Keep An Eye On Diana Shipping

| About: Diana Shipping, (DSX)

One of the less publicized success stories of 2007 was the shipping industry. In particular, the dry-bulk category has experienced sharp swings but on average, impressive gains.

The primary source of these gains revolves around the day rates for dry bulk shipping. The industry has become somewhat commoditized in that there is an active market for shipping days complete with a spot price (current price today) for a particular size of ship as well as forward contracts that companies enter for long-term agreements with clients. These contracts can range from a few weeks to several years and are typically paid based on some agreement of a price per day.

Due to the expansion of the global economy, there has been increasing demand for shipping. Countries like China have a strong need for iron ore to make steel for building projects. Grains such as corn and wheat are being shipped as industrialized nations ramp up ethanol production, and developing nations require more food stocks. As day rates for shipping rose sharply this summer, many of the stocks such as Dryships Inc. (NASDAQ:DRYS), Genco Shipping (NYSE:GNK), Diana Shipping (NYSE:DSX), and TBS International (NASDAQ:TBSI) saw incredible gains.

In typical fashion, Wall Street was extrapolating the present far out into the future, and modeling substantial growth indefinitely. Since rates began to level off, the stocks have given back much of their gains and now appear to have value at current prices.

In looking at the structures of different companies within this industry, I was intrigued with the variety of capital structures represented. Diana Shipping struck me as particularly unique because the company proposes to pay out the majority of its free cash flow in the form of quarterly dividends. This strategy is typically seen in mature companies, but Diana continues to expand at a moderate pace by buying new ships and increasing the capacity of shipping days available to customers.

In order to finance these new ships, the company issues new stock periodically when it finds an opportunity to purchase a new vessel. With a low debt ratio and a solid yield, the stock will likely turn out to be less volatile than its peers over the course of this expansion. In comparison, Genco pays a smaller dividend (lower yield) and finances many of its vessel purchases with debt.

Another differentiating strategy for these companies is the degree to which they enter long-term contracts with customers. There are benefits and detriments to either side of this argument. Companies who choose to lock in rates with long-term contracts are unable to capitalize on increases in the spot market for shipping, but at the same time enjoy the benefit of having stable cash flow and lower risk.

Diana shipping has chosen this method although there are several vessels that will come to the end of their contracts in the next 5 quarters. Genco on the other hand, has decided to leave about a quarter of their vessels off contract in order to capitalize on the increasing spot rates. The decision has paid off as rising rates transfer directly to the profitability of the company, but the risk of a slowdown will have more of a direct effect on the bottom line.

There has been some concern that a global slowdown will cause shipping rates to drop significantly and thus cause the transportation companies to suffer losses. While this is a legitimate concern, it appears that the possibility is already included in the price of many shippers.

When considering Diana, the company has long-term contracts that will allow it to be profitable in a rough environment because clients are legally obligated to continue to employ the vessels. There are four vessels coming due for contract renewal in the first quarter of 2008 but the event should be a major positive for Diana as the current rates are significantly higher than the current rates of the completed contracts. This will allow the company to continue increasing the dividend over the next year and provide some sort of floor under the stock price.

The overall market has started 2008 on a sour note. As such, I am limiting new purchases to very small amounts until the current downtrend is resolved. I would not recommend purchasing Diana outright at this time, but I think it is a quality name that should be on the radar.

Aggressive traders may wish to sell puts with a strike price under current levels in order to capture some premium - but only if one is willing to take delivery of the stock as a long-term investment. The good thing with this name is that investors will get paid a healthy dividend while waiting for the stock to rebound. I do not own the stock, but will be considering a purchase as the picture becomes clearer.

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