Listing for Dryships' Drillships

DryShips' Drill Rigs: Best in a Class of One?

Updated to include comments from DryShips' Chief Operating Officer, Pankaj Khanna

NEW YORK (TheStreet) -- It remains one of the riskier stocks around. Breaches in loan covenants that have required waiver after waiver. A rather non-transparent management structure led by a cult-figure CEO. A volatile core business.

What's not to love?

Given the many risks and potential pitfalls to investing in its stock, it's arguably difficult to describe DryShips(DRYS_), the Athens-based shipping company, as the best in its class. Better to reserve that distinction for its more conservative, and transparent, peers.

Still, under the leadership of its love-him/hate-him chief executive, George Economou, the company has made a bold bid to diversify itself away from the erratic, cyclical, increasingly China-dependent dry-bulk trade. So much so that we have chosen to give DryShips a new distinction: best in a class of one.

The strategy is not new. It began in 2007, when DryShips purchased a 30% stake for $405 million in a Norwegian company called Ocean Rig. Ocean Rig operated two highly specialized vessels, outfitted with drilling tackle and designed to explore for crude and natural gas wells in extremely deep waters. (DryShips has since bought the rest of Ocean Rig, paying about $1.4 billion more and using about $800 million in short-term bridge financing to fund the investment.)

At the time, critics asked what, other than being waterborne, this new line of business had to do with dry bulk. Some investors wondered why Economou would spoil one of the major things DryShips then had going for it, in their minds: offering a large, relatively liquid pure-play dry-bulk stock in which to put money to work. Now there was this new, highly complicated side-operation to attempt to value and understand. One hedge fund, run by Steven Abernathy, dumped its DryShips stake after learning of the move.

Fast-forward two years, and DryShips now has four more so-called "drillships" on order, their deliveries expected throughout 2011. Also, in the wake of a certain financial/economic convulsion that capsized global trade, asset values for dry-bulk ships plummeted, which, like McMansions on the outskirts of Vegas, sent the loans used to pay for them deep underwater. Not so drillships, the values of which have held up relatively well by comparison. Suddenly, the MIT-trained Economou was looking a little brighter.

For some time now, Economou and his management team -- including his new chief operating officer, Pankaj Khana -- have been marketing DryShips as a drilling company with exposure to the dry-bulk trade.

But to find success in this new business, DryShips needs to overcome some well-documented obstacles. Namely, about $1 billion.

The company still lacks that enormous sum to make due on what it owes the shipyard, South Korea's Samsung Heavy Industries, for two of the four drilling vessels it's ordered. (The other two orders, which will cost the company a total of $1.6 billion, are fully funded.) To obtain the financing, DryShips must first ink contracts under which the company essentially rents out the vessels to oil-exploration concerns.

DryShips has indicated that it's close to signing at least one of these contracts by the end of the year, but so far it has announced nothing. To some with ears to the ground, including sell-side stock analyst Urs Dur, who covers DryShips for Lazard Capital Markets, the company may, by the end of the year, announce contracts for "up to two" of the four vessels. Largely on the basis of this hoped-for outcome, Dur upgraded DryShips' stock last week.

It's the hottest topic right now for the company. "If I had anything I could disclose, I'd be shouting it from the rooftops," operating chief Pankaj Khanna said from Athens, in a telephone interview with The Street on Tuesday. "It's what everybody is asking us about right now."

Khanna did say, however, that talks are ongoing between DryShips and a number of parties, including national oil companies, which are "the biggest users" of ultra-deepwater rigs in the world. He said the company has also put in bids for drilling work -- known as tenders -- with several publicly traded oil concerns, including Total and Chevron.

"We're fairly confident that by the end of the year we'll have one or two of the vessels fixed," Khanna said, though he admitted that the publicly traded oil conglomerates will, for the most part, wait until next year to spend on exploration projects.

And, he said, talks with Korean and Norwegian export financing agencies have suggested to DryShips that the $1 billion in loans would come from these sources should DryShips obtain contracts for the vessels, though there are, of course, no promises.

Still, the longer the company goes with all this up in the air, the more some investors will call into question the credibility of the company's management. And credibility has long been one of the sticking points when it comes to DryShips.

For instance, the role of an entity called Cardiff Marine has rankled some investors. Cardiff -- 70% of which is owned by Economou, the other 30% by his sister -- acts as DryShips' fleet manager. For these services, DryShips pays Cardiff an annual fee north of $7 million, a set-up that's common in the Greek-based dry-bulk industry, but which has given rise to much skepticism about conflicts of interest among investors in the U.S.

