Head Straight for This Ship

In a wide bay on the Potomac River, about 30 miles south of Washington, D.C., the decomposing wrecks of a hundred or so ships sit as a sad monument to a past shipping boom. After the United States entered the First World War, there was a tremendous need for cargo capacity. But then demand ebbed.

Mallows Bay is a very visual example of the ultimate truth of the shipping industry. A few years of frenzied activity and shipbuilding will be inevitably followed by decades of rust and rot. The boom is always short, the bust is always painful, and long dull periods are the rule rather than the exception.

It might sound depressing, but this realization will help you ferret out what is arguably the best current name in the industry.

First, some history
Investors remember the perfect storm when the bottom dropped out for bulkers in 2008. Rates plummeted, bids for ships disappeared, orders were canceled and bulker stocks like DryShips (Nasdaq: DRYS), Excel Maritime (NYSE: EXM), and Genco Shipping (NYSE: GNK) each fell more than 90% from their highs.

Things looked bleak indeed, and some bulkers likely survived only due to their bankers' largess.

In the two years since the crash, fleet growth slowed as ships were scrapped and building contracts were canceled. Rates have improved, and the industry has again transitioned to the dull normal with less excitement and lower margins. Although demand has tailed, and the fleet is probably still too large, bulk shippers can still make money. Brazil has iron, China and India need it, and iron ore doesn't swim.

Unfortunately, the biggest problem with public bulkers like Eagle Bulk Shipping (Nasdaq: EGLE), Navios Maritime (NYSE: NM), and others isn't on the revenue side, but instead from balance sheets laden with debt from ships ordered in the boom years. In a persistent environment where the supply/demand picture will likely constrain margins, the interest on this debt will take a heavy bite of cash flow. That's assuming, of course, rates stay high enough to service the debt in the first place.

Check out the scary debt-to-equity ratios common to the industry:

These ugly numbers don't tell the whole story
Although some companies have stronger balance sheets than others -- Diana Shipping, for one -- the overall leverage in the industry is sobering. An oversized debt load can crush cash flow, increase overall risk, and hinder opportunity, and that's just for starters.

Debt can undo a company in other ways as well, most notably in the small print of the debt covenants required to secure the credit lines. In fact, it was ship value, not lack of revenues, that was the greatest threat to the existence of some of these companies during the darkest days of 2008. As ship prices fell, the fair market values of the fleets fell below thresholds required by debt covenants. Lenders could have demanded ship sales or additional capital contributions. Some of the listed bulkers could have disappeared overnight.

To understand the full risks of each bulker, you have to drill down into the particulars of its credit lines. The best way to eliminate the risks of debt covenants is to not have much exposure in the first place.

But why buy liabilities if you don't have to?
Baltic Trading is the best option from a balance sheet standpoint. It purchased its fleet primarily with cash from the IPO rather than debt financing. And although a recent acquisition has put some debt on the balance sheet, leverage ratios are far lower than existing bulkers. Less debt not only reduces risk, but also reduces interest costs. These improved margins essentially make Baltic the low-cost producer, and could allow Baltic to remain more profitable than other bulkers.

If history is any guide, we are a year or so into what is likely one of the long dull epochs that comprise the majority of the dry bulk cycle. How long it will last is unknown, but if there is money to be made in the meantime, it will come from good management, low debt loads, and completive advantages.

Good times in shipping make for bad decisions, but you don't have to buy the companies that bear the scars. Don't pay extra for management's mistakes, or your investments could wind up as tragically as the wrecks in Mallows bay.

More on dry bulk shippers:

• How Much of A Bargain Is DryShips Stock Right Now?
• Navios: Enigma of the Seven Seas
• Are Dry Bulkers Catching a Falling Knife?