INDUSTRY EVALUATION
Industry Overview – what is it?

The present development of the Chinese shipbuilding industry follows a similar pattern to what had happened earlier in Japan and Korea. Japan used its shipbuilding industry in the 1950s and 1960s to rebuild its industrial capability, while Korea saw shipbuilding as a strategic core for its economic development in the 1970s. China is now also taking that development path by taking full advantage of the demand shift towards centres of low cost production, and making full use of its low cost advantage and large domestic demand to build a solid industrial foundation.

This appraisal of industry will draw on the key comparables between Korea and China, the two key players in the Shipbuilding Industry.

The development of the Chinese shipbuilding industry is often compared to the development of the industry in South Korea, but the conditions for the process of development differed considerably. While, the South Korean shipbuilding industry was aimed from the outset at producing vessels for export, in contrast the economic strategy in China has initially been to develop shipyard capacity to sustain domestic economic development. In other words, the substantial construction of shipbuilding capacity in China has primarily been aimed at enabling China to be self-sufficient in sea transport. Above all, from the Chinese perspective, the supply of raw materials for domestic manufacturing, meeting the food needs of its populations and the transport of exports should to the extent possible be undertaken by Chinese built ships. However, China has for some decades actively explored the international market, and the trend in the mix of vessels being constructed indicates that the share of that market captured by Chinese shipbuilders is continuously increasingly.

From 2000, South Korea had the world’s number one shipbuilding industry until China surpassed Korea in new orders and order book in 2009, and in completions in 2010. Korea’s shipbuilding industry had a hard time with the financial crunch and decreased orders. Meanwhile, the Chinese shipbuilding industry, which had been expected to suffer due to their large new investments, was financially supported by the Chinese government.

The fact that Korea was overtaken by China in completions means that China outpaced Korea in shipbuilding capacity. China’s shipbuilding capacity increased 15.8 times from 2000 to 2010. The increase is attributed to the facts that, in addition to private shipyards, three major state-run shipbuilding bases, built by China State Shipbuilding Corporation (CSSC) and China Shipbuilding Industry Corporation (CSIC), were completed and began operation.

Global demand for new shipbuilding orders plummeted, but has shown stuttering signs of recovery. Current demand is much smaller than facility capacity, which had expanded to meet surging demand during the shipbuilding boom. This means that overcapacity will become a major issue in the near future.

The below tables extracted from JP Morgan markets report 8 May 2012 are provided by Clarkson, an independent shipping research house and show new orders in China and South Korea. It is evident in both that orders peaked around 2007 and have fallen off since. China did see resurgence in 2010 to 11 however order levels have again fallen. Please note the scale on the axis as South Korea has a higher peak.

Backlogged orders from the shipbuilding boom still under construction

After 2000, the global shipbuilding market had ups and downs before reaching its peak in 2007, and then plunging in the aftermath of the global financial crisis.

The global shipbuilding order book increased, partially due to speculation. Financially distressed ship-owners postponed delivery of the ships they had ordered in the boom years because they were unable to secure time charters. Therefore, shipbuilding periods were prolonged. For this reason, ships ordered in the boom years even now still under construction. Because of the large backlog, the global shipbuilding industry has been insulated to a potential oncoming crisis. Due to recent postponements of deliveries, there have been significant discrepancies between contracted delivery times and actual delivery times for every ship type. “Just-in-time” delivery had been an important factor in determining shipyard competitiveness.

In 2009, bulk carriers, which had a high rate of speculative orders, had a 31.8% difference between planned delivery time and actual delivery time. Container ships, which were last to recover from the decrease in global shipping volume, had a 41.6% difference.

Worsening overcapacity

Until the first half of 2008, excess demand in the global shipbuilding market drove up marine freight rates. At one point, second-hand vessels were more expensive than new vessels under construction. In a heated competition, major shipbuilding countries rushed to expand their facilities. Construction of some of these facilities has been suspended, but most has continued. As a result, shipbuilding capacity has increased. This expansion is expected to spur high overcapacity rates in the future.
Completions in the global shipbuilding market peaked in 2010, when the volume of orders from the shipbuilding boom years were most concentrated. Since then, completions have decreased and will continue to dwindle.

