High risk translates into high returns when you hit it right. But that same high risk translates into horrible returns when you miss. This week's "Buy, Sell or Hold" stock – DryShips Inc. (Nasdaq: DRYS) – is a perfect case in point.
If you want to see the dismal picture of what can go wrong on a stock when you miss, consider how DryShips' shares have performed since the company first listed its shares five years ago.
'Global Synchronic Growth'
DryShips was established in late 2004 by Chief Executive Officer George Economou, and went public early the next year. Based in Greece but incorporated in the Marshall Islands, DryShips owns and operates one of the industry's largest dry-bulk fleets with 40 ships of varying sizes, according to the latest Morningstar.com research. DryShips' vessels carry such "drybulk" commodities as coal, iron ore, grains, bauxite, phosphate, fertilizers and steel products. DryShips Inc. employs its drybulk vessels in several ways, including under period-time charters, on bareboat charters, in the spot-charter market and in drybulk carrier pools.
Its subsidiaries include the formerly public Ocean Rig ASA, DrillShips Investment Inc. and Primelead Shareholders Inc. For ship management, DryShips turns to Cardiff Marine, a private company founded by Economou in 1991.
DryShips listed in February 2005, just ahead of a period defined by what I have labeled as "global synchronic growth" – a stretch during which all the world's major economies shift into a strong, simultaneous growth mode. This is something I had never before seen during my Wall Street career; in fact, I could not even recall any time in previous decades when this phenomenon had occurred.
During the initial spike, the company, as well as most shippers around the world, struggled to meet demand from clients. Shipping rates went through the roof and the industry as a whole indulged in a bonanza that led them to order a large amount of new ships. Since shipbuilding requires a lot of capital – typically with a huge amount of debt – shipping companies raised debt in order to finance the large increases in capacity.
With global synchronic growth, and with the systematic debasing of currencies by the three major economic blocs of Japan, Europe and the United States, commodity prices and volumes increased dramatically. And since a very large part of the demand for commodities is being fueled by the torrid growth in the Chinese economy – and since China must import increasing amounts of these badly needed materials and resources from outside its borders – shipping rates for those commodities also benefited hugely.
So did DryShips' shareholders. In late October 2007, DryShips shares hit their all-time closing high of $123.50 a share. Fast-forward to today: The shares closed Friday at $4.81 each.
That all changed with the Lehman Brothers Holdings Inc. (OTC: LEHMQ) collapse. Economic activity came to a standstill, and shipping rates collapsed to a multi-year bottom.
The company was whipsawed by the huge spike – and subsequent collapse – in global economic activity.
After the activity collapsed, most shippers were left over-leveraged and became unprofitable. What's more, the tenuous market conditions raised huge uncertainties about the ability of these companies to refinance their debts at maturity and this demanded a much higher risk premium, both for debt and for equity.
Even though DryShips has very strong management – and is experienced in the industry – it was last year forced to issue equity and renegotiate debt covenants with its lenders. Recently, it issued convertible debt obligations that further diluted existing shareholders. With this, the company's debt-to-equity (debt/equity) level has come down strongly, from a peak 63% to all the way down to 45% at the end of the first quarter.
A Shipper Gets Becalmed
Now that the G20 economies coordinated a global plan of both fiscal and monetary actions aimed at bolstering global growth, activity has returned and, with a lot of volatility, shipping rates keep recovering.
Since the economies of the key emerging markets – especially China and, increasingly, India and Brazil – have recovered strongly, and their prospects for continued strong growth in China and for acceleration in India, Brazil and Russia are very favorable, the issue was so successful that the company's dealers claimed their over-allotment.
Looking at the current financial structure, the critical EBITDA/interest-coverage ratio of 4.3 times is very strong. This is very reassuring to bond investors and dramatically reduces the risks from debt importantly. But the company is still not making money. And the recent earnings report was disappointing, as well.
For the first quarter of 2010, the Company reported net income of $5.7 million, or $0.01 basic and diluted earnings per share. Included in the first quarter 2010 results are various items, totaling $61.9 million, or $0.26 per share. Excluding these items, net income amounted to $67.6 million, or $0.27 per share.
