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Bull/Bear Stock Report - Should You Buy DryShips, Inc. (DRYS)

I've always despised the concept of style boxes made popular by firms like Morningstar. While possibly good intentioned, although I doubt it, putting stocks in a box based on a static view makes absolutely no Rational sense.

Instead, I prefer to float above the boxes if you will in search of value wherever and whenever I can find it. That means I'll buy growth, value, dividend, defensive, small, large, and anything in between.

I'll invest anywhere that I can generate significant returns for my portfolio. One situation I am particularly keen on is stocks that trade for low multiples of earnings and sales and yet demonstrate huge growth potential.

Investors pouncing on these opportunities can make lots of money.

That's what initially attracted me to DryShips, Inc. (DRYS) late last year. The stock was getting battered in the global economic slow down story and yet its near term growth story was still impressive regardless.

You see, DRYS operates in a world whereby supply cannot increase overnight. It takes a long time to build a ship. That means, no matter what happens in the economy, the current tight status of demand versus supply plays to DRYS advantage.

I was so confident of my analysis of DRYS that I made the company one of my top 10 stocks for 2008.

Oops. Not so fast. DRYS dropped over 30% during the first to weeks of the year.

Was I wrong? I don't think so. Facts are facts. This company is a cash cow in my opinion and the selling on global recession fears was overdone.

Or, if indeed the economy goes in the tank worldwide maybe we do have something to worry about with DRYS.

Well, the jury is still out on the economy, but DRYS has recovered all of its year to date losses and now stands solidly in positive territory for 2008.

One reason for the rally is anticipation of continued positive results on the earnings front. Last night DRYS reported numbers for the fourth quarter that beat the street by a whopping $.43 per share. Revenue growth was well above 100% year over year.

The stock is up over 8% in after hours trading as a result. Maybe that explains why the preponderance of opinion on DRYS was bullish. That being said, here are two views on both sides of the coin:

Bull Case - Don Barrett

DryShips Inc. is a marine transportation company operating about 30 vessels. Thecompany reported in November 2007 for the 3rd quarter net income of $103.5 million or $2.92 per share which included a one time capital gain of $19.2 million or .54cents on the sale of 2 ships. Excluding the 1 time capital of .54 cents,they still netted $2.48 a share. At $73 dollars that gives them a current p/e of about 7.

Shipping rates are dictated by the Baltic Dry Index or BDI as set by the Baltic Exchange in London. The BDI spiked from about 4300 in January 2007 to about 10,800 in October 2008.
If you examine the costs of operating an ocean vessel,you have labor and fuel costs. Labor should be fairly stable and that leaves fuel costs. Fuel costs have sky rocketed,but companies such as DryShips have a built in fuel surcharge rate which increases as fuel costs rise. The trucking industry in the U.S. operates in the same fashion,as fuels cost go up,the shipper pays a higher surcharge and absorbs the higher cost,not the transportation company.

So,as BDI more than doubled,DryShips and the other ships company's costs hardly moved and thus they had a great 2007. Drys and others are buying ships and consolidating because the industry is booming. The BDI has dropped off to about about 5500 and now is starting to increase again.
A lot of these ships are hauling coal and agriculture products from the U.S. to China. As the dollar weakens,shipments from the U.S will continue to grow. I have seen estimates as high as a full 1% of the U.S. GDP is now coming from exports. As we open new export markets and we have a weak dollar,these marine transport companies should continue to grow.

Based on current BDI rates and comparing those current rates to past rates,the marine shipping industry is doing very well. This is one major factor in my predicting this is a slow down and will not be anything near the 2000-2003 recession.

Drys and these other transporters are in a great position and I think are a great buy at current price levels.

The Bear Case - Tom Armistead

To start with, Marc Faber, in the January 28 issue of Barron's, mentioned DRYS as a short. He is bearish on the US economy and expects our troubles to spread to other economies. He says: "the Chinese stock market is closely correlated with the Baltic Dry Index. Tanker rates have plunged, but the Baltic Dry Index is still in the sky. If you can't short the index, short DryShips (DRYS)." These remarks were made at the roundtable meeting which took place on January 7, and I imagine the advice would still hold.

