There are plenty of reasons to be critical of DryShips (NASDAQ: DRYS ) as a long-term fundamental investment. Between its over 1,300% in dilution (and climbing) since its IPO and no earnings current to show for it, its looming debt problems coming in December, and its questionable related party transactions, the company leaves a lot to be desired. But its shipping business often trades at a value less than zero when all is said and done, so if there is any real value there, then an opportunity exists.
Less than zero -- how can that be?
I'll give you the short version. There are two parts to the stock that is DryShips: Its shipping business and its stake in publicly traded Ocean Rig UDW. The market value of that stake is greater than the market cap of DryShips. Since the market cap of DryShips represents the shipping business plus the Ocean Rig stake, do a little algebra, and the market is assigning a negative value to the shipping.
Opportunity or red flag?
Let me explain this using an analogy with Blockbuster. I know, I know, Blockbuster isn't in the same business, or even the same galaxy, as dry shipping. However, money is blind when it comes to value. If you own a money-losing business, it's hurting your bank account and not a great situation to be in whether you sell teddy bears on the street corner or military fighter jets to a defense department.
If I were to offer you my Blockbuster store with $1 million in debt for a purchase price of $100,000, would you be interested? How about if I offered to give it to you for free? Odds are you'd have no interest in owning a money-losing video store while also being on the hook for $1 million in debt. In this case, this Blockbuster really does have a negative value, because owning it is a money-draining burden, and I couldn't realistically even pay you to take it. You'd be stuck with $1 million in debt, no income to service that debt, and have to cough up extra money to pay for the ongoing losses.
Such is the case, and the value the market is giving it, for the dry shipping business of DryShips.
Using the same analogy, if I told you my Blockbuster happens to have turned its business around because the market rates for certain vintage movie memorabilia are going through the roof, and my store is suddenly making a $3 million profit per year, perhaps you'd reconsider placing a bid and a value on this business. If global shipping rates explode as DryShips expects, a similar scenario could play out.
The problems here and now
At the moment, the Street doesn't seem to have any confidence in that second scenario playing out. DryShips' shipping business at the end of last quarter had $1.65 billion in liabilities. Net loss last quarter alone was a staggering $33.6 million. While that figure includes interest, taxes, and depreciation, those are very real expenses over time.
Many of its ships are between 13 and 15 years old, which means they're getting close to approaching the end of their useful life and will have to be replaced in a few years. It's great that perhaps the company will save some short-term cash not having to replace those ships right away, but long term, it's inevitable. The shipping operations need to turn profitable to survive over time, and DryShips needs to accumulate earnings to later invest in new ships down the road.
The other problem for DryShips is its contract arrangements. The company generates the majority of its revenues from two sizes of dry ships: Capesize and Panamax. The good news is that most analysts and executives expect the market environment to improve greatly for the Capesize ships in particular. The bad news is that it doesn't matter for DryShips.
Most of DryShips' Capesize fleet is locked in very long fixed-rate contracts that don't expire for quite a while. The few that expire sooner are mostly at rates that are much more favorable than the current rates. It's a lose-lose situation.
The Panamax ships operate mostly based on daily spot rates. The problem is that the global fleet of Panamax ships is currently so vastly oversupplied that its rates are pushed so low to the point that the market rates are less than the cost of operating. All but three of DryShips 28 Panamax ships are stuck in this terrible rate environment. They might as well be Blockbuster kiosks. They would lose less money.
The market expects at a minimum that DryShips will be forced to liquidate some of its Ocean Rig UDW shares in order to service its debt and keep its dry shipping business afloat since there doesn't seem to be much hope of it sustaining itself on its own any time soon. With $1.65 billion in liabilities, continuing net losses, and only a $1.56 billion stake in Ocean Rig UDW (or less than its liability value), the company is left stuck between a rock and a hard place.
Perhaps the company can sell off some of its ships, but I wouldn't bet on it. More often than not, you see dry-bulk shipping companies file bankruptcy protection and start all over rather than sell off key assets. Looking at DryShips' history, a more realistic scenario is more severe dilution, which will cause the stock price to suffer.
This is not to say that DryShips stock won't necessarily rise in the short term. It often does in sympathy with a broad dry shipping rally. However, long-term Fools will probably be better served to stay docked until DryShips looks in better financial shape. DryShips' shipping business trades with a negative value, and I believe that negative value -- and more -- is justified. If I owned DryShips, I would be looking for opportunities to sell.
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