Not only did DryShips miss slightly on revenue, but many non-cash adjustments to earnings are actually recurring, and thus should be included as detracting from earnings and not added back as the company did. So the 27 cents of adjusted per-share earnings (EPS) that the company reported should actually have been 15 cents to16 cents, according to my calculations.
DryShips does not meet my standards for having the type of transparency that I usually demand, and this perception in the market is demanding a higher risk premium in the stock, as well. And there are some controversies surrounding top management.
So where is the upside?
Investing in DryShips is not only a risky investment, it is also a contrarian one. And contrarian investing is proven to offer the best returns, when executed properly. But it demands huge attention, as well. In addition, the company has to be seen as a turnaround situation. And turnarounds are extremely lucrative investment propositions when they work.
The company has no meaningful sustainable competitive advantage to differentiate it from other shippers: At the end of the day, a ship is a ship is a ship. And the structure of the business is such that it is saddled with huge fixed costs, financed with a lot of debt. So when activity levels are low and competition is high, shipping rates drop like a rock and companies lose money. On the other hand, when activity picks up, rates surprise to the upside and, once the equilibrium point is surpassed, companies such as this one become a profit bonanza, as the mostly-fixed-cost base does not increase as revenue flies, driving profits to the ceiling – as well as the stock.
So right now, as the Baltic Dry Index recovers, these dynamics could be at their incipient moment.
In addition, the company is looking to divest its drilling ships business. Since market conditions have been very poor recently – and since the company has declined to provide a timeframe for the planned initial public offering (IPO) of this unit – investors have punished the stock. But I expect to see market conditions improving for the summer and beyond – for three key reasons:
- Europe keeps showing strong resolve in defending the euro by having its members, especially the fiscally-weakest ones, pass important austerity plans.
- The so-called BRICs (Brazil, Russia, India and China) continue to operate in an expansion mode.
- And the United States economy is leaving its slump behind – albeit slowly – and its recovery is gaining momentum.
At the same time, the shipping industry has been very slow in replacing the 5% capacity that comes offline annually. In order to conserve fuel, ships are sailing slower, which actually results in an additional 5% loss in global capacity. As demand picks up, and with capacity down, shipping rates should climb nicely. And these dynamics should be favorable for the company's refinancing and for the IPO of the drilling ships business. Just last Thursday, we saw a strong turnaround in drilling company stocks that might be an indication of improved market perception for the industry.
A Bottom-Line Analysis
At these valuation levels, and with a greatly improved balance sheet from last year, the company appears much more likely to survive and the stock appears ready to take off. But in this risky environment, this stock is not one on which one could bet the farm. So be very mindful of position dimensioning. It is probably advisable not to go in all at once: I recommend dollar-cost average into it over the next three months. Once you have a position, this could be a stock that you hold for a long time.
The idea is that, as the secular growth in "Chindia" does its magic, idle shipping capacity gets reabsorbed and shipping rates continue to stabilize and then recover. DryShips then becomes much more profitable and keeps reducing debt and growing revenue. As profits rise, the stock will quickly follow.
At Friday's closing price of $4.81, the stock appears to be extremely oversold after the recent market turmoil and due to the problems deriving from the global uncertainty. Over the last 52 weeks, the stock has traded between $4.37 and $8.64, and appears well due for a retracement of the recent heavy losses.
That's well below where they were when the company went public (the adjusted close after their first day of trading back in February 2005 was $19.99), and is but a small fraction of where they were in October 2007, which is when DryShips shares established their all-time closing high of $123.50 each.
On a long-term basis, it is very near absolute bottom levels. So the risk-reward over the very long term appears to be heavily favored, provided the global economy recovers and the company is able to keep servicing and refinancing its debt as it is doing today.
Recommendation: Buy DryShips Inc. (Nasdaq: DRYS) at market (**). Dollar-cost average to establish a position that you'll then be able to hold for a long time.
(**) – Special Note of Disclosure: Horacio Marquez holds no interest in DryShips Inc.
[Editor's Note: Horacio Marquez knows how to make a market call. It was Marquez who told investors that lithium was going to be big – a year before other "experts" made the same call. Now Marquez has isolated the major profit opportunities being created by the possible broadband breakdown – a situation that the news media is only just now starting to understand. To find out all about those top profit opportunities, check out this new report.]
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