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DryShips: Value with a Catalyst Set to Double

July 27, 2011 | About:

CSP2014

1 followers
Company: DryShips (DRYS)

Price: $3.70

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.

Business Segments

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'regoing 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.

Rating: 3.9/5 (67 votes)

Comments

tighanx
Tighanx - 3 years ago
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.

Doesn't Drys have about $3B debt?

Another question: if Drys spins off UDW, what will be the tax consequence?

thanks
asw310
Asw310 - 3 years ago
agree with much of your article, but the announced acquisition of Ocean Freight yesterday seems impractical considering drys debt load... comes back to the questionable management bit again. how does this impact your thesis?
tonyg34
Tonyg34 - 3 years ago
Walter Schloss would be proud. Looking at one of the worst performing sectors for a pure asset play.
CSP2014
CSP2014 - 3 years ago
yes they do have substantial debt. As someone buying the equity, you just have to make sure that they are still able to generate substantial cash flows, even after interest payments. I think that they can. I would rather them pay down some debt than continue to be so aggressive in expanding the fleet, but if that were the case, we wouldn't get such an attractive entry price.

Their great leverage is certainly a risk. However, given that they are still on pace to generate over $100 million in cash flow (defined here as EBITDA - interest payments) in 2012, I think that their earnings power is capable of servicing the debt-- and still generate substantial cash flow for equity shareholders.

To your second question, the
CSP2014
CSP2014 - 3 years ago


In regards to the Ocean Freight Acquisition.. I'm not a huge fan of it either. However, I think its impact on valuation is minimal.. they only used a very small portion of the Ocean Rig stock and then some cash. Again, I'd rather them be more conservative, pay down the debt, and monetize their assets but that's just not the way George E. thinks. The acquisition is essentially one year of EBITDA however so it's not a huge addition to their debt, although their debt is already substantial.

tonyg34
Tonyg34 - 3 years ago
So the comments thread made me curious enough to look up the Ocean Freight buyout. It looks like he was bailing out his nephew.

In addition to the $118 M price tag and assuming the debt of OCNFD ($127 M), they are also assuming OCNFD's contract to buy some VLOC's for another $254 M in additional debt. Bringing the total to $499 M in debts plus the roughly $1.9 B of existing balance sheet debt for a grand total debt per share of (2.399 B divided by 399 M) of about $6 per share versus a stock price of $3.75 - ish. Also, they sold off three panamax ships at a loss of $107 M. Which brings the book value into question.

The entire industry is getting kicked around right now which makes the entire sector basically cheap based on any turnaround in shipping rates. I totally get your thesis that the stock is really a play on the drilling rigs and that you're buying the dry bulk business for free. Just wanted to point out that the stock value (the dry shipping part) is based on turnaround in earnings because with that much debt there is no safety in the underlying assets (the boats). It will take a while to unwind all that leverage they took on during the boom years.
CSP2014
CSP2014 - 3 years ago
@ Tony,

Yes, I was not thrilled with the related party transaction with his nephew. However, what I would say is that some of these transactions (meaning related party) in the past have actually been good deals for DRYS. In this case, they get some long-term charters with a younger fleet.

Also, you're actually getting paid to take the DRYS bulk carrier and tanker business.. better than free. You can also short another dry bulk pure play (plenty of options) if you want to hedge the risk of a prolonged slump in the dry bulk business
CSP2014
CSP2014 - 3 years ago
In regards to the debt, they still generate substantial cash flow after interest payments. Also, their stake in Ocean Rig gives it more flexibility-- because if things got really bad, they could monetize ocean rig to get them out of the slump (which is a bit of a competitive advantage I think against the other pure play shippers).

Also, I think Ocean Rig itself is really undervalued (even though I included current mkt price in my analysis).

Comps: OCRG SDRL RIG

EV/EBITDA 6.4x 12x 8x

EV/RIG 694m 1100m 900m

^Source: (recent VIC write-up on Ocean Rig)
superguru
Superguru - 3 years ago
How about ANW instead?
ramisle
Ramisle - 3 years ago
I'd love to hear about those related party transactions that worked out well for DRYS shareholders.

In 2008 DRYS agreed to purchase 4 Panas from Cardiff for $400 million. Then cancelled the deal later that year and paid a penalty to Cardiff of $160 million.

In Oct of 2008, DRYS agreed to purchase 9 Capes from Cardiff for $1.17 billion, and in Jan 2009 cancelled that deal, again for a hefty penalty.

