DryShips (NASDAQ:DRYS) is an interesting case - the company has a lower market cap than its own subsidiary, Ocean Rig (NASDAQ:ORIG). It may come as a surprise to some readers, but market anomalies like this exist. There seems to be some confusion when people talk about DryShips and Ocean Rig. A number of readers do not seem to understand the relationship and how it works. I have tried to explain the relationship in this article.
DryShips and Ocean Rig: The Relationship and Benefits
Offshore Drilling is one of the most attractive segments of the energy sector at the moment as it is growing at an impressive rate. It is the reason Ocean Rig is valued more by the market as there is more growth potential in the offshore drilling segment. On other hand, DryShips' core business is on the decline and the market is pessimistic about the companies operating in this sector. DryShips has good presence in the sector through Ocean Rig. However, it should be kept in mind that DryShips does not actually benefit in terms of cash flows until Ocean Rig starts to pay dividends or DryShips sells some of its shares. Investments in other business are consolidated in the financial statements and DryShips' stake in Ocean Rig will certainly make its balance sheet look good - however, the company cannot register any earnings until it receives cash dividends or realizes capital gains.
Since Ocean Rig is majority owned by DryShips, the company consolidates Ocean Rig earnings into its own. Impressive performance of Ocean Rig has been hiding the poor performance of DryShips' core business as the shipping industry has taken a major hit over the past four-five years. Let's analyze one quarter in order to gauge the impact of Ocean Rig's on DryShips' own results. For the third quarter, revenue for DryShips was $76.4 million while the revenue from Ocean Rig was $328.5 million, four times more than the revenue coming from the core operations of DryShips. Let's now look at the expenses in order to determine the margins. For the sake of analysis, let's ignore depreciation, impairment, legal and general and admin expenses - let's just focus on the expenses necessary to operate the rigs/vessels.
According to the above mentioned criteria, the total expenses for DryShips' shipping business comes close to $51 million, giving the company a gross margin of about 33%. However, when we take into account the operating expenses and depreciation, the operating margin for DryShips' core business becomes negative. On the other hand, gross margin on the drilling business is close to 61%, almost double the core business of DryShips. The consolidation of Ocean Rig's revenues gives DryShips operating income of over $78.4 million, when the company would have reported an operating loss based only on its core business. We have seen the impact of Ocean Rig's earnings on the total earnings of the company. However, what is the gain in terms of cash? None. As I mentioned above, the company will benefit in terms of cash once Ocean Rig starts to pay cash dividends. If that happens, the cash will start to flow from Ocean Rig to DryShips.
Ocean Rig announced at the end of the third quarter that the company will pay $25 million in cash dividends in May 2014. Since DryShips is the majority shareholder, a large chunk of that cash will come to DryShips, and if the company continues to pay a regular dividend, then we will see a steady stream of cash flowing towards DryShips. In the past, DryShips has used Ocean Rig to raise some emergency cash - sometimes parent companies use subsidiaries to raise cash if the parent company does not have the ability or if the parent company gets a cost advantage by raising money through subsidiary. Cash raised through equity/debt issue can be paid to the parent company.
By no means am I trying to discredit the progress DryShips has made in the offshore drilling segment or their efforts in the core business of the company. The decision was right to invest in offshore drilling and it will pay off. However, my motive for writing this article was to explain the relationship and when the real benefit in terms of cash flows can be expected from Ocean Rig. The company can only benefit in terms of cash by selling its stake right now. However, in the future, cash dividends will most likely be the benefit from its investment in Ocean Rig. DryShips should not sell its stake in Ocean Rig as this is a rapidly growing segment. I am also optimistic about the prospects of its core business - the charter rates have improved and the recovering global economy should increase the demand for its services.