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Never Enough Lessons on Forward P/E

by: The Stalwart October 08, 2008 | about stocks: DRYS    
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The Stalwart

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Never enough lessons on forward P/E, especially for cyclicals. On Tuesday, dry bulk shipper DryShips (DRYS) hit an all-time low of $21.8, down from a peak of $120, and down from the $64 back when Barron's called the Buy on the stock. Everyone is wrong at times, and being wrong for decent reasons is fine. But in a previous post in April, we outlined that we mostly took issue with Barron's completely missing some of the most important issues with dry bulk commodities transportation stocks such as DRYS, and worst of all arguing for the stock given a very low forward P/E, which was completely ridiculous given that the bulk shipping industry is prone to earnings swings of +/-80% within short, unforeseeable periods of time. The below was our previous excerpt from Barron's:

Global trade might slow this year, but it will come back eventually, and DryShips' profits -- and shares -- should move up over the long term, even if 2008 growth turns out to be lower than Wall Street expects. At its recent quote of 64, DryShips stock was trading at a price/earnings ratio of 3.5 times consensus analyst earnings estimates of $18.18 a share this year and about 5 times the $12.22 forecast for 2009. DryShips also trades at a more than 50% discount to its peers, although rivals generally seek long-term contracts, which are less volatile.

And then our following criticism.

This article fails to mention that dry bulk spot rates are extremely volatile and forecasting where they will go is subject to massive room for estimation error, even for industry veterans. Thus forward P/E can be very deceptive and is a silly way to look at the companies. Last year Clarksons research surveyed a large collection of readers to forecast where rates would go in 2007 and EVERYONE was wrong by a large margin. (they spiked massively) They can also spike massively downward in the same fashion... If forward earnings ends up being 80% lower, which historically isn't a crazy notion at all if you look at a rate chart, your P/E will be 5x what you thought it was. Thus using forward P/E is pretty silly given its forecast error range is so wide as to be near meaningless.

Well, this post came under some fire from commenters on Seeking Alpha for either a) being written by an author looking to push the stock down (we wish we had that level of influence on The Stalwart) or b) not understanding that without earnings forecasts and resulting forward P/Es, then there wasn't a way to make an investment case:

If you think "... using forward P/E is pretty silly given its forecast error range is so wide as to be near meaningless" then you must think there is no meaningful way for an analyst that follows DRYS to do his job (to forecast earnings). THAT'S silly.

There are many tools for analyzing a company beyond just forecasting its next year's income. And for highly cyclical ones with little visibility, forward earnings barely deserves to ever be a tool, and is usually much more dangerous than useful.

DRYS is now at $24, down massively due to, well, the fact that the Baltic Dry Index, which is an index for bulk shipping rates, has fallen from a peak of 11,500 just earlier this year to below 3,000 currently, for a 74% decline in just a few months. The rates for DRYS bulk ships have fallen in a roughly similar fashion. This dramatically changes the earnings forecasts of analysts across the board for 2009 and onward, though even these new earnings forecasts remain rubbish given the fact that rates are so volatile and for the most part "unforecastable" for dry bulk shipping. They could cut their earnings drastically, only to see a surprise rate rally in 2H09. DryShips 2009 earnings forecasts have dropped 25% already, though this to me looks timid given the drop in rates seen. DRYS is now at a 2009 P/E of 2x, but again, if the current rate situation were fully reflected in analyst numbers it would have to come down substantially further, as much as to say make the P/E 15x or worse.

Now, maybe DRYS is decent here, I haven't done a full analysis of the company's assets (at $24 maybe the scrap value of its fleet could be enough to argue for value, potentially), nor intend to in this space. But the point is more about using forward earnings as a justification rather than whether buying DRYS at $64 was correct or not. At the very least, the DryShips debacle is another great example of forward P/Es being undependable for this industry and many cycical industries.

What's even more shocking is that some top-tier transport analysts use forward P/Es when arguing for these types of stocks and some fund managers don't bat an eyelid upon hearing such justifications. Highly cyclical companies with low earnings visibility = companies where forward (forecast) P/E is essentially meaningless.

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This article has 19 comments:

  •  
    Oct 08 08:37 AM
    You are extremely mistaken in your valuation of dryships.