Cardiff is a private company, 70% owned by George Economou, and 30% owned by Cryssoula Kandylidis, George's sister. ( that is also the mother of Anthony Kandylidis, CEO of OCNF)

And after DRYS purchased Ocean Rig, Cardiff purchased the options on two Drill Rigs for $225 million, and they turned around and sold those options to DRYS for $317 million.

The related party transactions have been an opportunity for George to raid the Piggy Bank.

The Piggy Bank was filled with the help of continued dilutions that took the DRYS outstanding share count from 30 million, to 400 million.

There is plenty of value in the Drill Rig part of the business, but you have no idea what percentage of that you will retain after it is listed on the NAS.

CSP2014
CSP2014 - 3 years ago
@ Ramisle

1) Yes, investors have been upset about the related party deals.. for good reason. If you look at the majority of the deals, they have been about in line with the market over time. I'm not saying that's an excuse. However, IMO, his questionable mgt. is already discounted (and then some) in the stock price. Unless you can make a compelling argument that the dry bulk business and the tanker business are worth NEGATIVE value, then I don't think you have a convincing bear case. I do agree that mgt. is a wild care here-- I just think that you are well compensated for taking that risk at the current valuation. In fact, I believe that your comment, which focuses on all of the negatives without regard to how it relates to the current valuation, is one of the reasons why the opportunity exists. At the end of the day, we have to ask how much it is all worth given the current information. I think the answer, based on my analysis above, is significantly more than the current price. I have never found, however, arguments that do not translate into the valuation very convincing. O.k. so you don't like George E. I'm not the biggest fan either.. but how do you translate that into the valuation? I think if you have a huge margin of safety, which I think you do at the current price, it's still worth the risk. Let's also not forget that he owns a large chunk of stock and that the company seems to be trying to fully monetize its assets (with the dual listing and the potential tanker spinoff).

2) What do you mean I have no idea what percentage they will retain? They OWN 75.7% of it. (78% - the 2.3% in the Ocean Freight Acquisition). This cannot be questioned.. it's a matter of fact. They also manage the company.. so I don't really know what you are getting at here.

Thanks for the comments.

Connor
Sivaram
Sivaram - 3 years ago


CSP2014: "2) What do you mean I have no idea what percentage they will retain? They OWN 75.7% of it. (78% - the 2.3% in the Ocean Freight Acquisition). This cannot be questioned.. it's a matter of fact. They also manage the company.. so I don't really know what you are getting at here."

I think his/her point is that given how the insiders have been siphoning off hundreads of millions of dollars to themselves in a few years, how do you know that the 75.7% you cite won't be whittled down to, say, 35%? Another few transactions like the past can easily transfer, say, 50% of the wealth to themselves.

I'm not saying any of that is going to happen; all I'm saying is that unethical people tend to be unethical for a long time--unless they change themselves. People who get ahead in life by lying or stabbing others in the back aren't going to change all of a sudden. If these guys have been looting shareholder wealth in the past, I don't see why they would change all of a sudden. I hope the best for your investment but getting involved in poor corporate governance situations is very dangerous. It's like getting involved with criminals (I am no way suggesting these insiders are criminals; this is just an figure of speech).

ramisle
Ramisle - 3 years ago
I've been trading this stock since 2006. I don't dislike George at all. He's quite a character, and he's brilliant.

Again I will say there is tremendous value here in the Drill Rig business, and I have have enough experience with DRYS to warn people that you can't be certain whether a DRYS shareholder with get his "fair share" of that value.

No, The "deals" were not normal, the penalties were exorbitant, and George bragged later that he saw in 2007 the glut of ships and the downturn coming. He took credit for putting the Capes on long term charters due to that foresight, And yet he made those deals.

I believe he did see it coming. I say, he was unloading those ships on DRYS to save Cardiff. Just my opinion, no emotion involved. I sold at $111. I'm not mad.

But that is why there is such a cloud hanging over this stock. The market doesn't trust George.

Three years ago, the 44 million shareholders of DRYS were told they would get one share of Primelead for every share of DRYS they owned. It was right there in the earnings report.

Now what? You say It's obvious, 75.7%. Well last week it was 78%. Don't you get it? You never know what's next.

I've seen dilution after dilution. SPO's, ATM after ATM. 400 million now, Every time a Drill Ship gets delivered, Mandatory Convertible preferred shares are converted to 10 million common shares. And the frustrated shareholders each time. Lot's of broken promises to go along with those questionable deals. And the OCNF deal does nothing to counter that distrust.

