A Rising Tide Lifts All Boats?

Knowing of my nautical background, a Fool colleague sent me an article from a rival site that extolled the virtues of drybulk vessel operator Excel Maritime Carriers (NYSE:EXM) as an example of a company selling at a severe discount. The principal virtues of Excel were listed as:

• Seven years of continuous profitability.
• Continued demand for its vessels, for as long as countries trade.
• Forward P/E ratio (based on analyst estimates) of 4.41.
• Return on invested capital of 40.75%.
• Year-over-year earnings growth of 489%.

This sounds like the can't-miss value opportunity of a lifetime, and that was exactly what the article was implying.

The inevitability of the shipping cycle
I can't really blame the author of that article because on the surface, Excel really does look like a great buy -- shares at the time the article was published were going for $13.75 -- until you understand the boom-bust cycle of the charter market for drybulk and, for that matter, tanker vessels. This is not a company-specific problem; it also affects competitors such as DryShips (NASDAQ:DRYS) and tanker operators General Maritime Carriers (NYSE:GMR) and Tsakos Energy Navigation (NYSE:TNP).

Here is how the shipping cycle works. When the balance of supply and demand is more or less in equilibrium, ocean freight rates are reasonably stable. In this state, the main incentive to build new ships is to replace aging tonnage with newer vessels that are cheaper to operate. With an average vessel life of 20 years, about 5% of the world's fleet is scrapped each year.

If the world demand for shipping starts to exceed its long-term average growth rate, then tonnage capacity becomes constrained. The first thing that happens is that the scrap rate drops to about 1%. Then if demand really ramps up, as happened in 2003 and 2004, supply just can't keep up. And it's not as though you can simply go down to your friendly bulkship dealer and buy the floor model. New ships must be ordered, and that creates backlogs for shipbuilders, which will generally take a couple of years to catch up with demand.

The problems now begin to surface as shipowners seem to mimic the actions of momentum investors piling into the latest hot stock as their new-building frenzy leads to an oversupply of expensive new tonnage in the market. The problems of oversupply are exacerbated by governments giving massive grants to shipbuilders to secure jobs and tax breaks to shipowners, such as 100% depreciation in the first year of operations. In a normal cycle, ocean freight rates plummet, not only because of the oversupply of tonnage but also because demand eventually slackens. This leads us into the "bust" part of the classic boom-bust cycle.

The Baltic Dry Index (BDI) is the leading index of the drybulk freight rates and is a composite of the rates on 24 major ocean routes. Check out the movement of Excel's share prices with the index.

"This time, it's different"
Those four words should be a red flag to all investors and potential investors. The argument for shipping is that the enormous growth in demand from China and India for energy and raw materials will be sustained for several years, thus keeping the ships in demand. Even if demand growth remains steady for a while, I believe that this will do no more than delay the cycle as growth in new tonnage outstrips growth in demand.

According to the U.K.'s Home-Grown Cereals Authority report of August 2005, the world's shipping tonnage increases by 8 million tons, or 4%, per year. This compares with current tonnage increases of 22 million tons, or more than 10%. It doesn't take a genius to figure out that, notwithstanding continued growth in China and India, increases in supply of this magnitude are bound to reduce ocean freight rates. Any stumbles in the Chinese or Indian economies could precipitate a collapse.

The Foolish bottom line
Shipowners traditionally also make money by the sale and purchase of ships. They buy when rates are low and sell when they are high. Excel just sold one of its older ships for a $2.5 million cash profit. However, this isn't the signal that would have me concerned -- rather, it is the rash of IPOs at the height of the freight boom, taking advantage of the recent high rates. Take a look at this IPO list:

• Quintana Maritime (NASDAQ:QMAR) -- January 2005
• DryShips -- February 2005
• Eagle Bulk Shipping (NASDAQ:EGLE) -- June 2005
• Genco Shipping & Trading (NASDAQ:GSTL) -- July 2005

Excel has been in existence for much longer than these companies, but the essential point is that no shipping company is immune from the ocean freight rate cycle. Even if a company has locked in some rates by time chartering its vessels, these charters eventually need renewing, just like your mortgage. And unlike your mortgage, next time the rates are likely to be much lower.

Excel may do well in the shorter term, but in my opinion, the longer-term trends for ocean freight rates are down. As ocean freight rates go, so will the earnings and share price as surely as night follows day.

Philip Durellis the advisor/analyst of theMotley Fool Inside Valuenewsletter. You can join Philip aboard Inside Value for free with a 30-day trial, which gives you full privileges to the service (including his top picks for new money now). He owns none of the companies mentioned in the article, but he does have a Master Mariner's certificate. The Motley Fool is investors writing for investors.