DryShips: Come Aboard, Just Make Sure You Have Your Sea Legs

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 |  Includes: BP, DRYS, RIO
by: Daniel Long

When the rumor mill gets going about a potential buyout target, investors can generally become interested for one of two main reasons. The first is when the potential target has a strong foothold on technology, staff or demographics that the potential suitor perceives as essential to its future earnings growth or even survival. When this is the case, shares for the firm being bought will often have high multiples due to big R&D and other costs relative to current earnings. The buyer in this case will likely be overlooking the value concerns just to get their hands on what they so desperately need, and a bidding war can easily ensue. Because of this, however, the stock tends to rise quickly, well before any buyout is announced, and can often trade higher than what is ultimately paid.

The other less exotic scenario occurs when a company has great long term fundamentals, but has been beaten down by short term forces. The buyer of these types of companies is generally looking for a solid investment to add to their balance sheet, something that will generate income right away. When this happens, the stock will likely see less action leading up to a deal, and a premium is often paid. This is because traders believe that the potential suitors will be more likely to low-ball any offers, and will have plenty of time to wait. The financial condition of the prey in this case is often the determining factor as to what price is paid. As different as the results can be for investors of these two scenarios when the sitting ducks are eventually acquired, a further divergence in results can occur if the companies are in fact not bought out. When something that was in dire need suddenly is not, chances are it will be left on the curb. Investors holding a value play, on the other hand, may benefit from the strong fundamentals that kept them from being overtaken in the first place.

Although we won't venture a guess on whether or not they will be acquired, DryShips (NASDAQ:DRYS) fits quite well into the later category being one of the latest speculation subjects. The Greek based company operating abroad generates about half of their revenue from 39 drybulk carriers that ship worldwide, and the other half from 6 deep water offshore drilling rigs that it leases out, all of which they own and operate. The rumor is that mining company Rio Tinto (RTP) may be interested in adding to their already diverse portfolio of metal and mineral properties. DryShips would bring some stability to Rio Tinto's market on the shipping front, as well as add Oil into the mix. It might not make the best of wedding vows, but it would fit with Rio's goal of being entwined in all facets of mineral and metal production. Rio Tinto was reportedly interested in challenging BHP Billiton (NYSE:BHP) for Potash (NYSE:POT) by teaming up with a Chinese company, all of which has been specifically denied by executives. Rio Tinto may be looking to sweeten some reportedly sour relations with China, and DryShips could also provide them a way to do that, albeit on a smaller scale.

DryShips has seen growing revenues and shrinking expenses lately, as well as substantial growth from an EBITDA standpoint. What has caused their GAAP earnings to be all over the place, however, are some big charges related to financing activity and interest rate swaps, as well as the payment of some preferred dividends. They also burned through more than half of their 1$ billion in cash this year and remain with about the same amount of short and long term debt totaling close to $3 billion. This heavy debt load has caused many to think the company may need some help staying afloat, but the strength and positioning of their 6 billion in assets could be the impetus to allow smooth sailing for years to come. The stock is trading at about half of book value, and an anticipated price for a purchase of the company being floated around and appeased by recent options activity is close to 50% higher than where it is now. That figure is also close to the average target price from 8 analysts that cover the issue. Investors, or lack there of, in the stock currently seem to be divided as to whether these numbers signal an extremely good value play, or a disaster of titanic proportions on the horizon, as short interest being at 8% of the float is a little on the high side.

The company has been adding to their fleet and making repairs to their current vessels and rigs in anticipation of tighter safety regulations that may be heading the industry's way. They believe they are well positioned over their competition to take advantage of any new rules brought about from the British Petroleum (NYSE:BP) Oil Disaster. 4 of their 6 rigs are newer, which will also give them an edge. There is also speculation that drillers may be required to dig two wells simultaneously in environmentally sensitive areas, which will require two rigs being leased instead of one. This won't increase revenue, but it will likely increase operating margins for DryShips. They are currently only involved in one area that is considered exposed to the possibility, but with more and more people wondering exactly what part of the earth isn't environmental sensitive, chances are they are not going to have trouble finding anyone to lease their Rigs. They company says they have a very good safety record, something that could also make them more attractive now.

On the shipping side, Asia's emerging markets already have, and will continue to have a thirst for raw materials. Seaborne trade in the commodities that this company ships are expected to expand 7.6% this year, and even more next year. It's not just China's consumption that is contributing to the shipping growth, although it is contributing despite producing a lot of their own resources. Other Asian countries that have been experiencing exponential growth recently saw import shipments grow 27% from a year earlier. All of this means that some concerns about excess carrier inventory in the industry may be short lived, and if there is any excess, DryShips still has plenty of cash on hand to take advantage.

Yes, there is a lot of debt on the balance sheet, and they do have a lot of people to pay before common shareholders, but their assets could be undervalued based on the future earnings growth they can bring. They have plenty of capital on hand to continue operating for a while, and they also have plenty of leverage available if they need to go down that road further. An investment in DryShips could yield an attractive short term return or discounted entry into another similarly positioned business if the company is acquired. If it is not acquired, it could be a solid longer term value play with some growth potential should the global economy continue to improve. What DryShips is not is a quick arbitrage play. If you can adjust your sense of balance to the choppy waters and hang on for the ride, your ship may just come in.

Disclosure: No positions