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Ocean Rig UDW, Inc. (NASDAQ:ORIG)

Q2 2014 Earnings Conference Call

August 6, 2014 8:00 AM ET

Executives

George Economou – Chairman and CEO

Gill Bocabarteille – COO

Anthony Argyropoulos – Capital Market Special Advisor

Analysts

Darren Hicks – Evercore Partners

Praveen Narra – Raymond James

Oliver Corlett – R.W. Pressprich

Gregory Lewis – Credit Suisse

Operator

Thank you for standing by ladies and gentlemen, and welcome to the Ocean Rig Conference Call on their second quarter 2014 financial results.

We have with us Mr. George Economou, Chairman and Chief Executive Officer; Mr. Anthony Argyropoulos, Capital Market Special Advisor to CEO. Mr. Gill Bocabarteille, COO of the company; and Mr. Stein Dunguard [ph] Marketing Director.

At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. (Operator Instructions) I must advise you the conference is being recorded today, Wednesday, August 6, 2014.

Matters discussed in this release may constitute forward-looking statements. Forward-looking statements reflect current views with respect to future events and financial performance and may include statements concerning plans, objectives, goals, strategies, future events or performance and underlying assumptions and other statements, which are other than statements of historical facts.

Please take a moment to read the Safe Harbor statements on Page 2 of the slide presentation. Risks and uncertainties are further described in the report filed by Ocean Rig with the US Securities and Exchange Commission.

And I’ll now pass the floor to one of your speakers today, Mr. George Economou. Please go ahead, sir.

George Economou

Thank you. Thank you [indiscernible], and good morning everybody. And thank you for participating in Ocean Rig’s second quarter earnings conference call. I’m starting with slide 3.

For the second quarter of 2014, Ocean Rig posted a US GAAP net income of $69.6 million or $0.53 per share. Net revenue from drilling contracts amounted to approximately $441.4 million. Finally, our EBITDA for the quarter was $231.8 million.

I’m turning to slide 4.

I would like to take the opportunity to address some recent highlights. Starting with operations; during the second quarter of 2014, our fleet operated at 96.3% utilization which is in line with our operating performance in 2013, as well as that of our fleet excluding the Ocean Rig Mylos during the first quarter of 2014.

I am pleased with our operating performance which is a testament to the superior operating results associated with modern assets and the collective efforts of our operating scheme.

In late March, we delivered the Ocean Rig Athena is Korea and in only 75 days have been mobilized the unit to Angola. On June 7, we completed acceptance testing under the three-year ConocoPhillips and commenced drilling operations.

During the second quarter, we signed final recommendation with Total for the six-year contract for the Ocean Rig Skyros, securing employment through the third quarter of 2021. In addition, we signed a minimum six-well program with Premier Oil for drilling offshore for Kent Isle for the Erik Raude.

With the additional risk contract, we are in a very comfortable position with 100% and 72% of our calendar days under contract in 2014 and 2015 respectively.

Consistent with our stated strategy to implement value creation in [indiscernible] for our stakeholders, our board of directors declared our second dividend of $0.19 per share with respect to our second quarter of operations and payable on August 11.

Another significant value creation initiative is goal to launch the initial public offering of a new master limited partnership subsidiary by the end of 2014. We are continuing to work towards achieving this objective. And as part of it, we successfully completed the refinancing of the $1.35 billion bank and ECA facility with our new $1.3 billion secured, senior secured term loan B facility.

This new term loan matures in the third quarter of 2021, and among other things, it includes provisions that allow the creation of a master limited partnership subsidiary.

I now turn to slide 5.

Ocean Rig’s technologically advance fleet as well as our marketing team’s efforts have yielded superior results as evidenced in this graph, which includes the rate secured for contracts with duration for 12 months. Since 2010, our modern assets have consistently secured average higher day rates than other harsh environment as well as standard ultra deepwater capable drilling asset.

