Ocean Rig UDW Inc. (ORIG)

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Ocean Rig Is A Great Buy For Patient Investors

http://seekingalpha.com/article/3999702-ocean-rig-great-buy-patient-investors

Summary

Ocean Rig (Orig) has been able to use depressed debt and asset values to increase shareholder value in a big way and has shown outstanding earnings so far.

The shares' huge valuation discount compared to competitors should result in significantly better performance in coming years.

Based on cash and current contracts, the company will not have financial problems in the next years and will be able to maintain a healthy cash balance.

Management displays a much more bearish medium term view on the market than competitors and says that it's evaluating long term restructuring options.

The main intention of that talk seems to be to frighten debt-note holders to sell the notes back to the company at significant discounts.

Model assumptions and Results

Below, I present an updated financial table for 2016 and 2017 for Ocean Rig (NASDAQ:ORIG), based on the current situation, updated cost and contract data and the announced ship delivery delays including payment rescheduling.

Among the assumptions:

- No further contracts in 2016 and 2017 (which is obviously the worst case)

- No more cold stacking

- Only cash revenues and costs are recorded - no deferred items

- An arbitration settlement of $75 M in 2017 (50% of the claims) regarding Eric Raude and Olympia

- Further buybacks of 2017 debt, leading to a repurchase gain of $100 M

- Ship opex costs (operating ships): 135k/d in Q1 of 2016, 115k/d thereafter (excluding maintenance)

- Investments in upgrades and spares of $ 105 M in 2016 and $ 50 M in 2017



Ship opex costs (for operating ships) came down again in Q2 to $113/d. Management thinks that's sustainable.

Under that scenario, cash flow from operations in 2017 will remain healthy with $ 365 M;

The EPS numbers exclude gains from debt repurchases. EPS from operations will be around break even to slightly positive in 2017. Ebitda is around $ 950M in 2016 and close to $640 M in 2017.

Under the simplified assumption that all revenues and expenses are translated into cash in the same quarter, cash is estimated at $470 M at the end of 2017. With no new contracts in 2018, which is highly unlikely, the company would start to burn cash in that year, but still have near $250 M cash at the beginning of 2019 (no payments for new ships assumed).

ORIG is currently trading around 3% of book, consisting of high end assets, as if it was facing immediate insolvency, having uncompetitive assets and a disappearing market. All that is absurd.

Management's market view

The stock is currently penalized by the display of management's extremely bearish market expectations for coming years, while the company's competitors see the bottom of the cycle near the beginning of 2017. I am not speculating here if there is an agenda behind management's very negative view and I am not bashing the CEO. But it has to be said that the arguments (Q2 presentation page 12) represent one sided selection of negatives. That includes the mentions of GS's (dated) prediction of $20 oil and of massive oil oversupply, while the consensus view is that supply and demand is moving into balance and several serious sources project a coming and lasting undersupply situation in the oil market.

From the presented floater data, you have to deduct that offshore drilling spending will fall to 15% of the 2014 level by the end of next year, which is far below consensus and would result in a decline of deepwater production by 1Mb/d per year from reduced infill drilling (such a reduced supply would provoke a surge in oil prices). Petrobras' planned budged cuts for the next 5 years are mentioned. Besides that PB makes new 5 year plans every year, depending on the current oil price, is has to be mentioned that the Brazilian government is relieving PB from its obligation to own 30% in any national offshore project. Without that PB roadblock, offshore investments there could surge when the oil price recovers.

Does ORIG's management really not have more updated information?

The market seems to reward companies that perceive the sunrise and penalize those that see only a black hole. But all are sitting in the same boat. That said, so far, ORIG's management has done a good job in a difficult environment.

Comments on management's restructuring ideas

Management mentioned that they are evaluating restructuring options in case of a multi-year market slump, including a Chapter 11 reorganization as one of many options. That has frightened investors. It's difficult to imagine how the company could justify such an extreme option now with the shown levels of cash flows and cash until 2019 in a worst case scenario.

For 2018, debt covenants may need to be adjusted. Such adjustments have become routine among competitors. Banks understand the market situation and have no appetite in taking over drillers or auctioning off their assets, certainly not if the companies continue to make their debt payments.

