Latest report in a multi-issue series covering value creation in transportation and logistics

INSOMNIA
Why challenges facing the world container shipping industry make for more nightmares than they should.
BY MERGEGLOBAL VALUE CREATION INITIATIVE

Get advanced copies of MergeGlobal reports by visiting www.americanshipper.com/TF2008

he container shipping industry has never been a good choice for executives who need regular sleep. Even in the best of times, operating a truly global busiThe MergeGlobal Value Creation Initiative comprises Brian Clancy, David Hoppin, John Moses and Jim Westphal. Clancy, Hoppin, Moses and Westphal are managing directors of MergeGlobal, a specialist firm that provides clients in the global travel, transport and logistics industries with services ranging from financial advisory to strategic consulting. This is the latest in a series of reports in which MergeGlobal will team with American Shipper for multi-issue coverage throughout 2008.

ness requires liner executives to roam the world, incurring far more than their fair share of jet lag and sleepless nights. These days, the lingering prospect of recession in the United States and Europe coupled with stubbornly high energy prices, and neatly coinciding with the delivery of super-sized

containerships ordered during boom times cant help their sleep patterns. During those long plane flights and regular bouts of insomnia, industry executives have plenty of time to ponder questions about the industrys future, including: How will the recent super-spike in energy prices impact consumer spending in the United States and Europe, global economic growth and the competitiveness of sourcing from Asia? If there is a downturn in global trade,

how are we going to fill the ever-larger containerships joining our fleet? Did we (and the rest of the industry) order too many big ships in pursuit of economies of scale? Moreover, if economies of scale are so important, how come certain smaller carriers seem to be consistently more profitable than the largest ones? Longer term, where can I make money in this business? Am I in the right markets, serving the right customers?

These are unsettled times for the world economy and by extension for the container shipping industry whose vessels serve as the floating conveyor belts that move most of the international merchandise trade. However, we also are mindful that humans (no matter how credentialed or experienced) are naturally prone to give more weight to recent events than we should when making judgments about the future. With the recency effect in mind,

Figure 1

Primary containerized ocean freight flows in 2007

Billions of laden FEU-Kilometers/a

North America Asia 43.2 96.8

Europe 10.9 9.1 5.6 9.8 10.5 9.2 3.4 10.7 Middle East 97.3 8.1 9.0 Africa Intra-Asia 54.0 Asia 119.6 43.2 96.8 North America

Latin America

Total flows shown: 497 Source: MergeGlobal SeaFlow model.

Note: a\ One FEU-kilometer represents a 40-foot ocean container transported one kilometer. A laden FEU is carrying revenue-generating traffic.

AMERICAN SHIPPER: JULY 2008

69

Value Creation in Container Shipping

Figure 2

Container shipping industry value chain and segment definition

Shipment origination, routing and capacity procurement Provide containers Provide and operate vessels Load and unload shipments Inland delivery\a

Key Activities

Customer sales Shipment routing Capacity procurement Customer service Billing Tracking Container carriers Forwarders / NVOCCs

Ownership of containers Storage and maintenance Repositioning

Ownership of vessel Operation of vessel

Terminal control (ownership or lease) Terminal operation Container handling

Control of trucks Ownership of railroads Container handling

Competitor types

Container carriers Container leasing companies

Container carriers Outsourced/ third party Dry leases Wet leases $102 billion 7%

Container carriers Captive terminal operators Third-party terminal operators $35 billion 11%

Railroads TL truckers Drayage truckers Container carriers (limited) $28 billion 7%

Total revenue Historical growth (Revenue 97-07 CAGR) Estimated ROCE\ b

$32 billion 10%

$8 billion 11%

50%

9%

3%

25%

34%

Notes: \a Defined as inland portion of itinerary purchased by customer (e.g., port gate to door); does not include transload market. \b ROCE = return on capital employed calculated at EBIT (earnings before intered and taxes) divided by net working capital plus book value of plant and equipment. Source: MergeGlobal analysis and estimates.

we offer a relatively sanguine assessment of the world containership industrys prospects. We will provide our answers to the above questions with supporting analysis and logic. We will also discuss implications for shippers, forwarders, carriers and other industry participants. Briefly, our views are: Consumption and production markets are resilient and will continue to adjust to an environment of higher oil prices relative to 2007. The International Energy Agency recently reported that it expects world oil consumption to grow a mere 0.9 percent in 2008 (compared to an expected 3.8 percent growth in real world GDP for the year, according to the International Monetary Fund). This suggests swift and generalized market adaptation to higher energy costs. While we offer no point estimates of future oil prices, we adopt the current U.S. Energy Information Administration outlook of relatively stable prices for the balance of the year, at about $130 a barrel. Thereafter, and as the global economy starts to climb back up to stable growth of 4.5 percent to 5 percent per year (which we believe will be achieved by early 2010), oil prices will rise steadily but at a much slower rate than seen in the first half of 2008. After weak growth in 2007 (and virtually nil growth in many North American
70 AMERICAN SHIPPER: JULY 2008