    You are not taking into consideration the fact that dryships has over half of its vessels under time charters or long term fixed contracts. Therefore, those ships rates are not affected by the current Baltic Dry Index. 24 vessels out of 49 have Time Charters. In addition with the fleet expansion as of Oct 6, dryships acquired 9 more ships, 5 of which with time charters, or fixed contracts.

    Oct 6, 2008 DryShips Announces Strategic Expansion Adding 9 Capesize Vessels and 2 UDW Drillships Conference Call to be Held Today at 9:00 A.M. EDT

    The following is an email from Paul Lampoutis

    Vice President
    Capital Link, Inc.
    230 Park Avenue, Suite 1536
    New York, NY 10169

    T:(212)661-7566 x236
    F:(212)661-7526
    plampoutis@capitallink...
    capitallink.com
    capitallinkforum.com

    The following link will take you to the DryShips fleet deployment chart www.dryships.com/ir.cf.... As you can see from the chart, DryShips has a balanced mix of both spot and fixed rate contracts, fixing half its fleet on long term charter coverage. This secures the company from market volatility, such as we are experiencing today.

    For the three months ended June 30, 2008, the total vessel operating expenses were 6,559, based on this figure, DryShips vessels are still very profitable even in the current freight rate environment. I.E. the Baltic Dry Index.

    As you may already know, the decline in DryShips shares is not related to the change in Company fundamentals but to the weakness in the Dry Bulk sector. Dry bulk stocks specifically have suffered due to the decline in the Baltic Dry Index. The fall in freight rates is mainly due to seasonality, the Olympics and weakness in steel prices. Today’s volatility in the BDI can also be attributed to the demands from Brazil's Companhia Vale do Rio Doce (Vale), China's largest supplier of imported iron ore, to increase its prices to its Asian customers. Until this is resolved, China is not importing Vale’s iron ore. Market sentiment is that dry bulk fundamentals will remain strong and that industrial and construction activity is expected to resume in China in the fourth quarter which should allow rates to strengthen.

    This post contains forward looking statements.
    Reply
  •  
    Oct 08 09:06 AM
    Many dry bulk companies have a portion of their ships in fixed contracts, yet lower rates on their spot portion of their fleet still hurts. There are many examples of bulk shippers with some fixed contracts who have seen their share prices collapse. The main point of the piece was in regards to the unreliability of depending on forward earnings performance of a bulk shipper. At the current price, DRYS might actually be a decent Buy now but I don't have time for the full analysis. Note that I have seen tons of company reassurances such as you show above. The reality of the situation is that dry bulk rates hit sky high levels and weren't sustainable long term. Even the current levels on the BDI are strong by historical standards. What this means is that we could still have a strong demand story, but rates could actually fall. Why? Massive vessel supply is coming online, and this will accelerate through 2010. Credit problems could slow some of it, but supply growth is so large that we could have a lot of cancellations, yet still have strong dry bulk supply growth nevertheless. The China steel slowdown will compound with the supply growth problem and is likely to really hurt dry bulk rates. Again, realize that the current BDI level is actually a strong level historically. It still represents a lack of ships globally. As this bottleneck gets cleared, and chinese steel demand softens, the BDI could still go lower and not be a disaster situation relative to history. BDI 3,000 is very strong actually. The problem for dry bulk stocks like DRYS was one of the stock price depending on meeting sky-high forward expectations. To believe that BDI 10,000 was sustainable long term was utterly ridiculous. Dry bulk as a business can't earn outsize profit margins, higher than a lot of advanced tech or branded media outfits, for what is basically an easy to enter business. Sky high expectations are easy to miss, and they were, thus dry bulk stocks when from ridiculous valuations down to what actually could now be decent levels for value investors. Finally, while fixed contracts are likely to be honored, keep in mind that in the past major dry bulk downturn, a lot of customers walked away from their fixed contracts when times were tough. Thus while its good DRYS has some fixed contracts, they aren't bulletproof. If its worth a lot of money to walk away from a contract, or force a renegotiation, then some customers might think its worth the loss to their reputation. It happened last time.
    Reply
  •  
    Oct 08 09:19 AM
    I also forgot to mention the ultra deep water drill ships. Dryships owns 2 ultra deep water drill ships which they acquired from Ocean Rig ASA.

