Cosco’s 2Q09 results were soft but not unexpected – net profit fell 71% YoY to S$37.0m, and was in line with 1Q09’s S$33.2m. Turnover also remained flat sequentially at S$718.5m. Earnings were also boosted by a reversal of an allowance for impairment of receivables of S$25.9m.

Operationally, all segments continued to see softness, with bulk shipping margins falling to under 40% from around 60% previously, from lower rates. This situation is likely to persist with bulk rates depressed by weak demand and more capacity coming into the market. As for shipyards, gross margins have fallen across the board, with new buildings at just 1%. Current orderbook stands at US$6.8bn; however, this remains at risk from more cancellations and the ability for Cosco to execute.

We are concerned about Cosco’s cash flow. Despite the drop in cash earnings, Cosco will proceed with its capex plans to increase yard capacity by 26% by end-2010 so as to meet its newbuilding obligations. Bank borrowings have risen to S$1.2bn from S$656m at end-2008, for a gross gearing of 0.8x. While cash stood at S$1.8bn, around 60% of this is from customer deposits, yielding an adjusted net gearing of 0.3x. .

We estimate Cosco’s interest costs to balloon to S$50m in FY09 (S$8.8m in FY08), for interest coverage of just 3.2x. On top of its operational funding, cash will be further eroded by another S$100m in capex and some S$60m in returned deposits, with potentially more to come. Cosco expects to borrow more in tandem with its incremental increase in capacity. However, it believes that it will not need to raise funds from shareholders at this point in time.

We are further cutting our net profit forecast for FY09 by 14% to S$158.6m, while maintaining those for FY10 and FY11. With earnings expected to be volatile, we peg fair value at 1.7x price-to-book, or S$0.81. Our SELL recommendation is maintained.