Hapag-Lloyd: Getting a Second Wind
At first glance, one might assume the global container shipping industry would be thriving due to rapid globalization over the past decade and the recent decline in the price of oil. However, over the past 10 years, this industry has been plagued with unattractive cost structures and unprofitability. Several factors have contributed to this dismal outlook: weak demand, intense competition, and an industry-wide overcapacity problem.
Hapag-Lloyd, the fifth largest industry player in terms of capacity, feels these effects acutely. The company’s 2016 revenues totaled €7.7 billion, yet the company failed to turn a profit in four of the last five years. For Hapag-Lloyd to achieve long-term profitability in light of the industry-wide issues, the company needs to recognize how it can improve its cost structure and outcompete its rivals.
Red Sky at Morning
Companies in a commoditized industry can do little to shelter themselves from the effects of the economy; they must try to mitigate economic downturns while fully capitalizing upon growth periods. In the container shipping industry, the cyclical nature of global trade results in fluctuating demand and freight rates. With low differentiation amongst competitors in a commoditized industry, Hapag-Lloyd is in a challenging position.
Increasing international division of labor and productivity gains within the industry allowed the container trade to grow at an average rate of 8.2 per cent between 1990 and 2010. The attractiveness of the market influenced the leading players to increase their ship sizes and capacity to take advantage of economies of scale, effectively reducing unit costs and solidifying their market dominance. The trend initially started with Maersk, which began placing orders for ‘ultra-large’ container ships—those with capacity greater than 15,000 twenty-foot equivalent unit (TEU), a measure of shipping capacity. The industry followed with the expectation that the global container trade would continue experiencing double-digit growth. However, the 2008 recession struck unexpectedly, causing trade to fall and leaving companies with significant overcapacity. Given the excess capacity and commoditized nature of the industry, shipping rates tumbled and the Shanghai Containerized Freight Index, a measure of relative cost of container shipping, plummeted from a high of 1,500 in 2012 to 772 in 2018. The drastic change to this industry has ushered in a new era where traditional shipping companies must adapt or perish.
Current Strategic Routes
Hapag-Lloyd’s motto centres around its continued transformation into a “bigger, younger and more efficient” shipping company, explicitly communicating the company’s desire to establish itself as a low-cost producer. The company anticipates that larger ships, with fewer fixed costs per unit of shipping capacity, will help it achieve better long-run margins should global demand recover post-2020. However, in the short-term, financial performance is likely to suffer: the greater fixed costs of larger ships are not offset by volume and margins fall below that of competitors. In the near future, average global freight rates in major trade routes are likely to remain depressed, resulting in lower top-line growth for Hapag-Lloyd.
To address the short-term supply-demand imbalance, the industry has trended toward consolidation. Hapag-Lloyd is no exception, given its mergers with CSAV and UASC—two powerhouse shipping companies dominating the Latin American and Far East trade routes—in 2014 and 2017 respectively. The spread between global shipping supply and demand implies that by 2020, the industry will see consolidation and competition between the top 10 players intensify.
Despite the current trend of consolidation in the industry, this is not a sustainable strategy for Hapag-Lloyd. As of the third quarter of 2017, Hapag-Lloyd had incurred total debt levels of 20.1 times EBIT and net debt levels of 16.7 times. With debt-to-capital adjusted for operating leases of 59.7 per cent and interest coverage of 1.1 times, Hapag-Lloyd is reaching beyond its optimal capital structure. As such, to maintain balance sheet health and flexibility, Hapag-Lloyd needs to deliver cost efficiencies through means beyond mergers and acquisitions.
Shipping companies which charter vessels between two fixed points do not pay for the ship’s fuel. When shipping demand is high, vessel owners can raise chartering rates to reflect any increases in the cost of fuel and effectively pass off this cost to the chartering party. However, when oil prices start to rise in an industry riddled by overcapacity issues, the fierce competition amongst vessel owners makes it difficult to pass costs.
The four largest shipping companies—Maersk, MSC, CMA CGM and Cosco—do not own most of their ships but instead outsource an average of 63.8 per cent of their capacity. In an environment rife with overcapacity, these companies realize savings as vessel owners absorb rises in the cost of fuel. In contrast, Hapag-Lloyd owns just approximately 50 per cent of its ships. This is aligned with the company’s desire to become a bigger and more efficient producer but means that any changes in the price of fuel directly impact the profitability of Hapag-Lloyd’s operations. For example, over the first three quarters of 2017, freight rates increased by 2.2 per cent while the cost of raw materials and supplies, including fuel, increased by 78 per cent.
Hapag-Lloyd thus benefits proportionally more from reductions in fuel costs and is uniquely positioned to take advantage of opportunities that other companies may be reluctant to pursue. In the current competitive environment, chartering companies realize little benefit from reducing their fuel consumption and have no incentive to apply new technologies to their ship. The industry has a traditional mindset, and while executives are interested in fuel-saving technologies, they do not want to take the risk of piloting innovations on a large scale. Competing on cost is especially important in the commoditized business, but for those willing to invest in technology, a solid business case can be made for doing so.