    The Leive Ericksson and the Eirik raude both are Fifth-generation semi-submersible drilling units. They also have 2 UDW Drillships that are in the process of being built. Aslo during this month they will acquire two newbuilding UDW drillships to be delievered by Samsung in Q4 2010 and Q1 2011.

    The Leive Ericksson is contracted to Shell and will be available for contract in 2009.
    The Eirik Raude is contracted at $637,000 average day rate.

    The average revenue from drilling contracts daily during the previous quarter was $512,222.

    The rig operating expenses daily was $148,755.



    Dryships is going to pay all dryship stock holders an issuance in the form of a dividend, stock in a new company called PrimeLead which will be the Ultra Deep water Drilling company listed on the NASDAQ. This will be a total of 6 ultra deep water drill ships and as you can see from above this will be a very profitable company.

    Value of UDW Unit for DryShips

    This is taken from the presentation on Oct 6th:

    We estimate the equity value of Primelead based on different valuation
    methodologies ranges:
    From $ 2.55 to $ 2.80 billion
    Which, if correct, and divided by the 75% share owned by DryShips shareholders
    should result in a Primelead common stock price(1):
    From $30 to $31 per share
    DRYS Share Closing Price on October, 3, 2008: $31.50

    If you play the spin off and vaulue Primelead at the 31 dollars per share then what are you getting dryships for? With yesterday's closing price of drys at 21.85?

    58 DryBulk ships, 29 of which have time charter fixed contracts?


    Reply
  •  
    Oct 08 09:56 AM
    Just how many public comanies' stock are trading at less than half the book value of the enterprise?
    Reply
  •  
    Oct 08 10:38 AM
    In the first quarter 2008 I suspended my stock screening activities looking for deep value based on trailing and forward earnings. Past earnings have no meaning in the current environment and published forward earnings estimates are currently "wish lists" and are unlikely to reflect informed assessments. In the same vein, many book values are suspect (obviously for financials, but possibly elsewhere as well).

    My strategy since the beginning of the year has been to look for a baby in the discarded bathwater where earnings and assets may be understood well. I haven't found much and have had to resort to holding cash and doing some short-term trading.
    Reply
  •  
    Oct 08 11:05 PM
    P/E's in general have little predictive value. Both P/S is overall better, tho your cyclicality argument would apply here, too..., and also changes in earnings estimates are better. These statements are data-supported.
    Thank you for your article--I found it very informative.
    (Please excuse my syntax).
    :-)
    Reply
  •  
    Oct 09 12:39 AM
    I don't think much of writings that point finger without offering a hand, and the author's is certainly of this kind. If forward P/E is not a good measure, fine, tell people how you would value it and why your alternative approach is superior.

    It's true that everyone is wrong at times. Thus pointing out other people's mistake is the best way to get famous -- just write ten articles pointing out ten potential mistakes and after six months, you know what, two out of those ten will indeed turn out to be mistakes. Then just write two follow-ups quoting your writing six months ago and bingo, you are hell of a visionary. It's funny games like this can still fool people.

    Too cynical? Maybe. But I'm quite tired of reading this I-am-smart-because-I-s... type of nonsense. Tell people how you would value it constructively, and I'll take back what I said. Otherwise, this article is a complete waste of time.
    Reply
  •  
    Oct 09 07:20 AM
    Good article. Most good predictive ratings have some sort of "outlook" or stability rating attached to them. Bond ratings, for example, come with an estimate of the risk of a near-term downgrade. Forward PE needs to be regarded the same way.
    Reply
  •  
    Oct 09 08:20 AM
    I simply don't have the time to do a full analysis on DRYS. I also tend to not make full recommendations for stocks online. The decision making process would also probably take more than a blog post to fully explain and defend. My goal with the post was to try and cut through a lot of false reasoning when it comes to arguments for or against stocks. Criticism is healthy for thought.

