Distressed asset opportunities for listed shipping companies

The recent Navios acquisition of three Capesize units seized by Commerzbank may set a precedent for similar deals to come. Current economic conditions are stressing shipping companies. As time goes on, senior lenders will be increasingly pressed to cleanse non-performing loans from their balance sheets. An obvious means to reduce losses is to shift assets to stronger owners.

Private companies have a financing advantage over private companies. They can raise capital in public markets. They have many options like issuing more shares, doing a preferred issue or going to the corporate bond market.

Navios, of course, has its own share of problems with charter party defaults and downside earnings announcements and it is not the most transparent company, but recently Neuberger Berman increased their share in the group. Generally analysts like Omar Nokta of Dahlman Rose have become bullish again on the dry bulk sector.

The Capesize sector has performed well in this year's improvement on the BDI. The rate volatility attracts owners to this size. There are only a few major cargoes for the larger bulkers. When market orders rise, rates surge. When they wane, rates collapse. The effects are multiplied by port congestion and longer voyages in boom times. The profitability has been very good the last few years before the crash. These vessels in the Navios deal come with attractive charter commitments.

Dry bulk is very dependent on continued China growth. The issue is whether the recent increase in demand is sustainable. I believe that the surge in dry bulk rates this year is due to Chinese inventory stockpiling. The Chinese renegotiated supplier rates with substantial discounts. They have been more successful than the US in their stimulus program. Government easy money policies lead the way to commodities speculation regardless of demand in the underlying economy.

On the other hand, I do not see a lot of evidence yet that Chinese export markets are coming back. After all, Europe is really in the doldrums and the US consumer markets have not turned around. China has a lot of excess capacity. They will have to restructure. They cannot go on indefinitely by stimulus money. If there is a sluggish recovery in 2010, China may have a growing problem of non-performing loans. Meantime, the dry order book is still big despite cancellations.

All in all there is a high probability for future distressed asset deals. Publicly listed companies will be favored players for many senior lenders.

George Economou vs Jim Kramer

Both George and Jim are iconoclastic personalities. They both have had a mixed performance record with personal ups and downs. Until 2008, DRYS had an exceptionally successful strategy of building up its fleet by retained earning from profitable operations and vessel sale transactions. The company seems often a one-man show with lack of transparency with the Principal appearing to use his private company for business development and passing the transactions to the public company for financing. Stockholders have benefited by this process in results in the past but lately they have been taking some hard hits. The turning point for DRYS was Economou's decision to diversify into the offshore drilling business acquiring OceanRig and ordering additional deep water oil rigs. The financial crisis hit DRYS very hard. Since then, DRYS has been increasing capital with major share dilution. George Economou is not as bad as Kramer says but he has been struggling lately.

The offshore transaction was large for the existing DRYS balance sheet. It absorbed the companies reserves and required a substantial increase in leverage. The company postured itself by reducing spot market exposure on its fleet and moving to longer term employment. The timing was good.

Last fall Economou added some new building contracts generated from his private company that later DRYS was forced to cancel and take losses. This caused some negative comments.

This year, DRYS has been raising capital by issuing new shares and dribbling them out at the market prices. This increase of capital was initially needed in the Groups arduous loan restructuring negotiations for its loan/ asset coverage clauses. In subsequent share issues, DRYS announced a strategy to acquire additional vessels, but there has been some market skepticism about company capacity for additional finance to leverage this new capital.

The China story has enthralled investors in the dry cargo sector for many years now. In the boom years, Far East demand consistently soaked up new tonnage in the market and drove rates to ever higher levels. China now has a great deal of over capacity that it has built largely to service its export markets in the US and EU. These markets have now collapsed.

The US seems to be improving since March this year if one takes Wall Street as a guide but mainly in the financial sector due public monetary policies to bail out lame duck companies and reflate asset prices. The EU has been worsening. It is still an open question how robust the recovery will be so the revival of Chinese export markets is still in question.

China has ample reserves for stimulus and they have probably outperformed the US in putting this money quickly to work. They have renegotiated their commodities contracts and moved to inventory replenishment that has brought a revival in the BDI for dry cargo sector. The Capesize tonnage has had the most benefit with a recent mini-boom. It is not clear whether this is sustainable.

China will most likely need to restructure their export model and this could have a negative impact on future demand projections for dry bulk commodities cargoes in coming years. Meanwhile the dry cargo orderbook is large and China has a significant share of the newbuilding contracts.

DRYS has taken large asset impairment charges for its foray into the offshore sector. It has new rigs on order that need to be financed. It also has had plans to spin off this business to a separate entity.

DRYS is facing large challenges in the present environment. Whatever the outcome, shareholders have gone through significant share dilution this year that will affect future share value. There is the issue of dry market recovery. This year things so far have gone pretty well for the sector. DRYS is completing its first round of debt restructuring. Prolonged market weakness in 2010 could lead to a much more difficult period with its senior lenders but markets may also improve and beat expectations. The main issue in the offshore side of the business is the future of the spinoff plans and its impact on DRYS shareholders. If it goes well, it could boost share value but the company is right now carrying the debt liabilities for this.

Kramer has the ease of being a pundit who can say whatever he likes without much responsibility. George Economou has a lot more weight on his shoulders. I have been critical of George for his excesses in the boom years but I appreciate his struggle in present market conditions. I think that Kramer should show a bit more generosity here. I have outlined the risks for shareholders.

Is the surge in commodities prices due to improved aggregate demand or counterproductive monetary policies?

I would be inclined to support the view that oil prices will continue to rise this year along with other commodities. The issue is whether this will be driven by aggregate demand in the underlying economy or excess liquidity from present monetary policies. We have seen huge speculative swings in commodities prices with the rise of futures markets, where there has been a decoupling with the underlying goods and services economy. So far export markets remain weak and there is a lot of excess productive capacity. Tanker markets have been terrible with very low rates, indicated little movement of physical product. As the panic in financial markets has passed, money seems to be flowing from treasuries and cash back to higher yielding assets like oil and other commodity speculation.


Since last fall as a policy response to the financial crisis, the US has adopted a 'spend our way out of the crisis' strategy based on a revival of Keynesian economics. US politicians have been massively expanding deficits and public borrowing to support these policies. They perceived the financial crisis last fall as a matter of liquidity rather than solvency. They have been socializing losses and bailing out lame duck industry. They have transferred leverage from private balance sheets to sovereign public balance sheets, trying to re-inflate asset prices rather than de-leverage.

The issue is how effective this revered 1930's economic theory will be in today's open economies and global markets as a policy response to the bursting of an asset bubble financed by high debt leverage.

The politics in the US raises the risk of debt monetization. The rise in commodities prices as well as longer term treasury yields may be driven by growing market perception of this danger. If this scenario pans out, it could lead to a very weak, sluggish recovery, plagued by commodity and asset inflation as well as renewed US dollar weakness.

It will be a very interesting fall this year!

Is Goldman Sach's optimism on the drybulk market justified?

Goldman Sachs was optimistic on US recovery before many others. Now they are taking a bullish stand on the drybulk market based on the China story, which has been driving the market for many years now. Although once considered immune to a global recession, China has had a hard landing due collapsing exports to US and EU markets. Drybulk rates have made a modest comeback this year. One has to distinguish between short-term inventory replenishment and longer term restructuring of the export-oriented economic model. China has considerable productive overcapacity that needs to be reduced and it will take time to create domestic demand to fill the slack.

US fiscal and monetary policy has been focused on increasing asset prices at any cost. The FED now has a vastly expanded balance sheet. The US has been the importer of the first and last resort with very low savings rate and heavy debt burden. The major problem for the US is how to de-leverage. The US response has been for the Federal government to bail out their major lame duck industries by expanded deficits and massive increase in public debt as opposed to reducing it by write-offs and conversions to equity. The looming risks are higher than expected funding rates, currency devaluation and a reduced debt rating. Lately the US dollar has been weakening and long term treasury rates hardening.

The Chinese have tremendous productive overcapacity and sharply declining export markets. They have a high savings rate and hard cash that they have put into domestic stimulus. They are in a more favorable position than the US since they do not have the debt load to carry. Their stimulus programs are likely to be more effective. Longer term, however, they will have to reduce capacity.

The drybulk market depends on steel production and the construction industry is the biggest source of steel demand in China. The Chinese have been renegotiating their supply contracts to reduce prices since demand has fallen and commodities markets have become weaker. It is very likely that they will in the future change their supply chain management and more cargo will be carried on longer-term contracts of affreightment. They may try to channel more of this business to their national fleet.

We could have some improvement in the fall markets but it is also possible that markets will again weaken and remain sluggish throughout 2010 and even 2011.

There is a considerable range of views between economists because of the complexity of these structural economic changes, major disputes on correct policy decisions and untested responses like the FED quantitative easing. The politics that drive these policy decisions favoring certain groups over others does not guarantee the best allocation of resources or most appropriate course of action so we have to expect backing and filling as events evolve.

As a postscript to this article, this past week there has been a surge in demand for Capesize bulk carriers and rates have soared to US$ 70,000 per day for trip charters. Omar Nokta of Dahlman Rose has made the case that the worst is over for the drybulk sector. He sees vessel values rising 20% or more in the second half of the year. This is based on firming Chinese steel prices and rising demand that brings rates up. Others like Drewry do not see sustained improvement in this sector until 2011. Both have reservations on the vessel order book, but Dahlman place much bigger faith than Drewry in the Chinese demand.

We have discussed the China situation in the above article as well as our previous piece. Short term there will be renewed demand from stimulus programs. Long term, there is likely to be some significant restructuring. In the past, Chinese demand has always exceeded expectations. Looking forward, this is harder to evaluate in view of their excess capacity and over reliance on export markets. If the Chinese choose to restructure and reduce capacity, then the demand factor will be less dominant than previous years.

Future Dry Bulk outlook mixed

Whilst dry bulk rates crashed hard last fall, this winter there has been a nice rebound that is now meeting resistance and looking choppy. Some like Omar Nokta of Dahlman Rose think there could be a big jolt in the second half toward the upside based on Chinese stimulus and rising steel prices. Since vessels for 2009 are well advanced in construction, cancelations will play a bigger role in 2010 and 2011. HSBC believes that two thirds of dry-cargo newbuildings penned for delivery next year could be axed or delayed by shipowners reducing the total world order book by as much as one-third. Short-term Chinese stimulus will boost demand but longer term, the Chinese are likely to cut supply. This is likely to mean a longer recession for the dry bulk sector than anticipated despite some short term recovery.

The positive thing about the dry bulk sector is that second-hand values now seem to be in balance with three-year charter rates. Values have plummeted 60% for this result albeit still US$ 5000 per day above long term (1992-2008) average rates. Despite the cancelations, the order book situation is alarming. If 66% of the 2009 and 79% of 2010 orderbook never reach the sea, annual deliveries will still average those of 2008!

Whilst the Chinese have hard cash and can cover fiscal expansion without increase in public debt, this cannot keep China running at 8% growth for more than a few years. The big problem is that China is an export-driven economy and EU/ US markets are not likely to rebound quickly. China will have to take measures to restructure and increase domestic consumption. This will not be easy as the banking system is very underdeveloped and there are renewed risks for non-performing loans.

Chinese steel production is down 18% and iron ore demand fell by 22%, Steam coal was the only commodity to maintain momentum in 4th quarter 2008. Global Insight expects China dry bulk demand to hit a 10-year low in 2009. Whilst there may be some increase in demand as we have seen already this year and even unexpected surges due domestic stimulus, the longer term likelihood with Government policy shifts to cut supply and boost domestic demand bode ill for dry bulk shipping even with substantial order book cancelations.

Most publicly listed dry bulk companies are recent enterprises without large reserves from past years. Many expanded their assets bases at top of the market prices in the boom years and took on substantial bank leverage. They been through the first round of renegotiations with their senior debt creditors on loan/ asset covenant defaults. Many have raised additional capital often by 'at the market' issues.

If there is not a robust recovery and the market continues weak over time, pressures will mount for further industry consolidation. Bankers will be increasingly tough on terms and may start to press to liquidate their losses. For these reasons, a cautious approach is still required for this sector.

Lucky George...

After successfully raising US$ 500 mio by selling shares over several months at market levels, DryShips is now planning to sell up to US$ 475 mio shares in its second ATM equity offering of 2009. As long as investors continue to purchase the shares at ever higher values above NAV, the more accretive it is for previous shareholders as it aids net asset value.

DRYS management is reserving the widest range of options for the use of the proceeds: to opportunistically acquire additional dry-bulk vessels in the current market environment, and for working capital, existing capital expenditures, repayment of indebtedness, general corporate purposes and, as needed, to continue to enhance our liquidity and to assist in complying with our loan covenants.

The company remains overleveraged. Whilst there has been some improvement in dry cargo rates, the Panamax-size units, which are the core of the fleet, are probably the hardest hit sector in this market. Some forecasters feel that supply-side pressure is likely to cap the Baltic Dry Index in the next two years. In addition, DRYS has taken a sizeable impairment charge on its oil rig acquisition and has more drill rigs on order.

Continued investor enthusiasm to purchase additional shares of this company may prove that positive expectations can be a self-fulfilling means of recovery for this company. The expectations are largely based on steel producers hiking output ahead of the Chinese government's stimulus measures, and fixing iron ore from abroad to meet their anticipated needs.

The Liquidationists vs Big Government: mounting public concern

There is a growing debate that the deadwood has to be cleared in the US economy for a meaningful recovery to take place. So far the Beltway has avoided and short-circuited normal bankruptcy procedures preferring back-room deals without much transparency like the Bear Stearns - JP Morgan shotgun marriage or complicated schemes like the Chrysler restructuring where FIAT puts up no money and is taxpayer funded. Concern is mounting that this is not a sustainable or viable strategy.

There is little doubt that the corporatist form of capitalism that has developed in the US is vindicating Joseph Schumpeter's worst nightmares. Schumpeter famously argued that the essence of capitalism was creative destruction, by which new economic structures are born from the rubble of older ones. Schumpeter’s biggest fear was that creative destruction would lead capitalism to collapse from within, because society would not be able to handle the chaos. He was right to be afraid. The response of governments worldwide to the financial crisis has been to give the structure of private profit-taking an ever-growing scaffolding of socialized risk.

US policy makers have lately done their utmost to promote the demise of creative destruction. Their vision is a corporatist capitalism that is government funded and guided by public policy. This system as exhibited by the US financial industry that has been operating for years now on a system of political patronage and expanding government involvement in credit allocation primarily in the housing markets, which the Obama administration appears to be expanding on all fronts. Certainly with the massive stimulus programs, the moral hazard for political cronyism is on the rise. This system risks potentially creating a web of ever more parasitic relationships between the public and private sector.

Whilst market discipline would force organic industry reform for businesses to survive the market place, the buzz word of government bail outs give the favored a free ride. The path of the least resistance is to follow the government instead of facing market risks. What is inducing FIAT - a foreign automobile company - to jump into Chrysler, as opposed to putting their own funds and starting a US operation on their own? What keeps large US banks from their breaking themselves up and creating more economically viable and manageable units?

In effect, the US government under the mantra of saving jobs and temptation of expanded political patronage is impeding a natural clearing of the deadwood in the market place. The emerging US economy from this crisis is likely to be debt ridden and uncompetitive in a global markets.

The risks are that the declining productivity will weigh negatively on US government tax revenues, dashing hopes of paying down the surge in public debt. If the US State governments are any harbor to the future, even a small rise in interest rates would create a crushing burden leading to even larger federal deficits. What was originally envisaged as public debt levels of 80% GDP could reach over 100% GDP.

There are growing signs of broad-based concern. This ranges from the 'tea-parties' on the grass roots level to high level figures in the business community like Warren Buffett and Charles Munger.