import trades), global container traffic, measured in FEU-kilometers, will continue to grow steadily at about 8 percent per year over the next two years (2008-2009). For the 10-year period starting in 2010 we expect traffic to grow at a rate of 6 percent per year, which we believe is close to the industrys sustainable long-term demand growth. This demand outlook reflects our belief that past patterns will repeat i.e., that post-World War II economic downturns have translated into brief declines in long-distance trade, followed by sharp recoveries and that both consumers and firms will adapt to higher fuel prices in ways that are less harmful to intercontinental trade growth than some predict. For example, available evidence suggests to us that many U.S. consumers are curtailing spending by foregoing services (e.g. restaurants, long-distance travel) rather than physical goods (e.g. clothing or toys from China). It may be a rough ride for many carriers over the next 24 months. Utilization rates will soften, especially in Asian export trades, but will be somewhat protected by many carriers decision to reduce steaming speeds in order to conserve fuel which has the beneficial result of constraining capacity growth despite the wave of newbuild vessel deliveries. Certain carriers will significantly underperform the industry, both in the

downturn and in the subsequent recovery. The root cause of these carriers poor financial performance is not big ships per se, but rather a failure to properly select and focus on specific market segments and customers therein. Global market share is of little value or meaning; the winners are those who achieve strong positions in specific trade lanes and end-customer segments. By the same token, the industry is likely to see a series of tuck-in acquisitions that add specific geographic or customer vertical industries to the acquirors portfolio, rather than large mergers of the Maersk-P&O Nedlloyd variety. Based on the above points, shippers will be partially shielded from the super-spike in energy prices, as softening utilization rates make it more difficult for carriers to pass on higher fuel costs. But within 24 months their transportation costs will rise (whether through base rates, BAFs or some other mechanism) to fully reflect prevailing energy prices.

Industry definition
The global container-shipping network is the backbone of intercontinental supply chains, carrying some 98 percent of intercontinental containerized trade volume and 60 percent of trade value (with the balance moving via air freight). We think the most meaningful way to measure demand and capacity is the concept

Value Creation in Container Shipping

Figure 3

Container shipping industry cost structure map

Shipment origination, routing and capacity procurement Provide containers Provide and operate vessels Load and unload shipments Inland delivery

14% 17%

100% 14% 17%

50% 4% 16% Key cost driver metrics Salesforce cost per shipment IT cost per shipment Customer service cost per shipment Container and maintenance cost per FEU per day Bunker cost per FEU-Km Vessel leasing and depreciation cost per FEU-Km Port costs per sailing Terminal handling charges per FEU loaded or discharged Rail cost per FEU-Km Drayage cost per FEU-Km Barge cost per FEU-Km
Variable

50% 4% 16%

Cost structure

Variable

Fixed Local Regional Global

Fixed Local Regional Global

Source: MergeGlobal analysis and estimates.

of 40-foot equivalent unit (FEU)-kilometers, representing one FEU transported one kilometer. In 2007, the global containershipping network transported almost 600 billion FEU-Kms of goods (see Figure 1 for a map of the most important trades). Interestingly, the largest trade based on this metric is Asia/Europe with 174 billion FEU-Kms, which represents 29 percent of global flows. The transpacific, with 140 billion FEU-Kms and 24 percent of global flows, is a close second. In terms of originated container shipments, intra-Asia still dominates with 19 million FEUs, but is only the third-largest container trade due to a much shorter average length of haul. What is more striking is the size of other trades relative to the Big 3, where the transatlantic is only 12 percent the size of Asia/Europe, and Europe/Latin America is 11 percent.

Industry value chain

The container shipping value chain, i.e., the activities required to move a container from shipper to consignee, comprises five discrete segments (Figure 2), which have been defined such that they approximate
72 AMERICAN SHIPPER: JULY 2008

standalone industry segments. We discuss the definition, resident competitor types and financial performance of each of these segments below. Our key measure of financial performance, from a value creation perspective, is segment return on capital employed (ROCE) defined as operating income divided by working capital plus net property, plant and equipment. We should note that, since the value chain segments are presented from the perspective of a container carrier, segment-level ROCE should roughly approximate that of pure-play service and capacity providers to the container shipping industry. For example, the best ROCE benchmark for the shipment origination value chain segment would be the freight forwarding industry segment. Similarly, the provide container segment should be compared to the container leasing and maintenance industry segment (the North America portion of this segment includes chassis as well, which typically are not owned by container carriers elsewhere). Finally, returns for the load and unload shipments and inland delivery segments

should roughly approximate those of thirdparty container terminal operators and intermodal marketing companies/truck brokers, respectively. Taken as a whole, the ROCE for the container shipping industry is the weighted average ROCE across the industrys value chain segments. We estimate this industry ROCE to be 12.2 percent in 2007. The first value chain segment (shipment origination, routing and capacity procurement) represents the shipping industrys retail level at which customers contract and pay for door-to-door transportation of their containers. The remaining four segments represent the industrys wholesale level at which transportation providers purchase specific services from each other. We allocated the industrys retail revenue to the downstream segments of the value chain based on estimated wholesale prices for the services provided. We estimate that the container shipping industry generated $206 billion in gross revenue last year, of which about half went to cover the cost of the actual ocean voyage, with the balance allocated to on-shore activities. There are a number of distinct com-

Value Creation in Container Shipping

Figure 4

Sources of economies of scale in the container shipping value chain

Shipment origination, routing and capacity procurement Provide containers Provide and operate vessels Load and unload shipments Inland delivery

Scale driver High local market share

Scale impact Enables facility scale (through high local throughput) Improves drayage buying power Lower unit cost of shared activities (e.g. IT, corporate G&A) Increased buying power for equipment/services purchased on a global basis Enables vessel economies of scale Improves buying power for line-haul services, including intermodal unit trains Lower sales and customer-facing IT costs Improves LCL profitability through mix of dense and voluminous freight Increases capacity utilization because of contra-seasonal demand patterns

High global market share

High origin and destination market share

High share of specific customer segment Customer/commodity mix

Opportunity for scale economies Source: MergeGlobal primary research.

