At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.
But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.
Iceberg, ho!
DryShips (Nasdaq: DRYS ) investors got off to a fast start in the New Year … and I mean "off" literally. When Morgan Stanley led the new year with a downgrade of DryShips shares yesterday, investors abandoned ship in droves. The stock sank 5.5% in a day of frenzied selling. Yet what news inspired the sell-off? It seems that Morgan Stanley keyed on an announcement DryShips made nearly two weeks ago -- its plans to purchase 12 new tankers for a combined $770 million over the next three years.
Ever since the news came out, DryShips shares have been taking on water, and now Morgan Stanley thinks it knows why. DryShips is paying is $50 million more than the market value of the ships -- overpaying, in fact -- and raising suspicions (in Morgan Stanley's mind, at least) of potential conflicts of interest at the company. This fear (not a new one at DryShips, unfortunately) was apparently sufficient to scare Morgan Stanley into a full reversal of its earlier bullish sentiment on the stock, as the analyst downgraded DryShips all the way from "overweight" to "underweight."
But is the news really so scary?
Let's go to the tape
As I think I've mentioned before, Morgan Stanley is one of those shy bankers that steadfastly refuses to open its own recommendation books to public review. Thus, we can't check on how well its picks pan out over time -- so we can't really endorse (or refute) the analyst's arguments based on its reputation alone. Instead, we'll have to delve into the numbers ourselves.
Those numbers are actually pretty simple. On its face, DryShips looks like the obvious "sell" candidate that Morgan Stanley now says it is. The stock costs 25 times earnings today -- a significant premium to the 10% long-term growth prospects most analysts assign it, and a sizeable premium to the P/Es of other players in the dry bulk-hauling business as well.
Scanning the field, Eagle Bulk (Nasdaq: EGLE ) comes close to DryShips in terms of valuation, with a P/E ratio of less than 12. Meanwhile, Excel Maritime (NYSE: EXM ) and Genco Shipping (NYSE: GNK ) , Diana Shipping (NYSE: DSX ) and Navios Maritime Holdings (NYSE: NM ) can each be had for single-digit multiples to trailing earnings. A Fool can be forgiven for wondering why DryShips deserves such a premium valuation to its peers.
Here's what's so special
The answer, in a word, is "drillships." Some months ago, if you recall, a truly stellar stockpicker by the name of Deutsche Bank laid out a bull thesis on DryShips: ""[Dryships]' long-term dry bulk charter coverage" gives the stock a "stable structural backdrop," while the market undervalues its "intermediate-term exposure to the drillship charter environment."
In short, Deutsche thinks DryShips will make beaucoup bucks from its involvement in oil drilling -- and just this morning, we saw that thesis begin to play out. Casting down the gauntlet before its detractors, DryShips announced Tuesday that its big bet on drillships is already paying off. The company inked contracts leasing three such vessels to Cairn Energy and Petrobras (NYSE: PBR ) for a combined $590 million.
Foolish final thought
Successes like this one are one reason why analysts predict we'll see DryShips earn enough money in 2011 to drop its P/E ratio right down to the levels of its more bulk shipping-focused peers. (The company's forward P/E is only 5.0.)
If this is the way things continue to play out, maybe Deutsche was right about this stock all along, and maybe Morgan Stanley was a bit hasty to begin letting down lifeboats.
On the other hand, the question of free cash flow remains unanswered. Remember that DryShips has only generated positive free cash flow for its shareholders in one year out of the past five. More years than not, it burns cash, averaging a burn rate of about $400 million a year between 2005 and 2010. And while the company churned through only $280 million over the last 12 months, the new dozen-tanker order it announced last month seems destined to increase capital expenditures by an average of $250 million or so over each of the next three years.
Long story short: If you're investing in DryShips in hopes that its drillship bet will pay off, today's news should thrill you. However, I simply cannot bring myself to invest in a business that doesn't generate cash for its shareholders. Unless DryShips patches that hole, I'm not setting foot aboard.
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