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Ocean Rig (ORIG) Trades 50% Below Book Value

By Dan Shainberg (dshainberg@bhicllc.com)

Leiv Eiriksson

SUMMARY

OceanRig is an international deep and ultra-deep-water (UDW) independent driller and a subsidiary of DryShips (DRYS). ORIG's strong operating performance is being overshadowed by the overhang of poor performance at its largest shareholder and parent company. Due to the trough in the highly cyclical shipping industry, the parent company cannot easily attain traditional funding. Overall financial performance of the company is extremely poor and voyage revenues have come down by about 40% over the past year. It is a "forced-seller" on a stock with limited float but excellent high-quality assets, contracted/visible growth and clear near-term catalysts.

ORIG's backlog stands at $5.1bn over three years with a healthy balance sheet and significant contracted free cash flow and growth visibility. ORIG's stock is simply "technically" pressured, down over 20% from $17.55/sh on 2/11/13 to $14.05/sh currently, as DRYS announced its third non-dilutive offering of ORIG stock to generate needed liquidity.

Due to this forced selling of ORIG stock amidst an illiquid public float, ORIG is currently valued at an incredible opportunity for investors: ~50% below its $22/sh book/appraisal/replacement value and at a sizable 185% below its forward fair Cash Flow based valuation of $40/sh. Besides the technical selling, the company is in transition, recently increasing term debt by $1.35bn to fund the final payments for its three new rigs under contracts set to begin throughout 2013. While the leverage should rise, the considerable Free Cash Flow (FCF) through 2013 and 2014 should pay off this new debt, leaving the company with a similar level of net debt but materially higher EBITDA and FCF. EBITDA and FCF are set to explode from $294mm and $90mm in 2012 to $900mm and $630mm in 2014. Leverage should drop as well from 8x LTM to a very reasonable 3x LTM (and 2.5x fwd) in 2014.

PROFILE

ORIG owns and operates six drilling units including two drilling rigs, the Leiv Eiriksson and Eirik Raude, and 4 drill-ships, the Corcovado, Olympia, Poseidon and Mykonos. All six units are constructed for the UDW and harsh environments. In addition, they have 3 UDW drillships under construction, capable to work in 12k feet water depth and scheduled to begin operating under new contracts in 2013.

WHY IS ORIG ON SALE?

1) The technical ownership structure of ORIG's stock is creating a significant overhang. DRYS still owns 57% of ORIG's stock even after this latest March offering of 7.5mm shares. ORIG shares fell hard, over 20%, after DRYS announced it is increasing its sale (2/2013) from 5mm to 7.5mm shares.

Further, DRYS pledged some of ORIG's shares to cover for any covenant breaches and had cross-default and cross-acceleration clauses in ORIG's credit agreements creating a linkage with its parent. In April 2012, ORIG amended its agreements to eliminate all cross-default and cross-acceleration clauses with its parent, although the pledged shares may still warrant the overhang as some investors may be concerned about a short-term forced selling event.

The recent non-dilutive DRYS offering was upsized by 50% from 5mm shares to 7.5mm shares, further pressuring the limited float. As an illiquid, majority-controlled stub, ORIG has very limited analyst coverage and few investors aware of the story.

2) Q4'12 earnings were slightly disappointing. There were an unexpected 130 total days of downtime for the Eirik Raude and Leiv Eiriksson and 10 days of downtime for the Ocean Rig Mykonos in Brazil. Further, it experienced a $44mm expense related to the class survey for Eirik Raude.

VALUATION

The stock price is currently $14.05/sh. A fair value estimate is $20-$22/sh simply based off of their NAV, representing 40-50% upside to current asset value.

Assuming they remain a traditional corporation and institute a reasonable dividend this year (per guidance), it should trade in line with Pacific Drilling (PACD), its closest peer in terms of rig depth, age, and asset quality. PACD does not have a dividend, so using its 7.5x fwd EBITDA multiple is certainly conservative. At 7.5x fwd EBITDA of $950mm in 2014, ORIG should have an Enterprise Value over $7bn and a Market Capitalization of ~$4.3bn, or $33.00/sh stock price representing nearly a 2.5x return.

Should it successfully convert to an MLP and/or institute a strong recurring dividend per its guidance, it should trade in line with Seadrill (SDRL), it's only publicly traded MLP comp with a 9% dividend yield. Given projected Free Cash Flow from operations of $650-$700mm by 2014 (net of maintenance capex), ORIG should certainly be able to commit to a comparable dividend payout. SDRL trades at 8.5x Fwd EBITDA. Using this multiple, ORIG should have an Enterprise Value over $8bn and a Market Capitalization of ~$5bn, or $40.00/sh stock price representing nearly a 3x return.

