DryShips Survival Depends On Ocean Rig Earnings

Aug.16.12 | About: DryShips Inc. (DRYS)

DryShips (NASDAQ:DRYS) shareholders need to pay close attention to Ocean Rig's (NASDAQ:ORIG) results today. This earnings report will be perhaps the most important event in company history. The results will function as a key indicator for full-capacity profitability levels in Ocean Rig, which will ultimately dictate survival odds for parent company DryShips.

Result Expectations

Yahoo currently has the estimate pegged at 25 cents with a high of $0.57 and a low of $0.10. In contrast, the Street has the estimate pegged at 17 cents with a high of $0.32 and a low of $0.10. The difference in estimates is based on the survey number, with Yahoo reporting 6 and the Street reporting 4.

Uncertainty Already Priced-In

I have covered both Dryships and Ocean Rig extensively, and late last June, I highlighted the fact that future uncertainty is already priced into ORIG shares. In a comparison to similar competitor Pacific Drilling (NYSE:PACD), I estimated if ORIG was valued similarly than 53% of potential upside existed. This 35% of upside could be tapped if investors shared the confidence in management since all other factors of the two companies were virtually the same. ORIG has since appreciated 21% while PACD's increase has been slower, at 13%. It appears that the two valuations are slowly merging, but strong disparity still exists. Assuming that PACD is priced correctly, based on my June assumptions, ORIG should now command a $22.50/sh valuation.

Catch-22 Overhang Scenario

Management is the key to ORIG's underperformance. After watching the fiasco of Dryships from 2007-onward, investors do not trust the CEO, George Economou, who is known for disastrous related-party transactions. Economou controls Dryships, and Dryships controls Ocean Rig through a 65% ownership stake. Dryships must sell off a portion of this stake to make scheduled debt repayments and to finance an increase in the drybulk fleet during a strong buyer's market for secondhand vessels. Dryships has a few months of financial wiggle-room and they are holding out for a higher share price for their ORIG shares. Institutional investors will likely avoid ORIG until after DRYS decreases there stake. This is a classic catch-22 standoff type scenario.

Win-Win Scenario

The only scenario in which everyone wins is if Ocean Rig can prove themselves in their first full operating quarter. If margins are comparable to the competition, namely Pacific Drilling, and profits top expectations, ORIG will begin a steady climb towards $22.50. Once DRYS decreases their stake below 40%, ORIG will finalize their descent and should hypothetically trade at nearly the same valuation as PACD. DRYS will likely sell a significant stake in late 2012 or very early 2013, but this sale will be expedited if ORIG surpasses the $18-range soon.

My Projections

With 91 days in the quarter for 6 vessels, and 55 planned mobilization days (Q1-12 Presentation), I expect a utilization rate of roughly 85%. This compares to a utilization rate of 51% for the first quarter. I expect revenues to be approximately $237M, net income of close to $30M, and EPS of 23c/sh. If margins are stronger and utilization is closer to 90%, revenues will be approx. $250M with a net income of close to 50M, and EPS of 38c. It's important to note that approximately $55M, or close to 42c/sh, is expensed each quarter for depreciation and amortization. This is a non-cash expense, and should be added back to EPS to get a more meaningful OCF/sh. I believe that any result in the 23c+ range will be positive for ORIG stock.

What if Earnings are Poor?

If earnings disappoint, ORIG shareholders will obviously lose, but the bigger loser will be DryShips shareholders. Mediocre performance is already priced-in to ORIG shares, so I don't expect a dramatic decline in value. However, a decline to $13 levels is highly probable after a few weeks. With a 65% stake, if DRYS can sell for $18 on the first 25% and $22+ for the remaining 40%, this represents $1.75B in equity versus a scenario where DRYS can only achieve $1.11B. This $640M difference represents a DRYS valuation differential of $1.51/sh. Quite a big deal for a stock that has spent the last 52-weeks trading in the range of $1.75-$3.84 ($2.31 currently).

End Game

It's expected for Dryships to post a massive operating loss on dry bulk and tanker fleet segments. The unknown is how well Ocean Rig will perform. These results and their resulting trading patterns could potentially impact DRYS shareholders by up to 65%. This is perhaps the most important press release in DRYS' public history.

Disclosure: I am long DRYS.