Never enough lessons on forward P/E, especially for cyclicals. On Tuesday, dry bulk shipper DryShips (DRYS) hit an all-time low of $21.8, down from a peak of $120, and down from the $64 back when Barron's called the Buy on the stock. Everyone is wrong at times, and being wrong for decent reasons is fine. But in a previous post in April, we outlined that we mostly took issue with Barron's completely missing some of the most important issues with dry bulk commodities transportation stocks such as DRYS, and worst of all arguing for the stock given a very low forward P/E, which was completely ridiculous given that the bulk shipping industry is prone to earnings swings of +/-80% within short, unforeseeable periods of time. The below was our previous excerpt from Barron's:
Global trade might slow this year, but it will come back eventually, and DryShips' profits -- and shares -- should move up over the long term, even if 2008 growth turns out to be lower than Wall Street expects. At its recent quote of 64, DryShips stock was trading at a price/earnings ratio of 3.5 times consensus analyst earnings estimates of $18.18 a share this year and about 5 times the $12.22 forecast for 2009. DryShips also trades at a more than 50% discount to its peers, although rivals generally seek long-term contracts, which are less volatile.
And then our following criticism.
This article fails to mention that dry bulk spot rates are extremely volatile and forecasting where they will go is subject to massive room for estimation error, even for industry veterans. Thus forward P/E can be very deceptive and is a silly way to look at the companies. Last year Clarksons research surveyed a large collection of readers to forecast where rates would go in 2007 and EVERYONE was wrong by a large margin. (they spiked massively) They can also spike massively downward in the same fashion... If forward earnings ends up being 80% lower, which historically isn't a crazy notion at all if you look at a rate chart, your P/E will be 5x what you thought it was. Thus using forward P/E is pretty silly given its forecast error range is so wide as to be near meaningless.
Well, this post came under some fire from commenters on Seeking Alpha for either a) being written by an author looking to push the stock down (we wish we had that level of influence on The Stalwart) or b) not understanding that without earnings forecasts and resulting forward P/Es, then there wasn't a way to make an investment case:
If you think "... using forward P/E is pretty silly given its forecast error range is so wide as to be near meaningless" then you must think there is no meaningful way for an analyst that follows DRYS to do his job (to forecast earnings). THAT'S silly.
There are many tools for analyzing a company beyond just forecasting its next year's income. And for highly cyclical ones with little visibility, forward earnings barely deserves to ever be a tool, and is usually much more dangerous than useful.
DRYS is now at $24, down massively due to, well, the fact that the Baltic Dry Index, which is an index for bulk shipping rates, has fallen from a peak of 11,500 just earlier this year to below 3,000 currently, for a 74% decline in just a few months. The rates for DRYS bulk ships have fallen in a roughly similar fashion. This dramatically changes the earnings forecasts of analysts across the board for 2009 and onward, though even these new earnings forecasts remain rubbish given the fact that rates are so volatile and for the most part "unforecastable" for dry bulk shipping. They could cut their earnings drastically, only to see a surprise rate rally in 2H09. DryShips 2009 earnings forecasts have dropped 25% already, though this to me looks timid given the drop in rates seen. DRYS is now at a 2009 P/E of 2x, but again, if the current rate situation were fully reflected in analyst numbers it would have to come down substantially further, as much as to say make the P/E 15x or worse.
Now, maybe DRYS is decent here, I haven't done a full analysis of the company's assets (at $24 maybe the scrap value of its fleet could be enough to argue for value, potentially), nor intend to in this space. But the point is more about using forward earnings as a justification rather than whether buying DRYS at $64 was correct or not. At the very least, the DryShips debacle is another great example of forward P/Es being undependable for this industry and many cycical industries.
What's even more shocking is that some top-tier transport analysts use forward P/Es when arguing for these types of stocks and some fund managers don't bat an eyelid upon hearing such justifications. Highly cyclical companies with low earnings visibility = companies where forward (forecast) P/E is essentially meaningless.
This article has 19 comments:
You are not taking into consideration the fact that dryships has over half of its vessels under time charters or long term fixed contracts. Therefore, those ships rates are not affected by the current Baltic Dry Index. 24 vessels out of 49 have Time Charters. In addition with the fleet expansion as of Oct 6, dryships acquired 9 more ships, 5 of which with time charters, or fixed contracts.