Our contracts depicted with red triangles in the graph average about $600,000 per day which based on our calculations is approximately $100,000 per day higher than what certain peers secured for the three-year contract. Which means, over the three year period, $500 million in extra revenue, cash flow and net income.

In addition, our contracts incorporate a very strong high provisions for BOP and general maintenance, clauses that will lead to increased revenue efficiency going forward.

I move on to slide 6.

The potential creation of an MLP subsidiary by year’s end could bring significant benefits to Ocean Rig. Currently, the driller MLP peer group which includes civil partners and transaction partners trade at an enterprise value per ultra deepwater unit of about $1.1 billion to $1.2 billion. Assuming comparable trading multiples, Ocean Rig will be able to monetize the [indiscernible] of water drilling assets at a higher valuation through drill downs, through MLP subsidiary.

The higher valuation of our drilling assets under an MLP structure have substantial potential to increase Ocean Rig’s implied enterprise value for ultra deepwater unit which today stands at only $638 million.

In summary, the potential MLP provides a low cost funding solution and further diversify their funding sources while enabling Ocean Rig definitely deleverage balance sheet and thus, directly increase shareholder value.

I will now turn over the presentation to Mr. Gill Bocabarteille, to provide you with the second quarter operation highlights.

Gill Bocabarteille

Thank you, George. I start from slide 8.

The average term of our contracts is 2.3 years of 3.8 years including our options. Excluding operational periods, we are under a contract for 100% of 2014, 72% of 2015 and even 39% for 2016.

We are in advance discussion and in [indiscernible] through entering into two additional long term contracts for the Corcovado and Mykonos which will keep the close ship employed until 2018.

Pro forma to this contract renewals are contract operational increase to 86% for 2015 and 58% for 2016. In addition, we have already started discussions with Total to extend the current contract for Ocean Rig Rig Olympia through 2016.

In general, we boast the most solid contract coverage amongst our peers which we believe will assist us to weather this soft patch in the market.

Furthermore, we have, over the last month seen an increased interest for the Ocean Rig Santorini, our mid-2016 new build for clients in the US Gulf, Brazil, West Africa, and the Black Sea. As mentioned before, our other 2015 new builds, the Apollo, has already secured a three-year contract with Total.

Turning to slide 9.

With this slide, we’ll provide again an analogies of our fleet operating performance during the quarter. Included in this slide is breakdown of the $49 million amortization of our detailed revenues that are recognized during this period.

During the quarter, we had 819 calendar days and we spent 67 days in the quarter on mobilizing and completing acceptance of the Ocean Rig Athena from Korea to the drilling location in Angola to commence the ConocoPhillips contract.

Our fleet available drilling days for the quarter amounted to 752 days. The operating performance of our fleet for this quarter was outstanding with minimal downtime except for the Ocean Rig weakness that had some few related downtime for about 17 days.

In total, we only experienced 28 days fleet-wide downtime. And as a result, we were owning revenue for 724 days. So our fleet-wide operating efficiency rate that is our revenue rounding days over, our available drilling days was 96.3% during the quarter. With the Ocean Rig Athena, operating in full in this third quarter, we expect our available drilling days to increase to about 830 which will lead to an increase of our revenues.

Turning to slide 10, now, moving to our operating expenses, on this slide we highlight our direct and onshore rig operating expense run rates during the quarter. And provide the breakdown of the $29.6 million in amortization of our deferred operating expense that were expense during the quarter.

Our daily direct and onshore rig operating expense this quarter, averaged $191,000 versus $194,000 during the first quarter of 2014, and $208,000 today [ph] during the second quarter of 2013. Direct and indirect operating expenses excluded amortization of deferred expenses related mainly to mobilization and maintenance expenditure spent during the period.

Now, I turn over the presentation to Mr. Anthony Argyropoulos to provide you with second quarter financial highlights.

Anthony Argyropoulos

Thank you, Gill. I’ll start from slide 11, our income statement to tie all the revenue and operating expense items. During the quarter, we had $392.5 million in drilling revenue and $49 million in amortization of deferred revenue.

