Risk assessment for shipping and shipbuilding industries

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1 Risk assessment for shipping and shipbuilding industries May 18, 2010 Contents I. Gauging risks for the shipping and shipbuilding sectors Why there is a need to assess the risk level for the shipping and shipbuilding industries 2. The year 2010 is a turning point in the government s policy support 3. Shipping and shipbuilding conditions: Robust newbuilding orders during the boom created a snag 4. Shipping and shipbuilding sector restructuring 5. KAMCO s shipbuilding fund management 6. What lies ahead? Restructuring risk is greater for the shipbuilding sector than shipping Why there is a need to assess the risk level for the shipping and shipbuilding industries According to the credit risk evaluation of 41 conglomerates conducted by creditor banks, three conglomerates, Hyundai Group, Seongdong Shipbuilding and SPP Shipbuilding, are reportedly added to the list of companies in need of financial reform. The three conglomerates have a shipping or shipbuilding business as a core unit. The year 2010 is a turning point for policy support The government s support programs introduced in the wake of the global financial crisis will soon fade out. The fast-track resolution program was extended once to last until end-june Lenders support program for the construction industry will vanish in end-august Numerous companies will probably suffer financial troubles in the course of removal of the support programs. Robust newbuilding orders during the boom created a snag Despite better industry conditions, Korea s two biggest shipping companies are compelled to reform their financial structures by creditor banks. For the shipbuilding industry, there is a wide gap in financial conditions between top-tiers like Hyundai Heavy and mid- to low-end companies. We attribute this to robust newbuilding orders seen during the boom period. Falling ship prices are unfavorable for ship financing because the loan-to-value ceiling is usually set at 80%. The shipbuilding sector learned from past market slumps and put legal safeguards into place against contractual breaches by ship owners. But shipbuilders avoid taking legal actions even though buyers fail to make progress payments due to the tight market conditions. If a default is declared against the ship operator, it would cause collateral damage to the shipbuilder as well. Small to midsize shipbuilders with heavy debt burdens, little cash holdings and limited chances of business diversification are under intense financial pressure. Jung Brum Lhee jblhee@truefriend.com Na-JungOh Jungoh.na@truefriend.com Risk will unfold differently As the used ship market works normally, there is a way for ship owners to beat oversupply woes. The government expressed its willingness to support the shipping sector. The Korea Asset Management Corp. or a shipping fund established by the Korea Development Fund should continue extending financial support to ship owners. Even if restructuring sweeps across the shipping sector, it would help market players to regain self-sufficiency, rather than weeding out uncompetitive firms. Unlike the shipping sector, shipbuilding overcapacity is not an issue that can be addressed by an individual player. We cannot rule out the possibility that some small to midsize shipbuilders will be left to perish.

2 I. Gauging risks for the shipping and shipbuilding sectors 1. Why there is a need to assess the risk level for the shipping and shipbuilding industries Creditor banks likely to add three firms from the shipping and shipbuilding industries to the financial reform list Need to check the risk level in the shipping and shipbuilding industries According to the credit risk evaluation of 41 conglomerates conducted by creditor banks, nine are reportedly needed to sign an MOU on financial structure reform in Earlier in 2009, 10 conglomerates signed the reform agreement with their major creditor banks and six of them, such as Kumho Asiana, Dongbu, Aekyung, Taihan Electric Wire, Eugene and Hanjin groups, have reentered the category in Three other conglomerates, Hyundai, Seongdong Shipbuilding and SPP Shipbuilding are newly added to the reform list. We believe Hyundai Group may be ruled out during the final review but, at present, it is on the reform list due to earnings erosion at major affiliates, including Hyundai Merchant Marine (HMM). The addition of Seongdong Shipbuilding and SPP Shipbuilding were probably because of the weakened financial structure amid the shipbuilding slump. We note that the three conglomerates newly added to the reform list all have a shipping or shipbuilding business as a core unit. At this point, we believe it is worth assessing the level of risk embedded in Korea s shipping and shipbuilding industries. 2. The year 2010 is a turning point in the government s policy support Measures to support SMEs will fade out Since the advent of the global financial crisis, the government viewed the construction, shipbuilding and shipping sectors as the most vulnerable financially and thus has encouraged restructuring and provided aggressive support. The fast-track resolution program is the best-known support solution. Under the program, effective October 2008, creditor banks carried out credit evaluations and graded struggling small and medium enterprises (SMEs) from A to D. Banks were intended to render immediate financial support to companies rated A and B and to force C-grade companies to enter a debt-workout program. D-grade companies were to be liquidated. In particular, creditor banks categorized all SMEs running construction and shipbuilding businesses into four groups and led them to restructure or offered a helping hand. The fast-track resolution program was extended once to last until end June Lenders support programs tailored to the construction industry will fade out in end-august That is, the financial environment will return to normal in 2010 as the emergency measures adopted to clean up the mess caused by the global financial crisis will come to an end. 0

