Date: July 27, 2011
The investment thesis on DRYS is both complicated and simple. It’s complicated because:
· It requires a long overview to understand the past few years of DRYS, which is important in understanding the stigma attached to it today.
· It requires the investor to accept the questionable management and dealings of George Economou.
· It takes time to sift through and understand their mix of a bad dry bulk business, good deepwater drilling business and substantial debt. I believe that this complexity is the source of the investment opportunity and why investors can buy into DRYS at half of its intrinsic value. To make things even more attractive, there is an impending catalyst: the dual listing of their oil rig business, Ocean Rig.
It’s simple because at the current market price:
· DRYS is clearly being valued as a dry bulk play, even though over 75% of its EBITDA going forward is from the UDW business.
· The market is paying you to pay $0.66 per share for the dry bulk and tanker segments, even though these segments are expected to produce $77 million in EBITDA in 2012 and $102 million in 2013 even after deducting interest payments.
· There are two catalysts: 1) the dual listing of the Ocean Rig segment in the next month and 2) the potential spin-off of their tanker segment in the fourth quarter.
A) The long overview
a. Before the financial crisis, DRYS’s strategy was rather simple. It took on massive debt to finance the purchase of dry bulk carriers. Then, rather than locking in some of those carriers with long-term charter rates, it maintained the most aggressive exposure to spot market pricing for shipping of any of the major carriers. This was perfect as spot markets rode higher, driven mainly by Chinese demand for commodities. In 2007, the stock rose more than 800% reaching a peak of $123.50 in October 2007. Speculators loved it because it was a pure play on spot market pricing. However, as demand for shipping crashed and an oversupply of ships hit the market, all the dry bulk carriers plummeted — with DRYS falling the most due to its lack of long-term charter rates. It fell from its peak of $123.50 to just $3.77 today.
b. However, in 2007, near the peak of the spot market bubble, the company bought 30.4% of Ocean Rig, a deepwater oil and gas driller that trades on the Oslo stock exchange. The company paid $405 million for the stake, valuing the entire company at $1.32 billion (it was financed with about one-third cash on hand and two-third debt. If only it had been paid in DRYS stock).
Ocean Rig now has a market cap of $2.25 billion (that uses the latest exchange rate). DRYS eventually bought the rest of the company before selling 22% of it in December at a valuation that valued the company at $2.27 billion (which was a premium to the stock price at the time). Buying into Ocean Rig was, from what I can find, not popular with most investors at the time. It had no real synergy with their main business and made DRYS no longer a pure play on dry bulk spot pricing. However, this gamble is paying off now. The drilling business is doing well as the dry bulk business still struggles with oversupply in the market. Therefore, the drilling business is much more attractive — and is expected to be over 75% of EBITDA in 2012 and 2013.
Despite this, the company is still valued as a dry bulk carrier when it should clearly be valued as a deepwater driller, which has created a significant mispricing. I think the main reasons for the mispricing are:
· Complicated mix of two very different businesses and a substantial amount of debt.
o Most investors think of the dry bulk business when they think of “Dryships,” especially since the company was formerly the pure play on the Baltic dry index.
· Currently trading under $5.
· Many investors have lost a lot of money on DRYS and are bearish on the dry-bulk business, which has always been a tough industry marred by oversupply.
· The company has a hidden asset in its 78% of Ocean Rig, which trades on the illiquid Norwegian over the counter market.
· Many investors stay away from investing in George Economou because of his history of questionable related transactions and conflicts of interest.
1) dry bulk shipping (100% owned)
a. Overview of dry bulk shipping: http://www.slideshare.net/aehsan/a-primer-on-dry-bulk-freight-rates
b. 39 vessels
i. 7 capesize
ii. 26 panamax
iii. 2 handymax
iv. 4 new buildings
1. Average age 8.1 yrs
a. Total DWT: 3.7 Mt
· Total revenue from time charters for the next 2.5 years is about $470 million
· 75% charter coverage in 2011, 37% in 2012, and 19% in 2013
2) Tankers (100% owned)
a. (3 vessels in water with nine more coming in 2011-2013)
i. 2 in 2011, 4 in 2012, and 3 in 2013
3) Offshore OCR UDW Inc. (78% owned)
a. 2 UDW drilling rigs, 2 UDW drillships, 4 UDW drillships under construction
b. By 2011, according to Pareto, a Norwegian ship broker, only 22 rigs will exist in the world that can drill to depths of 7,500 feet and below. The four rigs that DryShips has on order all will be capable of plumbing such depths.
i. Want to grow fleet to 10-15 units by 2015
ii. Plan to institute dividend
iii. Estimated to be 68% of 2011 EBITDA, 77% of 2012, and 76% of 2013
c. Management in house
d. Breakeven cash flow/ driller per day: slide 18/51
e. Trading on NASDAQ expected to commence this summer, probably in August
i. Slide 20 gives comps
f. Deepwater production has doubled in last 5 years.
g. Deepwater discoveries accounted for ~50% of world discoveries from 2006-2009.
h. Deepwater discoveries 6x larger in size than new onshore discoveries.
