By Mike McDermott
• Dry-bulk shippers have traded lower as overcapacity pressured day rates and the financial crisis depressed shipping activity.
• Shipping rates appear to have found a floor and will likely increase as emerging market demand for commodity continues.
• Shipping companies are trading at attractive multiples as investors fear debt levels and industry overcapacity.
• Three shipping companies are attractive breakout candidates as business prospects improve and long-term bases are completed:
Shipping stocks have been out of favor for a number of years now …
The current shipping environment offers a stark contrast to the heady growth days just three years ago. Midway through the last decade, demand for shipping overcame the amount of capacity available and all hell broke loose.
Since there is a significant amount of lead time before a new ship can be built, commissioned, and chartered; day rates for existing ships skyrocketed. Naturally, stock prices for shippers with capacity also took a moonshot.
Many of these shipping companies were able to issue equity or significant amounts of debt to build out their fleet, and customers were required to sign long-term contracts locking in years of capacity at inflated prices.
In an ironic twist, shippers who locked in the longest-term rates were often penalized by investors. The perception was that day-rate prices would continue to ramp higher, and any long-term agreements simply kept shipping companies from capturing the future increase in rates.
Stormy Seas Sink Speculators
The financial crisis of 2008 / 2009 couldn’t have come at a worse time. Just as the shipping industry became fully leveraged with plenty of capacity, economic turbulence hit. Demand slumped, and many customers had to cancel long-term contracts (and either pay the penalties – or in some cases renegotiate).
Slowing demand wasn’t the only major issue facing these companies. Financial liquidity also became a major concern. Many of the more speculative companies in various stages of the fleet building process were relying on short-term financing.
Once it became clear that demand was drying up, banks began to charge punitive rates or deny capital. Shippers were forced to issue debt securities with costly terms, or dilute current shareholders by issuing depressed equity shares.
Low demand and overcapacity naturally led to depressed day rates, crushing shippers who relied on spot prices instead of locking in long-term contracts. Even shippers with solid revenue visibility took on water. Investors expected that once the long-term contracts ran out, renewals would take place at lower rates, and stock prices began to discount this disappointment.
At this point, shipping rates are very close to multi-year lows, and shipping stocks are trading at incredibly discounted prices. Today, we are seeing the opposite perspective from investors. Shippers with long-term contracts are trading at higher multiples (due to perceived stability) and those with more exposure to spot prices are being shunned by investors.
The environment creates some tremendous opportunities if the shipping business remains relatively stable or re-enters growth mode.
Over the past month, we have begun to see a slight turn in shipping rates. If this trend continues, it could have a significant impact on the profitability of depressed shipping companies. And considering the fact that many of these shippers are trading at single-digit price / earnings multiples, the group could run a long way before becoming overvalued or vulnerable to a sharp decline.
We’re watching the price action carefully. It’s never a good idea to enter a trade based on valuation alone. But if the industry is turning, valuations are cheap, and price action points to a rebound; this trifecta could lead to a tremendous trading opportunity.
Below are three shipping companies poised to trade higher as the shipping industry rebounds:
Seaspan Corporation (SSW)
• Recent growth in revenue and earnings proves the company can profit even in the toughest of environments.
• High capacity utilization is a testament to strong customer relationships.
• Seaspan enjoys access to liquidity, allowing them to take advantage of fleet expansion opportunities.
• Stock pattern stronger than peers, but still has plenty of room considering low valuation.
Seaspan currently owns 42 vessels and the company primarily operates under long-term charter agreements. Because of these agreements, SSW has been able to remain profitable throughout the challenging environment of the last few years.
Over the last few quarters, SSW has posted impressive growth in both revenue and earnings as new ships have been put into service, and margins have remained healthy. For 2010, the company reported earnings of $1.70 per share, a 30% increase over 2009. For 2011, analysts are forecasting earnings of $1.53, but the recent trend is for estimates to be revised higher.
From a valuation perspective, SSW looks very attractive with a PE multiple of 11.6 compared to 2011 estimates, and 9.1 compared to next year’s expectations. The company pays an attractive 2.8% dividend yield which appears very safe considering the ample cashflow and long-term contracts.
Seaspan has continued to build its fleet and on March 21, the company took delivery of its third ship this year. The ship was immediately placed under contract to a large customer who is entering the 9th of 18 planned vessels under charter ...
Historically, SSW has been very effective at keeping productivity rates high. In the fourth quarter, the company reported vessel utilization at 99.7%, and for the full year (2010) Seaspan had 98.7% vessel utilization.
Strong operations give investors confidence, and SSW currently enjoys attractive access to capital markets. In January, Seaspan raised $241 million by issuing preferred stock – capital it can now use to pay for new ships being delivered. Management recently announced a new agreement to order an undisclosed number of new vessels which will be coming online over the next several quarters.
