from 18 offices across the UK and in Singapore. The company also has joint agency arrangements in Brazil and Gibraltar.

The ship agency business generates just over half of divisional revenues, 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 arranging 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 with 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.

The global shipping market has grown with the expansion in world trade, augmented by the increased flow of raw materials and finished goods stemming from the shift in manufacturing capacity to lower-cost territories. There was a minor dip in the volume of seaborne trade in 2009, but it was quickly reversed and continues to grow steadily.

There were capacity shortages for several years up to 2009, leading to 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, with an obvious 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 now slowed considerably and, with the earlier than planned retirement of a number of older vessels, the extent of the oversupply situation has started to ease. Nevertheless, shipping capacity in most sectors remains significantly above demand.

The ensuing uncertainty led to increasing consolidation in shipbroking, with the larger broking houses, which have major research teams, taking an increasing share of the market. The Braemar/ACM merger was just one of three major shipbroking deals announced in recent years; 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.

The downward shift in this cycle was deeper and more prolonged than in previous recessions. This reflects the heavy shipbuilding order books ahead of the downturn and the sudden and unexpected nature of the setback in demand. The original backlog of orders has now been either delivered or cancelled, while the pace of new orders has slowed. Some shipyards were closed or mothballed. There has been increased recent investment activity, notably for tankers.

The price of new ships has fallen considerably over the past five years, with shipyards fighting to stay in business. Moreover, the lower running costs associated with modern, more efficient engines suggests that new ships can compete effectively with the overpriced vessels delivered during the immediate post-recession period. This will, however, almost certainly lead to an acceleration in the retirement of older, less efficient ships, especially as new environmental laws come into effect. In addition, following the recent environmental problems linked to a number of the oil majors, there is a growing desire to use modern ships.

Braemar’s ongoing business strategy includes the following aspects:

Braemar has delivered sound results for the year to February 2016, with revenue up by 9% to £159.1m and underlying pre-tax profits by 19% to £13.4m, The major factor was the previous year’s merger with ACM, which was consolidated for the full period in FY16, compared with seven months in FY15. The oil price had a major operational impact, with a strong advance in tanker broking earnings outweighing the adverse effects on the group’s offshore broking and service operations. Dilution from the equity issued as part of the consideration for ACM restricted the increase in underlying EPS to 7% from 31.3p to 34.7p. The dividend was unchanged at 26.0p, with cover increasing from 1.2x to 1.3x.

Exceptional items totalled £3.4m; these were in line with management indications and related directly to the ACM merger. There was a £2.0m increase in net cash from £7.2m to £9.2m.

Braemar’s shipbroking operation was transformed by the ACM deal; the size of the business increased by some 70%, with the team invigorated. The subsequent restructuring led to a £4m (10%) reduction in the cost base. Last year saw a major advance in divisional operating profits from £5.6m to £9.7m, with a strong performance in tanker broking, responding to a favourable trading climate. Increases in the number of movements plus longer journeys related to the development of the Atlantic Basin led to a reversal of the previous over-capacity in deep sea tankers. The tanker market contributed 62% of divisional revenues, up from 53% the previous year.

By contrast, the dry bulk cargo (down from 18% to 14% of revenues) and offshore (halved from 13% to 6% of revenues) markets remain subdued. In both segments, there is still considerable overcapacity, with little sign of change in the immediate future. There has been increased retirement of older bulk carriers, as owners try to reduce the imbalance, but the process remains incredibly slow. We frequently hear of plans for the larger operators to take concerted action, but there seems to be a reluctance to take the necessary pain. Offshore desks cannot avoid the impact of sharply reduced exploration activity. A timely and close attention to the cost bases of both operations meant that both desks remained profitable.

On the other hand, the sale and purchase operation (still 18% of revenues) did well. The desk increased its involvement in the scrapping of ageing bulk carriers, with several owners forced by their financiers into distressed sales. Tankers activity in the S&P area remained subdued.

There were contrasting performances across the Technical division. Despite a 9% increase in revenues to £54.3m, underlying operating profits slipped back by 17% to £5.2m, somewhat below our (£5.9m) estimate. The principal adverse factor remained the drop in the oil price, which undermined trading at both Braemar Offshore and Braemar Adjusting. Each business invested in broadening its base of operations, but the benefits will accrue in the future.

By contrast, there was the expected strong performance from Braemar Engineering, which lifted revenues by almost 50%, as deliveries on the three-year LNG tanker design, site supervision and crew training project in Nigeria reached its peak levels. The momentum of new business is building under a number of management initiatives, notably in its Houston office, but there are still some gaps in the forward order book.

