Is Neptune Orient Lines Ltd’s Sale of Its Logistics Arm a Smart Move for Shareholders?

It’s Chinese New Year Eve today and shipping outfit Neptune Orient Lines Ltd (SGX: N03) seems to have given shareholders an early Ang Bao (a red packet usually given during Chinese New Year; it’s filled with money as a form of blessing).

Yesterday evening, the company had proposed a sale of its profitable logistics arm, APL Logistics, to Japan-listed Kintetsu World Express (KWE) for US$1.2b. Neptune Orient Lines had first mulled over a sale or spin-off of APL Logistics in August 2014.

The market seems to like the move, with Neptune Orient Lines’ shares up 3.0% to S$1.02 as of the time of writing (11:20 am).

At first glance, there are some positives with the sale, which is subject to shareholder and regulatory approvals:

  1. It allows the company to reduce its borrowings and strengthen its balance sheet (Neptune Orient Lines’ net gearing ratio is expected to be halved from 2.25 to 1.08 if the sale’s successful).
  2. It helps the company to unlock latent value in APL Logistics.
  3. And more importantly, it allows the company (in its own words) to “Focus on liner shipping.”

The first two are great for Neptune Orient Lines’ shareholders. The last- and arguably the most important reason – not so much. Here’s why.

A poorly performing business

Shipping is an industry where participants hardly have any pricing power. And when you get to businesses without pricing power, here are some of billionaire investor Warren Buffett’s choice words on the subject:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Neptune Orient Lines has also arguably not been running its liner shipping business in the best possible way as seen from the table below, which breaks out the company’s profits by business segment.

NOL liner and logistic segment profit

Source: S&P Capital IQ

2014 marks at least the fourth consecutive year in which Neptune Orient Lines has clocked losses in its liner shipping business.

A poorly-aimed focus

The intention of Neptune Orient Lines’ management to focus on liner shipping and channel any possible proceeds from the sale of APL Logistics to grow that business might just be a poor use of resources, in my view.

I say so because capital that’s put to use to grow a business in an ultra-competitive industry (where businesses within generally lack pricing power) is often capital that’s wasted. I’d quote Buffett again on the topic – this time, Buffett’s describing his experiences back when his investment holding company Berkshire Hathaway was still running a nondescript textile manufacturing operation:

“Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide.

Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”

Besides the potential for poor rates of return on the capital that would be invested in Neptune Orient Lines’ shipping business, there’s also the business dynamics to consider in the industry.

And in there, the outlook’s murky at best. Over-capacity remains a huge problem. As a tangentially-related sign of the times, the Baltic Dry Index (BDI), a key measure of shipping costs for commodities, reached an August 1986-low just earlier this month. Meanwhile, lower fuel costs – which can be a positive for Neptune Orient Lines and which has come with the recent collapse in oil prices – are at best, a temporary fix.

A Fool’s take

Given Neptune Orient Lines’ poor track record with its liner shipping business and the inherently poor economic characteristics found in shipping, the company’s sale of APL Logistics and the subsequent focus on shipping might not be the smartest move for shareholders.

But, things are always subject to change. For all I know, management might really have a master plan up their sleeves to turn things around at Neptune Orient Lines’ shipping arm.

Although, on that matter, Buffett’s wise quip below ought to be kept in mind:

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway.