Drybulk Shipping: Normalizing Proportional Risk To Determine Asset Quality

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Includes: DSX, EGLE, ESEA, EXM, GNK, NMM, SB, SBLK, SEA
by: Donald Rudow

Pick any of the drybulk shipping companies that trade on any of the exchanges and you will see something common to all of them. The market valuations for these companies have been severely depressed. Value oriented investors are tempted to look at companies within this industry in the hopes of finding an investment that will pay off nicely in the long run. Many of these companies have either lined up additional sources of financing or are in the process of planning to raise more financing through the equity markets to cover cash needs and update their fleet. Fleets of lower quality are going to require more financing to compete, and those with the least costly form of financing are going to have an advantage in updating their fleets to improve returns. This is an important consideration for going concerns. Value investors are also interested in liquidations but this is not the industry for that right now, in my opinion, unless perhaps you are a cash buyer of ships for scrap. I am more interested in who will survive this period of low shipping prices and come out of it prepared for more profitable times. It is from this perspective I plan to examine the assets of several drybulk shippers through the use of cash and debt levels to normalize their proportional exposure to risk.

Not all drybulk shippers are alike concerning their respective balance sheets. It is useful to normalize the balance sheet figures to compare the various shippers. Not all fleets have the same mix of ship sizes, nor are the ages of the various ships identical. I have chosen the following mix of drybulk shippers: Navios Maritime Partners L.P. (NMM), Safe Bulkers, Inc. (SB), Euroseas Ltd. (ESEA), Excel Maritime Carriers Ltd. (EXM), Star Bulk Carriers Corp. (SBLK), Eagle Bulk Shipping Inc. (EGLE), Diana Shipping Inc. (DSX), and Genco Shipping & Trading Limited (GNK).

The table below is derived from the audited annual financial reports over the last several years, recent quarterly reports, and prospectuses; demonstrating each firm's ability to generate operating income over a five year period. Using reported asset levels and the most recently audited income statement figures, I present an upper bound estimate for 2012 operating income along with a proxy estimate for the current P/E based off the estimated returns. Obviously, the returns are trending downwards and it is well known that the Baltic Dry Index (BDI) has been lower this year, strongly suggesting the actual 2012 return figures will continue to reflect diminished ability of the fleets to generate income from operations.

Operating Return on Assets (OROA)

2007

2008

2009

2010

2011

Assets MRQ ($000,000)

E(Operating Income; assets MRQ, OROA 2011) ($000,000)

Market Value (MV) 7/20/2012

MV/OI 7/20/2012

SB

48.92%

36.78%

31.99%

17.00%

12.95%

909

117.74

469

3.98

NMM

10.66%

10.89%

9.03%

9.47%

7.46%

868

64.78

752

11.61

DSX

18.96%

22.67%

10.46%

9.20%

6.96%

1,674

116.45

566

4.86

GNK

11.75%

7.16%

9.73%

8.02%

3.57%

3,115

111.35

120

1.07

EGLE

7.08%

6.15%

4.40%

4.32%

1.68%

1,848

31.10

47

1.51

ESEA

15.95%

7.67%

0.00%

-0.31%

1.62%

296

4.79

35

7.29

EXM

13.11%

2.13%

12.35%

10.48%

-5.84%

2,669

(155.85)

37

(0.24)

SBLK

-1.86%

22.05%

-5.97%

0.04%

-9.16%

696

(63.75)

50

(0.78)

Click to enlarge

SB is obviously a standout with exceptional operating returns relative to the others. Of the above firms, if the 2011 OROA represents an upper bound on each firm's ability to generate operating income from its asset base in the near term then surely EGLE, ESEA, EXM, and SBLK all represent problematic capital investments. Assuming 30 year Treasury bills are less risky with a 2.60% yield, and in all honestly I'm not willing to concede that 30 year Treasuries are the best opportunity cost measure right now but I'll use it anyway; EGLE, ESEA, EXM, and SBLK do not generate positive economic profits from their operations. They represent a chunk of the industry that can be viewed as poorly allocated capital right now.

With the exception of DSX, ESEA, and GNK most of these firms maintain low cash balances as a portion of their assets. Scrap prices for ships are expected to run between $350 and $450 per light ton displacement (LTD) through the year. Liquidating some fixed assets will free up cash for an improved fleet but drybulk shipping is capital intensive, and a 60,000 - 80,000 dwt vessel yields roughly $4 million on the scrap market and costs about $35 million to replace with a new one. Let's examine the fleets a little more closely along with the potential for improvement.

dwt 2011

dwt MRQ

Average build year/dwt

Average dwt/ship

Source

Scrap Value SV ($000,000)

Cash Eq. MRQ ($000,000)

Cash eq./Assets MRQ

SB

1,886,400

1,886,400

2,008.18

94,320

6-k ex. 1 5/8/2012

94.91

19

0.02

EGLE

2,451,259

2,444,259

2,006.98

54,317

10q 5/10/2012

122.98

29

0.02

GNK

4,482,674

4,482,674

2,006.39

72,301

10q 5/10/2012

225.53

247

0.08

DSX

2,609,611

2,973,237

2,005.84

110,120

6-k 5/31/2012

149.59

442

0.26

NMM

1,945,432

1,331,291

2,004.33

95,092

424 b2 5/4/2012

66.98

33

0.04

EXM

4,137,488

4,137,488

2,002.15

88,032

424b5 5/7/2012

208.17

31

0.01

SBLK

1,475,005

1,475,005

2,001.12

105,358

6-k 6/1/2012

74.21

24

0.03

ESEA

595,063

628,730

1,994.13

39,296

424b5 5/25/2012

31.63

31

0.10

Click to enlarge

Fairly significant reductions in fleet capacity occurred in a relatively short period of time by NMM, one of our two top OROA generators. Rational management practice should cause the fleet quality to rise as represented by the average age of dwt through attrition. SB has the most modern fleet on average, which I use as a proxy for fleet quality. DSX and ESEA are the only two firms that have expanded fleet capacity in a relatively short period of time. These two firms also have the most cash on their balance sheets as a portion of assets. However the age of ESEA's fleet causes me to think it is of the worst quality, and OROA figures consistently below 2.6% over the past three years render this investment as relatively unattractive. It is, however, in a much better position than EXM and SBLK because of the relatively high cash available to improve its fleet quality and thus improve its OROA. EXM and SBLK are both relatively old with very little cash available as a portion of assets on their balance sheets. Both of these latter firms have filed for more equity financing.

Given that 26% of DSX's assets are cash equivalents, DSX has by far the greatest flexibility. The quality of its fleet is nearly equivalent to GNK's and it is positioned to improve the quality of its fleet through use of a healthy level of cash. Likewise, GNK has a healthy cash level to improve its fleet but the figures above imply that the book value of its total assets and its cash are 182% and 56% that of DSX's respectively. Thus, DSX has a significant advantage in improving its fleet quality relative to GNK, SB, EGLE and NMM. Obviously, these capital expenditure decisions can be made at the margin by DSX with less flexibility available for SB and EGLE due to their need to tap into credit markets or dilute present shareholder returns through some form of equity offering.

But, what kind of threat are GNK, DSX, or anyone else to SB, who has the highest quality fleet, should they decide to at least match SB's proportional risk exposure in the industry? SB's proportional risk exposure is given by its debt/asset and cash/asset measures. (Debt-cash)/assets give a measure of exposure to risk proportional to its assets. For SB, this measure is 0.50. In other words, if SB paid off its debt with cash, 50% of its assets remain financed with debt. According to a 2011 report by UNCAD, Panamax vessels cost an estimated $467/dwt while Capesize vessels cost an estimated $341/dwt. If the other firms increase their proportional exposure to risk at least equal to that of SB through debt and cash, how can we expect them to perform relative to SB? To answer this question, I will increase any firm's proportional exposure to risk to at least equal that of SB's. Note that despite NMM's higher debt level I can still improve its fleet quality, given that it has less proportional risk as defined above, by converting cash to fleet expansion. Reducing its cash such that its cash/asset measure equals 0.04 will give NMM proportional risk equal to that of SB. EGLE has greater proportional risk exposure so I will make no changes to its fleet.

Proportional Exposure to Risk such that (debt-cash eq.)/assets is at least .0.50

Proportional Exposure to Risk such that (debt-cash eq.)/assets is at least .0.50

Debt MRQ ($000,000)

Debt/Assets MRQ

Cash as portion of Assets

Additional Panamax 2012 dwt

Total dwt

Average build year/dwt

Additional Capesize 2012 dwt

Total dwt

Average build year/dwt

DSX

393

0.23

0.26

1,900,545

4,873,782

2,008.24

2,599,595

5,572,832

2,008.71

SB

474

0.52

0.02

-

1,886,400

2,008.18

-

1,886,400

2,008.18

EGLE

1,129

0.61

0.02

-

2,444,259

2,006.98

-

2,444,259

2,006.98

GNK

1,677

0.54

0.08

276,886

4,759,560

2,006.71

378,729

4,861,403

2,006.83

NMM

291

0.34

0.04

378,166

1,709,457

2,006.03

517,261

1,848,552

2,006.48

EXM

1,031

0.39

0.01

719,932

4,857,420

2,003.61

984,734

5,122,222

2,004.05

SBLK

250

0.36

0.03

262,249

1,737,254

2,002.76

358,708

1,833,713

2,003.25

ESEA

75

0.25

0.10

223,206

851,936

1,998.81

305,305

934,035

1,999.97

Click to enlarge

Notice the rankings do not change regardless of whether the increased risk exposure is all Panamax or all Capesize. Thus, any combination of Panamax and Capesize that meets the proportional risk requirement for any firm will not change the ranking either. Under proportional exposure to risk, DSX should experience superior performance to that of SB. However, this obviously requires DSX to increase its proportional exposure to risk, and given the pressure on charter rates now and in the near term along with the expectation of a substantial increase in shipping capacity over the next few years I prefer the less proportional risk approach that DSX is taking for the moment. DSX could pay off its debt and still have more proportional cash (cash/assets) than SB does at the moment. This puts DSX into a choice-rich position to negotiate for pricing on fleet additions that will improve its OROA.

SB, DSX, and GNK are all in the top half of all three rankings: operating return on assets, existing fleet quality, and potential fleet quality under proportional risk. DSX has the least proportional risk, though, and should weather a rough period better as a result of that. GNK looks like a potential value play given its market value relative to the 'upper bound' estimate for operating income and it is exposed to less proportional risk than that of SB. SB is performing exceptionally well, but it also has the least flexibility of the top three firms examined here and will most likely experience the greatest decline in operating income as a percent of its assets, should charter rates continue to stay at very low levels or fall further. Regardless, though, all three look to be cheap right now, with SB and DSX on opposite ends of the charter rate risk spectrum.

Disclosure: I am long DSX.

Additional disclosure: I may initiate a position in any of the other stocks mentioned in this article over the next 72 hours.