I started with what I call the Four Metrics Test:
Metric DRYS Industry
Price/Earnings 7.94 15.74
Price/Sales 6.06 4.14
Price/Book 3.57 2.79
Price/Cash Flow Not available

This shows DRYS with an attractive P/E, but with P/S and P/B that are on the high side, and are above industry averages. Because cyclical demand has been so high, it is necessary to form an idea of DRY's long term average earning capacity to realistically evaluate the stock price.

The DryBulk shipping industry consists of transporting commodities such as grain or iron ore, frequently to China and India. Demand has increased rapidly with the growth of the world economy, and capacity is now starting to catch up, as new vessels are put into service. Rates have been at historic highs, but are starting to decline. The industry is cyclical, capital intensive, and commodity-like. The lead time to build a ship is about 2 years. I would imagine it would be similar to the basic chemicals industry, boom or bust depending on supply and demand, with single digit P/Es appropriate at periods of peak profitability.

The source of information on rates is the BDI, or Baltic Dry Index. I searched it, using Google, and found a graph. It has soared in recent years, declining steeply in the last several months, and is just now starting to increase slightly. It is an excellent leading indicator to the world economy. The graph looked an awful lot like a bursting bubble phenomenon to me.

If or when the US goes into recession , if it spreads to China and India, an increased supply of vessels could be competing for reduced demand, sharply reducing rates. Meanwhile, DRYS has been growing at a breakneck speed, on borrowed money.

The industry price metric is TCE, or Time Charter Equivalent. DRYS includes it in their Financial Statements, as does the similar Diana Shipping, (DSX). It is the net figure of voyage revenue less voyage expense expressed as a daily amount: it is dollars/vessel/day. I computed an average TCE for 2002 through 9 months of 2007, using DRYS and DSX figures, which are remarkably similar. I got a figure of 22,350, vs. the 45,525 that DRYS recorded for 3rd quarter 2007.

Using DRYS 3Q2007 income statement, I annualized it and then projected 2008, adjusting for an increase of vessels from 32.84 to 46, and using the average TCE as computed above. Based on these computations, I got EPS of 2.11, compared to the 7.89 DRYS reported for the first 9 months of 2007. DRYS has concentrated on the spot market, avoiding long term charters. This strategy increases profits at times of peak demand but could backfire in a slowdown.

Of interest, DRYS recently agreed to acquire 30.4% of Ocean Rig (OCR), the owner and operator of two Ultra Deepwater drilling rigs. They affirm their continued commitment to drybulk, but think the deepwater drilling is a new field of opportunity. I question this, and would prefer that they stick to their knitting in their current niche. Perhaps the current niche seems less attractive than it did a few years ago.

I would avoid DRYS, based on my estimation of earnings potential at historical average TCEs, which would be 2.11 per share. At a P/E of 15, that would be 32 per share, a long way down from the current 73.28. The business, by its nature, requires the heavy use of borrowed money, so if the going gets tough you have another factor that can create complications. For you momentum players, if you see it heading up and elect to take a flyer, I would recommend a stop loss.

I have had my problems with value traps, sporting an NAV of 8.2, and so lately I have been thinking about how to define one. A tentative definition: A Value trap is a situation where an investor can lose serious money by buying a stock that is trading very low to some basic measure of value. DRYS, at a P/E of 7.94, may very well fit that definition.

I can appreciate Tom's point. Value traps are numerous on the street and they are to be avoided at all costs. In most value traps though, the valuation appears attractive, but the fundamentals are deteriorating.

That does not appear to be the case with DRYS. The biggest risk in my view is the collapse of the economy. If that scenario occurs, DRYS could fall dramatically.
On the flip side, industry fundamentals and tight supply should damper any negative impact a recession would have. We seem to be protected on the downside here with still plenty of upside.

I'm still on the Bull side of DRYS.

Next week, I'll have another stock for this report. The blogging on these topics has been fantastic. Keep up the great work. If we are fortunate we all will prosper just as we have with DRYS.

Jamie Dlugosch

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Bull/Bear Stock Report - Should You Buy DryShips, Inc. (DRYS)

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