At the peak of the business cycle, the only way is down

Few industries are as cyclical as the container shipping sector, and China Cosco is coming to market at the very top of its business cycle.

That will not unduly trouble the management of China's largest shipping company. According to bankers close to the deal, the institutional tranche of Cosco's initial public offering was fully covered by the end of business on Monday, the first day of the roadshow.

By the time Cosco's executives have swung through Singapore, London and New York, the $9.5 billion to $12.9 billion deal should be comfortably oversubscribed.

Cosco's lead managers, HSBC, JP Morgan and UBS, are pitching the company as a direct play on China's growth as a trading economy. With businesses from container manufacturing, to terminals to freight-forwarding, Cosco offers services along the whole freight chain, which bankers contend places the company head and shoulders above pure shippers such as CSCL or OOIL.

To bolster investor confidence, Cosco has enlisted the usual parade of big-name corporate investors, and to sweeten the deal further, it has promised to pay out as much as 35 per cent of this year's earnings in dividends. According to projections by HSBC, that will mean a windfall of at least $624 million for investors in the first year.

Nevertheless, Cosco is carrying some uncomfortable risks. Although the syndicate banks are stressing the breadth of the company's businesses, Cosco still made 79 per cent of its net profit last year from plain old container shipping. For the past couple of years, this has been a great business to be in as soaring demand after China's 2001 accession to the World Trade Organisation sent freight rates skyward, more than doubling Cosco's earnings last year.

Owners have rushed to order more ships, and today half as many container ships are being built as are already at sea. For the biggest vessels, which can carry 4,000 or more 20-foot containers, the ratio is even higher, at 78 per cent. Next year, global container shipping capacity will grow by more than 14 per cent, according to Drewry Shipping Consultants.

The worry is that much of this new capacity will be launched just as trade growth begins to soften. The Organisation for Economic Co-operation and Development's widely-followed composite leading indicators fell for the fourth consecutive month in April to enter negative territory, pointing to a slowdown in economic activity ahead.

Drewry forecasts that demand growth for container shipping will slow to 8 per cent next year, from 12 per cent this year and 13 per cent in 2004. Shipbrokers in Hong Kong say freight rates are already beginning to slide, and even Cosco's investment bankers admit that the company's margins are going to be squeezed.

Excess capacity and slackening demand are not the only concerns. Like most shipping companies, Cosco is highly leveraged and vulnerable to rising interest rates. With its dependence on demand for Chinese exports, yuan-denominated costs and foreign currency revenues, Cosco's earnings are also more exposed than those of most companies to any appreciation of the Chinese currency.

The company's position in the market still makes it an attractive long-term investment, but Cosco is a company at the peak of its business cycle. Investors may well want to consider whether its stock will be an even better buy in two years.