By Jeffrey Alton & Bill Feingold
Convertible Bond Analysis
The DryShips 5% convertible bond of December 2014 would appear at first glance to be trading as a cash substitute, quoted just below par. But a 5% coupon these days is no cash substitute. Indeed, depending on the quote and where in the bid/ask spread the bond trades, the yield can vary enough to make extrapolating difficult—especially because yield is such a potentially overrated calculation on a very short instrument with considerable credit risk.
What's the right way to think about the bond? Well, given the looming maturity and the company's challenged liquidity, it makes sense to think in terms of an exchange offer. Although the new-issue calendar has picked up of late, the convert market still has a lot more cash than it can put to work, especially in balanced paper.
So what might DryShips offer holders of the 5% bonds to extend? We started with the assumption that the credit is reasonably reflected in the existing bond—somewhere in the vicinity of a 750 CDS. We'll go with 35% volatility.
All told, we think DryShips holders could be looking at the opportunity to swap their maturing bonds for a new five-year bullet with a 4% coupon and 40% conversion premium. We think such a deal would be viewed as a couple of points cheap theoretically and would quickly trade rich to that valuation
Dryships Inc. (DRYS) is a Greek drybulk and petroleum shipper that also holds a majority ownership in the publically traded oil drillship subsidiary Ocean Rig UDW Inc. (ORIG). ORIG is a newer part of the company having been established in late 2007. The company ranks as one of the top drybulk shipping companies in the world and its fleet includes 38 drybulk carriers, ten oil tankers and eight drilling units.
While the company is still considered by many to be primarily a shipper, revenues tell a different story. Total revenues for consolidated DRYS in 2013 were approximately $1.49 billion of which only about $312 million were attributable to the drybulk and tanker segments. Total net loss for 2013 for the entire company was $223 million. The main reason for the shrinking shipping business is plunging shipping rates due to an oversupply of ships ordered during the bubble years prior to 2009.
The Drybulk Market Sinks DRYS
The Baltic Dry Index reached a level of 11,793 in May of 2008, only to fall to 663 in December 2008 as the Great Recession decimated international trade in drybulk items. The 18 months beginning in 2012 proved another harsh period for drybulk shippers as the index remained below 1,200 due to an oversupply of ships. In 2012, DRYS lost $288.6 million on revenues of $1.2 billion versus better times in 2010 when the company reported net profit of $172.6 million on revenues of $859.7 million.
Keeping the Parent Company Afloat
To keep Dryships afloat during the downturn, the company has employed several strategies:
1. Diluting Shareholders
The company has never been shy about diluting shareholders. Shares outstanding in 2005 were about 30.5 million versus 454.8 million at the end of last quarter. DRYS currently has a $200 million “ATM” equity raising program underway way where the company sells stock on the open market to meet their cash needs. Through Q1 2014, the company has issued about $107 million in stock.
2. Leveraging up
The company’s total debt to total equity ratio has increased from just over 1.1 in 2009 to over 1.6 times in 2013. Total Long-term debt was about $2.7 billion in 2009 and $5.6 billion in 2013.
3. Bond Covenant Violation Waiver
Dryships is in technical default of financial covenants for $398.8 million of outstanding debt as of March 31, 2014. As part of negotiations with the banks to waive technical default, Dryships has pledged a total 3,800,000 ORIG shares. DRYS is in negotiations to restructure loan documents and extend bank waivers past December 31, 2014.
4. Selling Ships
In the beginning of the second quarter, DRYS has sold a Capesize vessel for $53 million. During the Q1 2014 conference call, management also said it was considering selling the entire oil tanker fleet if the market proved advantageous.
5. Unlocking Value from ORIG
Although ORIG has been prosperous, it has been difficult for the parent company to unlock value to help DRYS cash flow. For the first time, ORIG paid a dividend at the end of Q1 2014 equal to 19 cents per share. That resulted in a total dividend of about $14.88 million paid to DRYS from ORIG.
Have Shipping Rates Finally Bottomed?
Shipping rates bottomed last year and appear to be rising as the fall 2013 prime drybulk season brought the highest rates since 2010. While rates have dropped precipitously again during the spring off-season in 2014, the chart still shows higher lows for cape size shipping rates.
Reflecting improved shipping fundamentals that began in the second half of 2013, Dryships lost $35.1 million on revenues of $457.5 million in Q1 2014. Backing out the data by segment, the Drybulk segment lost about $38 million on revenues of $54 million. The tanker segment made about $3.9 million revenues of $43.3 million and the Offshore Drilling Segment lost about $1.3 million on $360 million in revenues.
To take advantage of what Dryships management believes is the coming bull market in shipping in 2014 and 2015, the company is transitioning its dry bulk ships from long-term contracts to the spot market. Dryships fleet consists of 12 Capsize ships, 24 Panamax and 2 Supramax ships. The company’s Panamax fleet is most exposed to the spot market currently. Panamax ships carry about half the tonnage as Capesize ships, so rates should roughly be in line. Current spot rates are as follows:
A couple of factors lend credibility to the story that the drybulk market is set to further improve.
- Demand is expected to rise faster than supply.
Dryships projects that the industry dryship fleet will grow 5% in 2014. Demand is expected to grow 6%, providing a boost for shipping rates.
- Global iron ore prices are expected to decrease.
China has high iron ore cost producers. As iron ore prices drop globally, China is expected to shutter domestic iron ore production and increase imports – increasing drybulk shipping demand.
Dryships reports the following increases in EBITDA / free cash flow generation per improvement in spot rates:
Even modest improvement of $5,000 in dry bulk spot rates would significantly move the company toward operating in the black.
Risks to the improving Scenario
Because China is the greatest importer of drybulk goods including grains and iron ore, the greatest risk lies in slowing Chinese economic growth. Of particular note is the slowing housing demand which in turn will affect demand for steel/iron ore.
Other risks include a rising order book for drybulk ships beginning in 2016, meaning any improvement in rates may be cut short as new ships hit the market.
Jeffrey Alton currently owns DRYS common equity.