With all of this expansion, SSW has a hefty amount of debt – with a debt to equity ratio of 178%. Of course this is a highly capital intensive business – requiring most companies to issue significant amounts of debt. The high level of debt is a bit of concern, but could turn out to be a positive for equity investors who were not diluted by any recent equity offerings.
If SSW is able to continue placing its vessels under long-term charter agreements, the debt will be well covered and investors will benefit. On the other hand, if the shipping business enters a new crisis stage, it will be very difficult to service this debt.
The nice thing about approaching SSW from a trading perspective is that we can participate in the positive movement without being married to the stock and riding it lower if conditions change. For now, SSW is leveraged to a recovery in the shipping market – and should grow profits tremendously.
SSW could potentially trade through $30 based on current expectations for 2012, and a more optimistic multiple near 15. If rates increase and Seaspan is able to lock in higher rates, the $30 price target could prove to be conservative. For now, we will be watching for attractive spots to add exposure, and will manage our risk points along the way.
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Dryships Inc. (DRYS)
• Profit levels appear to have found a floor, with stability returning to the company.
• With a price / earnings multiple below 5, industry challenges appear to be fully discounted.
• Charter coverage rates provide enough stability to maintain profits with plenty of room for improvement in 2012.
• The stock is finding support above the 200 EMA and should attract interest from value investors.
Dryships fell hard as a result of the financial crisis. In 2008, the company booked earnings per share of $10.64 and the stock price traded as high as $116.43.
In 2009, earnings dropped to only 97 cents per share, and the stock price plummeted below $3. The company was a major victim of dropping day rates, canceled contracts and industry overcapacity. As cash flow dropped and liabilities became due, management was forced to take action, issuing a large convertible senior note and rising nearly a half billion in capital.
Today, the company is in much better condition with stable earnings, a listed debt to equity ratio of 35%, and a stock trading at roughly half book value. Of course book value is a bit subjective at this point because the market value of vessels may differ materially from the carrying value on the balance sheet. Still, with a P/E multiple below 5, it appears that investors are discounting a worst-case-scenario for the company.
Leveraged to Day Rates
In contrast to shipping peers who enter multi-year contracts with customers, Dryships has a significant amount of capacity available over the next two years. According to a recent press release, the company has only contracted out 40% of capacity in 2012. This leaves the company plenty of room to benefit from rising day rates.
The strategy could very well pay off, as the 40% capacity agreements should bring in significant revenue for next year. If the company begins signing contracts for the remaining capacity at higher rates, investors will bid up the stock as visibility returns and profit expectations rise.
For the time being, an 82% charter coverage rate for 2011 gives near-term stability and plenty of cash flow. The company will report fourth quarter earnings after the close today (3/30). Expect management to give more clarity on the company’s charter arrangements, and barring any significant disappointment, the clarity should translate to confidence and push the stock higher.
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Diana Shipping Inc. (DSX)
• Discount valuation offers reversal opportunity if conditions improve.
• Company is signing contracts with key customers, creating better revenue visibility.
• Analysts are beginning to revise estimates higher, optimism may be returning.
• Young fleet of vessels allows for years of operation without costly upgrades or repairs.
Reversing direction for a large shipping vessel takes space and time. The reversal story for Diana Shipping is much the same.
After a long period of quarterly declines in revenue and earnings, DSX is starting to string some winners together. Over the past three quarters, DSX saw revenue increase by 15%, 23% and 24% (year over year), and earnings increase by 8%, 17% and 18%. For 2011, the company is expected to earn $1.39,m putting the stock multiple in single digits.
From a financial perspective, Diana is in a decent spot with a debt to equity ratio of only 32% (among the lowest in the group) and a relatively young fleet. The average age of its dry bulk vessels is 5.4 years. This means that the company will be less likely to have to pour significant capital into refurbish or repair projects, and the fleet can stay active – generating revenue for the company.
The management team has done a good job of keeping Diana’s ships in play, and in 2010 the fleet operated at 99.5% capacity. In January, the company signed two different time charters with Cargill International. One contract was for 11-14 months at a daily rate of $13,750 and the other was for a period of 23-25 months at a daily rate of $16,500.
Over the next several months, analysts will be watching new charter agreements carefully. If rates rise and Diana is able to lock in more attractive terms, the stock could rise quickly. Investors would have better visibility into future earnings and the price multiple will increase as a result.
The current price indicates more pessimism, despite the fact that estimates for 2012 have begun to rise. DSX could easily trade into the high teens or low $20′s with just a few data points of good news. We will be watching the price action for a good opportunity to take a position with our risk carefully managed.