That the company is in talk with debt holders is currently common in the drilling industry, but the first meaningful refinancing of debt is not required before 2020. ORIG is relatively well placed in that regard. Painting a long term Armageddon scenario for the industry and then asking banks to provide continuing financing for a period starting four years from now seems to be a strange negotiating strategy.

GE and president Kandylidis own a meaningful amount of equity in the company. While they may try to get the shares from other shareholders cheaply, as some people pretend, it's certainly not their intention to diminish the underlying value of those shares unnecessarily. Handing over control to creditors is the last thing they would consider. So, what's the intention behind mentioning that option?

The company's mention that, in a possible restructuring, some debt holders would be significant losers, indicates that the main objective is to frighten note holders, although the 2017 notes are secured by the company's assets and only the 2019 notes are unsecured. ORIG stopped buying back the notes in March after their price had significantly recovered. With prices down again, a new round of notes buying would be a very logical and rewarding activity. If 50% of the remaining notes outstanding can be bought back at an average 50% discount, the net cash benefit, including interest savings, could amount to $170 M by the end of 2017, significantly improving the cash situation and the covenant compliance by then. In my projection, I assume a $100 M gain from further 2017 notes buybacks ($210 M nominal for $125 M) after 2016-Q2. But a repurchase of 2019 notes could also be targeted. The best and easiest "restructuring" option is simply to use some of the cash for the buyback of early maturing low priced debt, as that results in more cash after maturation.

Investors should remember last October: Negative talk, which later turned out to be without substance, preceding massive debt buy backs.

Debt-equity swaps? SDRL earlier this year exchanged some bonds for shares. Debt at nominal value was swapped for shares valued at 30% of their book value. Analysts project more of such deals for SDRL - up to 30% of bonds outstanding. But at ORIG, first talking the share price down and then persuading note holders to switch? That doesn't make sense.

BTW, ORIG hasn't cancelled the repurchased debt. That's not uncommon. SDRL still has debt in inventory repurchased years ago. The reason might be taxes. The interest paid on the still nominally outstanding notes at ORIG's Drill Rig holdings is reducing the corresponding income taxes while the interests received on the notes repurchased and hold by another entity in another jurisdiction seem to be tax free.

Ship delivery postponements

Prepayments for new ships are reaching $600 M in 2016 - in sum worth 85% of one new ship,

The delivery of the first two ships has been delayed by only one year. That is surprising in light of management's negative market view. Construction of the third ship, Amorgos, originally scheduled for 2019 delivery, is "on hold". ORIG can reactivate that at its discretion or walk away from the deal with no further obligations. I think that the project could get reactivated when the floater market tightens, based on the signing of a long term employment contract first. Shareholders would have preferred a two year delay for the first two ships, but the agreement has released ORIG from its corporate guarantee. The ship delivery in 2018 requires financing on the basis of a healthy contract. The chances two years from now for a high end ship to get such a contract are not that bad. Otherwise ORIG is in an excellent position to further delay delivery and final payments.

Besides the prepayment in 2016, the arrangements regarding the new ships are OK. In practice, they will not have a negative impact on cash and cash flows in coming years, but will be a meaningful plus in the next up phase of the market. What is puzzling to me is the statement in the SEC filing that the final payments for the ships have to be made "upon the fifth anniversary of the delivery date".

Arbitration claims

ORIG wants $90 M from Total for the cancellation of the Olympia contract. I think that's better than cash-flow neutral. Not surprising that Total is objecting. The other claim for $62 M concerns the Eirik Raude, apparently for a contract extension that ORIG somehow had forgotten to mention to shareholders. I assume conservatively a total settlement around $75 M, recorded in 2017.

The ENI agreements

The company got a very generous compensation for the Olympia contract cancellation which I think is better than cash-flow neutral. By contrast, the mentioned day rate for the extension of the Poseidon contract is at cost. I think that both deals are linked and that at least $10M of the compensation is in fact attributable to the Poseidon contract extension.

Cold stacking

The company is cold stacking 5 of its 11 floaters. That contrasts with the behavior of other drillers who say that cold stacking is not worthwhile and who keep their modern floaters ready stacked. Indeed, it's probably a zero sum decision. The company may save $40 to $50 M per year compared to ready stacking, but it could also miss possible employment opportunities in the next two years, more likely in 2018. At the end, the costs of returning the ships to the market will eat up the savings.