Limited

Significant

petitor types in the container shipping industry, of which container carriers (also called liner companies) are both the most visible and most integrated across all five segments of the value chain. At the retail level, liner companies compete with freight forwarders for shippers business. Both competitor types commit to providing door-to-door transportation, but carriers use their own ships whereas forwarders rely entirely on other companies to actually move containers from origin to final destination. In theory, carriers have the advantage of guaranteed access to capacity during peak demand periods, whereas forwarders have the advantage of picking the best routings and carriers to meet each shippers requirements. In practice, carriers often buy space on each others ships, especially in markets where they lack sufficient traffic to support deployment of their own vessels, so the existence and amount of guaranteed capacity can be illusory. For their part, forwarders often are more focused on maximizing their near-term profitability by buying low and selling high than on providing the best possible service to customers. Returning to the first segment of the value chain, which we estimate generated about $32 billion in revenues in 2007, it is
74 AMERICAN SHIPPER: JULY 2008

worth pointing out that this segment has consistently achieved the highest return on capital employed of the entire value chain. At about 50 percent, the segments high ROCE reflects the fact that capital required for its underlying activities is limited to the occasionally owned facility, information technology and working capital to cover the timing difference between accounts payable and receivable. (For a more detailed discussion, see Forwarder Momentum, March American Shipper, pages 36-53.) The second value chain segment (provide containers) comprises the ownership, leasing and maintenance of containers and chassis (mostly in North America). There are some 11 million FEUs of containers used in container shipping operations globally, with 40-foot units comprising 66 percent of the fleet. Container carriers either purchase and maintain containers internally or outsource these services to third parties. In almost all cases, carriers have elected to pursue a mixed fleet strategy, where they lease and/or outsource the maintenance of a portion of their container fleet from third-party providers. We estimate that the industry spent $8 billion last year to provide and maintain its global container fleet and liner-operated chassis fleet. Growth in the container fleet

averaged 11 percent over the last decade and the segment earned an estimated 9 percent ROCE, reflecting the high degree of capital intensity. About 45 percent of the industrys container and chassis fleet is leased, with the remainder owned by carriers. The third party leasing market has gone through a lot of change over the last couple of years and has seen several companies go public, including Textainer, TAL and CAI. The third value chain segment (provide and operate vessels) comprises all resources and activities required to operate a ship from quay to quay. This includes: Providing ships either through direct ownership or leasing. Procuring and/or performing nonroutine maintenance and regularly scheduled dry docking. Operating ships with organic crews or outsourcing to crew leasing companies. Sourcing and fueling of vessels. Procuring harbor pilot services. Paying navigation charges. We estimate total revenues generated in containership ownership/leasing, maintenance and operations to be $102 billion in 2007. Vessel ownership/leasing and operations is a capital-intensive segment, as there were roughly 4,000 cellular vessels and

Value Creation in Container Shipping

Figure 5

Criticality of properly defining addressable market

Customer market shares within trade lanes Weighted average trade lane market shares
Transpacific Transatlantic Asia/ Europe

Weighted average market positions across industry

Maersk
Weighted average market share by trade lane

APL
Weighted average market share by trade lane

COSCO
Weighted average market share by trade lane

etc. Transpacific
Weighted average market share by trade lane Weighted average capacity share by customer end market

Industrial small Intermediate large Intermediate small

Consumer small

Transatlantic

Consumer large

Industrial large

Asia/Europe

Transpacific

Primary large Primary small

Food small

Food large

Freight forwarder

Evergreen

Maersk

COSCO

Market shares are measured within a trade lane, based on commodity and customer characteristics.

Weighted average trade lane market shares are combined (and weightaveraged) to arrive at a global weighted average market share.

Global weighted average market shares are compared across the industry.

Source: MergeGlobal analysis.

4.8 million FEUs of slot capacity available for deployment at the beginning of 2007 with a current replacement value of about $160 billion. During 2007 carriers and leasing companies were busy both ordering and receiving new vessels. According to BRS Alphaliner, more than 600 vessels were ordered in 2007 (which represents 1.8 million FEUs of slot capacity). By the end of the year, shipyards had delivered 400 vessels comprising 680,000 FEUs of slot capacity. Globally, container carriers own and operate about 48 percent of their slot capacity and lease the rest from ship charter companies. Several ship-leasing companies have gone public in the last few years, including Danaos and Seaspan. Similarly, container carriers have in certain cases decided to divest their ship-owning activities. For example, Global Ship Lease, a wholly owned subsidiary of CGM CMA, will merge with a special purpose acquisition company (SPAC) called Marathon later this year. The fourth value chain segment (loading and unloading shipments) comprises all activities that occur between quay and port gate. These include: Providing vessel berthing capacity. Loading and unloading containers from vessels. Transferring containers to staging
76 AMERICAN SHIPPER: JULY 2008

