News Analysis date published New: 
Friday, June 3, 2011 - 13:00
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Friday, June 3, 2011 - 13:00
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Friday, June 3, 2011 - 13:00

The ONLY Stock You Should Consider Buying in this Sector

Friday, June 03, 2011 1:00 PM

Economists love to run a series of experiments based on "Game Theory," testing whether individuals rationally account for the actions of others before making their own moves. When it comes to companies in the dry-bulk shipping industry, only one player has been acting rationally. The rest have been making foolish moves, making life brutal for investors -- except for those who have been smart enough to own that one rational player.

After the economic downturn in 2008, the industry was suddenly beset by too many ships chasing too few customers. The Baltic Dry Index (BDI), which is a handy proxy for the rates these companies can charge to lease their fleets, plunged sharply, from around 11,500 in the spring of 2008 to just 2,000 18 months later.

That kind of drop turned the industry on its head, as daily lease rates for these massive ships that carry iron ore, coal and other dry goods were suddenly so low, that profits turned into big losses.

Faced with such a sea change, you'd think these companies would show restraint and wait for demand to rebound and profits to rise back up before ordering new ships. Instead, almost all of them kept ordering new ships, and now they're paying the piper. The fleet of dry-bulk ships is set to expand 13% in 2011 and another 11% in 2012, according to research firm Sterne Agee. Faced with a glut of new ships, customers are able to work out sweet deals, while the BDI now sits at just 1,500.

Is it any wonder share prices are once again falling for the industry's key players?

It would be awfully tempting to look at these stocks as bargains, despite the foolish expansion moves by key players in recent months. Companies like Dry Ships (Nasdaq: DRYS) and Navios Maritime (NYSE: NM), for example, sport price-to-earnings (P/E) ratios in the mid-single digits. Stocks like Eagle Bulk Shipping (Nasdaq: EGLE) and Excel Maritime (NYSE: EXM) trade for half their 52-week high, a typical level that attracts interest for those seeking deep value plays.

But every one of these stocks carries the same risk. If the global economy cools, then lease rates for these massive ships might fall even further, turning current forecasts of decent profits or small losses into massive losses. This would spell real trouble for these firms, each of which carry too much debt. In most instances, big payments will need to be made against that debt load in the next few years. A lousy economy could conceivably force these companies into bankruptcy.

The wise player
As the table above shows, one dry-shipping firm chose to follow the rules laid out in "Game Theory." Seeing that the industry was embarking on an ill-conceived expansion, Diana Shipping (NYSE: DSX) decided to step aside and hoard its cash, assuming it may eventually be able to buy ships at fire-sale prices from distressed rivals if the industry hit another rough patch.

Analysts at Sterne Agee laid out a bold prediction back in January: "DSX's financial flexibility, ample cash balance and debt capacity put the company in a pole position to capitalize on the coming weakness in the dry-bulk market." That time is now at hand. Diana now has $373 million in cash and can borrow up to $87 million, according to Clarkson Capital Markets. This gives the company $460 million in fire power. Goldman Sachs believes "Diana has the cash/debt capacity to roughly double the fleet size."

Even before making any big moves, Diana is already nicely sheltered from the industry price pressures. Its fleet is already mostly booked at pre-negotiated prices, which are higher than the current spot-market rates.

Action to Take --> Even as Diana Shipping has held up better than peers, it's still a bargain, with shares trading below Net Asset Value (NAV) of $12.60 a share. In coming quarters, Diana may well acquire more assets for $0.50 or $0.60 on the dollar, pushing the ultimate long-term value of its asset base even higher.

Shares also trade for just 6.5 times projected 2011 earnings before interest, taxes, depreciation and amortization (EBITDA). It's not a cheap multiple in an industry that is suffering, but it's a nice entry point when you consider Diana's rivals are increasingly likely to retrench and take ships out of the water if the hard times continue. Picking up ships on the cheap now will boost EBITDA later when the industry re-strengthens. As a third leg to value, shares sport a free cash-flow yield of about 12%, based on Goldman Sach's 2011 free cash-flow projections.

P.S. -- If you're an income investor, why would you buy a stock yielding 2% when you can find one paying 26% right here? Watch this presentation for more.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.