So our total revenue was $441.4 million. Our direct and onshore rig operating expenses were $143.9 million. Maintenance and other expenses were $9.6 million. And the amortization of deferred expenses was $29.6 million.

Going forward, as we realize cost efficiencies fleet-wide, we now expect our direct and onshore rig operating expenses to average $200,000 per day fleet-wide. We will also incur an additional $16,750 per rig per day for maintenance CapEx including especial items, spare parts and upgrades.

So during the quarter, again, our $441.4 million in total revenues, we had $183.1 million in total rig expenses. Our depreciation was $81.4 million which increased from the first quarter as it includes our ownership of the Ocean Rig Athena for the entire quarter. And our G&A expenses were $28 million while our net interest expense for the quarter was $57.7 million.

Turning to slide 12, we are pleased with the successful refinancing completed this month, actually last month in July, of our Bank/ECA facility with a new $1.3 billion in Senior Secured [ph] Term Loan B facility, secured by our three on-the-water seventh generation drill ships. The new term loan B facility matures in the third quarter of 2021, and includes provisions for the creation of an MLP subsidiary.

In addition, following this refinancing, $75 million over restricted cash was released to the company. I’ll also remind you that in late March, we refinance the 9.5% unsecured notes to the new 7.25% senior unsecured notes that mature in the third quarter of 2019.

Following the refinancing of our 9.5% unsecured notes, as you can see in the bar chart below, our next significant maturity is our $800 million, 6.5% secured notes due in 2017 that we will most likely refinance in the fall of 2015.

Turning to slide 13, we’re in inevitable [ph] position where we do not have any un-contracted new buildings being delivered during this soft market. We have the ability in capital resources to further expand our fleet with new building deliveries in what we expect to be a very strong 2016 and 2017 offshore drilling market.

We have two new design advance specification seventh generation drill ships with an expected delivery in 2017. The all cost of each fuel in post of each [ph] of these units is projected to be about $685 million. We already paid approximately $155 million in the second quarter of next year and expect to incur approximately $130 million in un-yield three [ph] delivery capital expenditures for these two drill ships over the next couple of years. We expect these to be covered from our cash flow from operations and we’ll also pay about $480 million for each unit, our delivery [ph] through the combination of debt and cash.

Focusing on our 2015 and ‘16 new build drill ships, we have already paid $363 million for these two units. We expect to fund the remaining $447 million capital expenditures payments in 2016, January 16 specifically, with a combination of new debt and cash.

Now, on slide 14, I can provide some insights on our cash flow by way of a fleet-wide run rate example. These numbers are of course in a daily and on a per unit basis. Starting from the left, the breakeven [ph] EBITDA is $251,000 composed of operating expenses of $217,000, which includes the $5 million of maintenance CapEx for each drill ship and $10 million for our semisubmersibles, expense in our income statement as well as G&A of approximately $34,000 or $12.5 million per rig per annum.

Add to that interest expense of $90,000 per day, and the operating income breaks even at $341,000. Adding another $10,000 in mandatory debt repayment, and our cash flow breakeven is $351,000 per rig per day.

So Ocean Rig’s cash flow breakeven level is at a very low day rig level. Any cash flow above this point can be used to create additional value. The average contracted met day rates for our fleet is $516,000 adjusted for utilization, local taxes and other top line items.

The gross level is approximately $600,000 a day, which results net cash flow of $165,000 per day or about $60 million per unit per year on a nine-unit fleet basis. The free cash flow is a little bit in excess of $0.5 billion per year.

The main point though is that a rig can generate about $175,000 per day for debt repayment and other purposes that create value for our debt and equity holders. This gives you an idea of the cash flow generation of the Ocean Rig fleet on a nine-unit basis.

On slide 15, we provide a further analysis of what exactly our $4.8 billion backlog means. It provides us with on average over $1 billion of revenue each year through 2017 are in average contracted day rate of about $600,000 as shown in the graph. But what does this really means?

