Dry Bulk Shipping Valuations Approach “Bubble” Proportions

Genko Shipping and Trading (GNK) rose almost 20% on Thursday, July 19th after it announced late Wednesday that it had agreed to acquire nine Capesize vessels from companies within the Metrostar Management Corporation group for a total of $1.1 billion. Two of these deliveries are expected during the third quarter, while the remaining seven vessels are expected to be built and delivered to Genko between the fourth quarter of 2007 and the third quarter of 2009. This announcement added 250 million dollars to GNK’s market cap. Can creating wealth be that simple? If so, a widget making company should immediately announce that they are acquiring a few bulk carriers (even at market prices) and watch the markets swoon over their share price. And any widget maker can do so-for there are no barriers to entry in this industry. Shipyards do not have any spare capacity but one can buy ships at market prices in the very active second-hand market. The management of the ships can be outsourced to a third party (even a related third party; Dryships (DRYS) anyone?).

The share prices of most dry bulk shipping companies follow the rise and fall in the Baltic Dry Index or BDI. This is an index covering dry bulk shipping rates and is managed by the Baltic Exchange in London. Between 1985 and 2003, this index ranged between 600 and 2200. But then, in 2003 it took off and is close to 6600 today. No wonder then that the dry bulk shipping sector has been red hot. The share price of the most leveraged shipping company DRYS, is now almost 6 times its 52 week low. It trades at 4 times book value. Is the rise in the BDI and related share prices justified or is this a mega short opportunity? Let’s take a look at the facts.

The demand for commodities from China and India combined with the shortage of dry bulk ships, is leading to an enormous increase in dry bulk rates, which for cape size ships are now almost $95,000 a day. The cost to operate these ships is under $10,000 a day.

The world’s shipyards are backlogged with orders and the earliest deliveries available for new orders are in 2009.

As energy hungry China has increased consumption of its own coal at the cost of exports, Japan and Korea have had to get supplies from Australia, resulting in extreme port congestion and tying up dry bulk capacity for weeks on end, thus leading to a further increase in dry rates.

In the long term for this industry, there are no barriers to entry, no pricing power, and this sector should not trade at much above Net Asset Value.

This sector is notorious for reneging on contracts. All those fixed time charters at today’s stratospheric rates? Once rates fall, the long term contracts will sink along with the sector!

So it comes down to this: If you believe that the supply and demand imbalance fueled by the growth of world trade and especially the rise of India and China, will continue, then by all means go long. But if you believe, as I do, that human ingenuity combined with capitalistic greed, leads to efficient pricing, then this is a wonderful opportunity to short the entire sector. I shorted DRYS today at $63 and GNK at $62 based on the knowledge that even as you read this- Australia is taking measures to relieve port congestion, China has 14 yards under construction and another 9 due for completion by 2010 which are already taking orders, shipyards are doubling shifts to meet orders, old tankers are being converted into dry bulk carriers, insiders are looking to sell you their shares and the smart money is going short even as analysts raise estimates. And the BDI ? It has never disappointed-always volatile it always reverts to the mean.

Baltic Dry Index

Sources:
http://shipping.capitallink.com/baltic_exchange/stock_chart.html?
http://alzahr.blogspot.com/
http://www.tradewinds.no/

Comments

[Eric Fox]

Interesting opinion....can you short the Baltic Dry Index?

[Eric Fox]

Or is there a U.S. based ETF for shipping companies?

[sandeep gill]

I don't believe there is a way to short the BDI but there are some hedge funds which trade in forward-freight agreements (FFAs). Also, no ETF exists for dry bulk shipping just yet.
I believe there is demand for such a product, but strangely no one has stepped up to offer it.

[User 105485]

Is there a shipping focused mutual fund?

[glenwpeterson]

Sounds like a very big dose of talking your book to me. Let's short the shares of a company that has, indeed, run up big time, and then hope for some help. Trouble, is the sector is on fire for good reasons.

1. There is currently, in the 2007 and 2008, a dearth of the ships this author thinks the new ship yards (unfinished shipyards) in China are going to pump out. Problem there is it takes awhile to build them. Like about three years. And there is a three year back log. Go figure. Did I mention that these shipyards aren't coming on-line until 2010.