When DryShips acquired its initial stake in Ocean Rig, Economou took 4% of the Norwegian outfit for himself. Not long thereafter, Cardiff placed two drillship orders (the pair that now require the $1 billion in funding) and eventually sold them to a DryShips-owned vehicle in exchange for a 25% stake in that vehicle. DryShips, in turn, bought back that stake for $50 million in cash plus convertible preferred stock with a face value of $280 million. This complex web of ownership and dealmaking is the sort of thing that has raised concerns about DryShips from the beginning.

But Khanna argues that, in the end, DryShips got the vessels on the cheap. He said the deal valued Economou's' stake in the pair of rigs at 5.5 times their projected earnings before interest, taxes, depreciation and amortization. But, he says, the shares of some drillship operators are trading at multiples of between 6 and 8 times EBITDA. "Everybody on the street liked the deal," Khanna told TheStreet, "because it was fair as far as DryShips was concerned." The company now owns 100% of Ocean Rig and the four drillship newbuildings.

Khanna also trumpeted the way in which DryShips has recapitalized and deleveraged, mostly through a controversial series of at-the-market equity offerings that diluted shareholders. ("Look," Khana says to those critics. "People forget why companies go public: to access the equity markets.") At one point in danger of default, DryShips has now reduced its total debt to $2.5 billion from about $3.4 billion at the beginning of the year, he says, and now has a net debt-to-capital ratio of 43%, down from a precarious mark in the middle 60s earlier in 2009.

Another pertinent risk presented to investors by Economou's offshore ambitions is the very complexity of the mobile deepwater drilling business itself. These types of ships typically drill at depths of more than 7,500 feet and operate in corners of the world beset by storms and foul weather: the North and Irish Seas, for example. The competition in this particular segment of the offshore petroleum-extraction industry is also stiff, with giants such as Transocean(RIG) and Schlumberger(SLB) to contend with.

To Economou's credit, he has left in place Ocean Rig's top management, which includes its chief executive, David Mullen, who cut his teeth in high-level positions at both Transocean and Schlumberger.

Assuming DryShips does eventually square away its financing, just how lucrative could the business prove?

First, one should look at the vessels the company already owns, via Ocean Rig: the Leiv Ericksson, recently contracted to Petrobas for three years to drill in the Black Sea at a rate of more than $500,000 a day; and the Eirik Raude, contracted for three years to the U.K.'s Tullow Oil to explore for crude and gas off the coast of Ghana for about $670,000 a day. (Both rates assume the ships will be in use for 100% of the contract's lifespan.)

Analysts are generally expecting DryShips to put its four new drilling vessels to work at rates of between $450,000 and $550,000 a day. Anything from $450,000 and below would be deemed disappointing.

Operating costs for these vessels typically amount to about $150,000 a day, according to DryShips. The Ericksson and the Raude will bring in revenue of about $430 million in 2010 and produce earnings before interest, taxes, depreciation and amortization of about $240 million, according to various analysts' models.

When it comes to deepwater drilling, the basic DryShips investment is simple: demand for oil will remain robust enough to make such costly methods of exploring for the stuff a profitable business. The conventional thinking reckons that crude needs to stay above $60 a barrel for deepwater projects to remain financially viable. DryShips takes the more optimistic view that such projects are viable with crude prices as low as $50 a barrel.

But the chief reason that seems to have certain DryShips constituents excited is the relative scarcity of drillships on the high seas. None have been ordered in the last year, for example. By 2011, according to Pareto, a Norwegian ship broker, only 22 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.

From the get-go, DryShips has made clear its intentions to spin off the drillships business in an IPO. According to the company, the earliest that is likely to happen is March of next year. With shares of other offshore drilling companies trading with multiples from 5.5 to 8 times EBITDA, that could translate to as much as $5.8 billion in enterprise value for Ocean Rig, according to Khanna.

That, however, is probably the rosiest view possible, given the uncertainties surrounding not only DryShips' unsecured contracts and the $1 billion funding gap, but also the condition of the equities markets as a whole.

"I think one has to consider where the company is now compared to where it was, in terms of its debt position and in terms of the rigs," says Lazard Capital's Dur, before going on to echo the company itself. "I like DryShips for the drillships business. It really is a rig company with dry-bulk exposure."

-- Written by Scott Eden in New York