Why Ocean Rig’s developing fleet means substantial cash flow

Market Realist

Why Ocean Rig stock could double as an MLP (Part 4 of 4)

(Continued from Part 3)

Creating the assets at a 35% discount to replacement cost, providing downside protection

At ORIG’s current price of $20 per share, an investor is effectively paying $7.5 billion or $685 million per rig after factoring in construction payments outstanding. Based on its current backlog, ORIG should generate $2 billion of levered FCF, so this reduces the implied cost basis to $5.5 billion or $500 million per rig. Assuming that customers exercise their options to extend contracts, then this will generate another $0.9 billion of FCF and result in a cost basis of $425 million per rig. This effectively implies that you’re buying ORIG’s assets at a 25% to 35% discount to its replacement cost of $650 million each. Rig prices haven’t been below $500 million since 2005.

Conclusion

ORIG has a premium set of assets covered by customer contracts that will increase EBITDA by 2.5 times, yet it’s valued below TBV. Once its fleet is fully developed, the company will generate substantial cash flow, so management plans to close the valuation gap with the formation of an MLP.  This news is out in the market, but ORIG is still a relatively underfollowed stock. I’d expect ORIG’s value to appreciate as more details on the planned MLP are released. If not, then you’re left with ownership in a company that should have the ability to fund a dividend equal to nearly 20% of its current market cap once its entire fleet is operating.

Additional analyst disclosure

I am long ORIG. I wrote this article myself, and it expresses my own opinions. I have no business relationship with any company whose stock is mentioned in this article.

The Market Realist Take

The company achieved 98.4% average fleet-wide operating performance for the third quarter of 2013. It has provided a guidance of 92.5% revenue efficiency for its fleet in 2014. It said its fleet’s exceptional operating performance during the quarter resulted in net revenue from drilling contracts of approximately $328 million.

Its daily direct and onshore rig operating expense in 3Q 2013 averaged $201,000 versus $208,000 during the second quarter of this year, which reflects the recent cost-saving efforts. Going forward, ORIG expects its direct rig operating expenses to average $200,000 per day fleet-wide. It will also incur additional $15,000-per-day for onshore rig operating expenses and about $50 million per annum for general maintenance expenses—including special items, spare parts, and upgrades. During the quarter, against $328.5 million in total revenues, it had $128.9 million in total rig expenses. Its depreciation was $61.2 million, an increase from the second quarter, as it included the ownership of Ocean Rig Mylos for about half of the quarter. It expects depreciation expenses to increase as it receives delivery of the Ocean Rig Skyros and Ocean Rig Athena in early 2014.

By announcing dividends and MLPs, offshore drilling companies are taking steps to not only reduce the cost of capital but also simultaneously pursue growth. Ensco (ESV) and Transocean (RIG) have made dividend announcements, while Rowan Companies (RDC) revealed plans to propose a dividend during its 3Q 2013 earnings call. Ocean Rig and Transocean have made announcements to set up MLPs that will see an initial public offering in 2014. In October 2012, Seadrill (SDRL) spun off Seadrill Partners (SDLP), an MLP comprising drilling rigs. Seadrill said in its 2Q 2013 earnings announcement that the share price of Seadrill Partners has continued its positive development since the IPO in October of last year.

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