Ocean Rig: Uncertainty Is Already Priced In

| About: Ocean Rig (ORIG)

Ocean Rig UDW (NASDAQ:ORIG) is a relatively new entrant who must compete with Seadrill (NYSE:SDRL), Transocean (NYSE:RIG), Diamond Offshore (NYSE:DO), and many others for a piece of the world's drillship and exploratory demand. Ocean Rig has a young fleet of 2 UDW (ultra-deep water) semi-submersible harsh environment and 7 UDW drillships.

Comparison to Peers

Although operating in a tough competitive environment with 13 other major (fleet of 5+) operators, ORIG is one of only two companies to specialize in 100% UDW rigs (Pacific Drilling (NYSE:PACD) is the other competitor). ORIG also has the 3rd newest fleet, behind only Seadrill and Pacific.

Pacific represents the closest peer, and trades for approximately the same market cap ($1.76B PACD vs. 1.72B ORIG). The metrics of comparison will be deliverable revenue projections, operating margin, debt per vessel, and operating cash flows. Pacific lists this information in their June 2012 Investor Presentation. Ocean Rig lists their information in a Q1-12 Presentation.

Pacific currently has a deliverable fleet of 7 drillships, backed by 2 newbuildings for 2013, and a single newbuilding for 2014. Total deliverable debt (current+ lt outstanding+capex) is $3.69B or $527M per vessel. Pacific has demonstrated operating margins (with 90% utilization) of 14.82% (insurance payout was a one-time event). Deliverable revenue will be approximately (assuming contracts of 450k/day and 90% utilization) $1.03B with operating cash flows of approximately $300M (assuming 14.82% constant operating margins and $150M in annual depreciation).

Ocean Rig comparably has a deliverable fleet of 7 drillships and 2 semi-submersible rigs, backed by 3 newbuildings for 2013. Total deliverable debt is $3.97B or $441M per vessel. Demonstrated margins are 4.12% (with 51% utilization), pro-rated for 90% utilization, ORIG should have operating margins of approximately 22%. Although most of ORIG's contracts are booked far higher, for the sake of a fair comparison, assuming $450k/day for drillships and $550k/day for semis, deliverable revenue will be approximately $1.4B. Operating cash flows with 22% margins and $300M in annual depreciation will be approximately $600M.

My calculations are open to debate, but with ORIG contracted far higher for all of 2012 and most of 2013+2014, I see the $600M OCF as close to a floor.

Future Prospects of the Market

Drillship spot-rates have jumped dramatically since the early 2000s, peaking in 2008, and appearing to reach a new local maxima. The peaks represent corresponding peaks in the price of crude oil. If $400/k day is considered "lucrative" for UDW rigs, then the price of oil needs to remain above $75 barrel for Brent Crude, all else equal. The below chart was gleaned from the aforementioned 1Q-2012 Ocean Rig presentation. UDW rates are shown in blue.

Supply of drill ships is estimated to increase by 17 vessels in 2012, 21 in '13, and 19 in '14. If Brent Crude stays above $75 and new offshore developments continue, demand should steadily increase. Over 50% of the UDW fleet is over 10 years old, with 40% over 20 years old. Cumulative additions from 2012-2014 represent a fleet growth of approximately 51% since 2011, which could be disastrous if the growth in the order books continues unabated into 2015+.

The primary obstacle to UDW demand is a global drop in oil prices, caused by either a recession or a large land discovery such as the opening of ANWR, recently proposed by the US House of Representatives and partially supported by recent legislation. Although ORIG is secure in the near to medium term (fixed contracts), several analysts are predicting tough times for the drilling sector in the near future.

Debt Service

Ocean Rig has scheduled payments of $158M in 2011, $629M ($400M balloon payment) in 2013, and $177M thereafter. With remaining capex requirements of $1.23B, I estimate that debt service costs will increase by around $100M per year for 2014+.

If the balloon payment is deferred, ORIG should have no trouble meeting their debt obligations with an estimated $600M OCF "floor."

Dividend Payouts?

With $600M OCF and $280M in interest service, if ORIG pays out 50% of the remainder dividends could reach $1.20+ or around 9% yields based on current prices.

ORIG Value

I consider my $600M OCF projection and $1.20 future dividend payout to be conservative. I think that ORIG represents a strong play in the UDW sector, but the long-term value is questionable. If older vessels are gradually scrapped and the order books do not explode beyond 2014, I believe the future is very bright. My target for ORIG is around 4X forward OCF projections, or about $18 per share. If ORIG was valued by the market similarly to Pacific Drill, ORIG should trade for over $20/sh. I believe that the biggest factor holding down ORIG is the Dryships (NASDAQ:DRYS) overhang (65% ownership). Economou and company are not trusted after the DRYS public fiasco.

Investment Approach

The "ultimate insider," George Economou, CEO of DRYS and ORIG, bought himself 2.185M shares through affiliated companies at the recent offering price of $16.25. This shows strong confidence at a price level 24% above today's trade. I personally prefer to avoid ORIG until DRYS is no longer a majority shareholder, and I see more upside potential in DRYS stock. I think ORIG stock will stagnate until oil is either back above $100/b or DRYS ownership drops below 50%.

Disclosure: I am long DRYS.