DryShips Is Risky, As Value Is Eroding

Dec.23.11 | About: DryShips Inc. (DRYS)

On first inspection, DryShips (NASDAQ:DRYS) and Ocean Rig (NASDAQ:ORIG) appear to be very cheap, safe investments. But when investigated fully, it becomes much clearer that the investment is not quite the deal bargained for.

Macro Outlook

The 2012 world economy growth estimates are currently rather low at most sources. The World Bank is currently estimating world Real GDP growth of 3.2%, which is down about a half percent from 2010's growth (nearly complete). Of note, both the US and China are expected to have slower growth, and the Middle East and Japan are going to flirt with recessions. World trade is expected to have slower growth as well for the next three years. Oil prices are expected to rise in 2011, then fall slightly in 2012 and 2013, signaling no shortage in oil for the long term. Commodity prices such as coal and iron ore are expected to do much the same.

My own opinion of 2012 is slightly more bearish than that of the World Bank, because I think Europe will disrupt financial markets more than expected. At the least, I see high risk of a significant world-reaching banking or currency fiasco. Additionally, I think the US will likely get hit with one or more further credit downgrades in 2012, which could cause an unexpected jump in interest rates, which curtails growth further.

The Shipping Industry

Shipping rates are the best indicator of the industry's current prospects. Dry bulk shipping uses an indicator or index called the BDI. This index represents the rate of daily spot rates for shipping companies looking to lease out their boats. A chart is shown below. The index is down badly over the prior years, and even of late it has taken new weakness due to very recent developments with banks getting tougher and demanding more certain cash flows. This means that all of the companies are expected to have decreasing revenues for the near future, but some worse than others.

Click to enlarge

Company Specifics

DryShips (DRYS) deserves the sector's lowest valuation due to such horrible corporate governance procedures. Don't take that as an accusation of fraud; just get honest and admit companies with poor internal control deserve to be priced with more risk. Beyond the serious corporate governance issues, DryShips technically still offers significant equity per share. At this time the book value is around $9.70 per share. It is hard to say exactly because the share count is an issue. There are 408 million shares outstanding, but there are contingencies in place which could add tens of millions of shares if the stock price rose enough. Using an average of 420 million shares is probably a good estimate at this time, and that results in $9.42 of equity per share.

Then, we have to account for end-of-year impairments that are sure to occur. My sources show that drybulk ships are selling for conservatively 20% lower than last year. It depends on how the Ocean Rig subsidiary consolidated accounting is done (equity method, available for sale, trading securities, etc.) but I think the most accurate way to value Ocean Rig is to just mark it to market using the stock price. Conveniently, Ocean Rig is trading for roughly 20% lower than its IPO price.

Because the accounting will likely not use mark-to-market accounting, DryShips will likely see a 15% impairment charge, but a 20% impairment charge should be used to accurately value Ocean Rig's effect. When we multiply the $9.42 in equity per share by 80% we get about $7.54 in equity per share. As a final piece to the puzzle, I'm expecting some moderate swap losses and possible acquisition costs to essentially wipe out fourth quarter profits, so the equity value should stay roughly the same in that regard.

DryShips has another issue to deal with in 2012 because eight dry bulk ships and five tanker ships are due to be delivered. These ships will likely have to operate at an operating loss during 2012. In addition to this, DryShips convertible debt is trading with an extremely high yield, roughly 18%. This means that DryShips is likely going to find it nearly impossible to issue any bonds in 2012 because interest expense would be too expensive unless the balance sheet is cleaned up. DryShips will have to continue to get favors from banks in the form of short term lending facilities or it will run into a liquidity problem. Ocean Rig has several ships due to be delivered in 2013, but none that I see due in 2012.

In closing, I think the $7.54 book value is a relatively accurate number to use at this time, but should probably be discounted by another 30% due to horrendous corporate governance. This gives DryShips a true current book value of $5.28 in my eyes. Although this means that DryShips is trading at a discount to book value, it does not mean DryShips is undervalued one cent. The market is pricing in a bad 2012 and 2013 which could possibly destroy the company.

With the BDI where it is lately, I am personally expecting mild losses to the bottom line all 2012. And with such a severe oversupply of ships due to be delivered in both 2012 and 2013, it would not be at all surprising if this time next year there are significant impairment charges again which cut down book value even lower.

So those who argue that stocks which are trading below book value are a buy, are missing the bigger picture in this case. The market believes that the book value will continue to be cut down for the foreseeable future, and I agree. At first look, DryShips often appears to offer a real opportunity for a great long term investment because of good fundamentals, but on closer inspection one finds that the so called value is continually shrinking.

2012 will probably be the year which determines if DryShips will be able to survive as a publicly traded company. It may survive, but if it makes even one more large questionable transaction that destroys shareholder value, I think it is all over. There just isn't any more room for mistakes. Because I think the value in DryShips is eroding, and because the entire sector will see several bankruptcies in 2012, I have recently opened a very small short position in DRYS.

Disclosure: I am short DRYS.