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Wednesday Dryships (NASDAQ:DRYS) reported a GAAP loss of $6.2 million or $.02 cents/share for Q4 2011. Included in this is $32.6 million of vessel impairment charges from the Avoca, the Padre and the Positano. Both the Avoca and the Padre were sold during the 4th quarter and delivered this month. Excluding these impairment charges DRYS would have earned $.07 cents/share, a penny shy of analyst expectations. Ocean Rig (NASDAQ:ORIG) reported net income of $36.5 million or $0.28 cents/share.

Because ORIG is a majority owned subsidiary, its income and balance sheet is included on those of DRYS. Below, I have broken down the income statement for the just reported Q4 2011 in order to differentiate the two companies. For comparisons, look at my article from Q3 earnings where I provided the same breakdown.

Revenue (All numbers in 000s)

DRYS

ORIG

Total

Voyage (Shipping and Tankers)

90524

90524

Drilling

237658

237658

Total

90524

237658

328182

Operating Expenses

Voyage Expenses

5240

5240

Vessel and Drilling Operating Expenses

26517

93056

119573

Depreciation and Amortization

27751

54529

82280

Loss from Sale of Assets

27142

0

27142

General/Administrative Expenses

21655

15732

37387

Total

108305

163317

271622

Operating Income

-17781

74341

56560

Op Income ex Loss from Sale

9361

74341

83702

Other Income/ (Expenses)

Interest and Finance Costs

-19610

-28571

-48181

Gain/(Loss) Interest Rate Swaps

1595

703

2298

Other

2267

-99

2168

Income Taxes

0

-9872

-9872

Total

-15748

-37839

-53587

Net Income

-33529

36502

2973

Income Attributable to non-controlling interests

-9193

Net Income (Attributable)

-33529

27309

-6220

Loss on Vessel Sales

27142

0

27142

Net Income ex Loss on Sales

-6387

27309

20922

As you can see above, DRYS continues to rely on the drilling segment to generate income. The shipping and tanker segments had a net loss of $33.5 million dollars. This loss was much higher than the $12.8 million in Q3. Voyage revenue slid from $92 million to $90.5 million while expenses rose almost 60% to $5.2 million. Excluding the loss from vessel sales, net income would have risen from $-12.8 million to $-6.39 million, but the Q3 loss included almost $16 million in losses from interest rate swaps.

Even though the drybulk market is continuing to degrade, Dryships is still well positioned to ride out the slump and lead the recovery. With spot rates incredibly low and even unprofitable, DRYS still has 56% of its operating days on fixed charters at an average rate of $34,720/day. For the fleet as a whole Time Charter Equivalent (TCE) rates were $25,479/day. While this is down from $31,929 for Q4 2010, it is still very profitable.

The losses from interest rate swaps, which have been a major drag on earnings, may be stabilizing. The company announced they entered into nine different interest rate swaps with a total notional amount of $988.8 million maturing from October 2015 through May 2017 fixing 3 month LIBOR rates between approximately 0.90% and 1.20%. While this is above the current market rate of about 0.50%, it does protect the company from major increases in financing costs.

Even as the drybulk segment continues to drag on earnings, Ocean Rig continues to deliver. Despite expenses related to relocation of the rigs ORIG still produced $36.5 million in net income with $27.3 million attributable to DRYS. The backlog continues to expand with the signing of a 3 year contract for the Leiv Eiriksson and an extension of the 47 day extension for the Olympia. The total backlog at the end of 2011 was $2.3 billion. Additionally, Petrobras (NYSE:PBR) announced that Ocean Rig was awarded a 15 year contract for 5 rigs at a rate of $548,000/day starting in 2016. While the details of that contract are far from being finalized - the rigs haven't been built yet - it does show that ORIG has positioned itself as a premier deep water driller.

The question for Dryships continues to be valuation. It has had a major run up from its 2011 lows of $1.75, but I maintain that the shares are still dramatically undervalued. Currently the stock trades at about 0.42X book. The Dryships bears will tell you this is because the ships on the balance sheet are dramatically overvalued compared to current market prices. This is true, but what they fail to take into account is that a majority of Dryships' assets are drilling, rather than shipping and tanking, related. Using the balance sheet below I marked down the book value of all vessels and newbuilds by 40%, leading to a write down of $891,694,000.

DRYS

ORIG

total

Current Assets

73668

520585

594253

Vessels and rigs under construction and acquisitions

272964

754925

1027889

Vessels net of depreciation

1956270

1956270

Drill rigs, machinery and equipment

49078

4538838

4587916

Total Fixed Assets

2278312

5293763

7572075

Non-Current Assets

254354

201007

455361

Total Assets

2606334

6015355

8621689

Current Liabilities

328706

436729

765435

Non-Current Liabilities

1337422

2580170

3917592

Total Liabilities

1666128

3016899

4683027

BV/share

P/BV

Shareholder equity

940206

2998456

3938662

$ 8.41

0.416

40% Vessel and Newbuild Writedown

-891694

Dryships- Shipping and Tanking BV

48512.4

$ 0.13

DRYS Ownership of ORIG 73.9%

2215859

$ 5.90

Adjusted BV

2264371

$ 6.03

0.580

Shares Outstanding 12/31/11

375,495,260

Even with this dramatic valuation adjustment, DRYS ex ORIG has an equity value of $48.5 million or $0.13 cents/share. Layer onto that the $2.2 billion of ORIG shareholder equity ($5.90/share) attributable to DRYS and the appropriate book value for Dryships is $6.03/share. Ocean Rig currently trades at about 0.76X book. Even if you use that to value the stake that DRYS owns, the book value is about $4.63/share. (($5.90 X 0.76) +0.13).

The shipping industry is incredibly cyclical and right now not profitable. Some of the companies that overextended themselves will not survive. Dryships will. As the industry consolidates rates will improve, profitability will return, and Dryships will be in a position to capitalize.

For commentary on Q4 earnings listen to the Dryships and Ocean Rig executive conference calls.

Source: Shipping Is Weak But Dryships Is Still Cheap

Additional disclosure: I am short DRYS calls as a partial hedge to my underlying shares.