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.
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