Tuesday, November 24, 2009

Dryships turns to the bond market

After repeated ATM share offerings with massive dilution, Dryships (DRYS) has now turned to the bond market for additional capital with a new US$ 400 mio offering (initially US$ 300 mio). The deal also includes a US$ 150 mio loan in notes to Deutsche Bank, the sole bookrunning manager of the deal. As a feature, the deal appears to offer investors a convertible arbitrage where they can take a short position against the company common share value so they can hedge their investment.

Dryships was badly hit by the financial crisis and precipitous drop in the dry bulk market last year. The company had been outperforming its peers with a more speculative policy of older vessels, shorter term employment, building up the fleet by riding the market up and selling older tonnage to finance and expand into new tonnage. Bank leverage rose accordingly.

George Economou's decision to use Dryships to support his foray into off-shore drilling purchasing OceanRig changed the nature of the company. He privately booked several additional oil rigs and in his usual practice shifted them to Dryships, where there was broader access to capital markets to support the transaction.

An oil rig is a substantially higher capital intensive investment than a ship. The oil rig assets on the company balance sheet quickly overshadowed the shipping operation. Capital needs increased geometrically.

Economou was constrained to posture his fleet with longer term employment to support the burden of ever increasing debt on the company balance sheet under the strain of this new scaling up in another sector. The longer employment profile for the bulk carriers proved a timely move in view of the subsequent financial meltdown in the fall of 2008.

The crash in freight rates and asset values put Dryships into default with its senior lenders that has taken months to renegotiate this year. At the same time, Economou had to restructure the aggressive company capital expenditure program that included both dry cargo vessels and oil rigs. The company was obliged to cancel a large number of new building orders and forfeit deposit money as well as to take substantial asset impairment charges.

To cover the financial hemorrhaging, Dryships embarked upon a series of ATM (at the market) share offerings to increase its capital by massive share dilution. As things have stabilized in the dry cargo market and the oil rigs on order are coming up for delivery, presumably Economou wants to avoid further share dilution by turning to the bond market, hoping to lock in good terms in the face of future increase in interest costs.

The short hedge feature is likely a sweetener for potential hedge fund investors, who are a mainstay investor market for the shipping sector. Most hedge funds have considerable experience in commodities . There is close relation between shipping freight markets and commodities markets. Spot rates are driven by inventory levels and the pricing structure between the derivatives and physical markets.

The higher than expected interest cost of the recent Genmar bond issue, however, would appear to create some clouds on the probable pricing for the Dryships bond issue. With Dryships there is always an ongoing debate on how much new capital is being used to refinance and manage existing debt as opposed to going into fresh investments.

DryShips's two semi-submersible units and four drillships on order for 2011 delivery have recently been valued by analysts at US$ 3.7 bio against the value of its bulker fleet and above-market charters, which is barely half that at US$ 1.9 bio. Most analysts are in agreement that Dryships will have no problems in securing contracts and employment for its oil rigs, but divergence on rate forecasts drives the stock recommendations for the company. Nordea tends to be cautious whilst Lazard is showing some optimism for DRYS.  Both are placing their emphasis on the offshore drilling market and assuming firmer oil prices in 2010.

Thursday, November 19, 2009

A turnaround for Aries?

New CEO Michael Zolotas and CFO Allan Shaw recently gave a presentation of their plans to turn around Aries Maritime (RAMS) and use it as a platform for growth. They talked about recapitalization, fleet mix, in-house technical management, chartering strategy, steamlined GA costs and the new management team. Their new focus is on dry cargo and product trades. They have dropped in six additional units from GrandUnion and recapitalized with US$ 36 equity and US$ 182 mio additional debt. Let's evaluate.

The vessel transfer from GrandUnion consists of two 1990-vintage Capesize bulkers, two Panamax bulkers built 1990/ 2002 and two Dwt 37.000 product tankers built 2003/ 2004. The nominal purchase price is US$ 180 mio of which US$ 160 mio in debt liabilities and US$ 20 mio in shares (at a 125% premium to current price). The new management has booked the two remaining Aries container units for sale at US$ 11,4 mio .

In terms of hardware, Aries now has a fleet of 21 vessels: eleven product carriers and seven bulk carriers. Two Dwt 73.000 product tankers are on bareboat charter to Stena until 2H 2010. The two additional product carriers are time chartered until 2011. The remaining product tankers ranging from Dwt 38.000 t0 73.000 are on the spot market. All the bulk carriers are on time charters of various durations with fairly low rates mostly in the teens except the Cape unit Brazil, which has a good paying period charter with an initial rate of US$ 28.000 per day.

The large number of product carriers on the spot market presents a serious exposure problem since this sector was very hard hit this year and is suffering badly in the current market. The new management will have to determine a new employment strategy. This is a challenge but their new business director, Paul Wogan played an instrumental role in developing the Seachem pool for Livanos facilitating the Odfjell merger and is a capable person. They may have to invest to build up a chartering team. There appears to be no existing contract base from GrandUnion and they will have to create a viable customer base for Aries in the product sector.

Ironically their fleet mix is similar to Top Ships (TOPS), the other well-known Wall Street laggard of the Greek Shipping community, which seems to be doing a bit better lately. The Aries drybulk units are distinctly older than the TOPS units that were bought at the height of the market albeit with much better age profile. The Aries units are mainly Capesize units whereas TOPS focused on the Panamax size. The Capesize sector has been outperforming the market this year. Older units like the Aries vessels can be very profitable, but it is a very volatile market.  Presently they are tied up on time-charters with rate levels that are moderate compared to more modern units, excepting the Brazil charter. 

What is worrisome is the high level of debt on the six additional vessels (US$ 160 mio liabilities out of a purchase price of US$ 180 mio) and the large amount of additional debt in the recapitalization (US$ 182 mio against US$ 36 mio new equity). The 30.09.2009 pro-forma balance sheet looks ghastly with the shrunken asset values, high level of debt, free cash down to zero, US$ 124 mio loss of which a US$ 91 mio asset impairment charge and distinctly negative net worth.

It would have been helpful with all the additional changes and recapitalization that they had included in their presentation a restatement of their balance sheet after the additional changes in the fleet and capitalization. I find, however, difficult to see any major improvement in leverage in these subsequent events.  The largest share of new funds has been raised by additional debt. The new equity is small in comparison to the new debt and the drop-in units are highly leveraged. Aries still appears to be a company swimming in debt. Perhaps they preferred debt in the recapitalization to limit share dilution, assuming limited downside risk on further fall in vessel market values and looking to enhance returns. The positive hope is expectations of improved earnings from the expanded fleet and new management.

The new members of the management mark a considerable qualitative improvement from the previous management (the former CEO Jeff Parry was probably the sole credible person). It was a good move that they wrote down the assets and renegotiated the debt. Adding Newlead management was a very positive step. The previous technical management was disastrous and had a horrendous insurance record. It is now largely a matter of their commercial team and their opportunistic accreditive acquisitions to create value in their business.

They have secured additional funds for this, but they still appear to have a strained balanced sheet as a limiting factor. If there is a nice market upturn in 2010, it will provide them much necessary uplift in free cash flow and retained earnings to rebuild shareholder equity and deleverage. Rising asset prices will also help.  On the other hand, they will be at risk if market recovery is delayed and 2010 proves a poor year. In the negative scenario, they could end up with some of their new funds being cannibalized for debt service and require further financial restructuring.

Aries certainly shows significant progress, but it is still work in progress and a speculative play.

Saturday, November 7, 2009

Is Chinese demand for dry cargo as sustainable as industry analysts claim?

Despite the global financial crisis, this year has seen some revival in dry cargo rates, especially for Panamax and Capesize vessels. This has led to some renewed investor interest in the sector, notably by Peter Georgiopoulos. The investment thesis rests on Chinese growth potential. Chinese analysts tend to be more reserved. They see significant barriers to expansion in the hinterland and have mounting concerns over misinvestment and asset bubbles, jeopardizing future financial stability.

Western frenzy over China and its prospects tends to resemble the dot.com enthusiasm of the late 1990's with glowing forecasts of everlasting, insatiable demand. It is true that China is a resource-scarce economy with increasing import needs but there are serious issues of longer-term sustainability.

Whilst China entered the crisis with the highest investment rate in history, there is also very high investment misallocation. The primary source of China's high savings rate is their state owned enterprises (SOE's) that are sustained by energy and land subsidies, cheap credit, low wage costs and lax environmental standards. Without subsidized and controlled interest rates, even ignoring the other subsidies, the most important of which maybe the currency undervaluation, Chinese SOE profits in the aggregate would be negative. There is no guarantee that the current environment of low interest rates and cheap money is indefinitely sustainable.

Most of the cargo demand for larger bulk carriers depends on the steel industry, where iron ore is a major factor. The iron ore market has been brutal for China, partly due to China's own inefficient system. China imports more ore than Europe and Japan combined. Skyrocketing prices have cost China dearly.

For four decades before 2003, fine iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was plentiful, prices were driven by production costs. After 2003, Chinese demand drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per ton, and the spot price reached nearly US$ 200 a ton in 2008.  The gradual concentration of major iron ore mines by the world's three largest suppliers was a major reason for this price increase. The nature of Chinese demand was another major reason. China's steel production capacity has skyrocketed, even though capacity is fragmented.

China's local governments have been obsessed with promoting steel industry growth, which is the reason for fragmentation. Huge demand and numerous small players are a perfect setup for price increases by the Big Three miners, which often cite high spot prices as the reason for jagging up contract prices. But the spot market is relatively small, and mines can easily manipulate spot prices by reducing supply. On the other hand, numerous Chinese steel mills simultaneously want to buy ore to sustain production so their governments can report higher GDP rates, even if higher GDP is money-losing. China's steel industry is structured to hurt China's best interests.

The Chinese government is very much wedded to it’s 8% growth target and will do whatever it takes to come close to that target – including flooding the domestic banks with a wall of cheap money to lend as economic stimulus. However, preventing a downturn with easy money is a dangerous way to reflate the economy.

As profitability for the businesses that serve the real economy remain weak, there has been of shift of investment in the first half of 2009 disproportionately into property, stock and commodity markets rather than private sector capital formation. This shift in the medium term threatens to undermine China’s financial stability. Thus, China is experiencing a relatively weak real economy and red hot asset markets.

The Chinese imports that revived the bulk carrier market this year were mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

Even more foreboding is a looming real estate bubble. The real estate sector in China is especially critical to the bulk carrier market because approximately 50% of Chinese demand for steel is generated by the construction industry. Most Western shipping forecasts are based on unlimited future need in China for new construction. The reality is quite different. China’s urban living space is 28 square meters per person, quite high by international standard. China’s urbanization is about 50%. It could rise to 70-75%. Afterwards the rural population would decline on its own due to its high average age.

So China’s urban population may rise by another 300 million people. If we assume they all can afford property (a laughable notion at today’s price), Chinese cities may need an additional 8.4 billion square meters. China’s work-in-progress is over 2 billion square meters. There is enough land out there for another 2. The construction industry has production capacity of about 1.5 billion square meters per annum. Absolute oversupply, i.e., there are not enough people for all the buildings, could happen quite soon.

The most basic approach in studying bubbles is to look at valuation. For property the most important measures are price to income ratio and rental yield. China’s average price per square meter nationwide is quite close to the average in the US. Yet the US’s per capita income is seven times China’s urban per capita income. The nationwide average price is about three months of salary per square meter, probably the highest in the world! Consequently, a lot of properties cannot be rented out at all. Those that can bring in 3% yield, barely compensating for depreciation. The average rental yield, if one including those that can’t be rented out, is probably negligible. China’s property price does not make sense from affordability or yield perspective.

Some argue that China’s property is always like this: appreciation is the return. This is not true. The property market dropped dramatically from 1995-2001 during a strong dollar period.  Property prices could drop like Japan has experienced in the past two decades, which would destroy the banking system.

In summary, the market frenzy now will not last long. The correction may happen in the fourth quarter. There could be another wave of frenzy next year as China can still release more liquidity. The biggest risk is the global economy cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. With rising inflation expectations, the US Fed will be compelled to raise interest rates in an effort of soak up the excess liquidity created by its vastly expanded balance sheet. A stronger dollar and a weak US economy would almost surely send China’s asset markets and the economy into a hard landing like during the Asian Financial Crisis.

All this underlines the risks in overly optimist forecasts for China in the dry bulk sector and we have not even mentioned the huge order book overhang and new deliveries of tonnage in the coming years.

Thursday, November 5, 2009

Rising risks of an asset bubble in China threatened by US stagflation

China and the US are dealing with their imbalances by exacerbating the very things that caused them in the first place. China entered the crisis with one of the highest rates of misallocation of investment in recent times. With its enormous liquidity released for stimulus, China with waning export markets has become a giant Ponzi scheme, with money pouring into asset speculation. US expansionary monetary policies are leading to a stagflationary environment that will pop this bubble.

Rising productivity from the build-up in infrastructure and manufacturing outsourcing, together with a policy of keeping its currency undervalued, led to massive export growth in China. The resulting dollar earnings pumped up China’s monetary system. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Chinese state-owned enterprises (SOE's) are the primary source of their high savings rate that is financing US deficits and public debt. China has been keeping its currency undervalued to boost SOE exports by purchasing US dollars and placing the surpluses in US treasuries in a symbiotic relationship.

The SOE's surpluses in China are simply part of the transfer from household income to the state sector. The state sector ramps up investment more for policy, not profit, concerns. In the past, they ploughed this money into construction and factory investment projects that may well be already non-viable, but now they are significantly making matters worse letting the stimulus money go into massive asset speculation.

While China is experiencing weak exports now, the weak dollar allows China to release the liquidity saved up during the boom in the past five year without worrying about currency depreciation. As profitability for the businesses that serve the real economy remain weak, there has been of shift of investment into property, stock and commodity markets rather than private sector capital formation. Thus, China is experiencing a relatively weak real economy and red hot asset markets. This shift in the medium term threatens to undermine China’s financial stability.

China's corporate sector increasingly looks like a shadow banking system. It raises funds from banks, through commercial bills or the corporate bond market, and then channels the funds into the land market. The resulting land inflation underwrites corporate profitability and improves their creditworthiness in the short term. As land sales and taxes from property sales account for a big portion of local government revenues, there are powerful incentives to pump up the property market. Land sales are often carefully managed to spike up expectation through SOE's. When SOE's borrow from state owned band and give the money to local governments at land auctions, why should the prices be meaningful? The money circulates within the big government pocket. Tomorrow’s non-performing loans, if land prices collapse, are just today’s fiscal revenues. If private developers follow the SOEs to chase the skyrocketing land market, they could be committing suicide.

China's imports this year have been mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

The US is trying to reflate by massive government bail outs and stimulus plans that are financed by high deficits and rising public debt levels. The FED has embarked on an aggressive expansionary monetary policy, keeping interest rates low by purchasing agency debt in order to reflate the economy and drive asset prices up. Whilst these policies are prima-facie inflationary and there will be a huge unwinding problem in the future, the low monetary velocity and slack economic conditions counter balance any immediate risk. There is, however, a growing carry trade borrowing in US dollars at ZIRP and leveraging this wall of liquidity into more risky assets such as stocks and commodities.

Monetary stimulus is considered an effective tool to soften the economic cycle. It works by inflating asset markets. By inflating risk asset valuation, it leads to more demand for debt that turns into demand growth. In other words, monetary policy works by creating asset bubbles.  In this crisis, household and business sectors in the US have not been increasing indebtedness; falling property and stock prices have diminished their equity capital for supporting debt. The public sector has rapidly ramped up debt to support failing financial institutions and increase government spending to cushion the economic downturn.

US households cannot continue leveraging up to absorb the excess production that Chinese companies  have invested in additional capacity to export. The recent rise in US personal consumption was accompanied by a 3.4% decline in household disposable income. If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption. So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending.

Regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before -- money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough.

The global economy is cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. This scenario is the best that the central banks can hope to achieve; it combines an acceptable combination of financial stability, growth and inflation. This equilibrium is balanced on a pinhead, requiring central banks constantly to manage expectations. The world could easily fall into hyperinflation or deflation if one major central bank makes a significant mistake.

With rising inflation expectations, should the US Fed be compelled to raise significantly interest rates in an effort of soak up the excess liquidity created by its vastly expanded balance sheet: this would be the worst possible situation: a strong dollar and a weak US economy. China’s asset markets and the economy would almost surely go into a hard landing. It would reverse the US - China symbiosis.

The Chinese would face a serious financial crisis where their overinvestment and misallocation of resources comes finally to roost with a rash of non-performing loans that would threaten their banking system with permanent loss of capital. The US would risk being caught in a conundrum with sky-rocketing interest expense on its high level of public debt resulting in ever larger fiscal deficits and there would be a drying up of Chinese surpluses to finance the deficits.