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After reading an article by new Seeking Alpha contributor Bryce Istvan (titled “The DryShips Disconnect"), I was compelled to do some additional research on a company that I own and have previously covered. Bryce correctly identified a “disconnect”; however, he did little beyond comparing market caps. The next step is dissecting the balance sheets of DryShips (NASDAQ:DRYS) and Ocean Rig (NASDAQ:ORIG) to provide a closer look at the arbitrage opportunity.

I previously argued that DryShips was priced below liquidation value at $3.75 on July 29th; however, ORIG had not yet begun regular trading and DRYS carried almost double the market cap.

Current Valuation of DryShips

At the October 7 close of $2.24, and with 408.4M shares outstanding as of September 21, 2011, DryShips (DRYS) carries a market valuation of $914.8M. DRYS owns 36 dry bulk vessels (including 4 new buildings) and 13 tankers (including 9 newbuildings). These vessels are carried at an asset book value of $2.1B, which is likely far more than they are worth in today’s brutal secondary market. The debt that backs these vessels is approximately $1.47B. This is pretty scary considering that the stock holder will be left with nil if the vessels sell for less than 70% of their stated book value in a liquidation. However, this is forgetting one key fact: DRYS owns 75% of ORIG.

The Hidden Value of Ocean Rig on the Balance Sheet

Because DryShips (DRYS) is a majority holder and voting controller (75%) of Ocean Rig (ORIG), DRYS must carry ORIG’s balance sheets as its own. Although DRYS provided a separate breakdown balance sheet of ORIG in its 2Q-11 report, it did not provide a separate breakdown of DRYS sans ORIG. This DRYS-only breakdown is possible with a few simple overlay calculations. With a recent report that DryShips is open to selling ORIG, this new balance sheet could become a reality.

Total cash of $193M: ($480M total - $287M for ORIG)

Total debt of $1.47B: ($3.59B - $2.12B for ORIG)

Total assets of $2.55B ($7.87B - $5.32B for ORIG)

Total liabilities of $1.61B ($4.03B - $2.42B for ORIG)

Total equity of $940M ($3.84B - $2.9B for ORIG)

Book value per share of DRYS sans ORIG: $2.30 / Book value per share of ORIG: $21.50

The ORIG Sale

ORIG is currently trading at $16, which is a P/B ratio of .74, rather low considering how strong the market currently is; however, let us assume that investors stay wary and the $16 price of ORIG stays put. If DRYS sells its 75% stake in ORIG, it will instantly transform its balance sheet to the aforementioned numbers while gaining over $1.57B in cash ($16*98.56M shares of ORIG). If DRYS sells ORIG for a P/B of 1, which I believe is possible considering ORIG’s relatively low (34.5%) net debt to assets and contract revenue backlog of over $2B, than DRYS will receive roughly $2.12B in cash.

DRYS Sans ORIG Post-Sale

If DRYS sells ORIG for $16 per share, it will have net cash of $293M (72 cents per share). Based on DRYS trading at $2.24, this assumes a valuation of $621M for the entire fleet debt-free. This is an assumption that the combined vessels are only worth 29% of stated book and that DRYS will do nothing accretive with its newfound cash position.

If DRYS sells ORIG for $21.50 (book value), it will have net cash of $843M ($2.06 per share). This assumes a valuation of $73.5M for 36 dry bulk vessels and 13 tankers - roughly 3.5% of stated book value. I realize that we are in a bad market, but DRYS at $2.24 is absolute insanity.

What is DRYS Worth?

To put it bluntly, the CEO, George Economou, does not seem to care much about his shareholders. Thus the assumption that DRYS will do little to nothing accretive with its newfound cash position is probably not too far off. He has a penchant for dilution, so DRYS is not a place for a long-term investor. However, the absolute worse case scenario for an investor is a bankruptcy and forced liquidation. If DRYS were to shut down today, how much is the fleet worth on the secondary market? This takes even more detailed research, but based on the current industry average, it’s around 40-50% of book ($840M-$1.05B). This considers two combined bets:

  1. What is the true secondary value of the vessels?
  2. What will DRYS be able to sell ORIG for on a per-share basis?

Lower projection (40% / $16) on both gives DRYS a fair value of $2.77 (24% upside)

Higher projection (50% / $21.50) on both gives DRYS a fair value of $4.12 (84% upside)

Trading Approach

As an investor, you should only use my models as an aid to your own in-depth research; however, I personally believe that DRYS should trade at a minimum of $4. I will be long until this target is surpassed or until the fundamentals dramatically shift. The market is rough right now, so this is by no means a risk-free trade, but as Warren Buffett once said, “…invest when others are fearful!”

Disclosure: I am long DRYS.

Source: DryShips: Solid Arbitrage Opportunity