Description

Long Ocean Rig (ORIG)-A deep value offshore driller with near term catalysts and 100%+ upside

Stock Price: $16.20

Market Cap: $2.1bln

Thesis:

Ocean Rig is significantly undervalued given its asset quality and cash flow outlook due to its relationship with its financially distressed parent company, Dryships (DRYS).  Ocean Rig is currently controlled by Dryships, which owns 59% of the shares outstanding.  Dryships needs to raise capital to meet cap-ex requirements and due to the decline in drybulk shipping rates. They will have to sell some of their ORIG stake later in 2013 to meet those needs.  This along with the fear that founder George Economou will somehow misappropriate assets from ORIG to DRYS explains why the stock trades at both a discount to its peers and its fleet’s newbuild value.

However, ORIG has the tools and the desire to fix this valuation gap due to its significant contract backlog and its corresponding cash flow growth.  ORIG will transition from a stage of investing in building their fleet, growing from 6 to 9 rigs in 2013 to significant cash generation in 2014.  We believe by placing some of their rigs with long duration contracts into an MLP structure, similar to what Seadrill has done, ORIG will rerate materially higher.  Half of ORIG’s current 6 rig fleet is under contract thru at least 2016.  This is more than enough assets to initially form an MLP and provide a stable cash flow stream that MLP investors require.  Committing to an MLP and its resulting higher valuation would also give DRYS the opportunity to meet its liquidity needs thru an ORIG sale at a much higher price. 

Given what management has said on conference calls, we believe a potential MLP conversion is a Q32013 event, as they are currently in process negotiating with their bank group the necessary amendments to allow an MLP to be formed.  Coupling the MLP announcement with a plan to sell down a portion of DRYS stake would also lift that overhang, helping the stock to re-rate further. 

We believe that the announcement of an MLP will drive ORIG shares closer to comparable such as PACD, implying a $26 target on 2014 earnings.   Once the fleet is fully built out in 2015, ORIG can generate close to $1bln in EBITDA and trade at $35/shr as its multiple should expand to where SDRL trades.   

Business Description

ORIG is an offshore driller that currently operates 6 ultra-deep water rigs.  They have 4 drillships and 2 drilling rigs.  They are in the process of receiving 3 newbuild UDW drillships in 2013 and have another on order for 2015.  ORIG currently has a $5.1bln backlog, with 98% of its rig days contracted in 2013 and 88% contracted in 2014.  ORIG’s fleet is among the newest in the industry, with an average age of 5 years for the 6 currently active rigs.

Ocean Rig was founded in 1996 and in 2008 was acquired by Dryships, which is run by George Economou.  DRYS listed ORIG in 2011 in the US and currently owns 59% of the shares outstanding.  Economou has from time to time angered ORIG investors due to ORIG’s management agreements with one of Economou’s private companies, Cardiff Marine.  For example, in connection with ORIG’s recent secondary, some of the agreements with Cardiff that were previously paid for by DRYS are now being paid for by ORIG.  This caused the sell side to slightly take down numbers, and helps fule the perception that George is stealing from the company.  We feel this is more of an issue of perception as the contracts are fair, and given his stake in ORIG he has a very large incentive to get the stock higher. 

Industry Outlook

The ultra-deep water segment of the offshore drilling industry has a strong outlook over the next five years due to the significant number of deepwater discoveries that remain undrilled.  Currently the market for UDW rigs is very tight, with only 3 out of 15 newbuilds available in 2013.  This has pushed dayrates above $600k/day, while contract lengths have increased as oil companies want to secure rigs farther into the future.   While the fleet will grow from 121 units in 2012 to 174 units in 2015, the current mid water fleet is very old (67 rigs >35yrs) and will absorb the UDW newbuilds.  A recovery in the Gulf of Mexico activity, and large increased in offshore West Africa and Brazil demand will keep the market tight for a long time. 

Valuation

ORIG currently trades at 6X 2014 EBITDA and 5.5X 2015 EBITDA on 2014 and 2015’s capital structure. Peers such as PACD and SDRL that trade at 7.7X and 8X forward EBITDA.  They represent where ORIG should trade once it commits to a credible capital return strategy such as an MLP.  We believe that if ORIG announces its intention to form an MLP, it would remove some of the overhang related to its association with DRYS.  We feel it’s reasonable to assume that ORIG would rerate to where its closest non-MLP peer (PACD) trades first as investors begin to price in the conversion.  If they make an MLP announcement in the 3^rd quarter a reasonable target is $26/shr, which is 7.7x 2014 EBITDA, using 2014 YE capital structure.  Once the MLP seasons, we think ORIG should achieve SDRL’s valuation, which would imply a $35/shr target or 8X 2015 EBITDA.   Our earnings assumptions do not assume an improvement in day rates, which is conservative given the medium term supply/demand outlook for rates.  Should rates improve further from here, ORIG has availability in 2015 to benefit from those higher rates.

ORIG is also undervalued on an asset basis.   Accounting for the 10 rigs they will have by 2015 and incorporating the associated debt, ORIG trades at ~$620mln per rig.  According to ORIG management, it would cost ~$850mln per rig to replicate their fleet, which implies a replacement value of ~$32/shr.   Peers such as PACD trade at $680/rig and SDRL trades at ~980mln per rig. M&A transactions such as RIG’s purchase of Aker Drilling have taken place at $900mln per rig, which implies a $37/shr ORIG valuation.  Given its large backlog and the lead time to build an offshore rig (2 yrs+, if you can get a yard slot) ORIG should trade at a premium to its replacement cost. 

Catalysts

1.) Capital return decision.  ORIG will make a decision on what form its capital return policy will take, possibly by the third quarter.  They are currently in discussions with their banking group to get the appropriate modifications to do an MLP.  Because ORIG’s cash flow will ramp up significantly in 2014 and DRYS has another $100-$300mln in liquidity needs by 2014, it is logical that ORIG will commit to an MLP to boost its valuation, maximizing proceeds to DRYS. 

2.) Contract for the Skyros rig which will be delivered in October 2013.  This is the only near term availability that ORIG has.  Given the shortage of near term availability across the industry (only 3 newbuilds still available in 2013) this should come at an attractive rate of at least $600K per day.  

3.) Operational improvements vs. 2012. Earnings were pressured in 2012 by one of its rigs (Eirik Raude) undergoing it’s once every 10 year survey.  This will not repeat in 2013, so we expect this year to be a cleaner year operationally. 

Risks

There are several risks here, the first is a large and sustained decline in oil prices that curtails demand for offshore drilling.  The second is that should DRYS financial situation worsen near term, management would be forced to sell down more of its ORIG stake to meet liquidity demands.  I think this is a low near term probability given the sale in February, but as time progresses it increases in likelihood. 

Catalyst

Catalysts

1.) Capital return decision.  ORIG will make a decision on what form its capital return policy will take, possibly by the third quarter.  They are currently in discussions with their banking group to get the appropriate modifications to do an MLP.  Because ORIG’s cash flow will ramp up significantly in 2014 and DRYS has another $100-$300mln in liquidity needs by 2014, it is logical that ORIG will commit to an MLP to boost its valuation, maximizing proceeds to DRYS.

2.) Contract for the Skyros rig which will be delivered in October 2013.  This is the only near term availability that ORIG has.  Given the shortage of near term availability across the industry (only 3 newbuilds still available in 2013) this should come at an attractive rate of at least $600K per day. 

3.) Operational improvements vs. 2012. Earnings were pressured in 2012 by one of its rigs (Eirik Raude) undergoing it’s once every 10 year survey.  This will not repeat in 2013, so we expect this year to be a cleaner year operationally.