Oct 6, 2008 DryShips Announces Strategic Expansion Adding 9 Capesize Vessels and 2 UDW Drillships Conference Call to be Held Today at 9:00 A.M. EDT
The following is an email from Paul Lampoutis
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The following link will take you to the DryShips fleet deployment chart www.dryships.com/ir.cf.... As you can see from the chart, DryShips has a balanced mix of both spot and fixed rate contracts, fixing half its fleet on long term charter coverage. This secures the company from market volatility, such as we are experiencing today.
For the three months ended June 30, 2008, the total vessel operating expenses were 6,559, based on this figure, DryShips vessels are still very profitable even in the current freight rate environment. I.E. the Baltic Dry Index.
As you may already know, the decline in DryShips shares is not related to the change in Company fundamentals but to the weakness in the Dry Bulk sector. Dry bulk stocks specifically have suffered due to the decline in the Baltic Dry Index. The fall in freight rates is mainly due to seasonality, the Olympics and weakness in steel prices. Today’s volatility in the BDI can also be attributed to the demands from Brazil's Companhia Vale do Rio Doce (Vale), China's largest supplier of imported iron ore, to increase its prices to its Asian customers. Until this is resolved, China is not importing Vale’s iron ore. Market sentiment is that dry bulk fundamentals will remain strong and that industrial and construction activity is expected to resume in China in the fourth quarter which should allow rates to strengthen.
This post contains forward looking statements.
The Leive Ericksson and the Eirik raude both are Fifth-generation semi-submersible drilling units. They also have 2 UDW Drillships that are in the process of being built. Aslo during this month they will acquire two newbuilding UDW drillships to be delievered by Samsung in Q4 2010 and Q1 2011.
The Leive Ericksson is contracted to Shell and will be available for contract in 2009.
The Eirik Raude is contracted at $637,000 average day rate.
The average revenue from drilling contracts daily during the previous quarter was $512,222.
The rig operating expenses daily was $148,755.
Dryships is going to pay all dryship stock holders an issuance in the form of a dividend, stock in a new company called PrimeLead which will be the Ultra Deep water Drilling company listed on the NASDAQ. This will be a total of 6 ultra deep water drill ships and as you can see from above this will be a very profitable company.
Value of UDW Unit for DryShips
This is taken from the presentation on Oct 6th:
We estimate the equity value of Primelead based on different valuation
methodologies ranges:
From $ 2.55 to $ 2.80 billion
Which, if correct, and divided by the 75% share owned by DryShips shareholders
should result in a Primelead common stock price(1):
From $30 to $31 per share
DRYS Share Closing Price on October, 3, 2008: $31.50
If you play the spin off and vaulue Primelead at the 31 dollars per share then what are you getting dryships for? With yesterday's closing price of drys at 21.85?
58 DryBulk ships, 29 of which have time charter fixed contracts?
My strategy since the beginning of the year has been to look for a baby in the discarded bathwater where earnings and assets may be understood well. I haven't found much and have had to resort to holding cash and doing some short-term trading.
Thank you for your article--I found it very informative.
(Please excuse my syntax).
:-)
It's true that everyone is wrong at times. Thus pointing out other people's mistake is the best way to get famous -- just write ten articles pointing out ten potential mistakes and after six months, you know what, two out of those ten will indeed turn out to be mistakes. Then just write two follow-ups quoting your writing six months ago and bingo, you are hell of a visionary. It's funny games like this can still fool people.
Too cynical? Maybe. But I'm quite tired of reading this I-am-smart-because-I-s... type of nonsense. Tell people how you would value it constructively, and I'll take back what I said. Otherwise, this article is a complete waste of time.
As for how might someone value dryships? Well let's think as if one were actually in the industry looking to expand your fleet. An industry player can either buy ships in the market or buy a company that owns ships. If you get far more ships for your buck buying DRYS than buying int he market, then I think that's a decent starting point, but we must be very careful since even dry bulk (and rig) asset prices can fluctuate quite substantially. Thinking from an industry buyer perspective would be simply thinking about the value of a dry bulk company as the actual players in the industry do. I promise you they don't forecast 1 year of earnings and then calculate a multiple. Wall street analysts frequently do, and companies put simple multiples in their investor presentations, but trust me actual shipping players don't make decisions like this. DRYS has rigs and bulk vessels, plus perhaps some additional value from its organization and customer relationships. But you would probably want to be getting DRYS at a price where you were getting its assets at a good discount to market prices, as this would give you some cushion. (these asset prices can fall, so good to have a margin of safety). Just don't forget that DRYS has a lot of debt, so you would want your adjusted NAV (adjusted to include a margin of safety vs. asset price declines) to be much higher than Enterprise Value (not market cap).