yards to await pick up. Loading containers onto on-dock intermodal unit trains. Checking containers in and out of terminal gates. There are three competitor groups for container terminal services: container carriers that self-handle equipment in organically operated terminals, third-party container terminal operators, and integrated port authorities that act both as landlord and as terminal operators. We estimate that 43 percent of terminal throughput is handled at carrier operated terminals, 54 percent by third-party operators and 3 percent by integrated port authorities. Globally, the container terminal segment generated $35 billion in revenues in 2007, either as a transfer price in the case of carrier-captive terminals or arms length transactions with third parties. The revenue growth has averaged 11 percent over the last decade and ROCE was an estimated 25 percent last year. The fifth value chain segment (inland delivery) covers the movement of containers from shippers to load ports, and from discharge ports to consignees. This is the least integrated part of the door-to-door value chain: container carriers control these activities but generally rely on independent firms to handle and deliver containers.

They thus perceive a higher segment ROCE relative to that of asset-based transportation companies. Competitor groups providing these services are local and national trucking companies, railroads and barge operators. Segment revenues were $28 billion in 2007 and have been growing at 7 percent per year since 1997.

Industry cost structure

When all of the industry segments are put together, as shown in Figure 3, it forms an illustrative door-to-door cost structure. About half of total costs are in quay-to-quay vessel operations, followed by terminal handling (17 percent) and shipment origination (16 percent). Cost drivers vary by segment particularly geographic but are generally either transaction- or volume/distance-driven. For example, shipment origination and terminal handling costs are throughputdriven and insensitive to distance, while vessel operations and inland delivery costs are related to equipment capacity and stage length. The other key characteristics of costs are their fixed/variable relationship and geographic location. The ratio of fixed versus variable costs is important because it determines the potential for economies

Hanjin

CSCL

APL

Value Creation in Container Shipping

of scale and degree of operating leverage within an activity or industry segment. Fixed costs are all costs that are insensitive to volume at a set output level and time horizon. In order to correctly define fixed versus variable costs, it is important to choose the right time horizon. On the one hand, on any given day or week especially in transportation services where capacity is perishable a significant portion of costs for a container carrier are fixed, because schedules are established months in advance and voyages take weeks to complete. On the opposite extreme, over an extended time period all costs are variable because vessels can be sold or eventually returned to the lessor. For our purposes, we have defined fixed costs, from the perspective of a container carrier, as costs that are not sensitive to volume and cannot be eliminated within any six-month to one-year window of time due to service commitments made to customers, contractual commitments made to suppliers, and other market rigidities. In the shipment origination segment most costs are variable and sensitive to volume levels within a range, because much of the cost is labor-related and its indivisibility is low (head count can be resized to match changes in volume). The fixed portion of this segment is information technology, facilities and overhead. Container leasing and repair has a high ratio of fixed cost due to the capital intensity of the equipment relative to the labor cost involved in managing and maintaining it; a container carrier must pay for these costs regardless of whether the container is empty or full. Vessel operations are roughly a 50/50 split between fixed and variable costs. Fuel represents half of this activitys total cost structure and it is sensitive to speed, voyages and port rotations (the latter can be altered in a six-month window while still maintaining service and contractual commitments). Container terminals have a high ratio of fixed costs because the cranes and facilities make up a significant portion of the cost structure and are incurred regardless of throughput when the terminal is carrieroperated. The cost profile becomes more variable if the carrier uses a third party that charges for each box handled, but still subject to volume minimums over a specific time period. Finally, inland delivery is a highly variable cost activity because most container carriers purchase these services on an as-needed basis in order to complete door-to-door itineraries. The geographic location of a cost pool is important because it determines the
78 AMERICAN SHIPPER: JULY 2008

Figure 6

Comparison of ROCE/a versus relative capacity share/b in 2007

40% 35% 30% 25% 20% 15% 10% ROCE 5% Maersk 0% -5% 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 2.0 Relative capacity share in main trades (logarithmic scale) /c Note: /a Return on capital employed (ROCE) is defined as the estimated EBIT (earnings before interest and taxes) for each carriers container business segment, divided by the estimated capital employed (net working capital plus book value of plant and equipment) of each carriers container business segment. Estimates made by MergeGlobal. /b Relative capacity share (RCS) represents the weighted average of each carriers share of its respective market segments. RCS is calculated in terms of available FEU-Km based on ComPair Data analysis of published schedules for 2007 and MergeGlobal analysis. Capacity on alliance services is allocated to member carriers on a pro rata basis. /c - Defined as transpacific, Asia/Europe and transatlantic. Source: MergeGlobal analysis from ComPair Data. Figure 7 Carrier revenue
$10 billion $5 billion

APL Evergreen Hapag CSCL OOCL Hanjin NYK Hyundai MOL

Container shipping strategic options matrix

Small/medium APL Focused on highest value direct customers; customers low forwarder exposure Specialized itineraries Emphasis on customer service Specialized equipment Service guarantees Focus on reliability and visibility Customer service (billing accuracy, track/trace, single point of contact) Zim CSAV Focused on specific geography Cost leadership Sacrifice schedule reliability for lowest cost position and Large direct shipment visibility customers; Economies of scale heavy forwarder exposure Focus on specific trades

Customer focus

Maersk Generic service Focused on line-haul Lane concentration Cost leadership

Geographic focus

Broad, global network

Note: Upper right-hand quadrant is not a viable strategy, as there are not enough small and medium sized shippers to support a global network. Source: MergeGlobal analysis.

