IB Equity Research

November 11th, 2013

OCEAN RIG UDW INC. Thesis Overview

Ocean Rig (ORIG) is an offshore driller with EBITDA set to more than double by 2015 as the company expands its fleet. As its newbuild program comes to an end, levered FCF will reverse from -$0.5b this year to more than +$0.5b. These cash flows are supported by longterm contracts with an average duration of 3 years (4.5 years including extensions). At its current market cap of $2.6b, youre creating the company for less than 4x. This seems extremely cheap as a pure-play operator in the very attractive ultra-deepwater market, where supply and demand should remain balanced for the foreseeable future. To close the valuation gap, management will begin funding a dividend in 1Q14 and form an MLP in 2Q14. The only offshore driller thats structured as an MLP (NYSE: SDLP) trades for $1,350mm per rig compared to ORIGs current valuation of $685mm per asset. ORIGs also valued at a 10% discount to tangible book value, while peers with older fleets and much smaller revenue backlogs trade for 1.3x. I believe this stock could double over the next year from $20 to $40 as its rerated due to the lucrative MLP structure.

Stock Rating Catalyst Category Price Target Price (11/11/13): $20.15 Upside: 100% Ticker: ORIG Exchange: NASDAQ Industry: Energy Trading Stats ($USD millions) Market Cap: $2,663 Enterprise Value: $7,531 Price / Tangible Book: 0.9x Dividend Yield: 4.0% EV Per Rig: $685 EV / 2015E EBITDA: 6.9x
Source: Company filings, Analyst Estimates

BUY 6-12 Months $40.00

Price Performance 52 Week range: $13.45 - $20.58 Analyst Details IB Username: Chris Colvin Employer: Freeman Group, LLC Job Title: Portfolio Manager Analyst Disclosure ORIG Position Held: Yes

IB Equity Research
November 11th, 2013

Company Overview
ORIG, an offshore drilling contractor, through its subsidiaries, provides oilfield services for offshore oil and gas exploration, development, and production drilling. It specializes in the ultra-deepwater and harsh-environment segment of the offshore drilling industry. As of March 22, 2013, it owned 10 offshore ultra deepwater drilling units comprising 2 ultra deepwater semisubmersible drilling rigs and 8 ultra deepwater drillships. ORIG primarily serves oil companies, integrated oil and gas companies, state-owned national oil companies, and independent oil and gas companies. The company is headquartered in Nicosia, Cyprus. Ocean Rig UDW Inc. is a subsidiary of DryShips Inc. (NASDAQ: DRYS).

Market Overview
Positive Outlook for the UDW Market
ORIG has premium assets as one of two pure-play ultra-deepwater (UDW) drillers. Each UDW rig costs $650mm and takes several years to complete, so building a fleet requires a large capital base and a significant amount of time. Today, the UDW global fleet consists of ~130 rigs, but only ~15 of these operate in the UDW (> 7,500 feet) while the rest are in the deepwater (4,500 7,499 feet) or midwater (< 4,500 feet) (see Table 1). E&P operators and consultants have published a range of estimates, but UDW production is expected to increase by roughly 4x by 2020 so that implies another 45 UDW rigs will be needed. In addition, the average age of the 185 rigs making up the deepwater and midwater fleet is 30 years old (Table 1), which is approaching the useful life of these assets. Therefore, there could be demand for another 230 UDW rigs by 2020, which doesnt include the impact of growth in the deepwater or midwater markets. This implies that another 33 will need to be delivered each year, but only a handful of shipyards are capable of producing this sophisticated equipment and their annual capacity is only 30 rigs. Growing demand coupled with limited ability to quickly build supply has kept the UDW fleet operating at nearly 100% utilization since 2005 and Id expect this to continue for the foreseeable future.

Table 1:

IB Equity Research
November 11th, 2013

Future Profits Are Supported by a Large Backlog

ORIG currently operates six rigs, then one will come online in 4Q12, two more will be delivered in 1Q14, and another two in 2015 bringing the total to 11. Only one of these does not have a customer contract tied to it because it was ordered a few weeks ago. The backlog has grown from $1.6b in early 2012 to $5.8b today, which is equal to nearly 5x todays revenue. Stated differently, nearly 70% of my projected cash flows for the next three years (Table 3 on the next page) are backed by contracts from large, creditworthy E&P operators including ConocoPhillips, Eni, Lukoil, Petrobras, Repsol, and Total (Table 2). If these customers exercise extensions, then almost 80% of the forecasted cash flows are covered. Therefore, the outlook for ORIG and its expected earnings are fairly visible over the next few years regardless of the fundamentals in the general UDW market.

