Don’t Dock DryShips

DryShips (DRYS: Nasdaq)

By Sterne, Agee & Leach ($3.83, June 17, 2011)

We are upgrading DryShips from Neutral to Buy ahead of an ocean rig listing in the U.S.

We believe DryShips (ticker: DRYS) represents attractive value given the clear path to achieving our sum-of-the-parts valuation of $6.

The catalyst is the company’s plan to list shares of Ocean Rig, its UltraDeep Water (UDW) unit, on the Nasdaq over the summer.

DryShips is hosting an analyst day on Friday, June 24, to discuss its plans for Ocean Rig, which currently trades at about $19.60 in the Norwegian over-the-counter (OTC) market.

Ocean Rig’s market cap implies an Ocean Rig value per DryShips share of $5.32, implying a negative $1.49 value for the company’s dry bulk and tanker fleet.

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.

DryShips is set to capitalize on the tight UDW market; contracts are in place and financing risk is largely gone.

Two of the main concerns that kept us Neutral since we initiated coverage in January were: 1) financing uncertainties for the four 2011 drillshipdeliveries: financing was incumbent on DryShips achieving minimum day rates and at the time a contract for the drillship Mykonos was not yet secured; and 2) continued political uncertainty surrounding drilling in the Gulf of Mexico: though the moratorium was already lifted, at the time there had still not been a return to drilling in the Gulf given the government’s hesitance in granting drilling permits.

Since then DryShips has secured a contract for the Mykonos [Greece] and has secured loan facilities fully funding the 2011 deliveries. Moreover, through its $500 million senior note offering in April, it has the cash to almost fully fund its remaining $731 million of payments due in the second half of 2013 for the two drillship options it has exercised.

On the Gulf side, drilling activity lends support to our view of a tight supply and demand balance in UDW over the next two years. The remaining concern is continued uncertainty regarding management’s third-party transactions, which has historically constrained DryShips’ valuation.

While this concern may still be relevant, we believe at $3.83, the value is too much to ignore.

We are lowering our estimates to reflect reduction in our dry bulk spot-rate forecast. Note that our positive view of DryShips’ near-term value realization is due to the value of its Ocean Rig unit rather than a positive view of the dry bulk market. In fact we are reducing our dry bulk rate forecast to reflect our view of deterioration in dry bulk fundamentals.

The decrease in our estimates is based largely on our lower dry bulk and tanker rate forecast. We are reducing our earnings-per-share estimates as follows: 2011 goes from 98 cents to 88 cents, while 2012 goes from $1.08 to 98 cents.

Note that we are increasing our Ebitda forecast for the Ocean Rig unit from $657 million to $711 million.

— Salvatore Vitale, Dow Jones & Company

The companies mentioned in Hot Research are subjects of research reports issued recently by investment firms. Their opinions in no way represent those of Barrons.com or Dow Jones & Company, Inc. Share prices at the time the report was issued and the date of the report are in parentheses.