In attempting to value DRYS, there are a few factors to consider:
1) The value of their 78% stake in Ocean Rig, which is listed on the Norwegian OTC market.
a. This is fairly easy to value based on the current market cap.
i. OTCNO:OCRG currently has a market cap of about $12 billion in the Norwegian kroner. This translates into $2.23 billion U.S. dollars. DRYS has a 78% stake — so the value to DRYS is .78 * $2.23 billion = $1.74 billion. There are currently 399 million DRYS shares outstanding, so using the Norwegian market price, this stake is worth $4.36 per DRYS share.
1. This is a 15% premium to DRYS current price/share
a. With a current price of $3.77, the market is assigning a negative value of $0.59 per share to the dry bulk and the tanker business.
2. This is likely a conservative valuation because the Norwegian OTC market is relatively illiquid.
3. The company plans to dual list the shares on the NASDAQ as early as this month, which should act as a catalyst for DRYS.
The catalyst component to this idea is important. On the last conference call, there was considerable discussion not only about this catalyst, but also about potentially spinning off the tanker business as well:
Their CFO, Ziad Nakhleh, said:
“The intention is, investors give value to pure plays unless and there generally is a holding company discount. We are not interested in having that holding company discount. Already as it is we believe we are at half of what we should be valued at at DryShips. So over time we're going to ensure that we have standalone entities. But this cannot be done overnight. It takes time. So we have got Ocean Rig to a point where we have done the placement, we have fully funded it, we've got the contracts now, and we're doing the listing. [They predicted the listing would occur in August]. Over time you will see all these pieces fall into place.”
· Note that the listing of the ocean rig business is just one part of their strategy to maximize DRYS value. They also plan to spin-off their tanker business:
He went on to say:
“I'm personally bullish on the tanker market through the second half of this year. If you look at the new building deliveries, they're definitely not as significant as the dry boats market. And then if you look at the demand side as well, so far it's been okay, inventories have been running down. And then we have the Libya situation as well. Middle East OPEC production is up implying more ton-mile demand. So if you want to do an IPO on the tanker market, you want to go out in the fourth quarter; that is generally the best quarter for the tankers. So as far as timing is concerned for us, what we need to happen is you need some cash flow for a public company. We will have four tankers on the water by the fourth quarter. By the end of the year it's five. And that coincides with when the market should be looking much better than where it is right now.”
Considering the company has a hidden asset that is worth 15% more than their entire market cap, and has potentially two catalysts to unlock value in the next 12 months, is the negative value for the tankers and drybulk business really deserved?
I do not think so. Especially considering the fact that the dry bulk business is expected to generate $77 million in cash flow (which in this case I define as EBITDA - interest payments) in 2012 and $102 million in 2013. Much of this is based on already fixed charters. Just to get a feel for the valuation, if we apply the industry average multiple of 8.5X EBITDA to their 2012 estimate of $198 million for their dry bulk and tanker business, it’s worth $1.7 billion, or $4.21 per DRYS share. Adding this to the $4.36 per share in Ocean Rig value and you have an $8.57 stock, a 127% premium to the current price.
Another way of looking at the overall DRYS valuation is with the following logic:
1) The Ocean Rig UDW drilling business is more valuable than the dry bulk and tanker business.
a. Based on Norwegian OTC listing, their stake is worth 15% more than current market cap (see valuation below).
b. Majority of EBITDA (77% going forward).
2) The UDW business is more attractive the dry bulk and tanker business.
a. Higher and more stable day rates.
b. Significantly less competition.
c. Growing demand vs. excess supply.
3) Also, this is confirmed by the fact that UDW drillers trade at higher multiples than their dry bulk and tanker peers.
If this is true, then one would expect DRYS to trade in between a driller and a dry bulk carrier/tanker and closer to a driller since that comprises the vast majority of EBITDA going forward. However, this is not the case. A recent Barron’s article effectively communicated this point:
“With Ocean Rig comprising 77% of DryShips 2012 earnings before interest, taxes, depreciation and amortization (Ebitda), DryShips is at this point a dry bulk company in name only, yet it trades at just 6.4 times our 2012 Ebitda, a 17% discount versus its dry bulk peers despite the predominance of the higher growth UDW business.”
The Bottom Line: DRYS is a much different company than the pure Baltic dry index speculative play that it was in 2007. It has fallen so far that you are now able to buy an ultra-deep water driller at a 15% discount and receive one of the biggest dry bulk carrier and tanking companies in the world for free. At such a cheap price and two impending catalysts, I think that many of my issues with the company (bad dry bulk business, questionable management) are more than priced into the stock, and that DRYS is a strong bet to outperform. I think that DRYS is worth over $8 per share, more than double the current price.