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My Halloween Horror Story



October 30, 2007 – Comments (17)

Inspired by Katrina Chan’s article, The World’s Scariest Stocks, I thought I’d share with you my pick from the list.  It probably won’t come as much of a surprise to many of you, but my clear nominee is Dry Ships, hands down.

What I found perhaps most interesting were the comments to Rich Smith’s piece detailing the reasons behind Dry Ships nomination as a contender for this ghoulish contest.

Comments like:

U don't understand this company at all

You have missed the "boat."

Motley Fool does not understand the dry bulk sector.

Say What? The closer you look? Maybe you should look a little closer.

And this one directed at my pitch:

TMFEldrehead: Ever try to understand someone who does not speak the same language? There are translation errors. The company is growing like crazy and every deal thus far has been accretive. Can you ask for better?

I’ll openly admit that when I first made my Dry Ships call I was pretty much piggy-backing on Bill Mann’s (TMFOtter’s) call.  When I was down about 500 score points or so, I decided to start to snoop around just a tiny bit to see if I should perhaps end the pain, and found the CEO’s comments which I highlighted in my pitch.

That, though, was for the most part the extent of my research.

Rather than simply shrug off some of the comments above, as I’ll admit I’ve been tempted to do from time to time, I’ve decided to instead heed the advice and actually do a little bit of digging to understand what is going on here.

And while I don’t pretend the amount of research I’ve done is anywhere close to exhaustive, what I have found is definitely worthy of the nomination as one of the contenders for the World’s Scariest Stock contest.

As so many people bullish on Dry Ships love to point out, Dry Ships fortunes are tied largely to the spot market rates for dry bulk ships and point to the Baltic Dry Index (BDI).  The chart clearly shows these rates have been skyrocketing lately, right along with Dry Ships’ stock price (to the profound detriment of my CAPS score).  Many other folks point to the soaring earnings and the seemingly reasonable trailing and forward P/E ratios.

Granted, the day rates have been increasing at a blistering pace, as have Dry Ships’ earnings – but what has the company been doing with those earnings?  Returning them to the shareholders?

Well, not exactly.  Sure, the company pays a 20 cent dividend, but considering the soaring earnings, I’d hardly call this level of dividend on shares in the $125-$130 per stub range particularly noteworthy.

So where have all the earnings gone?

Well, into buying more ships, of course.

“Great!” say the Dry Ships bulls.  “Rates are skyrocketing; China and India are gobbling up resources and need ships!  Buying more ships when day rates keep rising is brilliant!”

Provided day rates keep going up, these folks may have a point.

But when I look at the company’s recent history, you know what I’m reminded of?  I’ll give you a hint -- it’s a scheme named after some famous ancient Egyptian structures.

The problem with Dry Ships is that they’re leveraged to the gills.  As of the latest quarterly filings (Q2 2007), Dry Ships debt/equity ratio was nearly 1.5.  Leverage is a double-edged sword.  I like to think of it as a financial magnifying glass.  When things go well (as they arguably have been lately for Dry Ships), returns are magnified.  When things go poorly… well… lookout below!

“Earnings are growing!” cry the bulls.  True.  Q207 net income was $147.5M.  Since then what has the company been doing?  Let’s see… they announced the purchase of 8 vessels for $620M in early August, announced the acquisition of yet 3 more in late August for $201.5M (while disposing of one), and announced the purchase of yet one more earlier this month for $147.5M.

Think that debt/equity ratio just got a whole lot worse since the last filing in June?  They sure aren’t coming up with the nearly billion dollar price tag for all those ships out of their current cash hoard considering that as of the end of Q2 total cash on hand was a paltry $2.5M.  Granted, the company’s ships are bringing in cash – to the tune of about $74M in operating cash flow over the course of Q2.  If, however, we take the amount of debt at the end of Q2 and assume that all these additional ships are likewise going to be purchased with debt, we come out to a total of somewhere in the neighborhood of $1.6B.  Suddenly $74M in quarterly operating cash flow doesn’t leave the biggest of cushions, does it?