My view of the offshore market

The recovery of the offshore market is tied to the recovery of the oil price. Depending on the sources, global crude supply is now coming in line with or has fallen below demand. Global commercially available oil inventories are probably less than commonly published. Probably up to 300 Mb of the oversupply in the years 2014 to 2016 have disappeared in Chinese and Indian strategic reserves. Up to 200 Mb will remain in the supply system because of a 4 Mb/d growth in global consumption in that period. Crude prices below $60/b lead to ongoing supply destruction outside OPEC. Prices in the $60 range should show some recovery there, especially in North America, but not enough to match the global demand growth of at least 1Mb/d each year. The negative effects of the postponement of long term upstream supply projects will start to show up in 2018 and are difficult to reverse because of capacity constraints and time lags.

A return to some form of managed supply by oil exporters, notably OPEC, with a reduction of crude price volatility, would be extremely helpful for all sides. With Iran having moved up production to pre- sanction levels and other exporters having shown an increasing willingness to participate in managed supply earlier in the year, its chances are slowly increasing. The Saudi boy prince, who had sabotaged a return to managed supply at the last minute in April, seems to leave oil policy now to the new oil minister, who appears to be a common sense person.

My view of the offshore market is closer to consensus than the view displayed by ORIG's management.

Class 6 ships will be the first beneficiaries when the recovery starts. I've laid out the base case for an offshore floater recovery here. That assumes that offshore spending in 2018 will be 20% higher than in 2016, but still 30% below 2014 levels. The number of older class 4 semis and class 5 ships getting scrapped will exceed the number of new arrivals by a factor 1.5 to 2 between 2015 and 2020. Many old cold stacked floaters will never work again. All that will lead to reduced supply in the years ahead, compared to 2014. Since I wrote that scenario, around 10 more old floaters have been scrapped or are held "for sale". The extreme pain now will lead to a faster market rebalancing later.

Day rate increases will lag utilization rate increases. Offshore Driller's earnings in the years 2017 and 2018 will be abysmal but the leading indicators - oil price and utilization rates of modern floaters - will most likely drive share prices and improve the mood among debt issuers and holders.

Valuations - a few competitors

Atwood (NYSE:ATW): With no new orders in 2017, as assumed in the model for ORIG, ATW would be cash flow negative and show a loss around $4/share in 2017. Including ATW's 2 new ships basically finished and parked in the yard and considering the related outstanding payments as debt, ATW's debt/class 6 ship equivalent is around 25% lower than ORIG's (2016 year end comparison).

Seadrill (NYSE:SDRL): SDRL carries 20% more debt per class 6 ship equivalent (EBITDA capacity adjusted rig volume) than ORIG. The company needs to refinance $3.7 B between now and 2018. It's obviously the worst time in the cycle to do that, but nobody expects seriously Chapter 11. SDRL faces significantly higher interest rates on the refinanced debt and probably some dilution through bond-equity swaps. SDRL and ORIG have the same asset quality. In that case, book value/share is a reasonable comparison metric. As ORIG is somewhat less leveraged, it should get an additional valuation premium, meaning that its share price should at least be double that of SDRL's.

Diamond Offshore (NYSE:DO). DO owns only 7 modern floaters (including only 4 ships and including the coming Great White semi). The rest, currently 17 units, is mostly more than 40 year old stuff. Eight of these old floaters have been refurbished and got new birth dates, but with the exception of two or 3 units with mooring capabilities, their economic value is low and fading fast. Life expectancy of all the old floaters is limited. In fact, based on current contracts, the modern floaters will generate more than 90% of Ebitda in coming years. Only the modern floaters have significant Ebitda capabilities in the future. The total realistic Ebitda capacity of the other floaters is probably just one third of the total modern floaters. After the final payment for the Great White, DO's net debt will be between 2.5 and 2.6 B by the end of 2016. Adjusted for Ebitda capacity, DO's debt/floater is at the same level as ORIG's (not counting ORIG's prepayments). DO's advantage is a better contract coverage of its modern floaters in 2018, but in 2019, the cards are likely to get redistributed. In a recovering market - 2019 and beyond - ORIG, with then 13 modern or specialized floaters, is likely to outperform DO with only 7 modern floaters by a significant margin. In that context, it's surprising that the market currently values a $ of free cash flow that DO generates more than 30 times higher than a comparable $ generated by ORIG.