Ocean Rig has some bills to pay, if DRYS retains it's 100 million shares, but after the listing, Rig sells shares, then DRYS percentage decreases.

And by the way, DRYS isn't close to being the largest bulk fleet in the world. Only the US listed ones.

COSCO owns 400 ships, Mitsui....275, NYK, STX Pan Ocean..etc.

And then there's VALE, the fleet they are building is going to take a tremendous amount of charters away from the shipping companies.
CSP2014
CSP2014 - 3 years ago
@ Ramisle,

Thanks for the comments-- very insightful.

I agree with you about most of it. I mean I think I clearly said in the write-up that the mgt. is a risk with DRYS. I also did not intend to insinuate that DRYS was THE biggest in the world-- probably should have been more careful with that (thx).

To your point about OCRG dilution, I disagree though-- I think the only reason any OCRG stock was included in the deal was because it gets OCRG over the 400 shareholder requirement for a Nasdaq listing.. which is obviously the positive catalyst I mentioned.

Anyways, so what are your thoughts about the valuation at this level? George E has been discussed many times along with dilution, etc. but how do you think that translates to the current opportunity in DRYS shares? I think the risk/reward is definitely skewed to the upside but would love your thoughts (or anyone elses) on what they think this is worth with some detailed valuation work (particularly on the dry bulk and tanker business).

ramisle
Ramisle - 3 years ago
I would buy this for a trade.

I'm not sure about the timing though. It's really a flip of the coin as to whether the next news will be accepted as good or bad.

By the time of the Nasdaq listing, I think there will be many DRYS shareholders that will be disappointed by the size of the piece of the OCRG pie they get. All these big moves are going to continue to require cash to go along with the lines of credit. Much of DRYS cash is restricted. And the cash received from the sale of the older ships was not enough to pay off the loans on those ships. You sell your house, the mortgage becomes due.

I'm not enthused about the future of Tankers so won't give you an uneducated guess as to valuations there.

I could give you a detailed run down of the dry bulk ships based on their age and size, but the value of their charters is more difficult. Ship values www.cotzias.gr

The biggest problem with valuing DRYS is trying to keep up with the share count. The weighted average outstanding shares as of the last earnings report was 317 million. and yet now there are 400 and counting. There have been preferred share converted, compensation rewards, and shares used as payment for ships.

And now George has contracted to build LNG tankers, but it is unclear which of his companies will be receiving them.

CSP2014
CSP2014 - 3 years ago
The following article argues that DRYS is selling below liquidation value:

http://seekingalpha.com/article/283079-value-play-in-dryships?source=yahoo
CSP2014
CSP2014 - 3 years ago
I think that anything that turns people off of an investment... without making them ask how it really affects valuation.. creates a potentially compelling opportunity. In this case, DRYS clearly has a lot of negative things that pop out at the potential investor that make him/her want to pass it over and stop really digging in and researching. However, this creates an opportunity for the value investor that is willing to do the dirty work.

I have heard a lot of people talk about George E. and his questionable mgt. However, I haven't really heard anyone quantify the discount that should be appropriate. What do you think DRYS is worth? Factor in a larger margin of safety with a higher discount rate, factor in more dilution, etc. but at the end of the day, what is your estimate of intrinsic value? Most bears on this stock, from what I have seen, have not done this. After all, it's easier to just blame George E. and say the stock is a sell.

As a value investor, this turn-off gets me excited to buy some great assets at a huge discount to intrinsic value (even factoring in George E.).
dajian888
Dajian888 - 3 years ago
CSP2014, I hate to say this, but I think you have mixed quantitative factors and qualitative factors. Not all factors are quantifiable.

Management plays a very important role, it is like business partners. If you partner with someone you can't trust (or the worse, you know you can't trust him), no matter how attractive that business is, you don't know where the money will end with. After all, you have to ask whose money that is.

Already we have seen too many value destroying acquisitions. BAC used be a high quality bank with good practices, now it is being dumped like trash. How could you come with a discount rate or margin of safety with it? Is 75% discount enough? It wasn't...

For a good business and/or attractive valuation, an incompetent management is acceptable. But bad management is not. No matter how much value there is, it doesn't take too long for them to destroy it. After all, a couple of bad acquisitions are all they will need.

That said, I made many mistakes too, and it hurts to admit them. Yes, I have a long "shame" list, with many symbols on it. When I summarize it, I think if I pay more attention on safety side instead of potential, and more attention on management, I will do better.

I like the other parts of your analysis though, otherwise, I won't even bother to post.

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