Well, it means a couple of things. In essence Ocean Rig is completely insulated from the current soft patch in the market. And we’re poised to take advantage of the expected market upturn in 2016 and beyond. Secondly, in order for us to average a rate of $500,000 per day fleet-wide for 2015 and ‘16, our uncontracted drilling units would need to earn only about $368,000 per day.

You will note that the required rate is far below even the most pessimistic market expectations. In additions, I hope that during the next conference, we will be able to update this graph during Petrobras extensions which will further insulate us from many market weakness.

Now, I turn over the presentation to Steve Dunguard [ph] to provide you with an industry update.

Unidentified Company Representative

Thank you, Anthony. I will begin from slide 17.

This slide provides support to the upcoming shortage in supply. On the right, the composition of the mid-deep and also deep model fleet. The mid and deep water floaters are about 30 years old but the 148 ultra deepwater fleet is only four years old.

The ultra deepwater segment has 81 new buildings on order which 28 of it will be built in Brazil. However, the bar chart on the left indicates that only 8.5% of the ultra deep well assets in the Golden Triangle; Brazil, Gulf of Mexico, West Africa, operates in ultra deep waters.

The vast majority of the ultra deepwater fleet operates and is rendering obsolete the old mid and deep water assets. There are effectively no mid and deep water new building vessels, so it is the ultra deepwater close ships that are poised to replace their fleet which has about 65 units over 35 years of age against the 52 ships on order outside of Brazil.

At the same time, oil companies focused on lowering cost increasingly trying to push general low and relationship drilling depth, hard pressure drilling and demanding low-age wells. We’ll prefer assets offering higher drilling efficiency in order to obtain substantial savings by refusing drilling time per well.

Finally, we see a continued focus on implementing and enforcing even stricter environmental health and safety regulations worldwide. As a result, we expect our customers to manage their potential liability by replacing all the units with advance ultra fleet deepwater capable units.

Moving on to slide 18.

Oil companies prefer modern ultra deepwater rigs, also when operating in mid and deep waters due to the better efficiency, flexibility and compliance with the latest safety regulations. They’re used off of Mexico and in Brazil, all drilling assets are no longer competing from new standards. [ph]

June activity drilling, high hulk load and wider capacity last X days, living [ph] pools as well as advanced BOP and moat treatment systems, a key rig features that enable oil companies to have flexible and seamless operation across borders, regulatory regimes and in different depth.

These features combined increase efficiency and reduce drilling time per well. Travel drilling cost, including freight costs easily exceed $1 million per day, solutions [ph] that will more efficiently result in significant savings for our customers. And in particular, the Ocean Rig maintenance utilizing dual activity drilling recently complemented the drilling of a well, 29% faster compared to an older single activity drilling unit.

The last graph on the top-left of the slide show historical employment utilization of the float fleet which includes mid, deep and ultra deepwater drilling assets. Employment utilization of all the assets have been in a steady decline and if you combine this with the line graphs on the bottom-left of the slide, it clearly indicates that over the next three years, the employment of the old assets will decline from 65% to 10% compared to 52% from almost 100% for modern assets.

In addition, the graph on the top right of the slide, shows the diversions between day rates for old and new assets. This becomes even more profound during times of market weakness as always [indiscernible] between 2010 and 2011.

Moving on to slide 19.

Over the last four years, approximately 300 explored oil wells have been built successfully averaging a water depth of 6,000 feet. In [indiscernible] five discoveries in the [indiscernible] and Bering Sea indicative that the geographical footprint of exploration and development drilling activity is spreading worldwide beyond the Golden Triangle.

Only 11% of these identified reserves are currently scheduled for development. As a result, this 300 plus discoveries will lead to multi-year and field development activity during the second half of the decade before they can commence production.

We estimate that the development field for which our customers have firm and probably plans were to be developed, 600 wells would need to be drilled. This would result in a significant increase in demand for drilling assets.