To illustrate the dislocation in ORIG's valuation, ORIG is currently trading at a pro forma EV / 2014 EBITDA of 4.9x and EV / 2015 EBITDA of 4.1x vs. peers PACD and SDRL @ 7.5x and 8.5x fwd EBITDA, respectively.

Large-cap peers such as Transocean (RIG), Ensco (ESV), Noble (NE) have much older rigs with higher maintenance capex, weaker technology and thus softer market dayrates. Those companies trade @ 10-15% fwd FCF Yields. PACD and SDRL trade @ 19% and 14%, respectively. Yet ORIG trades at a significant discount with a 35% and 42% pro forma 2014 and 2015 FCF Yield, respectively. Further, these FCF Yields should rise assuming it successfully converts to the MLP structure which can lower its cash taxes.

ORIG is trading at a Price / NAV of only 66% vs. large-cap peers that generally trade @ 100-130% of book value. "Vantage (VTG) is the only other comp trading at a discount to NAV" (Clarkson Capital).

ORIG's implied value / rig = "$600mm, yet replicating the assets today would cost ~$850mm/ rig" (per CEO Q4'12). The construction cost & appraised value / rig = $730mm (per company) for a book value / share of > $22/sh, so the current discount to book value > 40%. "Current assets would cost $8.8bn to generate the fleet today given the market newbuild cost for the current fleet is $850mm / rig" (Q4'12 call and 2/16/13 investor presentation). The Total Appraised Value of their 10 Rigs is ~$7.3bn (p. 26 of investor presentation).

Its pro forma 2014 P/E = 5.0x and 4.0x 2015. Large-cap peers trade @ 8.5x fwd P/E; SDRL @ 9.7x.

CATALYSTS

1) Strong Growth Visibility:

ORIG increased its backlog from $1.6bn in 2011 to $5.1bn in 2012. Its ramp-up of FCF in 2013 and 2014 is under contracts that are already signed with very high creditworthy customers such as Total (TOT), Exxon (XOM) Chevron (CVX), Eni (E), Conoco (COP), etc. It is fully contracted for 2013 with 90% contracted for 2014 and 65% in 2015. It recently established three long-term contracts for the new rigs: Leiv Eriksson, Olympia, Athena & Mylos.

2) Significant FCF:

EBITDA is set to rise from the three newbuilds entering contracts in 2013. Given they occur throughout H2'13, their contributions to 2013 EBITDA growth are not indicative of a full year of operations. The fleet is set to generate $900-$950mm EBITDA in 2014 vs. LTM EBITDA < $300mm. Even assuming some FCF leakage for refinancing its notes under the early call provisions, ORIG should be able to generate a minimum of $600mm of Free Cash Flow after all maintenance capex requirements in 2014. Including their new contract for the Apollo, they should hit $750-$800mm in 2015.

3) DRYS Overhang and Forced Selling:

OceanRig is a publicly traded subsidiary of DryShips. DRYS is in a depressed industry cycle, experiencing difficulty attracting traditional funding. The financial performance of DRYS is extremely poor with voyage revenues (-40%) year-over-year. The IPO of ORIG (12/2010) helped DRYS' liquidity profile, yet ORIG's strong growth has been overshadowed by the poor performance of its parent.

DRYS sold 7.5mm shares in 2/2012, reducing their ownership from 65% to 59% because it needed to raise more cash to repay its newbuild commitments and debt maturities. "Selling our ORIG shares was not a preferred action especially at today's pricing level. We continue to be bullish about the prospects for ORIG. Based on current charter rates, we estimate we will need to raise a few hundred million through '14." ORIG is "comfortable that there won't be any more DRYS selling in 2013." (CEO ORIG Q4'12 call)

Dryships already reduced its exposure to ORIG from a 73% ownership position to 59% in 2012 and 57% as of 3/2013. While it still has majority control, as it sell its stake, the public float should rise from only 35% currently and allow for inclusion into indexes and ETF holdings. An eventual DRYS exit would increase analyst coverage, new investor interest, and remove the ownership overhang. Larger mutual funds and hedge funds should be able to allocate capital to this position once the float rises.

4) Distribution / Dividend:

ORIG is not just a stock trading well below its asset value and fair multiple of free cash flow, but it also has a significant distribution catalyst. It should be able to institute a recurring dividend and/or convert its corporate structure to an MLP this year. Its strong contracts create visibility and reduce earnings risk, allowing for a distribution policy. This would likely attract a new set of investors.

According to the CEO: "Cash distributions are a high priority; it could be paid in a recurring dividend or as a distribution through an MLP conversion. The dividend will be paid as soon as possible; it is likely a late 2013 event. The only reason for a dividend delay would be an operational surprise. The dividend is a very high priority for management."

5) Refinancing & Deleveraging:

The financing risk for the three new-builds is now behind it after it closed on a new $1.35bn Jan 2013 bank loan offering.

