[Member] Making a Macro Case for International Shipholding Corporation (ISH)–Part 1

After 1 and half years of keeping some of these shipping stocks in the watch list, the time is now come to start a position in the sector. However, it is still not very clear how much longer the shipping cycle will stay down, so we will start with a shipping company that is relatively less exposed to the large carrier glut, has mostly medium to longer term charters, and is financially strong enough to be an opportunistic acquirer of cheap accretive assets when most other companies in the sector are struggling to stay afloat.

Another reason to consider International Shipholding (ISH) is that the economic environment that it operates under is quite different from most other shipping companies. Where other shippers may lose money, ISH can generate a profit because it operates under the auspices of Jones Act (for the most part). Before we go into details of the stock, it is important to understand what Jones Act is, since it has a bearing on the current and future operations of the company.

Jones Act of 1920

At its very basic, the Jones Act specifies that any ships operating between US ports are required to follow all US maritime and labor laws, operate under US Flag, use ships that are built in US of US materials and labor, and employ a crew made up of US citizens or permanent residents. This means, these ships cannot employ a crew from poorer countries and are required to pay wages above the minimum wage. These make these ships expensive to operate, however competition is not a problem since most Global shipping operators and international flag ships are in effect blocked from operating on the US shipping lanes.

Jones Act was passed to protect US shipping industry as it was and is still believed that shipping is a major strategic industry from a national security perspective. Occasional waivers are issued in periods of emergencies (for example, hurricanes Sandy and Katrina) for foreign relief ships to operate within US ports, however these are always temporary. No administration has made any serious attempt to repeal the Jones Act, despite it being a clearly protectionist measure.

Needless to say, any Federal shipping contracts, for defense or otherwise, are exclusive to the ships operating under Jones Act. So are the trade routes between Hawaii, Alaska and the US mainland.

For more information on Jones Act, see this Wikipedia article

How Does this Alter the Industry Dynamic?

Remember we are in middle of a deep shipping downturn due to a glut of new-build ships, that is taking time to work off. Charters operating on the spot rate are losing money as the spot market prices are not enough to cover the operating costs of the ships. However, most ships that operate under Jones Act have the following characteristics:

  1. The charters are mostly medium to long term contracts so they have been locked in at rates better than the spot market
  2. Because the ships are required to be build in US with US labor, they are expensive. Consequently, most Jones Act ships are older and the supply of new ships that qualify under Jones Act is not very high. Therefore the shipping glut is less pronounced.
  3. Customers therefore deal with less supply and the industry is protected from global competition and the rates have stayed firm

To summarize, there are barriers to entry and competition in this market and while these companies are unlikely to profit tremendously when the spot rates start climbing, they are also unlikely to go bust when the global markets are under duress.

A Macro Case for International Shipholding

International Shipholding, based in Mobile, Alabama, operates a diversified fleet of US and International flag vessels that provide international and domestic maritime transport services to commercial and government customers. The company is organized under 5 segments: Time Charter Contracts – U.S. Flag, Time Charter Contracts – International Flag, Contracts of Affreightment (“COA”), Rail-Ferry Service and Other. About 20% of the revenues are from the International Flag segment while the rest come from domestic operations. The US Flag segment comprises of the vessels operating under the Jones Act and make up for a little over 50% of the revenues.

Essentially, the majority of the company’s revenues and income is protected while it still has an exposure to International flag operations and the spot market. This gives us a downside protection when the global shipping industry is suffering, such as now, and an upside when the shipping industry cycles up, which is likely to occur in 2013. The company has continued to operate profitably for the last 10 years and while they have always traded at a discount to the industry (Price to Book averages 50% of the industry P/B in the last 10 years, currently at 55%), it is important to note the following:

  1. Industry Price to Book ratio is currently overstated, by as much as 100% or more, due to the fact that the ships that are currently being carried on the books are worth less than half in the market, and,
  2. The book value of the US built ships that ISH typically owns has NOT eroded since these ships continue to be in short supply. Also the company typically owns medium size fleet (Handymax) while the glut is more pronounced in the larger size ships (Capesize)

On an operating level, the company has done a few smart acquisitions as well as disposed off some of the assets at profit in the recent years. As a result, the average age of the company’s fleet is about 9 years, which is considerably better than the rest of the industry and gives them lower operating costs. ISH has also selectively expanded its service portfolio to further improve its gross margins and operating costs.

Why Now (as opposed to 6 months ago or a year ago)?

There are 3 reasons:

  1. Jones Act is protectionism and makes the shipping costs higher for the Federal government than they would be in a perfectly competitive environment. As we debate spending cuts and controlling deficits in the US, the 4 year extension provided to the current Presidency makes it unlikely that Jones Act will be repealed in the next 4 years. We do not talk politics, but it is important to take note of it when necessary.
  2. The company is acquiring US United Ocean Services LLC, which is expected to close anytime now. This adds 2 additional medium/long term charters with long standing customers and when this acquisition closes, it should be accretive to the earnings very quickly
  3. It is hard to place a bet on commodities, but I expect the fuel prices to ease up in the coming years that should bode well for the operating margins

In Part 2, I will deep dive into the business, look at the valuation of the stock and set a purchase price and sell price targets. It will be posted soon so keep an eye out for it (I will send an alert when it is up).