    As for how might someone value dryships? Well let's think as if one were actually in the industry looking to expand your fleet. An industry player can either buy ships in the market or buy a company that owns ships. If you get far more ships for your buck buying DRYS than buying int he market, then I think that's a decent starting point, but we must be very careful since even dry bulk (and rig) asset prices can fluctuate quite substantially. Thinking from an industry buyer perspective would be simply thinking about the value of a dry bulk company as the actual players in the industry do. I promise you they don't forecast 1 year of earnings and then calculate a multiple. Wall street analysts frequently do, and companies put simple multiples in their investor presentations, but trust me actual shipping players don't make decisions like this. DRYS has rigs and bulk vessels, plus perhaps some additional value from its organization and customer relationships. But you would probably want to be getting DRYS at a price where you were getting its assets at a good discount to market prices, as this would give you some cushion. (these asset prices can fall, so good to have a margin of safety). Just don't forget that DRYS has a lot of debt, so you would want your adjusted NAV (adjusted to include a margin of safety vs. asset price declines) to be much higher than Enterprise Value (not market cap).
    Reply
  •  
    Oct 09 10:23 AM
    This is one of the most interesting debates I have seen yet on SA. Here are a couple of questions that haven't been addressed yet:

    1) Why should we assume that (a) the China/Vale dispute will never end, or (b) Chinese materials demand will decline, even as they continue building railways, roads, factories, houing, cars, etc..? That's a pretty bold "decline of China" prediction. Might it be more accurate to say that the current drop in the Baltic index was caused by Olympics hoarding and the Vale dispute, issues that will soon be unwound with a violent uptick in demand?

    2) Has anyone done the work to see how new ship production compares with projected long term demand? How many ships? How much an increase? How many old ships are being scrapped? Can ship supply even be predicted?

    The point is taken that not all forward earnings estimates are created equal. As the author points out, some companies' earnings fluctuate violently as the demand & price of their underlying product or service fluctuates. Other industries besides shipping where this is the case include oil, refining, fertilizer, mining, chemicals, etc. - basically everything that has gone up in the past few years. The lesson I draw from this is to be careful not to overweight your portfolio with companies that depend on potentially volatile market prices for their earnings. Bricks-and-mortar businesses such as WalMart often have more stable earnings.
    Reply
  •  
    Oct 09 03:51 PM
    I like Stalwart's response this morning, reasonable and insightful I feel.

    All models are wrong by definition, and any valuation metric, P/E, P/B, P/S, ... you name it, has the garbage-in-garbage-out property -- the result is as good (or bad) as the input. Take forward P/E for example, it is obviously useless if you cannot predict the forward earning. I would thus rather focus on debating the underlying fundamentals than on the use of certain metrics.

    Sticking to the fundamentals, I'll try to respond to some of Chris B's points. First of all, the China/Vale dispute is not, in my opinion, the reason for BDI decline. The 80 million metric tons of iron ore stored at 20 Chinese ports are the main reason. Too much iron ore was shipped to China before Olympics and it takes some time (some estimates two quarters) to work it through. This may be temporary, but enough to kill the spot market. Second, and more importantly, there is a real worry now that Chinese demand will decline materially. Steel price in China has declined by more than 20%, and big Chinese steel producers are trying to coordinate a supply cut of similar percentage. Furthermore, there is a concern that many real estate markets in China would crash, which will reduce steel demand from construction sector. Do I believe in all these? Partly. The steel price drop and production cut are real, and the sentiment is very bearish in Chinese financial news websites. Anecdotal evidence from China, though not related to material sector, points to slower growth and even deflation in some markets. None of these bold well for the near term. Longer term, sure, I am very bullish in China. But we should keep in mind that there is a huge difference between the real long term (5+ years) and the long term (1 year) that's relevant to stock market.