1) Why should we assume that (a) the China/Vale dispute will never end, or (b) Chinese materials demand will decline, even as they continue building railways, roads, factories, houing, cars, etc..? That's a pretty bold "decline of China" prediction. Might it be more accurate to say that the current drop in the Baltic index was caused by Olympics hoarding and the Vale dispute, issues that will soon be unwound with a violent uptick in demand?
2) Has anyone done the work to see how new ship production compares with projected long term demand? How many ships? How much an increase? How many old ships are being scrapped? Can ship supply even be predicted?
The point is taken that not all forward earnings estimates are created equal. As the author points out, some companies' earnings fluctuate violently as the demand & price of their underlying product or service fluctuates. Other industries besides shipping where this is the case include oil, refining, fertilizer, mining, chemicals, etc. - basically everything that has gone up in the past few years. The lesson I draw from this is to be careful not to overweight your portfolio with companies that depend on potentially volatile market prices for their earnings. Bricks-and-mortar businesses such as WalMart often have more stable earnings.
All models are wrong by definition, and any valuation metric, P/E, P/B, P/S, ... you name it, has the garbage-in-garbage-out property -- the result is as good (or bad) as the input. Take forward P/E for example, it is obviously useless if you cannot predict the forward earning. I would thus rather focus on debating the underlying fundamentals than on the use of certain metrics.
Sticking to the fundamentals, I'll try to respond to some of Chris B's points. First of all, the China/Vale dispute is not, in my opinion, the reason for BDI decline. The 80 million metric tons of iron ore stored at 20 Chinese ports are the main reason. Too much iron ore was shipped to China before Olympics and it takes some time (some estimates two quarters) to work it through. This may be temporary, but enough to kill the spot market. Second, and more importantly, there is a real worry now that Chinese demand will decline materially. Steel price in China has declined by more than 20%, and big Chinese steel producers are trying to coordinate a supply cut of similar percentage. Furthermore, there is a concern that many real estate markets in China would crash, which will reduce steel demand from construction sector. Do I believe in all these? Partly. The steel price drop and production cut are real, and the sentiment is very bearish in Chinese financial news websites. Anecdotal evidence from China, though not related to material sector, points to slower growth and even deflation in some markets. None of these bold well for the near term. Longer term, sure, I am very bullish in China. But we should keep in mind that there is a huge difference between the real long term (5+ years) and the long term (1 year) that's relevant to stock market.
Coming to DRYS itself, I am very disappointed by the firm's recent move to acquire 9 capesize ships for $1.2B. The number simply does not add up: take the $50000 contract day rate of 3 of the ships as a starting point, the annual revenue of a ship is $18M max. Multiplying that by 9 (ships) and 10 (years), you can see that the combined REVENUE of these ships for the next 10 years will be $1.6B. What about income? What about discount rate? What about market risk ($50K rate is much higher than the spot rate now)? In such an environment, it's as reckless a move as one can imagine. On top of that, the fact that these ships were purchased from an entity controlled by Economu (DRYS CEO) raised a serious conflict-of-interest issue. I have been very interested in buying DRYS shares but this simply put a stop on it. Could anyone shed some light on the rationale behind this deal? I will really appreciate it.
However, though comparing supply with demand growth gives a rough picture, to actually quantify the impact, one needs to know the *elasticity*. Any rough idea on what the elasticity is in the dry bulk industry (I have no clue)? This measure is critical because without it, all that one can say confidently is "things don't look good, because supply is higher than demand". We need better than this to make intelligent investment decisions.
This is especially true now. Given that most dry bulk stocks have fallen by more than 60%, the real question is not "is it bad?", but "is it as bad as people think it is?". To answer the second question, quantitative measure is necessary.
Given the price drop relative to the intrinsic value of the stocks plus the soon to develop HYPE on water scarcity where the stock has invested the infrastructure needed to adress the creeping demand ,the stock give a BRIGHT RAY OF HOPE ON HOPE during gloomy times !!!
I did however see a disturbing article about DRYS and increasing debt. I suppose to pay for the new ships. Can anyone offer some advice on the debt level relative to the value of the company?