Flettner Rotors: Setting Sail
Within clean technology, the most attractive option is taking advantage of wind power in the open ocean. Wind speeds are greater over the open ocean than over land due to reduced friction from a lack of mountainous regions, trees, and human-made structures that cause resistance to wind flow. This opportunity is prominent in the Atlantic, Hapag-Lloyd’s second largest trade route and a region which yields the highest revenue per trade. By utilizing wind power to propel its fleet alongside traditional methods such as diesel engines, Hapag-Lloyd can lower its fuel consumption, increase margins, and become competitive in the long-run.
Clean technology, namely Flettner rotors, can be used to reduce fuel consumption. Flettner rotors are 18 to 30-metre rotor sails that rotate around their vertical axis. When wind passes the spinning rotor sail, the air flow accelerates on one side and decelerates on the opposite side and, as a result of the well-studied Magnus effect, a thrust is generated in the direction perpendicular to the wind flow. This thrust allows the engines to be throttled back; adopting the technology could cut fuel consumption on global shipping routes by an estimated 10 per cent. Since 2010, four Flettner rotors have been used by the wind turbine manufacturer Enercon on its E-Ship 1. In conjunction with other innovations like a streamlined propellor and rudder, Enercon has realized fuel savings of up to 25 per cent. However, Enercon has decided not to commercialize the Flettner rotors, with the E-Ship 1 used solely to transport wind turbines using global
Norsepower, a Finnish startup backed by European Union programs, has been improving Flettner rotor designs and preparing them for commercial usage. Fuel costs have been proven capable of being reduced by 5 to 20 per cent without lowering the operating speed of the ships. These rotors can be installed in new ships or retrofitted on existing ships, and thus could be implemented in Hapag-Lloyd’s vessels. Estraden, a ship retrofitted with two 18-metre rotor sails in 2014, was verified by NAPA, a maritime data analysis, software and services company, and VTT, Finland’s Technical Research Centre. The Flettner rotors on Estraden resulted in fuel consumption reduction of 6.1 per cent, saving the company $200,000 and 400 tonnes of fuel annually. In favourable wind conditions, each sail can produce upwards of 3 MW (3,000 kW) of power using only 50 kW of electricity, a multiple of 60 times.
Impact on Hapag-Lloyd
The required Flettner rotors for Hapag-Lloyd would be 30 metres in height and cost around €800,000 each to retrofit on existing ships. Hapag-Lloyd owns just under half of the ships they operate, 15 per cent of which are efficient ultra-large container ships that were put into service recently by UASC. The efficient ultra-large ships provide the necessary economies of scale for Hapag-Lloyd, and so the Flettner rotors would be better suited for the remaining 85 per cent, or 90 ships, that are less efficient. The number of Flettner rotors per ship depends on their size; to retrofit the entire 90 ships, a total of 194 Flettner rotors would be required at a cost of approximately €155 million. This retrofit could be accomplished within two years of contract signing.
By looking at comparable ships such as the Estraden and P-Class LR2 tankers, which weigh approximately 100,000 deadweight tons, Hapag-Lloyd can expect to achieve savings of three to five per cent per 30-metre rotor sail. By applying this benchmark to the 90 ships which would each be retrofitted with one to three Flettner sails, the average fuel cost per retrofitted ship is expected to fall by 14 per cent. This would generate €3.3 billion in savings over 25 years, the average life of the ships. The compounded annual return on investment is projected to be 12.9 per cent, surpassing Hapag-Lloyd’s 8.2-per-cent cost of capital.
Flettner rotors also benefit Hapag-Lloyd given the current regulatory environment; the International Maritime Organization (IMO) has implemented a global container fuel sulphur limit of half a per cent mass by mass, effective January 1, 2020. Container ships typically run on bunker fuel, comprised of residual hydrocarbons from the petroleum refining process; 84 per cent of Hapag-Lloyd’s current fuel mix is high in sulphur. IMO’s incoming 2020 sulfur cap could impose total annual costs of around $5 billion to $30 billion for the container shipping industry, based on Organisation for Economic Co-operation and Development (OECD) reports. The rise in the cost of fuels associated with the transition away from sulphur will amplify Hapag-Lloyd’s potential savings from using Flettner rotors.
When considering the implementation of this new technology, given that the container shipping industry is such a traditional one, at least some degree of resistance from Hapag-Lloyd’s leadership team is to be expected. It is true that the Flettner rotor technology has not yet been widely adopted by other leading container shipping companies; players have been reluctant to engage in risky ventures on a large-scale. However, Flettner rotors have been shown to be effective and Hapag-Lloyd has the opportunity to differentiate itself from its competitors.
Christening a Breakthrough
The container shipping industry has been relatively traditional, until recently when new innovations started materializing to reduce fuel consumption. The risk-averse mindset of the industry has prevented large players from engaging in risky ventures on a large scale, but Hapag-Lloyd is uniquely positioned to realize benefits from reduction in fuel costs. If economies of scale are achieved with the Flettner rotors, Hapag-Lloyd has the opportunity to realize savings of up to 30 per cent across its entire owned fleet, amounting to approximately €300 million in annual savings. In an industry as competitive as the global container shipping trade, the difference between success and failure can be as small as a few million euros; an extra €300 million could redirect a company’s course towards becoming an industry leader.