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Summary

  • DryShips reported quarterly results on Thursday, and while shares didn't move, the results confirmed DRYS is a sell.
  • Its reliance on day rates is dangerous given slowing emerging markets and less reliance on imported oil.
  • The company also carries too much debt with interest expense exceeding its EBIT.
  • With high leverage and a very cyclical business, DryShips is a sell.

On Thursday afternoon, DryShips (NASDAQ:DRYS) reported its first quarter results, and while shares did not react much on the news, there are important themes for investors to consider. It has been a crazy twelve months for DryShips. While shares are up 47% over this time period, they are off 39% from their high and down 35% year to date. As a shipper of dry goods and owner of oil rigs, DryShips is very reliant on a strong economic activity, and a slowdown in some emerging markets like China and Russia has spooked some investors. Overall, I think the bears have the stronger case, and I would be a seller of DRYS at current levels.

In the first quarter, DRYS lost $0.04 while analysts were looking for the company to break even (all financial and operating data available here). Revenue was a bit better than anticipated, beating estimates by $12 million at $457.5 million. Additionally, the share count jumped by 7% to 409.6 million shares. Despite DRYS' sensitivity to economic activity, it maintains a highly in debt balance sheet. This combination of its reliance on a strong economy and high debt burden is why I would continue to avoid DRYS.

In the quarter, dry bulk utilization was 97.6%, down from 100% last year, but day rates were much better at $13,564 vs. $11,396. Its tanker unit did even better, maintaining 100% fleet utilization with day rates nearly doubling to $24,781. Now, these results are pretty strong, but DryShips is reliant on day rates rather than contracts. About 70% of DryShips' dry bulk fleet is reliant on the spot market while virtually all of its oil tankers operate on the day market. When rates are stronger, this provides significant upside to profitability, but when rates fall, income can fall sharply.

In particular, DryShips' reliance on the spot market for its tankers is dangerous. Thanks to major onshore finds, the US is importing less oil than it has in 17 years, which cuts our demand for oil transported by tankers. China has also been working on developing a consistent supply of energy from Russia via pipeline. While this is several years away, it will put additional pressure on rates. With more oil coming domestically and from onshore regions, the demand for tankers will be soft for the foreseeable future.

At the same time, through its subsidiary Ocean Rig, DryShips has moved aggressively into off-shore rigs. Unfortunately, we are seeing weakness in the deep-water rig market with day rates facing headwinds, for some of the same reasons as tanker rates. Many companies like Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) are refocusing on onshore opportunities with U.S. production growing dramatically. With cap-ex dollars focusing onshore, there is less demand for rigs, which is bad for pricing.

Between oil sands in Canada and areas like the Permian Basin in the United States, more cap-ex dollars are being focused onshore, which puts pressure on higher risk deep-water projects. Now, oil remains a scarce commodity, so offshore demand is still strong, and many firms continue to spend billions offshore. Moreover with Mexico planning on opening the Gulf to foreign companies, there should remain solid demand. Now, these projects require high oil prices to be profitable and worth the risk. Increased U.S. output has put pressure on oil prices, which in turn cuts the demand for off-shore activities. As a consequence, DryShips' un-contracted rigs will face pricing pressure in coming quarters and years. Moreover as existing contracts expire, renewals over the next two years are in danger of being lower than current rates, which will put downward pressure on revenue and profits. Overall, the deep-water market is mildly weak, which will dampen results in coming quarters.

These trends put long-term pressure on DryShips. During this quarter, the company received generally strong day rates and utilizations, yet the company failed to make money. It needs a significant acceleration in the economy to turn a profit, which seems unlikely given slowing growth in emerging economies. At the same time, DryShips has a highly indebted balance sheet and faces the maturity of a convertible note, which may require equity issuance to pay off. The company carries $5.98 billion in debt against $3.9 billion in equity. For a company so reliant on a robust economy to power day rates higher, a 153% debt to equity ratio is just too high.

Consider during the quarter, EBIT (earnings before interest and taxes) was $91 million. However, interest expense was $114 million. DRYS needs to increase EBIT by another 25% to fully cover its interest expense. In coming years if DRYS has to roll over maturing debt when interest rates are higher, interest expense will be even more burdensome. Right now, DRYS isn't generating enough income to cover interest, let alone provide equity for shareholders. To get to a reasonable 12x earnings multiple given the high cyclicality of the business, DRYS would need to increase EBIT by over 50%.

The fundamentals do not suggest this type of growth is likely. In fact, there are long-term challenges to the company's tanker and rig business as the U.S. becomes less reliant on imported oil and companies focus cap-ex dollars on onshore opportunities. If you were very bullish on the economy, I could understand betting on DRYS if it did not have so much debt. However, its current interest expense is more than EBIT, and results would need to dramatically improve just to maintain the debt, let alone sustainably return capital to shareholders. Any slowdown could force the company to issue additional equity and dilute current investors. As a consequence, I advise selling DRYS.

Source: Sell DryShips: Its Balance Sheet Is Dangerous