Value Creation in Contaner Shipping

Figure 8

Primary intercontinental containerized trade flows in 2007: Relative segment size

Billions of laden FEU-Km
Customer classification: Commodity grouping Shipper type Large Medium / Small All Transpacific trade Asia/ N.A. 25 N.A./ Asia Asia/Europe trade Asia/ Europe Europe/ Asia Transatlantic trade Europe/ N.A. N.A./ Europe Comments
Dominated by department stores and big box retailers Mid- and small-sized shippers control fewer than 1,000 FEU/year (fewer than 20/week) Beverages such as beer and wine and specialty food are particularly important in EU/North America market Dominated by increasingly complex subassemblies Increasing reliance on freight forwarders Includes low unit value commodities shipped as backhaul filler freight Includes only containerized portion of primary commodity trade Schenker, DHL, and K+N are strongest in Asia/Europe trade; Expeditors has the biggest market share in the transpacific

Consumer (e.g., apparel, consumer electronics, furniture)

10 6 3

0.4

0.2

8 1

0.3 3

0.5 2

0.3 1

0.2 0.5

Food (e.g., refrigerated and nonrefrigerated food, beverages)

Industrial (e.g., machinery, components, professional equipment)

Large Medium / Small All

8 4 19

1 0.5 17

8 4

0.6 0.2

0.4 0.1

Intermediate (e.g., textiles, chemicals, metals) Primary (e.g., agricultural, minerals)

10 3

9 2

All

Freight forwarder

29 13

76

36 6 4

Key Total: 97 43 120 54 11 Source: MergeGlobal sea freight flow model and MergeGlobal primary research. 9

2007 market size

$20 billion $5 billion

ability to generate scale economies and related cost sharing. The complication is that segments with a high degree of local costs can only derive scale benefits at that location. Segments comprising activities with a high degree of location-independent costs, and for which processes can be standardized, can generate significant scale economies. Shipment origination costs are mainly regional because sales force, customer service and administration resources are typically located on a regional basis. If the company has a single integrated IT platform, it can spread these costs across global volumes instead of volume specific to a region. Container fleets are a global cost because they can be deployed anywhere with relative ease, but maintenance is local and specific to a depot. Vessel operation costs are more regional in nature because ships are deployed on specific routes. A route may connect two or more regions, and within each region pair there is a collection of origins and

destinations. Certain variable costs within vessel operations are local because they are incurred at specific ports. Container terminal costs, in comparison, are very local, with the exception of port operating companies that spread corporate overhead across multiple terminals. Lastly, inland delivery is mostly local and unique to specific origins and destinations.

Industry economies of scale

Economies of scale i.e. declining cost per unit as volume increases do not occur uniformly across a companys business as it grows larger. Rather, scale economies usually arise in specific areas of the business (or parts of the value chain, in consultant-speak), and at different levels of geography (local/regional/global), for a variety of specific reasons. Figure 4 depicts where and why certain scale economies occur in the container shipping industry. For example, local market share is an important driver of economies of scale in terminal operations and drayage. Having a

high share of volume originating in and/or destined for a local market lowers container terminal costs per unit by enabling larger, more efficient and more intensively utilized facilities. By the same token, high local market shares can reduce drayage costs per box because the container carrier has more loads to offer drayage companies on a given day and in a specific area. Cost segments that benefit from high global market share or firm size include IT (primarily used in shipment origination), corporate overhead (across all segments) and procurement of resources purchased or leased on a corporate level (like containers and ships). Unique to transportation is the concept of origin and destination (O&D) market share, which produces traffic density on an intercontinental route where the O&Ds use the same ocean leg. High O&D market share enables carriers to operate larger vessels that naturally enjoy lower per-slot costs than smaller ships. It also lowers capacity procurement costs on ocean routes where carriers purchase
AMERICAN SHIPPER: JULY 2008 79

Value Creation in Container Shipping

Figure 9 Figure 10

Historical average revenue and volume growth in major headhaul market segments
2001-2007 CAGR

Forecasted average revenue and volume growth in major headhaul market segments
2007-2012 CAGR

Global
18% 16% USD revenue growth 14% 12% 10% 8% 6% 4% 2% 0% 0% 2% 4% TA
Average: 11.1%

Global A-E
Revenue growth in % 16% 14% 12% 10% 8% 6% 4% 2% 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% FEU-Km volume growth
Average: 8.4%

18%

TP
Average: 10.6%

TA

A-E
Average: 6.2%

TP

6% 8% 10% 12% 14% 16% 18% FEU-Km volume growth

18% 16%

Transpacific

18% 16% Revenue growth in % 14% 12% 10% 8% 6% 4% 2%

Transpacific
Average: 6.9%

USD revenue growth

14% 12% 10% 8% 6% 4% 2% 0% 0% 2% 4%

Average: 10.8% Average: 10.1%

Average: 3.8%

6% 8% 10% 12% 14% 16% 18% FEU-Km volume growth Consumer - mid/small Consumer - large Food Freight forwarder Industrial - mid/small Industrial - large Intermediate Primary

0% 0%

2%

4%

6% 8% 10% 12% 14% 16% 18% FEU-Km volume growth

2007 market size

$10 billion $5 billion

Note: Revenue includes port-to-port transportation and terminal handling, and is gross of bunker adjustment factors. Trades and trade segments above the diagonal line are characterized by rising unit prices; those below the diagonal line are characterized by decreasing unit prices.