The "opportunity remains to refi our 9.5% notes callable 2014. Our first goal is to reduce debt and then we can pay a dividend. We expect leverage < 4x LTM by the end of 2014. We have no debt maturities prior to 2016. Our low net debt per rig which should drop to $350mm by 2016 would allow for very attractive refinancing." (Q4'12)

ORIG has 9.5% Notes due 4/2016 that are callable 4/27/14 @ 104.5. Assuming a very reasonable rate, it could easily save at least $10mm in annual interest expense. It also has 6.5% Notes due 10/2017 that are callable 10/1/15 @ 103.25. While a bit further out, it could save another $5mm in interest expense annually with this refinancing. Should it convert to an MLP structure, the interest savings would mostly flow through to a similar level of increased Free Cash Flow given the minor offset of higher taxes given the tax benefits of the MLP structure.

6) MLP Corporate Conversion:

"We have thought about converting the corporate structure to unlock the discount in our valuation. But our Deutsche Bank credit facility needs to be amended first; we are working on this. We will get our refi completed in 2013; the goal is for an MLP structure in 2013." (Q4'12 conference call)

"Each rig generates ~$100mm in EBITDA so an MLP vehicle would add 1-2x or $1.50/sh per rig." (Credit Suisse research analyst 3/7/13)

An MLP structure could also improve its tax rates.

OTHER FACTORS

1) Healthy Balance Sheet:

While it appears that ORIG is highly levered, its latest financial statements really should be adjusted materially for the new events. It refi'd its Eriksson / Erik-Raude credit facility into a new $1.35bn facility which covers 2013 new-builds and eliminated all Dryships credit risk "by removing all cross-default and cross-acceleration clauses on 4/2012". According to the DRYS Q4 2012 conference call, "We do not have any access whatsoever to ORIG's financial resources" (CEO of DRYS, 3/7/13).

2) Strong Insider Ownership:

CEO owns > 5mm ORIG shares worth ~$74mm, aligning interest with public shareholders.

3) Asset Quality:

ORIG has one of the most premium fleets in the publicly traded space along with Vantage and Pacific Drilling. It has 100% exposure to deep and UDW as well as one of the youngest fleets with an average age of 2.7 years. This materially improves contracted dayrates and reduces maintenance capex requirements. While the deep and UDW outlook remains bright, there is clearly a dislocation between new, young and technologically advanced rigs and older rigs.

4) Recent Contract Wins:

The Erik Laude rig secured a new contract with Exxon for a $120mm backlog starting at the end of March 2013.

The Leive Erikson is in dry-dock working on upgrades, but set to start drilling operations under a new three-year contract beginning mid-April 2013.

ORIG received a new contract offshore West Africa with Lukoil (OTC:LUKOF) adding $217mm to its backlog and a new three-year contract with a "major oil company" @ $633k dayrate for the Apollo rig starting in Jan 2015.

Its three newbuilds Mylos, Skyros and Athena have new contracts for July, October and November of 2013, respectively.

Petrobras (PBR) has asked contractors for pricing of extensions for rigs set to complete current charters in 2015, including the Corcovado and the Mykonos.

INDUSTRY

(Paraphrased per ORIG's CEO on their Q4'12 conference call): The UDW market should support sustainably high dayrates through 2016. Offshore drilling activity set to increase 61% by 2015 to $200bn spend globally, and spending is set to double from $50bn in 2011 to $90bn by 2015. There were 52 UDW discoveries in 2012 in 14 countries vs. 37 discoveries in 2011. These discoveries should lead into substantial UDW drilling demand for many years. Deep and UDW drilling will remain attractive as long as the oil price outlook remains above the UDW cost of drilling, between $30/bbl and $70/bbl. Further, oil companies prefer long-term offshore oil contracts vs. onshore which are more short-term.

The offshore drilling fleet is currently very old, over 30 years average age, and they are technologically stale. The market should keep supply capacity with very limited shipyard building spots available. The past year proves that the market can easily absorb 25 new UDW assets / year. The three-year Erik Laude contract signed to start in Jan 2015 is an indication of how tight the market is.

2012 was best year on record for UDW oil exploration with 36 discoveries >4k ft, 18 >7k, 9 > 8k. (Noble Corp)

KEY RISKS

Leiv Eriksson: Drills in Falklands which is in a remote, higher-cost region with harsh weather.

Operational: Downtime, rig maintenance, labor, acceptance testing delays, mobilization delays.

Industry Cycle: Guiding to no issues over next two-three years, given limited newbuild capacity and high demand.

Regulatory: GoM type permitting slowdowns, etc and new regulations that may increase operating costs.

Dryships Selling: "Comfortable that there won't be any more DRYS selling in 2013" (Q4'12 call). There could be more selling from DRYS or if bankers take their pledged ORIG shares and liquidate.

Source: Ocean Rig Trades 50% Below Book Value