3 Major economic policy directions in 2010 Extension of SME loans Debt guarantee (outstanding) (new) Core business support (exports, green and venture) Guarantee limit Long-term, large-amount guarantee Fast-track resolution program Bridge loan guarantee for construction projects Bond Market Stabilization Fund Bank Recapitalization Fund 1H10 To continue to extend the due date of the entire loans (Marginal companies loans will be extend selectively) 95% 90% Different by credit rating (50%-85%) To apply 95% debt guarantee Maintain a maximum guarantee limit of W10bn To follow more lenient guideline To levy additional guarantee fees To continue To halt management To halt additional purchases To halt additional purchases Source: Financial Superverisory Commission, Korea Investment & Securities 2H10 Determined by each institution 95% 85% To consider adjustment depending on economic conditions in 2010 To return to normal (1/2-1/4 of sales 1/3-1/6 of sales) To fade out The year 2010 will be a turning point as emergency support will be withdrawn Numerous companies are likely to face challenges Sungwon Corp. and Daewoo Motor Sales were placed under court receivership or entered debt workout programs, probably because they found it difficult to pay existing debt as the emergency measures were being gradually scrapped. As aforementioned, Hyundai Group led by HMM and Seongdong Shipbuilding and SPP Shipbuilding are on the reform list. It could be viewed as a preemptive measure before the large corporations possibly suffer financial troubles in the course of the removal of support programs. Companies will face challenges, no matter big or small, as the year 2010 will be a turning point where the government s post-crisis policy support is scrapped. For instance, real estate PFs, for which refinancing is unavailable, should emerge as a problem at nearly all construction sites and a company s recovery from financial troubles will depend on if it has a financial buffer. 3. Shipping and shipbuilding conditions: Robust newbuilding orders during the boom created a snag Despite better industry conditions, leading shipping companies are in need of financial structure reform A wide gap exists between top- and lower-tier shipbuilders Korea s two biggest shipping companies, Hanjin Shipping and HMM, already signed or will probably sign the reform agreement with creditor banks. Most shipping companies turned to an operating profit in 1Q10 backed by rising maritime freight rates. Newbuliding prices are on the rise as well. Nonetheless, leading shipping and shipbuilding companies are in need of financial reform led by creditor banks, not on their own, implying that both industries are still exposed to significant risks. For the shipbuilding industry, leading companies like Hyundai Heavy and Samsung Heavy, the risk of financial shortfall caused by tightening liquidity is fairly low. In contrast, the coffers of mid- to low-end dockyards like Seongdong Shipbuilding and SPP Shipbuilding appear to be nearly empty. That is, there is a sharp dichotomy in financial conditions between top-tiers and mid- to low-end companies. 1