Table 2:

EBITDA Should Grow by 2.5x and FCF Should Improve Exponentially (Table 3)
Currently, ORIGs six rigs are generating $400mm of annual EBITDA, but this will grow to $1b run -rate by 2015 when it increases its fleet to 11 because each new rig will generate $120mm of EBITDA. Over the next two years, the company will spend $1.8b finishing the construction of these newbuilds, then its cash flow should increase significantly. Its 11th rig will be delivered in 4Q15 and at that point, ORIG should be generating $660mm of levered FCF and $880mm of unlevered FCF. My forecast below is slightly more conservative than consensus, which I believe is because Im using the companys guidance of 93% utilization while theyve been achieving above 96% recently.

IB Equity Research
November 11th, 2013

Table 3:
($ in MMs)

Rigs Available Days Utilization Revenue Earning Days Dayrate Drilling Revenue Y/Y EBITDA Margin Cash Interest Expense Cash Taxes Newbuild CapX Maintenance CapX in NWC / Other Levered FCF Debt Principal Payments Excess Cash Flow After-Tax Int Exp Newbuild CapX in NWC / Other Recurring Unlev FCF Net Leverage

2008 2

Actual Results 2009 2010 2011 2 2 6

2012 6

2013 6

Estimates 2014 2015 9 10

2016 11

1,995 3,090 3,530 3,895 96% 93% 93% 93% 1,908 2,858 3,265 3,603 $ 539 $ 549 $ 566 $ 567 $ 219 $ 388 $ 406 $ 77% 5% $ 117 $ 234 $ 266 $ 54% 60% 66% (23) (52) (10) (17) - (131) (17) (14) (64) 175 $ (43) (18) (705) (7) 17 700 $ 942 $ 1,028 $ 1,568 $ 1,850 $ 2,044 72% 35% 9% 52% 18% 11% 371 $ 295 $ 53% 31% (32) (73) (31) (41) (1,865) (212) (78) (98) (37) 98 514 $ 749 $ 936 $ 1,055 50% 48% 51% 52% (145) (50) (686) (106) 24 (252) (78) (916) (51) 846 22 64 $ 50 131 (175) 41 705 (17) 31 1,865 37 70 212 (98) 2.2x 138 686 (24) 5.9x 239 916 4.8x (248) (92) (920) (56) (191) 235 920 4.2x (230) (102) (62) (191) 219 3.1x

5 $ 196 $ (490) $ (1,673) $ (32) $ (449) $ (548) $ (381) $ 660 $ 298 $ (572) $ 469

90 $ 201 $ 239 $

260 $ 152 $

352 $ 607 $ 774 $ 879

Trading at Discount Despite Premium Assets, a Large Backlog, & High Growth Expectations
The company currently trades for 6.9x 2015 consensus EBITDA and $685mm per rig, which is a premium to its peers but these have older & more commoditized fleets, lower growth prospects, and less contract coverage. The only true comparable is Pacific Drilling (NYSE: PACD) because it operates solely new UDW assets and its also expected to grow its EBITDA by 2.5x before 2016. This company trades at a 10% premium to ORIG. Also, ORIG is valued at 90% of tangible book value (TBV), w hile its industry currently and historically has traded for 1.3x TBV (Table 4). Using peer metrics, the implied value per share of ORIG is $25 $30 translating to 20% 40%+ upside (Table 5).

IB Equity Research
November 11th, 2013

Table 4: Comps
($ in MMs, Except per Share)

Ticker

Name

Share Price

Mkt Cap.