Source: MergeGlobal sea freight flow model.

slot capacity, and on intermodal routes where they have sufficient lane density to guarantee railroads and trucking companies bi-directional loads. Having high shares of specific customer types enables spreading of domain-specific intellectual capital across more customers. This resource helps lower shipment origination and inland delivery costs, particularly where customization of services for an industry segment is high. A final scale driver is the customer and commodity mix. Carriers with a balanced mix of customers with different seasonal shipping patterns can improve vessel and container terminal utilization by increasing
80 AMERICAN SHIPPER: JULY 2008

the year-round average load factor. In the case of less-than-containerload services, profitability can be enhanced by having a balanced mix of voluminous and dense shipments in the same container.

Market position determines profitability

It makes intuitive sense that scale drivers improve container carrier profit margins by enabling economies of scale, as argued above. It is crucial, however, to quantify these drivers in a meaningful way. Scale drivers are best quantified as a carriers weighted average market share across

specific markets relative to that of other carriers, a concept that is commonly referred to as relative market position. When carrier specific demands are not available, it is possible to use O&D capacity shares, weighted for utilization and customer segment participation, to arrive at a carriers relative capacity position. While it sounds simple, the definition of a market in container shipping can be tricky because it is defined across several dimensions, including geographic (O&D), customer type and commodity type. For example, a properly defined market could be that of large shippers (say, above 1,000 FEUs shipped per year) of consumer goods in the transpacific. Why is

Value Creation in Contaner Shipping

Figure 9 (continued) Figure 10 (continued)

Historical average revenue and volume growth in major headhaul market segments
2001-2007 CAGR

Forecasted average revenue and volume growth in major headhaul markets

2007-2012 CAGR

Asia/Europe
18% 16% USD revenue growth 14% 12% 10%
Average: 11.5% Average: 16.4%

Asia/Europe
18% 16% USD revenue growth 14% 12% 10% 8% 6% 4% 2% 0% 0% 2% 4%
Average: 9.8% Average: 9.0%

8% 6% 4% 2% 0% 0% 2% 4%

6% 8% 10% 12% 14% 16% 18% FEU-Km volume growth

6% 8% 10% 12% 14% 16% 18% FEU-Km volume growth

16% 14% USD revenue growth

Transatlantic

18% 16% USD revenue growth 14% 12% 10% 8% 6% 4% 2%

Transatlantic
Average: 4.6%

12% 10% 8% 6% 4% 2% 0% -2% -2% 0

Average: 2.4% Average: 7.6%

Average: 8.6%

2%

4% 6% 8% 10% 12% 14% 16% FEU-Km volume growth Consumer - mid/small Consumer - large Food Freight forwarder Industrial - mid/small Industrial - large Intermediate Primary

0% 0%

2%

4%

6% 8% 10% 12% 14% 16% 18% FEU-Km volume growth

2007 market size

$10 billion $5 billion

Note: Revenue includes port-to-port transportation and terminal handling, and is gross of bunker adjustment factors. Trades and trade segments above the diagonal line are characterized by rising unit prices; those below the diagonal line are characterized by decreasing unit prices.

Source: MergeGlobal sea freight flow model.

this a proper market definition? Because it is consistent with the scale drivers illustrated in Figure 4: a strong position along those drivers should improve profit margins and ultimately create value. In a global relative market position calculation, the numerator should include a carriers global weighted average market share in its relevant (i.e., properly defined) markets, and the denominator should be the share of the carrier with the highest weighted average share (in the case of the largest player, the denominator should be the share of its closest competitor). Figure 5 provides an example of how

we calculate segment-specific shares, use those to obtain a carriers weighted average market share and, when compared to that of other carriers, finally arrive at carrier relative market position. This matters because, other things being equal, the higher relative market position a carrier has, the higher its profitability. As Figure 6 demonstrates, there is a strong connection between carrier market position and return on capital employed. With the exception of one outlier, profitability increases with relative market position because high share of specific markets leads to lower costs at higher service levels.

That is, high relative market positions are associated with profit margin expansion and satisfied customers. The most significant outlier, Maersk, reflects the profit impact of a poorly executed merger and does not lead to a broad conclusion about negative returns to scale. The key point is that bigger is not better overall, but that bigger is better in properly defined markets.