4 Robust newbuilding orders during the boom period created a snag Financial troubles in the shipping industry as a whole and at lower-tier shipping companies are the result of the massive newbuilding orders seen during the shipping industry s unprecedented boom in the mid-2000s. Newbuilding prices have dropped about 30% from the level seen in mid Faced with financial difficulties, some shipbuilders have opted to bite the bullet and slash prices by half. Newbuilding price trend Secondhand ship price trend (p) (p) 200 Newbuilding Price Index 350 All Ships Secondhand Prices Index Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 0 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Source: Clarkson, Korea Investment & Securities Source: Clarkson, Korea Investment & Securities Falling ship prices are unfavorable for ship financing Falling ship prices add to the financial woes of shipping companies as well as shipbuilders. For shipbuilders, their profitability is under heavy pressure because the cost burden is mounting due to rising steel prices while newbuillding prices are declining. For shipping companies, a significant portion of their orders placed during the boom period are still under construction while ship financing conditions are tightening because of falling ship prices (ships are used as collateral). The loan-to-value (LTV) ratio is the key lending criteria for ship finance like real estate mortgage loans. The LTV ceiling is usually set at 80%. That is, if collateral or a ship is worth 100, the maximum loan amount that can be borrowed is 80. If the market price of a ship falls 30% below the newbuilding contract price, which was set during the boom period, additional collateral is required to fill the gap. Given that most of the fleet is already taken out as collateral, it is difficult to put up operating vessels as a security. Unless additional collateral is furnished, it may trigger the acceleration of maturity for the portion of loans that exceeds the loan-to-value limit. Moreover, ship owners should struggle to generate profits from high-cost vessels. Financial squeeze should exacerbate for the shipping sector, especially those who placed large-scale shipbuilding orders. Newbuilding orders and portion of project financed orders Hanjin Shipping Hyundai Merchant EuKor Car STX PanOcean Korea Lines SK Shipping Marine Carriers Total Credit standing A/Stable A/Stable A/Stable BBB+/Stable A/Stable A/Stable - No of orders (ship) Contract value (USD10mn) % of newbuilding orders financed by project loans % 46% BV of a ship (USD10mn) Newbuilding contract price/bv 75.3% 4.9% 101.0% 162.5% 62.5% 33.3% 63.3% Note: No of newbuilding orders include those issued by overseas subsidiaries or share of joint investments Source: National Information & Credit Evaluation ( Shipping Earnings and Outlook Forum held on Feb 23, 2010) 2

5 Shipbuilders have safeguards against contractual breach But legal actions would bring about unwanted repercussions Small to midsize shipbuilders are vulnerable due to their lack of a cash buffer and difficulties in business diversification The shipbuilding sector learned from the past market slumps and put legal safeguards into place against contractual breaches by ship owners. Nevertheless, the shipbuilding sector is no better than the shipping sector in terms of short-term liquidity. The shipping sector s financial stress reaches the shipbuilding sector. Even if buyers fail to make progress payments due to the tight market conditions, shipbuilders would refrain from taking legal actions. Financial hardships are not limited to an individual ship owner but pervasive across the shipping sector. If a default were declared against the ship operator, it would cause collateral damage to the shipbuilder as well. As such, the shipbuilding sector has no choice but to offer price discounts or delay the delivery for the ship owner. It is estimated that only 67% of the newbuilding projects was delivered as scheduled in Due to a lackluster order inflow combined with delivery delays, major shipbuilders departed from their net cash position in 2009 and turned to net debt position. After that, they fast accumulated debts. Major shipbuilders should be able to cope with market slump thanks to their business diversification and abundant cash holdings. But due to the absence of such countermeasures, small to midsize shipbuilders will probably feel a financial crunch. Total loans of major shipbuilders 15,000 10,000 (W bn) Total loans Cash & cash equivalents Net debts 5, ,000-10,000-15,000 Dec-06 Dec-07 Dec-08 Dec-09 Jan-06 Jan-07 Jan-08 Jan-09 Source: Major builders include Hyundai Heavy Industries, Samsung Heavy Industries, Daewoo Shipbuilding & Marine, Hyundai Mipo Shipyard, Hyundai Samho Heavy Industries, STX Offshore & Shipbuilding Source: Company data, Korea Investment & Securities Supply/demand conditions bode ill for the market outlook The market should remain bleak until 2012 due to a 10% increase in laid-up ships back in service and 30% or more growth in new deliveries. 4. Shipping and shipbuilding sector restructuring Full-scale restructuring in 2010 when the financial market normalizes The shipping and shipbuilding sectors share one problem oversupply. An increase in newbuilding orders continues to be the market s Achilles heel. We believe market restructuring is a must, not an option. The shipbuilding sector has undergone restructuring to overcome the latest global financial market crisis, but we do not believe it was drastic enough. Small to midsize shipbuilders slashed newbuilding prices to get emergency cash and thus further aggravated the market slump, which is attributable to insufficient restructuring. The government has voiced its commitment to normalize the financial market in 2010 and this signals the beginning of full-scale restructuring in

