Description

How would you like to own the world’s two largest and most modern deepwater drilling rigs for free? Ocean Rig (OCR NO – listed in Norway) owns and operates two offshore drilling rigs, Leiv Eiriksson (7500 ft water depth, 30k feet drilling depth) and Eirik Raude (10,000 ft water depth, 30k water depth) which are currently the worlds most modern rigs built for ultra deepwater including fields with harsh environments.

The basic thesis of this investment is quite simple: 1) both rigs are currently (or soon will be) contracted to A or AA rated oil majors on long term non-cancelable contracts, 2) the free cash flow generated by these contracts will almost equal the entire enterprise value of the company, 3) therefore you get the post contract value of the rigs (either measured on a replacement or PV of future cash flows) for free. Put another way, you get the company paid back to you with long term contracts and keep attractive long lived assets for nothing Because of this situation we believe the company is a very attractive takeout target. However, if the company is not acquired, we believe management will essentially securitize these contracted cash flows and pay a massive dividend which could be greater than 65% of the current share price. The remaining business will trade at 1.1x pro forma 2009 P/CF and management will use the remaining CF to enter into joint ventures to further grow the market cap without issuing new stock.

Many of you are likely familiar with the industry backdrop so I will provide only a brief summary. The offshore drilling industry, particularly the deepwater, has had unprecedented success in the last two years as higher oil prices and the reality of rapidly depleting oil fields has spurred oil majors, large independents and national oil companies to increase exploration budgets with a strong focus exploration of deepwater fields. Since 2003, rates for offshore semi-submersibles have gone up between 2x-8x depending on type of rig. Given the increased deepwater drilling activity, ultra deepwater rigs, those capable of drilling in greater than 7,500 feet of water are now in a situation where total demand greatly exceeds available supply for the foreseeable future. As a result, for the first time in history, rig operators are able to lock up their rigs on long term contracts, as opposed to well-to-well jobs. Ocean Rig currently has the Leiv Erickson contracted until March 2010 (revenue backlog of $715mm) and Eirik Raude until March 2008 (revenue backlog of $317mm). Based on extensive discussions with rig brokers and consultants, we believe that management is actively tendering for Eirik Raude for a 2-3 year contract around $550k a day. Eirik Raude is currently the first and only 5th generation rig available (all others are under contract), giving us faith in Ocean Rig achieving a record breaking contract. If that contract is signed, Eiriks Raude’s revenue backlog will increase by approximately $600m, leaving total backlog around $1.7B.In addition, given that opex for the rigs is currently around $90k per day, the free cash flows generated by the contracted business will almost EQUAL the enterprise value of the business. We currently have great clarity into the strength of the rig market as more and more rigs are signed on long term contracts. If we assume these rigs keep these rates until 2012, the free cash flow generated by the business will exceed the current enterprise value and you will be left owning two 9 year old 5th generation rigs for free (sorry to beat a dead horse).Approximate replacement value for rigs is $1.2B. Also, keep in mind that that the average age of the rig fleet is about 26 years old and Ocean Rig currently has the worlds youngest fleet.

Note: the enterprise value is currently $1.7B and the free cash flows generated by the business will be $1.7B, or about $1.4B if discounted at 6%. We use 6% as an estimated WACC based on a low cost of debt (lenders view their counterparties as the oil majors and national oil companies contracting the rigs from Ocean) and moderate cost of equity (long term contracts but rates are volatile).

We believe Ocean Rig will sign the Eirik Raude contract in the next few months and will announce a major capital repayment program shortly thereafter. Because this business is contracted, banks are willing to lend to ocean rig at the oil majors’ borrowing rate, making this a very favorable option for the company. We believe the company can easily lever up $800m-$1,000m to buy back shares and pay a dividend. Given current equity value of $1.2B, with about $500m in net debt, this implies a significant portion of equity being returned to shareholders. Assuming $1,000m in additional debt and a 10% repurchase of shares, the total dividend could be equal to 65 NOK or about 75% of the current share price. In addition, pro forma 2009 EPS (the first year the higher rate contracts are fully ramped up) is 12.1 NOK with CFPS of 16 NOK, meaning on a pro forma 2009 basis Ocean Rig would trade at 1.6x EPS and 1.2x CFPS. Note that the EPS and CFPS are the only places I use NOK since I’m using a P/E based on the NOK stock price. We believe that is far too cheap.

We also believe that Ocean Rig is a good takeout candidate given its significant operating experience and the young age of the rigs. Since many Norwegian speculators have ordered rigs and do not yet have operational capabilities, we believe Ocean Rig is a prime candidate for someone looking to get access to both high spec rigs and a solid operating platform. If they are not acquired by one of these guys, we believe Ocean Rig management will partner with these speculators to grow the business further once the capital repayment is completed.

Ultimately, Ocean Rig is company which we feel has very limited downside and many catalysts for providing significant upside.

Risks:
The bear case is that on a net asset value basis Ocean Rig trades at $800m per rig, which some view as high, but given the contracted cash flows guaranteed by the business we believe that is somewhat misleading. Speculators are placing orders, and the market is valuing, newbuild rigs at $500m-$600m which will not be delivered until 2009. Ocean Rig’s two proven rigs will generate more than $700m in cash flow by 2009, meaning that $800m now is really $450m per rig on a comparable basis. Newbuilds typically also have issues during delivery and operators will typically always get a premium for an existing proven high spec rig vs. an identical newbuild rig. This is evidenced by the market given Ocean Rig’s higher dayrates for forward contracts than any comparable newbuilds.

Catalyst

- Eirik Raude is signed to a 2-4 year contract at $550k per day or more, starting in March 2008
- Ocean Rig recapitalizes the balance sheet and pays a large dividend
- Possible sale of the company to a speculator or US player who wants to get quality assets with a world class operating platform