    Coming to DRYS itself, I am very disappointed by the firm's recent move to acquire 9 capesize ships for $1.2B. The number simply does not add up: take the $50000 contract day rate of 3 of the ships as a starting point, the annual revenue of a ship is $18M max. Multiplying that by 9 (ships) and 10 (years), you can see that the combined REVENUE of these ships for the next 10 years will be $1.6B. What about income? What about discount rate? What about market risk ($50K rate is much higher than the spot rate now)? In such an environment, it's as reckless a move as one can imagine. On top of that, the fact that these ships were purchased from an entity controlled by Economu (DRYS CEO) raised a serious conflict-of-interest issue. I have been very interested in buying DRYS shares but this simply put a stop on it. Could anyone shed some light on the rationale behind this deal? I will really appreciate it.
    Reply
  •  
    Oct 09 05:10 PM
    On China steel production growth long term, surely a huge story there, though we might have a near term slow down or contraction. The problem though is that Chinese demand growth only gives us the demand side of the shipping equation. The main danger is the supply side of the equation. Massive supply growth, well beyond even the best years we've seen for dry bulk demand growth, are on the way 2009 - 2011. So really its important to do some work on the supply side. Bulls will argue that a lot of ships scheduled to come won't be completed or will be delayed. It could be the case, but the supply growth well ahead of even bullish china demand scenarios, thus it has room to lose some steam due to ship cancellations, but still overwhelm a relatively bullish china demand story 2009 - 2011. I think nevertheless that the current global turmoil warrants a good study of what kind of cancellations we could see. They would have to be like 50% or more of the vessels scheduled for 2009 - 2011. Thus I think concerns for dry bulk go beyond the near term demand problems we have seen lately. I think no one will argue against the point that the China/Vale problems are temporary and that China still has a strong long term steel production growth story.
    Reply
  •  
    Oct 09 05:16 PM
    btw, I have done the dry bulk supply/demand math in the past using industry research data from Clarkson and Marine Strategies International. Roughly, Global demand growth in a bullish scenario for china is in the high single digits (and this includes both volume and distance effects), while 2009 - 2011 supply growth goes from about 10 - 18% per year (I think about 10, 14, 18 in that order), even with about 25% cancellations factored in. These are rough numbers, but when I did the math it was clear that supply growth was going to be well ahead, with room for error, of demand growth. The scary thing is that in a bearish near term china scenario, global demand could actually go negative. If a negative growth rate butts up against a 10%+ supply growth rate, rates would collapse substantially further to perhaps something like BDI 1,000.
    Reply
  •  
    Oct 09 05:44 PM
    Thanks Stalwart - all of this is great information.
    Reply
  •  
    Oct 10 12:20 AM
    I also remember seeing supply growth forecast of 10 for 2009 and 13 something for 2010, not sure about 2011. Most people seem to agree that supply will outpace demand in the coming years, and that was before the recent crisis.

    However, though comparing supply with demand growth gives a rough picture, to actually quantify the impact, one needs to know the *elasticity*. Any rough idea on what the elasticity is in the dry bulk industry (I have no clue)? This measure is critical because without it, all that one can say confidently is "things don't look good, because supply is higher than demand". We need better than this to make intelligent investment decisions.

    This is especially true now. Given that most dry bulk stocks have fallen by more than 60%, the real question is not "is it bad?", but "is it as bad as people think it is?". To answer the second question, quantitative measure is necessary.
    Reply
  •  
    Oct 10 08:30 AM
    For dry bulk, demand and supply are extremely inelastic, thats why the rates are so volatile and hard to predict. Iron ore & coal generally need to be shipped regardless of price, and on the flip side ships must be filled else they just lose money. Generally, even if rates are really bad, its still worth it to lose less money by filling your ships. (fixed costs are high, variable low) Same applies for a large part of dry bulk commodities demand.
    Reply
  •  
    Oct 10 11:33 PM




    Given the price drop relative to the intrinsic value of the stocks plus the soon to develop HYPE on water scarcity where the stock has invested the infrastructure needed to adress the creeping demand ,the stock give a BRIGHT RAY OF HOPE ON HOPE during gloomy times !!!
    Reply
  •  
    Oct 10 11:48 PM
    At times like these it is in depth valuation that matters besides DAYS move into an industry that will be the next HYPE- Water will position the Company into a waves of the future industry.Days give HOPE TO HOPE a badly needed commodity fro survival !!!
    Reply
  •  
    Oct 24 06:35 AM
    Seems at extreme market condition points people want to ignore things like PE ratios. This could using Dow theory define the turning points. Admittedly forward PE of DRYS may be difficult to predict given all the variables mentioned. Once expectations reach excessive levels in either direction it may be a good time to consider the converse.

    I did however see a disturbing article about DRYS and increasing debt. I suppose to pay for the new ships. Can anyone offer some advice on the debt level relative to the value of the company?
    Reply
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