Ripest Grounds for a Spec Play, Part III

 | Mar 24, 2013 | 9:00 AM EDT  | Comments
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stng

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egl

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Note: This is the final installment of a three-part series. Here are parts one and two.

The most vicious rally in the market at this very moment -- the hottest, the place where major speculative dollars are going -- is in shipping. Specifically, dry bulk shipping.

At first glance this makes no sense at all. None. Isn't the world slowing? We know Europe is, courtesy of the European commitment to austerity, which is playing a major role in that downturn. Japan might benefit from an influx of orders because of its devaluation of the yen, but that's more zero-sum than anything else.

China? Frankly, I am beginning to believe that we don't know what to believe about China. Some numbers come in hot, others come in cold.

But there's one thing for certain: The Baltic Index, which tracks the day rates for shippers, is slowly but surely taking. This index used to be a fairly important measure of the health of the global economy, but in recent years the industry has been swamped with overcapacity -- too many ships -- and the only thing the Baltic Dry Index has told us is that it's been lousy to be a dry bulk shipper.

In 2012 the index had its worst performance in 26 years, falling 41% year over year, thanks to worries about a Chinese slowdown as well as an oversupply of ships. In fact, when you look back, the Baltic Dry Index has been in a giant downtrend ever since it peaked at 11,793 in May of 2008. The index hit a low of just 661 last fall, but it's risen 50% since then. It isn't on a spike, either; it's been a more stable fits-and-starts climb.

So why do I think the Baltic Dry Index has bottomed, and with it the dry bulk shippers? Why do I believe this initial jump in the underlying stocks is sustainable? Well, the fact is, dry bulk shipping rates simply can't get much lower than where they are right now. When they do, the ship owners stop taking them on voyages because they don't earn enough to cover the cost of the trip. In other words, things are so bad that they literally can't get much worse. But it's not just that. See, the dry bulk space goes through periodic boom-and-bust cycles. When times are good, companies order lots of new ships, and it can take years to fill those orders, so when things take a turn for the worse, the market gets choked with additional supply for many years into the future.

Right now, 2013 marks the sixth year of overcapacity in the industry, but there are signs the dry bulk shippers could be approaching an inflection point at which things start to get better.

The pessimism about the business has meant that they're ordering fewer new ships and they're now scrapping old ships at record levels. That's how you get to a point where day rates can bottom and the industry can recover. In fact, we're seeing the same thing happen in other types of shipping stocks -- for example, the oil-tanker business is at long last getting stronger, with Nordic American Tanker (NAT) finally breaking out to the upside in the last few weeks.

Herbjorn Hansson, Nordic American's perennially optimistic CEO, earlier this month bought a brand new 2013 ship for half the price it was on the market for. That shows the industry itself is having tremendous difficulties getting financing. Many ships are being sold for scrap, and the rates have slowly gone higher. But I am not as optimistic about the oil tanker stocks as I am about the dry bulk carriers, simply because the U.S. is now importing far less oil than it had done even three years ago. Despite voracious Chinese demand, I doubt we will see a return to the halcyon day rates of yesteryear.

Plus, a number of very smart distressed-debt money managers are now focused on the dry bulk sector. The great Wilbur Ross Jr., of WL Ross & Co., is looking to raise a half-billion dollars for a new private-equity fund that will buy distressed shipping and other transportation assets. Meanwhile, you have the private equity outfits, like Apollo (APO) and Cramer-fave Blackstone (BX), betting on a recovery in shipping.

These are smart guys, and we want to invest alongside them. In the dry bulk space there are several companies that are hanging on, and if you want to roll the dice you should stay tuned to the rest of this article.

The most stable is Diana (DSX), which was so much smarter than the other guys that I think it can ride any wave up and capitalize off of it.

What got most dry bulk shippers into trouble was that they used a great deal of leverage to buy a lot of ships back at the peak of the cycle, before the Great Recession hit. Then the companies got crushed as day rates plummeted, and the value of the ships sank, but they still had massive amounts of debt. In 2008, a Capesize vessel, the largest size of dry bulk ship, cost around $155 million. Today, that same five-year-old ship is worth just $34 million -- a 78% decline.

Unlike the other players, though, Diana used less leverage. Instead, it raised equity and built up a big cash hoard. Plus, the company isn't hostage to the horrible sport rates, as 92% of its available days this year are covered by more defensive one-to-two-year time-charter agreements. That's not what you want if you think rates are going to shoot up overnight, but I do not think that's going to happen. Diana is the safest player -- and in 2014, the company will shift to a policy of short-term contracts if things keep getting stronger.

Meanwhile, Diana has used the weakness in the dry bulk market to expand its fleet, buying more ships at ultra-low prices. It has such a good balance sheet that it can speculate in this market, picking up $900 million worth of ships secondhand. If secondhand ships simply return to their long-term averages, they'll be worth 77% more than where they are now.

Diana's current net asset value is $9.29 per share, so the stock is now a buck north of that. I know that makes it dicier than it had been not very long ago, but absolute bottoms are hard to catch.

Now, for the true speculators out there, let me share with you some other ideas. First, just last week, Scorpio (STNG) placed a very successful 29-million-share secondary offering at $8.10 apiece, and is backed by some very smart people. The pricing has since gone to $8.47, another sign of a very strong stock in a red-hot group.

Many good people I know, including my co-writer Matt Horween, like Eagle Bulk Shipping (EGL) and DryShips (DRYS). The latter is a $2 stock that could double if these trends continue.

Let me leave you with the best speculative play of all here: Overseas Shipholding, a $3 stock on the "pink sheets" for which I have actually heard $15 valuations.

Mortgage insurers, airlines, bulk shippers, worst-to-first, happening right now. The best specs I have to offer.

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