Tom A's Stock Picks

DRYS - a potential value trap

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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.