6 Shipping restructuring: more focus on self-sufficiency, but Shipbuilding restructuring cannot rule out drastic measures weeding out the weak Shipbuilding funds help finance shippers but are insufficient to perk up shipbuilders Given that the used ship market works normally, we believe there is a way for a ship owner to beat oversupply woes if price is not an issue. The government has expressed its willingness to support the shipping sector. The Korea Asset Management Corp. (KAMCO) or a shipping fund established by Korea Development Bank (KDB) should continue extending financial support to ship owners. Even if restructuring sweeps across the shipping sector, it should help market players to regain self-sufficiency, rather than weeding out uncompetitive firms. Unlike the shipping sector, shipbuilding overcapacity is not an issue that can be addressed by an individual player. Small to midsize shipbuilders are sandwiched between heavy debt burden related to their capex spree in the mid-2000s and payment delays by ship owners. As part of self-rescue efforts, they are seeking to sell some of their shipyards to major shipbuilders but without much success. We cannot rule out the possibility that some of these players will be left to perish. In principle, financing shippers through shipbuilding funds is supposed to have a spillover effect to bolster shipbuilders. In reality, however, full support for shippers is not achievable and thus helping cash-strapped shipbuilders is way out of reach. In Korea, the state-run KAMCO and KDB set up and manage shipbuilding funds. As KAMCO mainly deals with ships in operation instead of new-build ships, most of the raised capital does not go into the coffers of shipbuilders. 5. KAMCO s shipbuilding fund management Shipbuilding funds are not a panacea for the financial strains Only 30% of the W1trn ceiling was raised in KAMCO s first fund raising Shipbuilding funds have some limitations in addressing all of the financial strains of shippers. First, ships on the shipbuilding funds are traded on a market value. But due to the recent sharp price falls, shippers are finding it difficult to make a profit. Second, shippers usually make loans to buy vessels and they are seeing their ship prices fall before they settle their ship financing. KAMCO has bought ships by raising shipbuilding funds twice so far. The first one was managed during a set period of time and only dealt with ships in operation. The price of a ship was set at an average presented by Clarkson Research and a Maersk Broker and was financed by KAMCO s restructuring funds (40%), private banks such as Foreign Exchange Bank and Hana Bank (20%) and seller s credit (40%). But participation in the fund raising was not aggressive as private banks have no buffer against unexpectedly large losses when ship prices fall and sellers were depressed by the low ship prices. As a result, the raised funds totaled a mere W282bn, or 30% of the W1trn ceiling. Except for one ship owned by Hyundai Merchant Marine, all the capital was used to buy Hanjin Shipping s vessels. Support for shipping industry restructuring (KAMCO s first fund raising) (USD mn) Ships Market value Senior bank loans Restructuring funds Seller s credit 17 vessels from two shippers 20% 40% 40% Note: Seller s credit is for guarantee of selling. Source: Korea Investment & Securities 4

