How Risky Is DryShips Inc.'s Stock?

By Matthew

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Shipping stocks are notoriously volatile due to the industry's cyclicality, which can cause financial stress for shippers that borrow heavily to finance fleet growth. That said, DryShips Inc. (NASDAQ: DRYS) takes that volatility to a whole new level. In mid-November, its stock spiked as much as 2,000% in a matter of days due to a perfect storm of factors. However, it has since given back most of those gains and is down nearly 98% this year. While some investors might see that number and assume that the downside risk is minimal, that could not be any further from the truth. Here's why.

Edging away from the precipice

DryShips entered 2016 in financial distress. The company noted in its earnings release for the fourth quarter of 2015 that:

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The company's precarious financial situation forced it to take several actions over the next several months to right the ship, including selling assets, negotiating with lenders, and raising outside capital. For example, in November, the company reached an agreement with one of its lenders to settle its outstanding loan obligations. Under the terms of the deal, the bank agreed to write off half of the outstanding principal and interest due. As a result, the company only owes $2 million more, after having repaid $8.2 million in principal thus far.

In another move, the company's founder and CEO George Economou became the lender of record on the company's $85.1 million syndicated loan arranged by HSH Nordbank. As a result of that and other moves, Mr. Economou took control of most of the company's debt, holding $154.5 million of outstanding principal while third-party lenders held the remaining $16.5 million.

These moves culminated in an agreement with an entity controlled by Mr. Economou to refinance the entirety of the debt he controlled under a new $200 million loan, secured by all of the company's present and future assets except one that already served as collateral for a loan with an existing lender. This deal significantly bolstered the company's liquidity.

As a result of these transactions, CFO Anthony Kandylidis stated earlier this month that:

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The downside of debt and dilution

Clearly, DryShips is not as risky as it once was. However, ample risk remains. For example, the company expects to end the year with $135 million to $140 million in debt. That is still an incredible amount of debt considering that it had just $229 million in assets at the end of the third quarter, with $93.7 million of that amount classified as assets held for sale. While there is comfort in knowing that the company's founder holds most of this debt, it gives him nearly total control over DryShips.

Furthermore, one of the moves the company made to firm up its balance sheet was to issue equity through convertible preferred shares. The potential exercise of these convertibles could result in the issuance of from 3.6 million to as many as 72 million new DryShip shares. That is a stunning amount of dilution for a company that had 1.3 million shares outstanding before the offering. This flood of equity could keep a lid on the company's stock price for quite a long time.

Image source: Getty Images.

The business of dry bulk shipping

Another risk worth mentioning is the company's business model, which is to lease its fleet of 15 dry bulk carriers on the spot market. What that means is that a shipper receives the going market rate for dry bulk carrier transportation, which fluctuates with supply and demand. In recent years these spot rates hit rock bottom, which caused the bulk of DryShip's financial problems.

Some shippers prefer the spot market because it allows them to capture the full upside of rising spot prices. Oil-tanker company Nordic American Tankers (NYSE: NAT), for example, only employs its ships under spot-market prices. This model enables Nordic American Tankers to capture the spread between its costs and the spot market. For example, last quarter, the company's cash breakeven rate was $11,000 per day per ship, while the company captured spot prices of about $20,000 per day. While the model works for Nordic American Tankers because of its low costs and moderate leverage, it still leads to very volatile earnings.

Meanwhile, other ship owners prefer the security of long-term time charters, which provides revenue certainty. Containership lessor Seaspan Corporation (NYSE: SSW), for example, signs the bulk of its vessels under long-term contracts, which currently have an average of five years remaining and represent $5.4 billion in future revenue. That financial certainty has allowed Seaspan Corporation to ride out the storm in the containership market, which has been under tremendous stress due to slowing global trade.

Investor takeaway

While DryShips might not be as volatile as it was to start the year, this remains an incredibly riskystock. The company still has an abundance of debt and investors could face staggering future dilution. Further, the company's business model exposes it to the volatile spot market. Suffice it to say: Risk-averse investors should avoid this stock at all costs.

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Matt DiLallo owns shares of Seaspan Corporation. The Motley Fool recommends Seaspan Corporation. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.