Declaring bankruptcy has one clear benefit. It allows management to restructure a business without worrying about near-term debts coming due. Airline carrier AMR, for example, is fixing the holes in its business and aims to exit bankruptcy in a financially and operationally stronger position.
That's the same path Overseas Shipholding Group (Nasdaq: OSGIQ) is taking. The company filed for bankruptcy on Nov. 14. "We will use the Chapter 11 process to definitively resolve our financial issues. An orderly restructuring in Chapter 11 will provide stability both to Overseas Shipholding and to the entire shipping industry," CEO Morten Arntzen said in a company press release.
This move comes after four lean years in the dry-bulk shipping business. The whole industry is still paying the price for ordering up too many new ships back in 2007 when global trade was robust. The subsequent glut of new ships has made it hard for almost every operator to command high lease rates for their ships and, in some instances, the debt burdens are adding another punch to the gut.
How bad has it gotten for this industry? A year ago, a typical ship leased for $26,000 a day, but now goes for less than half of that. When costs such as debt service and overhead are accounted for, these ships are operating at a loss every day. This situation can't go on indefinitely.
Adding insult, the glut of ships means that more than half of them aren't even being used, bringing in zero revenue on a daily basis. Game Theory would suggest that the industry's operators would pull enough ships out of service to cut supply and boost pricing. Yet these companies debt covenants are so restrictive that they are unable to make such a move.
How will you know when this industry has finally brought supply down to the appropriate level? When the Baltic Dry Index, a key measure of lease rates, moves back up above 2,500. We have to go back a couple years to find the last instance of when that happened.
All eyes on China
Industry analysts have been keeping a close eye on China, as that country's insatiable appetite for thermal coal, iron ore and other dry-bulk items can play a huge role in boosting demand. But the global economic slowdown has led to a reduction in demand for raw materials in China as that country now produces fewer finished goods for exports and earmarks fewer infrastructure projects at home. Simply put, it's unwise to expect China to rescue this industry in 2013.
You can see the ongoing distress among the stock charts for various industry players. Checkout the chart for DryShips Inc. (Nasdaq: DRYS).
This kind of drop suggests investors may be anticipating a bankruptcy filing here as well. At first glance, DryShips would appear to be quite vulnerable, with roughly $1.75 billion in debt coming due in the next 24 months, $250 million in planned CapEx in 2013 and only $130 million in cash in the bank. The company has been able to raise cash by selling its stake in Ocean Rig (Nasdaq: OREX).
Dry Ships now owns a little more than half of Ocean Rig, which is currently valued at $2 billion. Despite its financial troubles, DryShips is taking delivery of three more ships in 2013, which sounds quite senseless. The company will need to keep selling shares in Ocean Rig just to pay for the ships, let alone cover operating losses. DryShips hopes to finalize its funding agreements for the new ships in the first quarter of 2013 -- an event investors need to watch closely.
On a recent call with analysts, management suggested it would terminate the deals to buy the newly-built ships -- at significant financial penalties, before it is pressed to conduct a fire sale of its Ocean Rig stake. Don't be surprised if DryShips indeed looks to unload a big chunk of stock through a secondary offering. Though management says the stake in Ocean Rigs is inviolable, lenders have started to take pledges of stock as collateral in recent quarters.
But at least DryShips has assets in place against its debts.
Eagle Bulk Shipping (Nasdaq: EGLE) has a similarly distressing stock price chart and a balance sheet that may not be able to hold up. The company has generated just $2.6 million in operating cash flow in the first nine months of 2012, compared with $37.1 million a year ago. This cash flow is far short of the roughly $60 million in annual interest expense. At this rate, Eagle Bulk's current $18.5 million cash balance may have evaporated by this coming January. Analysts at Citigroup don't expect cash flow to exceed interest expense until 2014, which means this company is running out of time as cash dwindles.
Risks to Consider: As an upside risk, these distressed firms could buy themselves more time by restructuring loan agreements, though time is starting to work against them.
Action to Take --> Genco Shipping (NYSE: GNK) and Navios Maritime (NYSE: NM) don't look financially healthy either and need to see a quick industry turnaround. But there is a sliver lining: Stronger industry players such as Diana Shipping (NYSE: DSX) and Safe Bulkers (NYSE: SB) would surely benefit from an industry shakeout that would reduce capacity. So even as you focus on possible further bankruptcy filings in coming months and look to play the short side, also monitor the opportunity for long-oriented value opportunities in this distressed industry.