7 Inclusion of new-build ships and KAMCO s higher leverage in the second fund raising The government s financial backing for shipping industry is stronger than for than any other sector The ceiling for the second fund raising by KAMCO was lifted to W4trn and the fund is managed on a permanent basis. KAMCO s leverage through restructuring funds has risen to 60% from 40% per vessel (the remaining is raised by private banks and sellers) and the shopping list was expanded to include new-build ships in the pipeline. Since the initiation of the second fund, five vessels have been bought for a total price of W137bn. Ships in operation still carry a market price tag while new-build ships in the pipeline are priced at a discount to reflect the market price, not the price at order placement. Given that new-build ships are subject to mark-to-market valuation, financial support for shippers appears limited. Nevertheless, the government s financial backing for the shipping industry appears more supportive than for any other sector. It is because the industry is considered to be strategic for the national economy and financial risks have spread so far across the industry that even leading players are not free from risk. KAMCO s aggressive purchase of Hanjin Shipping s vessels, the industry s flagship company, in its first fund raising reinforces the notion that the top-tier shippers as well as mid to small shippers are in trouble. 6. What lies ahead? Leading shippers are unlikely to struggle given continuous financial backing; but SME shipbuilders may be liquidated We expect the shipping and shipbuilding industries to remain precarious for the next two to three years. As for the shipping industry, leading players are unlikely to become financially distressed thanks to scanty but steady financial backing. It is also true for leading shipbuilders but may not be the case for smaller shipbuilders. SME shipbuilders are not eligible for full financial support as their idle facilities need restructuring. If they fail to reinvent themselves, they may face liquidation risks. The contents of this report accurately reflect the analyst s views. Under no circumstances were there any external pressures or intervention during the analysis process or the preparation of this report. This report was written by Korea Investment & Securities Co., Ltd. to help its clients invest in securities. This material is copyrighted and may not be copied, redistributed, forwarded or altered in any way without the consent of Korea Investment & Securities Co., Ltd. This report has been prepared by Korea Investment & Securities Co., Ltd. and is provided for information purposes only. Under no circumstances is it to be used or considered as an offer to sell, or a solicitation of any offer to buy. We make no representation as to its accuracy or completeness and it should not be relied upon as such. The company accepts no liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. The final investment decision is based on the client s judgment, and this report cannot be used as evidence in any legal dispute related to investment decisions. 5

8 HEAD OFFICE WON-JAE RHEE, Executive Managing Director ) PAUL CHUNG, Sales Trading ) 27-1 Yoido-dong, Youngdeungpo-ku, Seoul , Korea Toll free: US HK SG Fax: ~3 Telex: K22966 NEW YORK DONG KIM, Managing Director (dkim@kisamerica.com ) ELAINE AN, Head of Sales (Elaine@kisamerica.com ) JU KIM, Sales (jukim@kisamerica.com ) Korea Investment & Securities America, Inc. 400 Kelby Street, 11th Floor Fort Lee, NJ USA Fax: HONG KONG STEVE KIM, Managing Director (steve.kim@kisasia.com ) SANGME LEE, Managing Director, Head of Asia Sales (sangme.lee@kisasia.com ) JEONGHEE LEE, Sales (jeonghee@kisasia.com ) DAN SONG, Sales (dan.song@kisasia.com, ) Korea Investment & Securities Asia, Ltd. Room Suite 2110 Jardine House 1 Connaught Place, Central, Hong Kong Fax: SINGAPORE SUNG NAMGOONG, Managing Director (snamgoong@truefriend.com ) TERRY SHIN, Sales (terryshin@truefriend.com ) Korea Investment & Securities Singapore Pte Ltd 1 Raffles Place, #43-04, OUB Center Singapore Fax: LONDON JJ MOON, Managing Director (jamesmoon@kiseurope.com ) PACO LEE, Sales (pacolee@kiseurope.com ) BRANDON JUNE, Sales (brandonjune@kiseurope.com ) Korea Investment & Securities Europe, Ltd. 2nd Floor, 35 Moorgate London EC2R 6AR Fax: Telex: This report has been prepared by Korea Investment & Securities Co., Ltd. and is provided for information purposes only. Under no circumstances is it to be used or considered as an offer to sell, or a solicitation of any offer to buy. While all reasonable care has been taken to ensure that the information contained herein is not untrue or misleading at the time of publication, we make no representation as to its accuracy or completeness and it should not be relied upon as such. This report is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on this report and the company accepts no liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. This report is not intended for the use of private investors All rights reserved. No part of this report may be reproduced or distributed in any manner without permission of Korea Investment & Securities Co.,Ltd.

Hyundai Mipo Dockyard (010620)

Hyundai Mipo Dockyard (010620) Company Brief / Shipbuilding & Machinery April 19, 2010 BUY (Maintain) Price target (12M): W190,000 Stock Data KOSPI (Apr 15) 1,744 Stock price (Apr 15, won) 154,000 Shares