I’ll now turn over the presentation to Economou for some closing remarks.

George Economou

Thank you, Steve [ph]. We now turn to slide 21.

I would like to summarize where the company is today. Ocean Rig is a large global pure play under ultra deepwater capable drilling company with premium assets run by an experienced management team.

Our focus on containing cost, maintaining efficiency and new value creation initiatives make this a very exciting time for our current as well as prospective shareholders. Our measured and well-timed fleet growth plans, supports the future growth of our business and earnings.

We are uniquely positioned with a $4.8 billion contract backed that provides strong cash flows from a diverse mix of highly credible rig [ph] counterparties. This cash flow will be further supported by these contracts and will fund our growth, better payments and dividends.

We have now reached the end of our second quarter presentation, and I open the floor to questions. Thank you.

Question-And-Answer Session

Operator

Thank you very much indeed. We will now begin the question and answer session. (Operator Instructions)

From Evercore, your first question comes from the line of Darren Hicks. Your line is now open.

Darren Hicks – Evercore Partners

Hi. Good afternoon. It is apparent that you guys are continuing to take steps towards establishing an MLP with your recent debt financing announcement. However, excluding any additional charting activity, are there any other steps that you have to take to create a structure that’s MLP friendly before year-end?

George Economou

No. We’re all done so there’s nothing that needs to be – and any steps whatsoever than [indiscernible]. It’s a matter of time and the situation.

Darren Hicks – Evercore Partners

Okay. And continuing with the MLP topic, what minimum contract lengths or just contract terms in general, do you believe are required to receive as similar valuation as some of MLP drilling peer group.

George Economou

I think Anthony can tell you the contract lengths of the intended annual fee subsidiary and compared with the market.

Anthony Argyropoulos

Yeah. It’s about four years, Darren, that I would say is the minimum that the market wants to comfortable with on average.

Darren Hicks – Evercore Partners

Are there any other constraints of characteristics of this contract that you think will impact the valuation?

Anthony Argyropoulos

No. The counterparties in general, in our businesses as you know are very solid so I don’t think we need to address counterparty risk. It’s just a term, and of course, the level the contracts and the amount of distributable cash flow they generate.

Darren Hicks – Evercore Partners

Okay. Great. Thanks. That’s all I have.

Operator

Thank you very much indeed, sir. And your next question from Raymond James comes from the line of Praveen Narra. Your line is now open.

Praveen Narra – Raymond James

Thanks. Good quarter guys. How do you guys think about the drop down timing on the MLP? Do you guys still expect the drop down another third interest in the rigs or could it potentially drop down the four remaining interest in the rigs at once?

Anthony Argyropoulos

Thank you, Praveen. It’s Anthony Argyropoulos. The expectation is that we will drop an additional fractional interest in the subsidiary that will form the MLP. That will be about approximately six months after the initial public offering. That fractional interest will be another, broadly speaking, 20% to 40% over that subsidiary.

And then on the one year anniversary, we will drop a fractional interest in the four 2011 build drill ships [indiscernible]. So that’s our current thinking.

Praveen Narra – Raymond James

Okay, perfect. Thank you. And then just a clarification on the OpEx guidance, the $200,000 per day that was for just direct or is that direct and onshore?

Anthony Argyropoulos

That’s direct.

Praveen Narra – Raymond James

Okay, perfect. Thank you.

George Economou

You’re welcome.

Operator

Thank you. Just one moment sir.

Thank you for holding. We now have a question from R.W. Pressprich, a question from Oliver Corlett. Your line is now open.

Oliver Corlett – R.W. Pressprich

Hi. And thanks for taking the call. Just on the MLP thing again, to be clear, the initial percentage that you wanted to drop down is about a third, is that correct?

George Economou

Correct.

Anthony Argyropoulos

Yes, the third of three units, yes.

Oliver Corlett – R.W. Pressprich

Right, got you. And the – you talked about the distributable cash flow [indiscernible] what would that be as a percentage of the total, would you – I mean, how does – how would one calculate how much cash would actually be distributed from the MLP?