Braemar SA experienced a slowdown in activity in South-East Asia, but more than balanced this with growing levels of consultancy work in the Middle East and the Americas.

The environmental problem-solving business, Braemar Howells, sustained its position last financial year. No new major incidents arose, but the previous year’s restructuring reduced the cost base and pointed towards a number of initiatives to broaden the base of the business.

Logistics results were disappointing, showing revenue down by 19% to £34.1m and operating profits sharply down, by 31% to £1.6m. The change of management in early 2015, involved the head of the port agency business taking control of the whole division, has created a much more focused strategy, but the benefits are coming through far more slowly than we had been expecting; several new contracts are in position, but uncertainties about global trading climate have delayed their implementation.

Returns from the Port Agency business held up well, with an increased share of a difficult UK market. Singapore has proved more challenging, while the new office in Houston has performed well and will hopefully start contributing to the group bottom line during the current year. As expected, the Freight Forwarding business was caught between rationalising low margin business and the slower than planned build up of the better quality contracts. Investment in overseas growth looks solidly based and should start to deliver recovery in the current financial year.

While the share prices of ICAP, Brewin Dolphin and Braemar have traded in a fairly narrow band since our Update report last October, Clarkson (global market leader in shipbroking) has seen a 9% reverse, and James Fisher (shipping services) has been in receipt of a sharp upward rerating. The Clarkson move reflects a cutting of market estimates – it continues to grow the underlying business impressively, but has a comprehensive business spread of shipping markets, including the broking areas where shipping rates remain under extreme pressure. At Fisher, we believe that there had been fears about the shift in world trade, which have subsequently proved to be unfounded.

For Braemar, the high exposure to deep sea oil tankers has led to a well above average performance by its shipbroking operation, tempered by the adverse impact of the oil price on certain of its other activities.

Braemar’s prospective rating is almost 30% below that of Clarkson on the basis of prospective 2016 calendar earnings, falling to a 16% discount on the basis of 2017 estimates. It is also rated at a discount to other members of its peer group. We believe that this discount reflects market fears that the strength of the tanker market may not be sustainable, while the ultimate recovery of other segments of the broking industry will be less beneficial to Braemar than to Clarkson. Our estimates do suggest much slower earnings growth at Braemar compared to the remainder of the peer group.

Nevertheless, Braemar’s strong position in the tanker market, its above average exposure to South-East Asia and action taken to develop further its non-broking interests all point positively to the medium term outlook. The reduction in risk stemming from the diversification strategy, the cash-generative nature of the business and the well above average (1.3x covered) dividend yield are all important positive factors in assessing the shares.

The statement accompanying the FY16 results suggests broadly similar trading in the current year, but with confidence about the medium and longer term. Shipbroking markets remain difficult to assess; while there will be numerous new ships delivered in the current year, we sense that global oil demand will continue to edge higher, with the producers still keen to supply that need. Iranian oil will feature more prominently, while increasing Chinese demand, despite its economic slowdown, from the Atlantic Basin, may lift the number of long-haul charters. Elsewhere, there seems little sign of any improvement in dry markets, while we need to see more stability in oil markets before there will be any recovery in exploration activity. There are encouraging noises about accelerating demolition activity to potentially benefit the S&P business. We have decided to remain cautious in our shipbroking estimates, indicating a 9% profits fall in the current year.

The key to profits in Technology and Logistics is the speed with which last year’s new business initiatives start to deliver. Braemar Engineering has gaps in its order book, but other Technology division companies are all looking more optimistic; similarly, we are hopeful that Logistics will recover the ground lost in FY16 this year and move further ahead next year. Nevertheless, our earlier underlying pre-tax estimate of £13.9m for the current year is looking too high; we are cutting this to £13.5m and introducing an estimate of £14.0m for the year to February 2018.

Net cash increased by £2.0m to £9.2m over the year to February 2016. Cash generated from operations rose to £13.5m, of which tax and interest payments absorbed £3.1m and dividend payments totalled £7.6m. Capex of £2.2m was largely balanced by the exercise of share options (£0.4m) and exchange movements (£1.1m). With capex likely to be lower, there should be at least a similar increase in net funds over the current year.

Since the year end, the group has negotiated a new £30m facility with HSBC, comprising a £15m RCF and a £15m accordion facility. The strong balance sheet enables management to seek further bolt-on acquisitions, while maintaining the generous dividend.