Current Valuation EV Net Div '15/LTM EV/ '15 EV per (w/CapEx) Lev. Yield EBITDA EBITDA Rig 6.0x 5.2x 3.1x 1.7x 2.1x 0.2x 2.0x 2.8x 2.1x 9.2x 3.4x N/A 4.3x N/A N/A N/A N/A N/A 5.8% 5.0% 2.7% 4.6% N/A 4.5% 5.2% 7.8% 2.5x 2.5x 1.9x 2.0x 1.6x 1.7x 1.4x 1.6x 1.3x 1.9x 1.8x 1.0x 1.6x 6.9x 7.5x 3.7x 6.6x 7.3x 5.3x 6.5x 6.0x 6.9x 7.0x 6.4x 14.3x 9.6x $ 685 $ 756 $ 50 $ 219 $ $ $ $ $ $ 422 259 262 231 354 422

P/ TBV 0.9x 1.1x 1.1x 1.0x 1.7x 1.8x 1.5x 1.2x 1.1x 1.3x 1.3x N/A N/A

Jackups Old New Total 0% 0% 100% 37% 13% 14% 45% 51% 8% 0% 27% 0% 2% 0% 0%

Fleet Mix Floaters Total Old New Total Rigs 0% 100% 100% 0% 100% 100% 0% 0% 20% 67% 13% 23% 48% 0% 17% 0% 11% 40% 17% 25% 14% 38% 50% 39% 0% 11% 60% 83% 38% 37% 86% 50% 57% 11 8 38 35 15 42 77 78 87 8 40 1 58

New Floaters Only ORIG OCEAN RIG UDW INC PACD PACIFIC DRILLING SA Primarily Jackups HERO HERCULES OFFSHORE INC RDC ROWAN COMPANIES PLC-A Mixed Fleet ATW ATWOOD OCEANICS INC DO DIAMOND OFFSHORE DRILLING ESV ENSCO PLC-CL A NE NOBLE CORP RIG TRANSOCEAN LTD VTG VANTAGE DRILLING CO Mean SDLP SEADRILL PARTNERS LLC SDRL SEADRILL LTD

$ 20.22 $ 2,663 $ 7,532 $ 11.71 $ 2,459 $ 6,051 $ 6.58 $ 1,051 $ 1,910 $ 36.90 $ 4,583 $ 7,669 $ 54.20 $ 60.35 $ 59.55 $ 37.62 $ 49.03 $ 1.88 $ $ $ $ $ $ 3,467 8,391 13,907 9,533 17,671 568 $ $ $ $ $ $ 6,323 10,878 20,190 18,011 30,770 3,374

0% 0%

0% 100% 51% 89% 27% 2% 17% 12% 6% 50% 16% 0% 52% 40% 17% 62% 63% 14% 50% 43% 0% 54%

$ 6,429 $ 11,271 $ 33.12 $ 1,370 $ 1,726 $ 46.95 $ 22,031 $ 39,515

$ 366 $1,351 $ 682

0% 100% 100% 1% 45% 46%

Table 5:

Using Peer's Valuation Metrics PACD's Value per Rig ORIG's Rigs Implied EV (-) Current Net Debt (-) Newbuild Payments Equity Value Implied Value per Share Upside Peer's P/TBV ORIG's TBV Implied Value per Share Upside

750 11

PACD's EV/2015 EBITDA ORIG's '15 Consenus EBITDA Implied EV (-) Current Net Debt (-) Newbuild Payments (a) Equity Value Implied Value per Share Upside

7.5x 1,010

$ 8,250 $ (3,032) $ (1,836) $ $ 3,382 26 27% 1.3x 22 29 43%

$ 7,576 $ (3,032) $ (1,311) $ $ 3,232 25 21%

$ $

(a) Doesn't include CapEx for the 11th rig being delivered in 2016 since that's not included in 2015 EBITDA.

Closing the Valuation Gap through Dividends and MLP Formation

The Board recently approved the companys first dividend for $25mm, which will be paid from cash flow in 1Q14. This will equate to a 4% yield and should grow significantly over time considering the excess cash flow ORIG will have once its entire fleet is complete. In addition and as part of this effort, the company will form an MLP that will go public in 2Q14. The plan is to likely sell a minority interest in its four rigs built in 2011 to this MLP entity. Over time, Id e xpect ORIG to drop down its five assets being completed between now and 2015. Seadrill Partners (NYSE: SDLP) is the only offshore driller structured as an MLP and it currently trades for $1,350mm per rig. Assuming (i) a 40% interest in nine of ORIGs rigs are sold to the MLP (3.6 rigs), (ii) each of those is valued for $1,350mm, and (iii) the retained interest of rigs held at ORIG (7.4 rigs) is appraised at $750mm per asset, then the implied share price is above $40 or 2x todays price (Table 6). SDLPs parent Seadrill Ltd (NYSE: SDRL) trades at an 8% dividend yield (Table 5). Im

IB Equity Research
November 11th, 2013

forecasting ORIG to generate $470mm of excess FCF after debt amortization once its rigs are complete (Table 3). Applying SDLRs 8% dividend yield to $470mm would result in a $45 share price (Table 6).

