Small-Cap Spotlight: Diana Shipping Taking On Water?

News was prepared under the information support of Online Daily Newspaper on Hellenic and international Shipping "Hellenic Shipping News".

29 Dec 2007

This week, Frank and Larsen put the spotlight on Diana Shipping (DSX), one of the major (but still small-cap) names in the Greek dry-bulk shipping sector. Companies in this sector own and operate fleets of ships that haul thousands of tons of cargo at rates set months in advance. Should you put this name in your portfolio? Diana Shipping offers a different investment opportunity in the small-cap sector. Its story is not levered to a specific growth story; rather, the stock trades in line with expectations for the global economy. More importantly, the recent pullback in Diana's share price has created an extremely attractive entry point for new investors.  I like this name as a pick for the holiday week, because it's a small-cap stock that truly gives back to investors. Trading at around $30, Diana Shipping offers a dividend yield of around 8%. This high return is rare in the world of small-cap stocks and is a major departure from the names Frank and I have offered in previous Small-Cap Spotlights. Diana Shipping operates a fleet of 17 ships -- 13 Panamax carriers and four larger Capesize bulkers. On any given day, its ships carry about 1.7 million deadweight tons (dwt) of cargo around the world. Diana stands out vs. its competitors because its entire fleet was built in the last six years, so its ships have an average age of about four years compared with the industry average of 15 years (the average lifespan of a ship is 25 years). This is important, because it means the company will have plenty of time before it has to replace existing revenue-generating ships. In fact, Diana is adding two more Capesize bulkers in 2010.Diana's fleet primarily carries iron ore, coal and grain, along with other basic commodities that benefit from broad demand throughout the world. Not surprisingly, China plays a major role here, as demand for iron ore and related commodities has been growing at a 15%-20% clip in recent years. The result has been a steady increase in the rates that Diana and other shipping companies can charge for their services. Just two months ago, shares of DSX surged when the company announced it had entered a 12-month charter agreement for its Erato Panamax ship at a gross rate of just over $80,000 per day. This was a pleasant surprise for investors who had been expecting rates to rise at a much more conservative clip. Most Street analysts had been using a Panamax charter rate well below the $70,000 mark for the coming year. Expectations for shipping rates have since pulled back, helping bring Diana's share price back to levels that are attractive for investors looking to get in on the action. Perhaps the best part of the story is that long-term investors don't have to rely on a major catalyst to make this a successful investment. If the stock merely treads water over the next 12 months, shareholders will earn a solid 8% return solely on the basis of the company's generous dividend payout. On the other hand, if expectations for shipping rates rise quickly, like they did in October, investors could see a nice profit in a small amount of time. Having pulled back sharply from the $45 level, shares of Diana Shipping sport a very attractive risk/reward profile along with a dividend that will become even more important if the Fed continues to move interest rates lower over the next year.After researching Diana Shipping, it's easy to jump on the bandwagon as global demand for raw materials remains strong and most of the company's contracts will be resetting at much higher day rates. The fundamentals of the dry-bulk industry remain solid, and almost every sell-side analyst who covers the stock has a buy rating. I can sugarcoat it more and say that Diana has already secured earnings per share of more than $2.50 on the basis of existing contracts and that new contracts will be renewed over the next few months at spot rates that are 170% higher year over year. Throw-in the 8% dividend that Larsen mentions on top of a pullback in the stock price of more than 30%, and we have the perfect investment for aggressive and conservative income oriented investors. But reading between the lines, I see a much different picture. Larsen mentions that Diana Shipping trades in line with expectations for the global economy, and I agree. However, my projections on global growth differ from most, including the talking heads on "Kudlow & Company" who suggest that not only is the global economy solid but domestically the U.S. is doing just fine. Looking at the top economies, China is in a bubble -- albeit one that could continue to grow -- India is showing clear signs of a slowdown as its finance minister attested to this week, and the financial crisis is taking its toll on Europe, as became evident when Germany (its largest economy) lowered its 2008 GDP forecasts. As for the U.S., financial companies still have no clue to the exposure of exotic loans on their books, and the housing market is in the early innings of its downturn, and that is leading to a pullback in consumer spending. Also, it's difficult to imagine that China, India and Europe's economies will experience no disruptions when the largest economy in the world is on the verge of recession. Turning away from the macro picture, most analysts are quick to point out the surge in dry-bulk day rates and how earnings will surge next year. But this catalyst is already on the table and therefore likely factored into the stock price, given that shares are up 100% even after the recent pullback. Income-oriented investors are salivating at the 8% dividend, but in the long term this will be difficult to sustain. Diana uses roughly all of its free cash flow to pay its $2.32 dividend, which is more than 100% of its net income over the past 12 months. On the basis of the underlying strength in the dry-bulk industry, the dividend is likely to be secure through 2008, but any downturn in fundamentals or disruption in growth in China will lead to dividend cut. Overall, Diana seems well-positioned to continue to benefit from strong industry trends, but considering the 100% gain in the stock over the past 12 months and a possible weaker global climate, there seems to be more risk than reward. Also, the huge surge in day rates is already reflected in earnings, removing a major short-term catalyst.