This is another reason for overcapacity. Shipbuilding tonnage is expected to decrease until the shrinking order volume returns to normal rates and becomes stable. The overcapacity rate is expected to rapidly increase from 7.7% in 2010 to 24.3% in 2015, according to Clarkson Research. On the other hand, Clarkson estimates that effective capacity will dwindle. This can be explained by the phasing out of obsolete facilities.

Competitive expansion of facilities since 2000

Global shipbuilding capacity has been changing with market conditions. In the mid-1970s, when the global shipbuilding industry went through a long recession after a peak in the market, the shipbuilding capacity of Japan and Europe, then the world’s shipbuilding leaders, plunged. Europe, which had lost its competitive edge in the market, saw both shipbuilding capacity and market share fall, while the more competitive Japan increased or at least maintained its market share in the face of shrinking shipbuilding capacity. In other words, Japan still led the market. South Korea entered the international shipbuilding industry right before the mid 1970’s peak. South Korea needed to adjust its system to cope with changing market conditions, but not to the extent required of Japan and Europe. As the shipbuilding market started to recover in the 1990s, South Korean shipyards expanded facilities on a large scale, targeting the replacement of old vessels made during the 1970’s peak (the first expansion).

Europe and Japan, which had suffered from overcapacity, harshly criticised South Korea, and Europe even brought a case against Korea to the WTO in early 2000. The global shipbuilding market began to flourish in 2000. Eventually the market became short on supply, and global shipbuilding nations rushed to expand their facilities.

In particular, China, which had designated shipbuilding a strategic industry and had finished restructuring the industry for efficiency by 2000, expanded shipbuilding facilities extensively.

Several privately-owned shipyards built large-scale shipbuilding bases at the Bohai Gulf Basin, lower Chang Jiang River, and Pearl River in Guangzhou. China’s shipbuilding capacity increased 15.8 times, from 1.2 million compensated gross tons (CGT) in 2000 to 19 million CGT in 2010. Korea’s capacity rose nearly three-fold over the same period, thanks to expansion of existing shipyard facilities and an increase in the number of new shipyards.

Restructuring in Korea, facility expansion in China

It is imperative for shipyards to balance capacity with global demand. Achieving appropriate shipbuilding capacity will require that many uncompetitive shipyards be eliminated from the market.
In the case of Korea, some shipyards which had expanded facilities lagged behind the competition in the aftermath of the global financial crisis. Witnessing abundant demand for new ships, shipyards accepted orders without having facilities in place, and borrowed money from financial institutions to invest in facilities. Financial institutions provided shipyards with refund guarantees without taking into account the changing market or carefully examining the financial position of the shipyards, thereby incurring losses. The shipyards being eliminated are mainly small and medium-sized shipyards under financial distress, or those lacking the capability to diversify. If these shipyards are eliminated from the market, the decrease in global shipbuilding capacity will be minor.

In Korea, the restructuring of the shipbuilding industry is underway by creditor financial institutions. In China, on the other hand, the government authorities control the market (recent announcements by The Ministry of Industry and Information Technology outline new 5 year plan, discussed further in Business Risk Evaluation) with active and unprecedented financial support and various demand-boosting policy measures.

China has made large investments in new facilities during the recent boom; now it limits additional investment but continues to support ongoing investment. Therefore, there seems to be little possibility that the supply capacity of the global shipbuilding industry will be adjusted elastically. In the future, the countries with the largest number of shipyards that can survive the dwindling demand for new vessels will become the world’s leading shipbuilding nations. As history has shown through the decline of Europe’s shipbuilding industry those that best survive the crisis will be best placed to take advantage.

To survive means being competitive; to be competitive means being able to build a vessel at a lower price. General purpose vessels, such as tankers, bulk carriers, and container ships, make up the majority of ships in the global shipbuilding market.