Table 6:

Impact of MLP on Valuation Rigs per Rig Value Non-MLP 7.4 $ 750 $ 5,550 MLP 3.6 $ 1,350 $ 4,860 Value of Rigs (-) Current Net Debt (-) Newbuild Payments Equity Value Implied Value per Share Upside $ 10,410 $ (3,032) $ (1,836) $ $ 5,542 42 108%

Excess FCF Dividend Yield Equity Value Implied Value per Share Upside

Non-MLP $ 469 8.0% $ $ 5,863 45 120%

Creating the Assets at a 35% Discount to Replacement Cost Providing Downside Protection (Table 7)
At ORIGs current price of $20 per share, an investor is effectively paying $7.5b or $685mm per rig after factoring i n construction payments outstanding. Based on its current backlog, ORIG should generate $2b of levered FCF, so this reduces the implied cost basis to $5.5b or $500mm per rig. Assuming that customers exercise their options to extend contracts, then this will generate another $0.9b of FCF and result in a cost basis of $425mm per rig. This effectively implies that youre buying ORIGs assets at a 25% to 35% discount to their replacement cost of $650mm each. Rig prices haven t been below $500mm since 2005.

IB Equity Research
November 11th, 2013

Table 7:

Implied Value Paid per Rig Share Price Shares Market Cap (-) Current Cash (+) Current Debt (+) Newbuilds Payments Remaining Current EV Value per Rig (-) Levered FCF from Contracts Value Paid for the Business Value per Rig after Contracted FCF (-) Levered FCF from Extensions Value Paid for the Business Value per Rig after Extensions

$ $

20 132 2,663 (529) 3,561 1,836 7,531 685

$ $

$ (1,994) $ $ $ $ $ 5,537 503 (870) 4,666 424

Conclusion
ORIG has a premium set of assets covered by customer contracts that will increase EBITDA by 2.5x, yet its 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. Id e xpect ORIGs value to appreciate as more details on the planned MLP are released. If not, then youre 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.

IB Equity Research
November 11th, 2013

Financial Summary
($ in MMs)

Rigs Available Days Utilization Revenue Earning Days Dayrate Drilling Revenue Y/Y EBITDA Margin Cash Interest Expense Cash Taxes Newbuild CapX Maintenance CapX in NWC / Other Levered FCF Debt Principal Payments Excess Cash Flow After-Tax Int Exp Newbuild CapX in NWC / Other Recurring Unlev FCF Net Leverage

2008 2

Actual Results 2009 2010 2011 2 2 6

2012 6

2013 6

Estimates 2014 2015 9 10

2016 11

1,995 3,090 3,530 3,895 96% 93% 93% 93% 1,908 2,858 3,265 3,603 $ 539 $ 549 $ 566 $ 567 $ 219 $ 388 $ 406 $ 77% 5% $ 117 $ 234 $ 266 $ 54% 60% 66% (23) (52) (10) (17) - (131) (17) (14) (64) 175 $ (43) (18) (705) (7) 17 700 $ 942 $ 1,028 $ 1,568 $ 1,850 $ 2,044 72% 35% 9% 52% 18% 11% 371 $ 295 $ 53% 31% (32) (73) (31) (41) (1,865) (212) (78) (98) (37) 98 514 $ 749 $ 936 $ 1,055 50% 48% 51% 52% (145) (50) (686) (106) 24 (252) (78) (916) (51) 846 22 64 $ 50 131 (175) 41 705 (17) 31 1,865 37 70 212 (98) 2.2x 138 686 (24) 5.9x 239 916 4.8x (248) (92) (920) (56) (191) 235 920 4.2x (230) (102) (62) (191) 219 3.1x

5 $ 196 $ (490) $ (1,673) $ (32) $ (449) $ (548) $ (381) $ 660 $ 298 $ (572) $ 469

90 $ 201 $ 239 $

260 $ 152 $

352 $ 607 $ 774 $ 879