Dry Ships is, in my mind, a lot like a pyramid scheme.  Aggressively buying more and more ships utilizing debt, debt, and more debt works great so long as the presumption that day rates will keep rising holds true.  But just like the more traditional pyramid scheme which collapses once it runs out of new participants, Dry Ships too is headed for a precipitous fall should day rates ever turn south – and the longer Dry Ships keeps on aggressively pursuing this strategy, the more inevitable the eventual implosion becomes.

And of course, this piece wouldn’t be complete if I didn’t poke just a little more fun at the CEO who, regarding the latest earnings report stated, “We are pleased to announce a second consecutive quarter with record EBITDA.”

Well golly gee, ships are a capital asset and depreciated (the D in EBITDA), and the company is buying them with debt, the expense of which is interest expense (the I in EBITDA).  He therefore might just as easily have said, "If you ignore the purchase price of all of the ships, and also ignore the interest expense on the debt we incurred to purchase them, we’re setting records!”  Now, to be fair, net income, which includes these things, is also rising – but EBITDA is a pretty lousy financial measure with which to evaluate this particular company.

Perhaps I’m wrong.  Perhaps day rates will keep climbing at a blistering pace.  Perhaps the company will one day decide to stop buying so many ships with so much debt and simply manage the fleet they have, pay down debt, and start returning some cash to shareholders instead of buying more and more ships.

But given the company’s history, and the history of the CEO, I sure wouldn’t bet on it.

17 Comments – Post Your Own

#1) On October 30, 2007 at 1:39 PM, imacg5 (< 20) wrote:

 Well, at least you are doing research now. Keep going and you will find that even though new ships are being built,(a favorite point of Fools) that the supply will still not meet demand for many years, this point was made by the CEO's of RIO, BHP and everyone else who needs them. And many CEO's of companies that have nothing to do with shipping, are coming home from China reporting that the country is booming. Most recently Warren Buffett.  All the Bulkers are scrambling to buy ships, because they become accretive as soon as they are chartered. Most have had very successful SPO's, including DRYS, nobody worried about dilution.The rates don't need to go any higher, at the rates DRYS gets today the new ships will be paid for in 6 years. The ships have a life expectancy of 30 yrs. And there are hundreds of 30 + year old ships out there that will need to be scrapped. The usual scrapping of older ships has been put off because they need them so badly. Most Fools love DSX, EXM, and NM, and yet they hate DRYS, all DRYS does differently than the other bulkers is make more money than them.

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#2) On October 30, 2007 at 2:42 PM, kristm (99.71) wrote:

Can you guys come up with some kind of Caps contest based on scariest stock or scariest sector? Or bubble-popping?

IE, look at stocks (or sectors) with a recent rise (six months or a year) of 100% or more and then pick the ones that will fall furthest the fastest.. Dunno, Caps needs more contests with different options besides picking a basket of stuff that will outperform or underperform in a certain period of time. Spotting the next burst bubble would be a cool contest and make Caps more useful as a stock picking tool, even for those of us who don't like to buy or sell based on sector performance. 

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#3) On October 30, 2007 at 3:04 PM, CMFEldrehad (99.99) wrote:

Most Fools love DSX, EXM, and NM, and yet they hate DRYS, all DRYS does differently than the other bulkers is make more money than them.

Respectfully, that statement completely glosses over the main point I was making regarding leverage.  The only difference is that Dry Ships makes more money?  Hardly.

A quick glace at Yahoo finance shows that at the end of 2006 (more recent quarterly data wasn't readily available) the debt/equity ratio of DSX was just under 0.4, for EXM it was just under 0.7, and while NM's debt equity ratio was higher, cash on hand at the time was equal to about 2x the current debt while recent cash on hand at DRYS at the end of Q2 covered about 4% of the current debt.

Leverage cuts both ways.  Yes, it has allowed Dry Ships to have greater earnings...  but it will also lead to Dry Ships suffering far, far more pain than its competitors if spot rates should ever drop.

