Neptune Orient Lines (NOL) Competitive advantage undervalued

• Assume coverage with OW: We are assuming coverage of
Neptune Orient Lines (NOL) with an Overweight rating. We
believe the market is undervaluing NOL’s significant cost
advantage and strong Trans-Pacific market share. We view this
combination of strengths as a potential protection of earnings
during a slowdown in global trade or excess capacity supply.
• Compellingly cheap: NOL’s valuation is compellingly cheap,
which reflects the market’s bias against the company due to its
limited capacity growth over recent years, in our view. NOL has
15 vessels on order for 2008, which should rectify this constraint.
In the interim, NOL’s slow growth has driven superior yield
increases, which can extend further, especially while it maintains
structurally lower cost than its peers. This cost advantage arises
from its US railway contracts, which expire in 2012, while other
carriers are suffering 20-30% cost increase every three years.
• Additional catalysts for the share: These could be any asset
disposals, M&A stories, or a privatization bid from its principal
shareholder, Temasek.
• PT and risks: Notwithstanding a 105% increase in the share price
since January 3, 2007, NOL is trading at a 50% discount to its
2007E EV/EBITDA multiple compared to its peers, which, in our
view, is unjustified. Our Dec-07 PT of S$5.50 is based on 4.7x
Dec-07E EV/EBITDA multiple. The risks to our PT include a
slowdown in the US economy.

Investment thesis
Positives
Industry leadership
NOL is the eighth-largest carrier in the world in terms of volume. It has a strong
brand associated with quality service and IT innovation. NOL is widely viewed as
having the best logistics capability among its peers, which helps it to secure a huge
market share of a large group of top customers, such as Target Store and Nike. NOL
also has a strong intra-Asia market share based on its original business—before the
APL acquisition. The company ranks third in our KPI scorecard.
Cost advantage in US Intermodal
The company’s US railway contract runs through to 2012, which is something of a
legacy issue for NOL. This gives the company a major cost advantage over its peers,
which are being hit with 20-30% cost hikes on their US inland freight contracts every
three years. In our view, NOL’s cost advantage, coupled with its premium service on
the Trans-Pacific trade, should be more than enough to overcome the relatively
slower growth in the Trans-Pacific trade.
High-margin business
Importantly, NOL has the highest revenue per TEU among our peer group, with a
gross profit margin that is second only to OOIL. As a result, NOL can generate
amongst the highest profit per TEU.
Negatives
High overheads
In 2006, NOL’s overheads amounted to 10% of revenues, second only to OOIL in
terms of high overhead costs in our coverage universe. We note that OOIL, Wan Hai,
and NOL have relatively the highest fixed overhead costs and conclude that good
management resources do not come cheap.
High off-balance-sheet items not really a concern
NOL has 58% of its tonnage on charter, which along with its attractive, long-term
terminal leases, constitutes 91% of its US$5.7-billion non-cancelable lease
obligations outstanding at end-2006. The market is currently strong for shipping
services and we remain confident that NOL should be able to trade out of these
future obligations at zero cost to the company, if not on a favorable net basis. We do
not believe that this risk exposure should be included in deriving NOL’s fair
valuation.
This risk would only really become a concern in the next major downturn. Having
said that, NOL’s level of chartered-in capacity is not materially different from the
majority of companies in our coverage universe. Hence, we do not see this factor as a
competitive disadvantage for the company.
Ambiguous objectives for its logistics business
NOL has always wanted to be a global logistics giant but we are not convinced that
management has put in sufficient resources to let this division develop beyond an
experimental venture. The balance sheet of the logistics business shows total assets
of US$297 million with US$46 million as equity, which is far from comparable to
any of NOL’s global logistics peers.