Euroseas equities (ESEA): sell in a context of excessive cyclical exposure

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Factoring cyclicality into one’s investment decision-making process is of the utmost importance. The financial literature has proven that most buy-and-hold portfolios underperform successfully rebalanced portfolios unless investors bet on countercyclical assets, which Euroseas (NASDAQ:ESEA) probably isn’t. Thus, we analyzed the outlook for the stock from a medium-term cycle perspective and the dominance found in a bearish case. Therefore, we are downgrading Euroseas to a sell with a 6 month time horizon.

Here are some variables to consider.

Revenue Review

To begin the analysis, let’s review some positives and negatives unveiled in the Euroseas third quarter results report.

Operational analysis

In the third quarter, Euroseas Ltd. achieved 99.4% year-over-year revenue growth, which certainly cannot be overlooked. In its most recent fiscal quarter and nine months, the company enjoyed above-average shipping rates. Port congestion and artificial economic demand stimulated by stimulus checks and expansionary monetary policy. Furthermore, Euroseas operates in an industry with high barriers to entry, which has allowed it to take full advantage of systemic tailwinds.

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Euromers; Looking for Alpha

Although the Euroseas fleet grew by 3.4% over the past year, most of its prime support was due to the mentioned macroeconomic tailwinds, which no longer exist. However, let’s expand on the company’s recent operational details.

Since the start of the year, Euroseas has increased its overall utilization rate to 99.5% from 98.5%. Additionally, the company increased its quarterly vessel average from 14 to 16.8, allowing for better overall production capacity.

Despite improving revenue, the company’s costs have risen significantly since January, pushing its break-even point up about 35% in the past nine months. Additionally, Euroseas free cash flow is on a downward trajectory largely due to lower operating cash flow, primarily due to lower CapEx.

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Data by YCharts

Cyclical risk

A common mistake we all make/have made as market participants is that we tend to look at financial markets in arrears, in turn ignoring cyclicality. The economy is a cyclical vehicle with peaks, troughs and troughs related to economic policies and natural consumption. Thus, it is necessary to consider that Euroseas revenue growth of 99.4% year-on-year may soon drop.

Euroseas dry bulk activities span the entire commodity space, which can be juxtaposed. There is a marked slowdown in demand for industrial metals; however, the demand for coal has increased sharply in recent months due to power shortages in many parts of the world.

Given the IMF’s survey of global economic health, it is likely that we are heading for a period of slowdown in industrial production, subsequently affecting shipping activity.

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IMF

The second mistake we make as investors is to assume that the stocks of the underlying companies will reach their fair value. Although the underlying activities of a company and the stock price are correlated, sometimes they are somewhat adrift.

Investor psychology plays an important role in determining the price of a stock. For example, during times of economic uncertainty, investors typically opt for countercyclical assets, which the Euroseas is unlikely to be due to its excessive exposure to cyclical industries in manufacturing and basic materials.

Despite my doubts about the cyclicality and the excessive standard deviation of Euroseas (compared to the market), the title harbors a low beta. Therefore, a valid beta analysis could completely derail my argument, something investors need to consider.

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Data by YCharts

Valuation and Dividend Profile

From a relative valuation point, you might think there is no reason not to invest in Euroseas stocks. While I agree that stock valuation multiples could boost investment, I doubt their sustainability. First, a stock’s price multiples are not static and can fluctuate with cyclicality. In addition, there is no guarantee that the market will value a stock at its fair value.

Price/earnings ratio 1.41x
Price to book 0.91x
Price/cash flow ratio 1.15x

Source: Alpha Research

In addition, Euroseas pays an attractive dividend, yielding 5.13%. In addition, the dividend has a strong dividend coverage ratio of 8.21x, and the company hosts a cash-to-share ratio of 3.82x, indicating that the Euroseas dividend is both lucrative and safe. Additionally, the current market climate appears to be conducive to high dividend yielding stocks, providing essential tailwind.

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Looking for Alpha

Nevertheless, I return to my argument of cyclicality by pointing to the oscillation of the net result, the dividend yield and the operating cash flow of Euroseas. I want investors to make up their own minds, but I’m betting on a cyclical downturn, which could be valued by financial markets in due course.

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Data by YCharts

Final Thoughts

Euroseas is a brilliant company, but financial markets may view this stock as a cyclical risk until global economic variables realign. Evidence suggests that buy and hold portfolios underperform managed portfolios and price entry points are of utmost importance. Despite Euroseas’ strong third quarter, lucrative dividend yield and attractive valuation metrics, we believe cyclicality will prevail. Thus, we assign a sell rating to the stock with a six-month horizon.

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