2. Ton miles have increased in the sector as well adding fuel to the fire. This is because India has created a tax on it's iron ore exports to keep the prices down for it's own steel-makers at home. As such, China is now seeking iron ore for those very same ship yards to build the ships (out of steel) from Brazil and S. America. Ergo, longer routes tie up more ships for a longer time. When is that situation going to change. Not anytime soon. I might add that India's GDP growth is also creating increased demand for shipping in and out of that country as well.

3. Bumper crops of corn and beans are coming out of N. and S. America this year too. China now imports a ton of grains from both places, as it's rising standard of living is fueling a better diet, filled with grain fed beef, poultry and hogs. Can you say, Brazil. I knew that you could. They've got the biggest reserves of arable land for Ag growth in the world. It's a long way from China to Brazil.

4. The author mentioned China's thirst for coal correctly. They recently became a net importer for the first time and that trend is not likely to go the other way any time soon. Especially if all those shipmakers actually do get up and running.

5. Ya wanna talk Australian infra-structure problems, it's not just a port problems, it's a rail problems too. If you can't get the stuff to market due to demand, ya gotta not only improve the ports, but improve the rail capacity too. Again, how long does it take to put on extra track and trains and locomotives. Not as fast as it takes to fire up a few "widget" plants in this authors mind, I can tell you that.

6. First and formost, you're comparing apples to oranges with GNK and DRYS. GNK book medium term time charters. Currently most of their ships are running on charters booked two and three years ago at $45K. 8 of the 19 panamaxes and handys are coming off charter from all those unhappy, fickle customers.
And current spot rates are miles, and I do mean, miles above current medium term charter rates. DRYS is a pure play on the spot market and it's fortunes will be volatile for sure. But I wouldn't bet against it in the next 18 months unless the world economy stumbles big time.

7. The author conveniently failed to point out that the industry is also highly fragmented. No single owner owns more than 5% of the the entire world fleet of any of the main classes of ships. In fact, the industry looks a lot like the oil tanker industry did back in 1999. A quick fact check will show you that there has been significant consolidation, and all of the public companies have benefited enormously as they have steadily grown their earnings and assets. Those with liquidity are going to be able to grow market share big time. GNK just bought 9 capesize vessels and will be increasing it's earnings power by over 50%. At the same time, it's increased it's position in a Chinese Shipping company as well.

Want to short these companies. Be my guest. In the very near term, sub-prime jitters in the U.S. market might help you out. But, with Brazilian, Indian and Chinese GDP's on fire and Europe, Japan and Korean doing just fine, I'll take my chances that those shipyards he talks about will start delivering ships in 2010. Until then, I think I'll be holding what I've got and adding a few more as these stocks continue to climb north and pay big time dividends to boot.

But thanks to all the shorts out there for putting the stock on sale from time to time.

Check back with me in six months and let's see whose still holding their position.

Glen Peterson
Private Investor
Northfield, MN

[sandeep gill]

It's funny but I get a lot of responses from people saying that the industry is in good shape until 2009 or 2010, after which supply demand economics will catch up. That is like playing the "greater fool" theory hoping to sell eventually to someone else willing to pay a higher price for what is essentially a zero EVA business in the long run.

1. At current valuations dont you believe that is priced in? At current rates, it becomes economical to delay scrapping and drydocking which will release supply far quicker than your 2010 projections. Not to mention the conversions (see article)

2.Agreed but consider that India's tax policy on iron ore exports could be reversed, it is not iron clad (no pun intended).

3, 4, and 5. Not much to agree or disagree on there.

6. Yes DRYS and GNK have different charter exposures but prices of both WILL follow the BDI. If you study the dry bulk history from 1970's onwards you will see that there have been numerous periods when freight rates have collapsed and contracts have been reneged on. What else can companies on the fringe of bankruptcy do?

[glenwpeterson]

Respect your opinion, but I think the commodity supercycle and emergence of India, China, Brazil, et. al economies represent a paradigm shift in the global economy that will have some legs.

So, no, I don't believe it's priced in.

Your argument amounts to analyst speak. What goes up must come down and is hard to argue with as everyone understand pricing elasticity. Trouble is, no one knows how big the rubber bands are or how long it will take them to snap. Years ago, there was the United States, and, er, well, the United states that drove world economic development. Now, that paradigm has changed (forever, I think) with the rise of China, India, S.E. Asia, and Brazil....you could throw Russia in to as we've all heard of the "BRIC" companies.