Anthony Argyropoulos

We haven’t provided this information yet publicly. So we have run a number of iterations, and we haven’t finalized it. Surprising to say [ph] that a third of these three assets will be contributed to the MLP, and of course the remaining two-thirds will still be own directly by the parent, by Ocean Rig. If you – and then we will of course know – raised capital at the MLP, at the IPO to sell a percent of the MLP to the public.

So through our indirect ownership of these three assets, meaning, through our ownership of the MLP as well as our remaining two-thirds direct ownership, and again, these are indicative levels. We will control approximately 85% of the cash flows of these three assets. So probably this is [ph] broadly speaking sort of an indication. The final numbers will be in our perspectives when we launch the transaction.

Oliver Corlett – R.W. Pressprich

Right. Is there a sort of a statutory amount that you have to pay out?

Anthony Argyropoulos

No.

Oliver Corlett – R.W. Pressprich

Okay. And you say that the process is all done, and you did say, I think on the last call, you expect it to be done by September. What is causing the slippage here?

Anthony Argyropoulos

Additionally we had said that we were going to do it in July pre-summer. That was an indication about three quarters ago. There was a little bit of slippage mainly because of the refinancing that we did, and which would took place in July, the financing of the debt of these three units, so that it accommodate [ph] the formation as well as the restricted payment cash for the MLP.

Oliver Corlett – R.W. Pressprich

Okay.

George Economou

At this point, so we move now into – I mean, we can certainly give guidance we will launch before the end of the quarter, the first quarter subject to market conditions of course, the most likely timeframe would be sometime in late September into October.

Oliver Corlett – R.W. Pressprich

Okay. That’s helpful. Thanks. And one other question in terms of your one rig increment [ph], seems to have had utilization problems two or three quarters in a row now, just related to the DOT [ph], can you – is this some kind of recurring problem here or is it just a coincidence that that one seems to be having, no problem for any other rigs?

George Economou

[Indiscernible] no recurring problems, we don’t expect to have scenarios use on this or others [ph].

Oliver Corlett – R.W. Pressprich

So these were different problems each time [indiscernible] –

George Economou

Well, yes, on Mykonos and on another occasion on Mylos exactly creating some problems [ph].

Oliver Corlett – R.W. Pressprich

Okay. That’s all I have. Thank you very much.

George Economou

Thank you.

Anthony Argyropoulos

Thank you.

Operator

Thank you very much, sir. Now, from Credit Suisse, you have a question from the line of Gregory Lewis. Your line is now open.

Gregory Lewis – Credit Suisse

Yes. Thanks, and good afternoon gentleman. George, when we think about DryShips, 60% ownership stake in Ocean Rig, I guess I have two questions, one is has it been – has the thought of spinning off their shares to investors in DryShips have been comp related [ph]? And then the other question I would ask is how much of that 60% ownership stake is actually pledge by DryShips to the banks [ph]?

George Economou

Yes. On the first – the second question, very little I believe it’s a little bit over $1 million – 1 million shares. But maybe Anthony can give you the exact numbers, because those are significant in any relationship perform [ph].

Gregory Lewis – Credit Suisse

Perfect.

George Economou

And the second question for the time being DryShips is happy to give the 6% shareholding. There’s going to be a time where we will be dividend out [ph] the shares. But I don’t think [indiscernible] expect to be done [indiscernible] near future, meaning six months.

Gregory Lewis – Credit Suisse

All right, guys, perfect. Thank you very much.

George Economou

Sure.

Operator

Thank you very much indeed. And as there are no further questions, we now pass the floor back over to the presenter for closing remarks [ph].

George Economou

We would like to thank everybody for attending the call. And talk to you in the next call. Thank you. Thank you everybody.

Operator

And with many thanks to all our speakers today, that does conclude the conference. Thank you for participating, you may now want to disconnect.

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