Strategic options for market position

Now that we have established the correlation between value and strong market
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Figure 11

Key assumptions by trade route, 2007-2012

Transpacific GDP Macroeconomic growth factors\1 Consumer spending Business investment Demand growth\a Trade factors Supply growth
\a

Asia/Europe 2.3% 2.3% 3.7% 9.8% 12.4% (9.0%) (0.7%) neutral

Transatlantic 2.7% 2.9% 3.1% 4.6% 3.7% 3.4% 3.8% positive

Intra-Asia 4.4% 3.8% 5.8% 7.9% 5.8% 7.6% 2.7% slightly positive

All other 2.5% 2.6% 3.5% 6.2% 7.6% (3.8%) NM NM

2.7% 2.9% 3.1% 6.9% 8.0% (3.7%) (2.8%) slightly negative

Load factor growth Financial factors Pricing\a Impact on EBITDA margin

Note: \a - Compounded annual growth rates (2007-2012) of headhaul destination region (e.g., North America for Transpacific trade) . Macroeconomic factors expressed in real terms (net of future inflation) NM Not measured Source: U.S. Commerce Department, Bureau of Economic Activity; Economist Intelligence Unit; MergeGlobal freight flow forecast; Containerisation International.

position, what are the strategic options a carrier can consider to improve its position (Figure 7)? The objective is for a carrier to construct a portfolio of markets where it is able to achieve high relative shares. In some cases, this means avoiding certain market segments altogether because it is too difficult to build a profitable competitive position. The trade-offs a carrier must make refer mainly to geographic focus and customer focus. It is important to remember that these trade-offs are not binary, but must be defined in terms of varying degrees of concentration. Geographic focus involves network scope (ports served), scale (relative allocation of slot capacity across a network) and the number and types of O&D itineraries offered to customers (port-to-port versus portto-railhead mix). Customer focus defines

which customers will be targeted within the specific O&Ds served. Carriers can seek out the largest customers in a specific O&D, or medium and smaller customers. The trade off is that targeting large customers requires less marketing and sales effort, but it also means lower prices due to customer buying power. Focusing on small and medium customers requires more marketing and sales resources, but should generate volumes with higher average prices. Deciding how much forwarder volume exposure a carrier wants is another key trade-off. Forwarders are direct competitors with carriers and are particularly adept at capturing small and medium sized accounts (forwarders control a majority of the less-than-containerload market segment). Carriers with small sales forces tend to rely

Our forecast assumes that energy prices remain fairly constant for the balance of 2008 and then trend to normal growth levels of about 15 percent per year within two years.
more heavily on forwarders than carriers with larger sales forces able to compete for lucrative small and medium-sized accounts. Broadly, there are three market positions available to carriers: Focused geographic scope combined with small/medium customer emphasis (e.g., APL). Focused geographic scope and broad customer mix (e.g., Zim). Broad geographic scope and emphasis on serving larger customers (e.g., Maersk). Carriers have the option of building their market positions by growing organically or by acquiring other carriers. Organic growth often requires ordering new ships to establish presence in new geographic markets. Examples of carriers that used mergers and acquisitions in 2007 to add niche market positions to their network portfolio include: CMA CGM bought Cheng Lie Navi-

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Figure 12

Primary containerized ocean freight flows: 2002-2017

Billions of laden FEU-Km
7.5% 798 749 695 8.2% 593 547 470 400 63 31 66 42 10 59 6 122 02 03 04 05 06 429 503 97 43 120 54 11 9 97 162 07 08 09 10 11 644

Forecast

5.8% 1,062 998 947

1,125 168 90 Legend EB Transpacific WB Transpacific 260 WB Asia/Europe EB Asia/Europe WB Transatlantic 100 07-12 CAGR 6.9% 8.6% 9.8% 6.8% 4.6% 7.9% 7.9%

895 850 135 65 191 75 143

16 17

EB Transatlantic Intra-Asia

10 6

199

Other intercontl flows 5.7% x% 5-year CAGR

214 12 13 14 15 16

276

17

Source: MergeGlobal sea freight flow model.

gation (Taiwan) to provide an intra Asia network. CMA CGM also purchased U.S. Lines to create a strong market position in the U.S./South Pacific trade. CMA CGM consolidated its position in the Moroccan market by acquiring Compagnie Marocaine de Navigation, which has 40 percent local market share. Hamburg Sud acquired Costa Container Lines to further consolidate its dominance of Europe/Latin America trades and add an intra-Mediterranean feeder network to build economies of density.

shored (we addressed this topic in detail in the June 2007 American Shipper, pages 8-21). The reason is that containerships are extremely fuel efficient when compared with other modes of transportation.

Consider the example of a shipment from a factory near Shanghai to a distribution center in Atlanta versus a factory in Guadalajara, Mexico. The Shanghai-Atlanta fuel cost is roughly $700 per FEU, including

Relative attractiveness of markets

Picking the right markets to build a defensible competitive position requires perspective. Carriers must identify not only long-term structural factors that will determine the size and shape of the global supply chain, but also understand how the industry cycle will likely behave over the next decade. Skyrocketing energy prices have led some analysts to the conclusion that there will be a reversal in globalization and that companies will rethink their decision to source products in Asia and bring manufacturing back to North America and Europe in order to reduce transport costs. Our view is that the total landed cost of products with high labor content sourced in Asia for consumption in North America and Europe is still lower than that of products sourced locally or, in many cases, nearAMERICAN SHIPPER: JULY 2008 83

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truck drayage, at todays marine bunker and truck diesel prices. A truck carrying the same shipment from Guadalajara to the same distribution center in Atlanta requires $811 of fuel per FEU, a difference of $111. At $200 per barrel of oil, the fuel cost from Shanghai rises to $1,075, while the cost from Guadalajara shoots to $1,250, for a difference of $175 per FEU. Trucking is simply more energy intensive than container shipping. The other factors affecting relative total landed cost, mainly manufacturing labor and the cost of capital, still favor sourcing from Asia, especially China and Vietnam. In our view, production networks will continue to shift and Asia will remain the worlds factory for at least the next two decades for products with high labor content. Since raw materials and high-value/low labor content products never were candidates for offshoring, these segments will remain the basis of containerized exports from the United States and Europe.
Figure 13