At first glance, China, with its low labour costs, seems poised to become the next number one shipbuilding nation. Still, cost is influenced not only by labour costs, but also by production efficiency. China’s labour costs rise exponentially each year, but its productivity is much lower than that of Korea.

China also has little experience with liquid natural gas (LNG) carriers and very large crude carriers (VLCC). Based solely on these credentials, China is in a less favourable position than Korea to win foreign shipbuilding orders. However, Chinese shipyards enjoy great advantages from their
Industrial and Government sponsored environment.

The Chinese government generally supports the shipbuilding industry by exempting it from tariffs applicable to imports for key components necessary for the production of some kinds of high-tech ships, and by providing incentives for investment in R&D and innovation. The tariff policy is also closely related to the Chinese Government’s endeavours to balance foreign exchange income and expenditure. The principal measures, aimed at increasing competitiveness in the industry, include promoting industrial consolidation and reconstruction, establishing international R&D and technical cooperation, improving management skills and risk control, and providing financing assistance.

Moving forward competition between Korea and China is expected to intensify as the overcapacity generated through the boom years looks to be filled.

The below chart shows the relative dominance of China and Korea on the world market.

BUSINESS RISK EVALUATION
SWOT Analysis
Diagram 1 – SWOT – COSCO Shipyard
Strengths Weaknesses

 Six strong and strategically placed ship yards on the Chinese coast
 Diversification of income streams
 Developed offshore expertise
 Limited availability of highly skilled work force
 Order book offshore biased
 Production efficiency

Opportunities Threats

 Planned consolidation within the Chinese Shipbuilding Industry
 International expansion
 Overcapacity
 Margin pressure in key segments
 Sevan Group financial difficulties
 Plunging new orders and cancellations due to Global Economy

Internal factors which impact a business’ industry position and competitiveness are classified as Strengths (“S”) or Weaknesses (“W”).

Strengths

• COSCO Shipyard operates six strong ship yards up and down China’s East Coast. These ship yards offer a large capacity and diversity of production.
• With the economic slowdown and the falling margins being seen across the shipbuilding sector the diversification and range of products and services offered by COSCO Shipyard puts the company in a strong position to “weather the storm”.
• The strategic partnership with shareholder Sebcorp to develop the company’s offshore business is seen as a key strength. The emergence of a strong offshore division is a positive for the COSCO Shipyard especially in light of managements concern over margin pressure for repair as well as shipbuilding business with offshore being one segment with steady margins.
• The successful deliverance to Sevan Drilling on behalf of Petrobras of a cylindrical deepwater rig in 2010 was a key milestone for the Group and catalyst for the current strong pipeline of offshore orders.
• With declining new shipbuilding mandates the offshore area has been important to maintain turnover and productivity

Weaknesses

• In terms of maturity the Chinese shipbuilding Industry is relatively young in comparison to the rest of the world. This has meant that there has been a need to develop and recruit the required highly skilled and technical staff, as previously a large talent pool did not exist.
• COSCO have taken on this challenge by developing a Centre of Excellence to train and develop new staff as well as recruiting a high level expertise from other noted ship yards.

• COSCO Group which owns 51% of COSCO Shipyard reported in Q1 2012 that while management remains constructive on potential offshore orders, it has highlighted rising competition in the segment.
• COSCO is also targeting 80% of new orders coming in from the “offshore” segment in 2012 with 55% of current order book offshore related.
• This biased towards offshore business, with only 37 shipbuilding vessels targeted to be delivered in 2012 and the company outlining completion prior to the year end, has raised the potential of the shipyards being underutilised beyond 2012.
• A slowdown on the other segments of the business however was to be expected as the global economic crisis hangover and ongoing turmoil in global economic regions cast a shadow over the shipbuilding industry.

• China has long had a competitive advantage over its International competition due to low labour costs. International shipyards have over the past 10 years had to adopt more efficient working practices and enhance the quality of their product to compete.
• With the average wage cost rising in China there is a need as addressed with the Centre of Excellence to adopt efficient working practices in order to continue to compete for global orders.

External factors firm which impact a business’ industry position and competitiveness are classified as Opportunities (“O”) or Threats (“T”).