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#4) On October 30, 2007 at 3:53 PM, 292972826 wrote:

You made your point and this stocks sink very hardly today.

I pick DRYS underperforming at 114 and i m confident in my call.

In my opinion, if it is very easy to make a lot of money in an industry (Like bulkers), a lot of people will want to make the same than you. If you don't possess a dominant position with technology or branding, your profitability can only decrease....

I don't think DRYS have any comptetitve advantage over the industry, so its profitabilty will only decrease over time.  

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#5) On October 30, 2007 at 4:39 PM, TDRH (97.30) wrote:

Eldrehad,  Appears the coiled spring is starting to pay off.   It was painful to watch and may never be duplicated.  

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#6) On October 30, 2007 at 5:35 PM, imacg5 (< 20) wrote:

 Eldrehad, I do appreciate your DD, and I think you might see why I get frustrated with posts like Rich Smith which are totally flippant, and not based on DD. I have much more stock in Diana, because they are more conservative, using two SPO's this year instead of using debt, and paying a good dividend. However DRYS made the right call on spot rates. (today is a great example of your point about what will happen when rates drop).  I can't begin to point out the difference between using last years numbers to deal with the current situation. I don't think Yahoo was taking the $700 million raised with the SPO last week,  or the amount of increased FCF we will see in two weeks, at earnings. I don't believe Yahoo is taking into consideration that the ships DRYS bought last year can now be sold for twice what was paid for them. The only way that will change is if China and India suddenly decide to stop expanding. New ships will not be built soon enough. Anyway, we will see! Good luck and Good trading

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#7) On October 30, 2007 at 8:55 PM, dwot (29.14) wrote:

What a timely post with drys dropping today...

I regretted putting my under perform on when I did as I only took a closer look later.

My take on the shipping industry is they have been going made because of the over building due to the credit bubble.  The "experts" may be predicting only about a 30% chance of recession in the US but I think it is a sure thing.  I am not so sure that with the increase supply of ships, as all shipping companies have more ships on order and the decreases because of a slow down in the US market will enable those day rates to remain as high as they have been.

I am not so sure the booming emerging economies can absorb increased supply from both US slow down and increased number of ships.  So, when rates come down, margins are squeeze and price based on continued speculation that things will continue as they have been comes to a screaming halt.

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#8) On October 30, 2007 at 10:32 PM, TDRH (97.30) wrote:

dwot, those booming emerging economies depend on the US for a large part of their consumption.   Not only the US recession, but the reduced buying power of the US$ will surely correct the short term spike in the bulk shipping market.   If the Fed drops rates as anticipated, there will be a further reduction in US buying power.    The US consumer can no longer use their house as an ATM machine for times of trouble or special needs.  It is going to get ugly and it could extend to a global recession.

 The question that is on my mind is not whehter or not the US is going to go into recession, but what is going to lead it out?    I do not have an answer, that is why I am asking the question. 


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#9) On November 01, 2007 at 4:50 PM, GS751 (26.87) wrote:

Long blog post with nice commentary.  I always enjoy your blogs.
Fool on.George

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#10) On November 01, 2007 at 10:51 PM, mgiv (43.39) wrote:

yep I've been having mixed feelings about this one.. time to end my drys position.  Im no expert for sure but the dry bulk shippers are able to bare more debt than the average company.   A year ago these companies were value plays.  TBSI had a PE of 7 when I made my play (with another id that is) and I made the bet only because I felt the dividend was reliable.  Actually at the time it was the best in the pack. 

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#11) On November 03, 2007 at 10:22 AM, topmo (< 20) wrote:

my take on this......with the dry bulk shippers??   well, i've been watching and buying since last winter, first for the dividends, next for the earnings and growth.  DRYS has the lowest PE, the greatest earnings of the group.  The latest report I read..... DRYS has 33 vessels (may be different now, supposed to rec. 7 more by 2010)......earnings for DRYS expected to increase 43% to $10.93 next year.  DRYS spot rates currently @ $85,000/day,1 yr. charter locks in @ $75,000/day....3 yr. @ $55,000  a day.  Many other shipping companies have locked in their rates for the longer periods...DRYS has the option of doing that at any time.  These companies rely on the economies of southeast Asia, mainly China and India, also Japan and Korea.....Is the next price target $206??  I don't know, depends on the earnings over the next 4 quarters.  We shall see.