Capacity utilization and freight rate development in major trade lanes, 1998-2012
Transpacific
220

Headhaul utilization Headhaul rate index Backhaul utilization Backhaul rate index

Forecast 200 180 Freight rate index 160 140 120 100 80 60 98 99 00 01 02 03 04 05 06 07 08 09 10 100% 90% 80% 70% 60% 50% 40% 30% 11 12 Utilization rate index Utilization rate index Utilization rate index

Historical performance
Annual volume in the three largest intercontinental trades grew an average of 10.6 percent, and revenue increased 11.1 percent per year, from 2001 to 2007. The transpacific and Asia/Europe trades, which will continue to benefit from consumer spending-driven imports, offer a wide mix of customer segments to target (Figure 8). The transatlantic trade is a question mark, since its anchored by two high-cost manufacturing centers in North America and Europe, and is experiencing considerable change in its industrial geography amid weekly announcements of factories relocating to Asia. This market is the most mature among the larger trades and will likely be a tough market in which to generate profitable returns. Since the last downturn in 2001, the Asia/Europe trade has been the fastest growing market in terms of FEU-Kms and revenue (Figure 9). The largest absolute increases in volume were generated by freight forwarders and direct shipper consumer product flows from Asia to Europe. Intermediate materials and components and food were the two fastest growing customer segments in the transpacific trade for the same time period.
220 200 180 Freight rate index 160 140 120 100 80

Asia-Europe
100% Forecast 90% 80% 70% 60% 50% 40% 30% 20% 11 12

60 98 99 00 01 02 03 04 05 06 07 08 09 10

Transatlantic
220 Forecast 200 180 Freight rate index 160 140 120 100 90% 80% 70% 60% 50% 40% 30% 20% 11 12 100%

Forecast
In the near term, we expect the U.S. economy to recover in 2009 and grow modestly over the next decade, averaging 2.7 percent per year. Europes economy will grow slightly slower at 2.3 percent per year, while Asia will be the fastest growing with
84 AMERICAN SHIPPER: JULY 2008

80 60 98 99 00 01 02 03 04 05 06 07 08 09 10 Source: MDS Transmodal, MergeGlobal analysis and estimates.

Value Creation in Contaner Shipping

4.4 percent real growth (Figure 11). Global container traffic, measured in FEU-Kms, is forecast to grow at 6.9 percent over the next decade. Growth in the next five years will average 7.5 percent per year, compared to 5.8 percent per year from 2012 to 2017, as the largest markets become mature and as certain product categories reach their maximum import substitution potential (Figure 12). Among the big three head haul intercontinental trades, we expect Asia/Europe to be the fastest growing, averaging 9.8 percent in volume and 9.0 percent in revenue growth over the next five years (Figure 10). We estimate Europe is about five years behind the United States in terms of large-scale shifting of production to Asia and thus has more import growth potential relative to the transpacific trade. To use a baseball analogy, the United States is in the sixth inning of network shift while Europe is in the fourth inning. Forwarders will be the fastest growing customer segment in the Asia/Europe market and will continue to take direct shipper business away from container carriers. Eastbound transpacific market volumes will grow slower than Asia/Europe, at 6.9 percent per year, and revenue even slower at 3.8 percent per year from 2007 to 2012. But similarly to the Asia/ Europe trade, forwarders will be the fastest growing customer segment within the transpacific. The bad news is that supply growth in both the Asia/Europe and transpacific will exceed demand growth from 2008 to 2010 (Figure 13). The subprime crisis and its impact on consumer spending and imports could not have come at a worse time since the industry is in the middle of adding a record number of post-Panamax vessels. This capacity addition will undermine carriers ability to increase rates enough to fully offset higher fuel costs, with the consequence that profit margins will be squeezed significantly from 2008 to 2010. We forecast that it will take until 2011 for the market to fully absorb the extra capacity and cause rates to rise again. Obviously, rates that have a North American intermodal leg in the itinerary will be more resilient because rail capacity is relatively tight compared to ocean capacity. There are multiple risks to this forecast, both to the upside and the downside. The two leading risks seem to be energy prices and inflation. Our forecast assumes that energy prices remain fairly constant for the balance of 2008 and then trend to normal growth levels of about 15 percent per year within two years. However, if energy prices were to continue climbing during 2008, the outlook becomes darker for consumer spending and general economic growth in oil-consuming countries, with negative implications for merchandise import growth. Paradoxically, our forecast for ocean freight rates would rise due to the pricing discipline imposed by high energy prices. The converse would be true if energy prices were to fall or grow less rapidly than assumed. The risks from inflation are all to the downside. Our forecast assumes that future inflation rates are about 1-1.5 percentage points above the levels experienced in 19982007, and that central banks in developed countries are not forced to react with interest-rate hikes that reduce future economic and trade growth.

Conclusions
We were not known for wild optimism during the boom years indeed, some of our previous forecasts assumed economic slowdowns that never seemed to arrive. By the same token, we have tried to deliver a balanced view of the current economic troubles and their likely impact on the global containership industry. Still, there are likely to be many more sleepless nights for industry executives in container shipping.

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