Opportunities

• The Ministry of Industry and Information Technology said in March 2012 that a 5 year plan was targeting CNY 1.2trn ($190mn) revenues from shipbuilding industry by 2015, with plans to raise annual shipbuilding exports to >$80 bn by 2015. It was also noted that there were calls for consolidation with a goal of 70% capacity among top 10 companies by 2015.
• The plan also says China should aim to claim at least five of the world's 10 largest shipbuilding companies by 2015.
• A separate meeting of executives from 8 major yards in Jiangsu in March 2012 outlined that they felt consolidation would become necessary due to expected rising costs and a lack of human resources.
• Other points of note from the meeting where, plunging new orders due to troubled global economy, order cancellations, shipbuilding unlikely to see up-phase for next 3 to 5 years and Chinese yards need to diversify product range.
• COSCO Shipyard is well placed to benefit from any consolidation in the market however this process will be extensive and will no doubt involve Government guidance since at present according to Worldyards, the top 20% of shipbuilders (in China) account for 63% of national capacity.

• The development of China’s Shipbuilding Industry focussed initially on the domestic market however increasingly exports are becoming the primary focus. In order to stave off overcapacity there is a need for China’s shipyards to win export business.
• COSCO Shipyard already has an established International reputation however will need to continue to work hard to take orders in, considering the state of the shipping market.
• Against stiff competition this is doable assuming that the high yen keeps the Japanese less competitive and any appreciation in the Korean won is taken advantage of.
• China's existing order book (May, 2012) for offshore and commercial merchant shipbuilding stood at US$109 billion, compared with US$140 billion for South Korea and US$41 billion for Japan.
• To maintain growth it is important to start to win market share from Korea and Japan.

Threats

• As previously mentioned due to a rise in development of new shipyards set off by the 2007 shipping boom, today’s global market faces overcapacity due to demand falling off due to the global macro-economic conditions.
• Diversification will be key to ensuring that COSCO Shipyards are not underutilised. The Group already has a good level of diversification however will need this to be maintained and market share to be regularly won within each segment.
• Information taken from COSCO Group Q1 2012 announcement indicated falling margins in certain segments. Shipbuilding was at 5 – 6% with downward pressure whilst offshore margins were steady at 10%. Management outlined that shipbuilding had the highest risk of further downside to margins.
• The decision by management to push forward offshore segment business is seen as a ploy to protect margins whilst uncertainty still surrounds new ship builds.
• Sevan Group (Norway) of which Sevan Marine and Sevan Drilling are listed subsidiaries, are key customers /partners to COSCO and have helped to facilitate COSCO’s acceleration as a top-notch Chinese yard in the offshore space, with Sevan providing the turn-key and execution capability on deep-water rigs and production jobs.
• COSCO has become the best offshore market provider among the Chinese shipyards (i) successfully delivering a cylindrical deepwater rig to Sevan for Petrobras operations in 2010 and (ii) receiving orders across the offshore segment, including (a) deepwater rigs, (three cylindrical rigs from Sevan Drilling, and one drillship from Dalian Deepwater), (b) jack-ups from KS Energy, and (c) FPSO conversion jobs in the past 12-18 months,
• As at June 2011 Sevan’s importance was demonstrated, by Sevan Drilling accounting for 20 – 22% of COSCO’s outstanding order book.
• It was noted in June 2011 that Sevan Marine was experiencing financial strains with an inability to meet FPSO upgrading costs leading to a 90% + drop in the share price this will slow down Sevan’s expansion in the FPSO segment as well as its drilling rig portfolio, i.e. have a direct impact on COSCO’s offshore expansion. This position should be monitored with caution by COSCO.
• Q1 2012 results for Sevan Marine announced in May 2012 showed a more uplifting picture:
“Operating revenue from continued operations for first quarter 2012 amounted to USD 24.4 million. EBITDA was positive with USD 10.7 million, and net profit from continued operations was USD 12.3 million.”
• The ongoing reduction of new shipbuilding orders will continue to be a concern to be managed: