Is It Time to Buy These Sinking Shippers?

The seas have been pretty rough lately for companies that transport the globe's bulk commodities from one continent to another. The Baltic Dry Index, or BDI, a measure of the dry-bulk shipping industry's short-term pricing, has doubled and halved twice through myriad demand and supply issues over the past year. The industry is now at a crossroads, depending heavily on the direction of Chinese industrial production and global trade. For dry-bulk ship owners and operators in particular, the uncertainty regarding Asian steel production, the backlog of ships, and the world's aging fleet will likely result in continued volatility.

China Is a Major Player
The world's dry-bulk fleet consists of about 6,000 ships, similar to the globe's tanker fleet. These vessels transport loose commodities such as iron ore, coal, grain, and steel around the world, though nearly 60% of last year's dry-bulk imports went to Asia. China's strong growth in steel production has driven robust demand for inputs such as ore and coal. In the past five years, China's steel production has grown nearly 23% annually versus worldwide gains excluding China of about 3.5%. As a critical cog in this trade, dry-bulk shipping has enjoyed a compound annual growth rate in ton-miles (measured by one ton of cargo moving one mile) of nearly 8% since 2003, compared with a 2% yearly clip in the 1990s. Furthermore, with the supply of ships slow to hit the water during this lofty demand period, shipping prices also shot up dramatically.

Since 2003, the BDI has generally enjoyed a massive upward trend (more than doubling), but boom and bust cycles have been short, volatile, and massive, especially in the past year. With vessel utilization near 100%, marginal demand becomes very expensive, driving the BDI upward.

Short-Term Weakness Takes a Toll
However, demand pullbacks or increasing supply can quickly correct on the downside. As evidence, demand has been generally very strong over the past year, but short-term factors such as China's strategy to draw down iron ore inventories in the face of increasing costs near the start of 2008 quickly affected vessel utilization. In the end, though Australian and Brazilian miners (primarily  Rio Tinto ,  BHP Billiton (BHP), and  Vale (RIO)) pushed iron ore price increases around 75%, stalling tactics by Chinese authorities beforehand drove the BDI down 50%. Because China continued iron ore deliveries following the agreement, strong demand and resulting port congestion buoyed the BDI as it rose to lofty heights. However, a pullback of Chinese production stemming from the Beijing Olympics in August, along with alleviated port congestion around the world, has led to the BDI's current muted level. In all, the BDI dropped from its high near 12,000 in June to under 4,000 today.

Where Does Demand Go from Here?
To make matters worse, uncertainty abounds for near-term Chinese production. After stellar growth for several years, recent steel-demand stagnation has led the country's steelmakers to cut prices, and volume pullbacks could be next. Furthermore, China's iron ore inventories are above historical levels due to the Olympic slowdown. This is curtailing import demand, while Brazilian miner Vale is trying to push through further iron ore price hikes. The end result is stalling import growth along the important Brazil-China route. In fact, though China's iron ore imports are up 22% year over year through August, those originating in Brazil have increased only 9%, lowering ton-mile demand and freeing ship supply.

That said, we think Chinese infrastructure demand will rebound as the country's gross domestic product per capita continues to expand (though likely at a slower rate). As a result, we anticipate further infrastructure construction that will drive steel consumption and subsequent demand for iron ore and coal imports from global suppliers as current inventories are burned off. We've factored considerably lower demand into our long-term forecasts, but nonetheless expect further production increases as China industrializes over the next five years.

The Supply Side Could Prove Problematic
Conversely, although we're positive on the long-term demand for dry-bulk shipping, the current order book of ships slated to hit the water by 2010 concerns us. Based on current backlogs, the world's fleet of dry-bulk vessels could increase nearly 50% over the next several years. However, we estimate that 10% of this future fleet will never hit the water due to credit issues and yard delays. We think further credit issues that may threaten demand more than we expect would also result in further cancellations and delays (perhaps up to 30%), buoying pricing. Similarly, ship scrapping has ground to a halt over the past few years, as lofty rates justified operating older, more costly vessels. Continued rate depression and high steel prices would force owners to scrap a substantial amount of ships, again mitigating supply concerns.

Another supply factor--port congestion--can tie up a substantial amount of ships, especially in Australia especially, and subsequently drive longer routes to Brazil (China's second-largest iron ore source). This congestion can build and wane quickly. Recent slow demand has alleviated this pressure, but we expect future congestion (and subsequent constrained supply), as a continued slowdown in Brazilian-sourced iron ore forces China to increase imports from often-port-constrained Australia.

However, several risks muddy our outlook. On the demand side, a continued slowdown presents the most significant risk to our long-term thesis. Though we expect ship scrapping and order cancellations to mitigate this risk, dramatically lower pricing would nonetheless threaten ship owners' profitability and asset values. Another risk is that continued conversions of older tanker ships to dry-bulk ships along with orders of large vessels by the commodity miners themselves could create head winds for ship owners. Finally, constrained worldwide liquidity could threaten some ship owners' fleet-expansion plans. Though these firms would avoid major capital expenditures under this scenario, the companies' growth could slow dramatically.

Nonetheless, we've included these factors in our recently adjusted long-term projections and forecast the BDI, after its recent run-off, at or near today's levels in 2011 (although we continue to expect short-term boom and bust cycles). We believe most of the dry-bulk shipping stocks we currently cover are worth a look and recommend keeping an eye on firms with a substantial portion of revenue that stems from long-term, fixed-rate contracts. Though these contracts prevented these companies from fully participating in the industry's recent upswing, we think the firms will enjoy solid profitability and stable dividend payouts during a downturn.

 Genco 
With the majority of its ships fixed on rental agreements through 2009, we expect Genco to continue to generate impressive profitability. Furthermore, the firm has recently added five-year charters to its fleet, which offer additional protection. We expect these contracts to support the firm's hefty dividend, which yields nearly 7% to our fair value estimate.

 Navios Maritime 
Like other shipping firms, Navios rents its fleet on long-term, fixed-rate charters. That said, the firm also participates in active fleet management by trading futures and renting in vessels on short-term agreements. Though inherently riskier than ship operations, we think this strategy offers investors upside potential beyond most other shipping peers.

 Star Bulk Carriers (SBLK)
A recent entry into the dry-bulk shipping industry, Star Bulk also rents its ships on long-term, fixed-rate contracts. Though several of the company's contracts feature declining pricing over their multiyear lives, these agreements still shield the company from violent spot-market volatility. Furthermore, we think the company's strong balance sheet will lead to growth opportunities down the road.