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Background:

Beginning in 2006, the volume of global trade began to surge forward relative to the supply of shipping vessels. This caused a sharp uptick in the spot market rates, as shown in the 10-yr Baltic Dry Index chart below. Most shipping companies sought to take advantage of the rising spot rates and issued massive amounts of debt and equity in order to place orders. Due to the delay between ordering and receiving ships, the initial orders did not come through until early 2008. The increasing supply of ships coupled with a reduction in economic trade (primarily fueled by the global recession and a reduction in Chinese purchases of raw materials) caused a rapid decline in the spot market rates. Unfortunately, most companies continued to order new ships throughout 2009 to “take advantage of the soft market,” and these 2006-2009 orders would come fully online between 2008-2012 (2-3 yr avg delivery).

http://www.investmenttools.com/images/wfut/crb/bdi.gif
(Click to enlarge)

Decreasing Book Value:

Although global trade is increasing, the overall drybulk industry is suffering a supply glut, which is reflected in the current spot rates. As a result of the low spot rates and low charter-hires, most drybulk companies are leasing their ships at a breakeven rate at best. Due to a lack of recent profits and a grim outlook, many shipping stocks are trading at extremely low price to book ratios. However, the P/B ratio is misleading due to the inflated rates charged by shipping manufacturers from 2006-2009. New orders for drybulk ships are selling for approximately 50% of what they sold for in 2008. To gauge recent selling activity, Dryships (DRYS) recently sold 2 Panamax and 2 Capesize bulkers for $75.5M. The book loss on these sales was $106.9M which means that only 41.4% of the book value was received. Another recent sale involves a drybulk vessel from Top Ships that is being sold at an undisclosed price for a $29.5M book value loss.

Valuation Metrics:

Based on these recent sales, P/B is obviously not a reliable indicator of value, and Debt-to-Assets should be used instead. Based on the recent BV sale by DRYS, any stock with a D/A of greater than 50% should be completely avoided (40% or less preferred). If a stock clears this hurdle, than P/B can be used as a relative measure of value; however, a lookover of the company’s balance sheet is warranted to ensure that there are no other massive non-debt liabilities exist. It is also important to check the coverage ratio for 2011 and 2012 to ensure that the company can generate enough cash flow to cover its debt payments. Due to the extremely low spot-market rates and bad investor sentiment in the sector, many companies are trading close to (or even below) liquidation-value. This liquidation value is based on 50% of BV for ship assets, but assigns no value to any future cash flows or charter contracts. A brief list is shown below (liquidation P/B calculated by: (.5-D/A)/(1-D/A)

  • OceanFreight (OCNFD) – D/A of 43.8% -- P/B of .05 – Liquidation equivalent at 0.11 (Discount of 55%)*
  • Excel Maritime Carriers (EXM) – D/A of 38% -- P/B of 0.13 -- Liquidation equivalent at 0.19 P/B (Discount of 32%)
  • Star Bulk Carriers (SBLK) —D/A of 29 % -- P/B of 0.22 – Liquidation equivalent at 0.30 P/B (Discount of 27%)
  • Baltic Trading (BALT) – D/A of 24.2% -- P/B of 0.40 – Liquidation equivalent at 0.34 P/B (Premium of 15%)
  • Paragon Shipping (PRGN) – D/A of 38.7% -- P/B of 0.21 – Liquidation equivalent at 0.18 P/B (Premium of 17%)

Time for Consolidation?

OCNFD was shown in italics above because the P/B reflects its trading range on Friday 22 July. On Tuesday 26 July, Dryships purchased the outstanding shares for $19.85/share (a premium of 179% of Friday’s closing price). The purchase price represents a P/B of 0.14, which is a 27% premium above my rough liquidation equivalent. On a larger scale, the liquidation equivalent is of less importance due to a larger company with a cleaner balance sheet having the ability to manage the smaller company’s debt. For example, DRYS has a market cap of $1.5B, and the outstanding debt for OCNFD is roughly $120M.

This buyout will give Dryships near-instant access to a larger fleet with charters attached. This will also increase the negotiation leverage of DRYS due to their larger fleet footprint. Diana Shipping (DSX) has an extremely strong balance sheet and might be a potential acquirer of struggling dry bulk companies. I think EXM is a likely target especially considering that they are on the brink of bankruptcy. SBLK is financially solvent, but is trading at huge discounts due to a recent equity dilution that hurt investor confidence while also causing strong sell-side pressures.

Just as consolidation improved the profitability of the U.S. airline industry and the U.S. rail industry, perhaps consolidation can also help the struggling drybulk industry. The strength of Dryships’ management (mainly relating to conflict of interest transactions) leaves much to be desired; however, if the financially strong carriers gobble up the smaller struggling carriers, eventually only the strong/ well-managed giants will remain.

Source: Consolidation Coming to the Drybulk Shipping Industry