Saturday, November 17, 2012

Rough Seas Ahead For Shipping

I apologize for the use of puns in the following article, it's simply too easy. As investors, we're constantly out looking for the best deals on the market. It's common nature for people to seek the greatest value in their purchases whether it's a can of soup, a new car, or a little piece of a company. Many of these people are looking towards the shipping industry as one which has been knocked down and is looking to come rising back up.

Unfortunately for these investors, they could be riding the bull straight off the cliff in this circumstance as many of the shipping companies are walking the fine line towards bankruptcy. These investors look towards the sun rising on commodities as the catalyst for correcting the diminishing shipping industry. They'll soon learn that even a growing demand for commodities will not be enough to right this ship. The demise of shipping companies worldwide is two-fold, and about to experience the second beat down in recent years.

A Brief History

The shipping industry experienced years of prosperity throughout the beginning of the century with commodities in high demand and globalization further increasing the exchange of goods across borders. Clear skies were surely ahead causing the shipping companies of the world to exponentially grow their fleets. Little did they know they were sailing straight into the "perfect storm." Unfortunately ships cannot be built overnight; they take years to construct, which causes the directors of shipping companies to predict future demand and correspondingly order more ships to be built. During the boom they simply could not fill orders fast enough as they were constantly working at full capacity. Then the crash came… In the second half of 2008, the prices of most commodities fell dramatically on expectations of diminished demand in a world recession.

2012 Outlook

Some shipping companies narrowly escaped the crash in commodities and have struggled to stay afloat during the global recession. Even as the price of commodities shows signs of rebounding, thus driving up the demand in the industry, they are about to experience further turmoil: The supply is too high. The boom in the price of commodities prior to the financial crisis led to a large increase in orders for the construction of new vessels. Those vessels are now coming onto the market, leading to a massive over-supply of ships. Consequently freight rates have crashed from $15,000 per day about 2 months ago, to less than half that today: $6,000. If you find yourself near a port in Singapore, Malaysia, South Korea, Hong Kong, China etc. you'll see first hand how these coast lines are becoming the largest parking lots on the planet. Miles of empty cargo ships sit idle with no plans of future use. These parking lots however are more damaging than leaving your car in a dark alley of Detroit. Boats that sit idle deteriorate very quickly. They must constantly be maintained and moving in order to be kept seaworthy.

This second wave of pain on the shipping industry is going to be far more destructive than what we've witnessed over recent years. Their income statements are about to produce another year of losses due to the decrease in freight rates. Furthermore, their balance sheets are going to be equally as devastated due to the decreased value of their vessels from over-supply.

Will This Lead to Investment Opportunities in Consolidation?

According to many reputable SA authors; Yes. According to this inexperienced, punk kid with too much time on his hands; NO. If you're the CEO of a large shipping company are you actively looking for a cheap buyout of your smaller, cash strapped competitors? No. These larger companies may be better prepared to endure more times of hardship, but they certainly will not be looking to add to their fleet through acquisition. This is not the tech world where a takeover leads to new subscribers and endless amounts of patents. This is the shipping world. A takeover will lead to more useless ships, smelly sailors, and increased docking costs. Take Overseas Shipping Group (OSG) for example. They currently are in one of the best positions to make it through the upcoming hardships. Market cap of $411.65M, yield of 6.62% and a strong cash position to back it up. They're certainly not going to be looking to diminish their cash position by acquiring a large fleet through a takeover. At a Price-to-Book ratio of 0.25 they certainly look like a cheap buy, but if you believe anything I've outlined thus far, this is no industry to go long in. Don't let this attractive looking stock be the Italian rock that sinks your portfolio.

Abandon Ship!

Expect the shipping industry to take another shot across the bow in 2012. If you do your due diligence you'll be able to find many possible short candidates.

Eagle Bulk Shipping Inc. (EGLE) for example, has an EPS of -0.16 accompanied by a Debt-Equity ratio of 168.53. From September 2010 to September 2011 their cash position went from $129M to $27M. Needless to say, this company cannot remain liquid if they go through another difficult year. If you're looking to short, allow this stock to continue rising as it has recently. Make sure to thank the bulls when you do enter the position.

If you're sitting here today having watched your stocks in DryShips Inc. (DRYS) increase over 16% yesterday and laughing at this article which is predicting we've hit a false bottom, I say kudos and congrats. Further, I caution you to recognize the sheer lack of reasoning for this rally, and reevaluate the horizon for this company.

Apologies for painting a bleaker picture for the optimists out there, but these ships certainly were not paid for with cash. The European banks, clinging to their life rafts as they weather the current financial crisis, hold majority of the debt used to finance these shiny new boats. But I digress...

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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