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#12) On November 03, 2007 at 11:54 AM, infoLust (24.28) wrote:

Too much bickering on this thread... but anyway, what do you think happens when 2 fifths of the world's population says we're coming on line and we want the life you have?  That means all resources and supply chains are running at a deficit to growth and will happen for years to come.  This is not a credit based expansion which can implode as soon as the M1 money supply dries up (as we've witnessed here in the US) but instead growth based on  productivity gains from energy leverage, improved infrastructure, and communication - the very base which led to our dominance.

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#13) On November 03, 2007 at 9:16 PM, ikkyu2 (98.01) wrote:

Eldrehad, full disclosure: I was ready to buy DRYS last year - I had my mouse pointer poised over the 'buy' button - at a price of 15 or so.  I was worried I'd missed the boat because when I first looked at the stock the price was 12.

Then I thought, well, ikkyu2, you did just sign up for this CAPS thing.  Why don't you go see what people are saying.  What's this, the Top Fool has red-thumbed DRYS?  OMG RED ALERT RED ALERT!!!  Your pitch made me decide not to buy.  Oyyyyy.. 

Interestingly, Cramer just had a CEO of a Greek shipping concern on his show on Friday.  Cramer asked him a question about bulk dry shipping rates going forward and the guy bristled and said that the rate environment going forward, even short-term, was "dangerous" and he wasn't going to essay a prediction.

As usual your analysis is appreciated and, a year wiser, I think you're shooting much closer to the mark this time, for what that's worth.  I'm not worried about missing this 'boat' - there's always another one coming. 

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#14) On November 05, 2007 at 7:29 AM, abitare (30.09) wrote:

Great report! Thank you.  

I thumb down many of these "dry bulk" shippers recently. Everytime I go to the Yahoo Message board with a question I am attacked by non English speaking goons. Something "shady" here with the "dry bulk" BS.

DRYS is a great leason in the Market ineffienctcy (at least in the short term).   

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#15) On November 08, 2007 at 6:13 PM, FoolWysocki (< 20) wrote:

Good research, very helpful, thanks.

I agree in principle with Eldrehad but believe there are still big gains to made here, especially with DRYS which depends more than other shippers on spot rates. A smart choice they made based on current raw material demand from Asia and as most analysts foresee, and as they apparently figured out themselves, still increasing demand for 2008 and 2009, and who knows maybe even beyond.   

So, when the spot rates come down, dry bulk shippers like DRYS who are not chartered out in advance at a fixed price will suffer and the stock will be hit hard. So when will that happen?  That is really the question I believe and not so much the debt /equity ratio. At this point I also want to mention that I think imacq5 is right saying that Yahoo will not reflect all the latest figures or even projections of future gains on ship resales. So I wouldn't rely to much on Yahoo for this sector.

Recently, I believe last week, Peter Georgiopoulos, CEO of General Maritime and chairman of Genco said: "...the current dry cargo market can be compared to the period immediately following World War II, when iron, steel and cement had to be brought to Europe and Japan to rebuild the war-damaged countries." Citing a similar environment in today's China, he said he believes there is a lot of room for growth in the shipping market. He further asserted that shipyards are "locked up," and it could be as late as 2011 or 2012 before a new dry bulk boat is built, meaning that supply should not change any time soon.

So, I think it is a classical supply/demand equation and that the stock has still room to go up. 

I hope my English is OK, I am not Greek but also European. 

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#16) On November 15, 2007 at 12:09 AM, dwot (29.14) wrote:

Boy, when you get to -1000 the point swings sure are enormous...  I thought my point swings were big and I was only at around -500 from this one...

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#17) On November 18, 2007 at 12:12 PM, iatemeself (67.72) wrote:

I believe DRYS is going up from the current price of 89$.

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