I also think you miss synergies and growth through market share acquisition. Consider the recent purchase (announced today) of EGLE and 26 new builds. There were contracts signed for 10 years on these ships. This is unpresidented. The customers were described as a major European shipping company and a public company, both having investment grade credit ratings (BBB). Not exactly fly-by-night iron ore steel mills in China. This industry is highly fragmented. And the supra-max class ships are being snagged by China for intra-coastal trade which is sapping up a lot of excess supply for trans-ocean transport.

I see FCF for 2009 on these contracts with profit sharing around $3-$3.50 for EGLE. Not exactly chicken feed. I Look at companies like QMAR, GNK, EGLE, OCNF and others as solid buy and hold divy yielders with years of earnings power in front of them and the ability to pay down debt, pay a divy and built NAV through debt and equity purchases and earnings and FCF paydown of that debt.

Can't see how this is all going to unravel when you're able to book this kind of contract with profit sharing for 17 of 21 ships.

You could be right eventually....in the next decade of so.

GWP

[js]

You were correct shorting was wrong since drys has doubled. do u know of an index fund or aan etf that tracks the baltic dry index? i like sfl and egle because of the yields. drys seems too high based on valuation..

[jksky]

So how's that short position coming along???

[sandeep gill]

10% stop loss did get triggered a while ago. Yes, there were losses. Markets can indeed stay irrational for a long time. Am short DRYS now @97. Have increased stop loss band to 15%. If I get stopped out again, I will actually be thrilled because it would mean a great opportunity to buy 2010 put options. Even the heavy premiums would be worth it.

[ari5000]

another one bites the dust...

Could have been up 100% if you just turned your logic around way back in ....July.

[turdfurgeson]

Good Call!!!

[glenwpeterson]

I thought I would return to Mr. Gill related to his comments back in July about the Shipping stocks being in a bubble. At this point, I'd say we are a lot closer than we were in July. But if you were short shipping stocks when Mr. Gill wrote this article, you would have been torched. The BDI is well over 10,000. DRYS, EXM and others are leveraged directly to next years rates as in the case of the former, over 90% of it's ships will be rechartered into this high rate environment which is taking shape for 2008.

I made a note on my calendar to remind myself to comeback to Mr. Gill and ask him what went wrong with his analysis.

But, to frank, this is all rather tongue in cheek. I know what went wrong.

1. China GDP is still surging.
2. India GDP is still surging.
3. Brazil GDP is still surging.
4. China is a net importer of coal now.
5. Incremental Drybulk supply is being sucked up by Chinese intra-coastal trade. So, while the supply numbers show these ships as available, they are not.
6. China and Indian demand for steel are increasing at rapid rates as evidenced by higher and higher prices for iron ore, as well as a return to high rates for met coal.
7. Australian drought means Asia will have to seek grain from North and South American lengthening ton miles in the sector. The same can be said for India's protection of iron ore exports. That's making China go to Brazil.

The order book doesn't look to turn unitl 2009-2010 time frame.

Until then, I'd suggest you close your shorts out, for the time being.
Yes there is still more room to run......

I hate to say it....but I told ya so.....!

GWP

[texinvestor]

glenwpeterson,

That was as good a call as any I have seen in a very long time. Congratulations!!

[texinvestor]

sorry about the multiple posts - I am not sure what happened

[JimCollins]

He tried to pick a top, which is a really bad idea. Much better is to ride the bubble with trailing stop losses. Never try to pick tops or bottoms. The trend is your friend. Trends tend to keep trending. Investing 101.

[bfartan]

Sixth months out, it looks like BOTH Sandeep and Glen were right: Glen was premature to call the 50% run-up in shippers like DRYS a top as it went on up >$60 to over $130 in October. Sandeep was right about there being a bubble as it's fallen below his initial July short of $63. With today's (1/22/2008) volatility and gloom, it'll be interesting to see how DRYS ends 2008--there may be another opportunity for a roundtrip!?!

[bfartan]

Er, that should be "Glen was right that it was premature...." Sorry!