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We upgrade our recommendation on DryShips Inc. (DRYS - Analyst Report) to Neutral ahead of its fourth-quarter 2012 financial results. The change of recommendation is based on an expected growth of drybulk shipping industry in the near future and the company’s low level of current valuation.

Why the Upgrade

We believe the company’s majority owned deepwater oil drilling unit Ocean Rig UDW, will boost DryShips’ top line going forward. Furthermore, an expected growth of commodity demand in the emerging markets, especially in China and India may help the drybulk shipping market to recover. We believe the company is currently fairly valued as the stock price plummeted 43.5% in the last year. DryShips currently has a Zacks Rank #3 (Hold).

Other Positives

The offshore drilling division continues to flourish buoyed by rising expenditures from oil companies and success in ultra deep water oil field discoveries. The deepwater oil drilling segment is currently witnessing shortages of rigs throughout the world, as the energy companies have raised the level of production.  At the end of the third quarter of 2012, Ocean Rig had approximately $4.5 billion of order backlog over the next three years. We believe the demand for deep water drilling services will improve in the near future due to the discovery of several big new deep water oil reservoirs. Ocean Rig has high quality drillship fleets, which will enable oil explorers to operate even under harsh environment.

DryShips decided to sell two of its unfinished Suezmax tankers, currently under construction at Samsung Heavy Industries, South Korea to a third party buyer. Last December, DryShips entered into two novation agreements with the buyer under which the third party owner will assume all rights, benefits, liabilities and obligations of the two Suezmax tankers. However, to get rid of the tankers, DryShips itself will pay $21.4 million in cash. The primary reason for this divestment is to reduce the annual capital expenditure of DryShips by a significant $101 million.

Other Stocks to Consider

Besides DryShips, other stocks in the shipping industry that are currently performing well include Frontline Ltd. (FRO - Snapshot Report), StealthGas Inc. (GASS - Snapshot Report) and Tsakos Energy Navigation Ltd. (TNP - Snapshot Report). All these stocks currently have a Zacks Rank #2 (Buy). 

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