Diamond Offshore Works to Stay Afloat

Diamond Offshore is the offshore drilling company that is 53%-owned by Loews Corporation.  The company currently owns a fleet of 17 “floaters” (self-propelled drillships and semisubmersible rigs), four of which are currently cold-stacked.

Industry Trends.  The offshore drilling industry has suffered from a decline in drilling activity since the collapse of oil prices in 2014.  Over the past few years, drilling companies like Diamond have faced tough decisions as more of their rigs have come off contract.  Warm stacking preserves the ability to put the rig back in service quickly, but it requires higher ongoing operating costs.  Cold stacking is cheaper, but the rigs run the risk of deteriorating more quickly over time.  Eventually, when there is little hope of bringing a rig back into service within a few years, the rig is scrapped.  Diamond has seen its rig count decline from 26 (with 11 cold-stacked and 2 warm-stacked rigs) at the end of 2015 to 17 (with 5 cold-stacked and 2 warm-stacked rigs) at year-end 2017.

With the rebound in oil prices since the middle of 2017, there have been more inquiries by oil & gas exploration companies about contract prices and availability and even a modest uptick in contract signings, but Diamond said in its latest 10-Q that there has not yet been a measurable increase in demand for offshore drilling services or a pickup in day rates.

Despite increasing retirements, the industry faces an oversupply of drilling rigs.  Citing industry reports, Diamond also points out that there are 40 newbuild floaters that have not yet been contracted and 90 speculative newbuild jack-up rigs with scheduled deliveries over the next 3-4 years.  Additional contract rollovers in 2018 and beyond will likely add to the oversupply, without an appreciable pick-up in demand.

In this market environment, competition is intense and most of the contract drillers have been forced to lower day rates in an effort to keep their rigs active, especially the newer and more advanced “higher specification” floaters.  Those exploration companies that have contracted for rigs has sought both lower rates and shorter contract durations (with options to extend).  Whether in anticipation of a pick-up in demand or simply to avoid the scrap heap, some contract drillers are planning to reactivate stacked rigs, despite the current oversupply.

Geographically, drilling activity has been mixed, but there have been bright spots.  Drilling in the deepwater Gulf of Mexico has rebounded this year and there is considerable interest building on the Mexican side of the Gulf.  A record number of projects are now underway in the Norwegian continental shelf, and many firms eyeing the UK sector of the North Sea.  Offshore drilling in the Middle East is also likely to rise sharply in the next few years, according to IHS Markit.  Rig tenders have also been on the rise in Australia.

So despite what seems like pervasive gloom, IHS Markit forecasts offshore drilling activity will rise over the next few years, supported by oil prices remaining at or above current levels.  Markit sees a 20% increase in active floaters from an average of 453 in 2018 to an average of 521 in 2018.  It also sees a 9.7% increase in jack-up demand from 321 in 2018 to 352 in 2020.  The increase in activity will be supported in part by the major focus of the offshore drillers in recent years to reduce project costs in order to improve competitiveness with onshore drilling.

Transocean’s CEO Jeremy Thigpen has recently been predicting an imminent recovery in deepwater drilling demand.  On his company’s Ocean Rig acquisition conference call, Mr. Thigpen said that he expects that tenders will pick-up in the latter half of 2018 and get stronger steadily in 2019 and 2020.  More Transocean customers are asking about longer lease terms, which to Thigpen is a sign that deepwater activity is on the rise.

While it is often difficult to predict the timing of the recovery, it is a fairly safe bet that demand for offshore drilling, especially in the deepwater, is likely to increase in the future.  Major integrated oil companies, like Exxon and Royal Dutch Shell, have said that cutback in exploration activity in recent years will have a pronounced effect on supply growth in future years, making it much more difficult for supply to keep up with expected growth in demand.

Oil Price Trends.  In the near-term, the timing of the rebound in offshore drilling may be affected by oil price moves.  As noted above, HIS Markit’s forecast assumes that the increase in the price of (WTIC) oil off the low of around $42 per barrel in June 2017 to around $70 recently will prove to be sustainable.  However, there could be some near term vulnerability in the price of oil.

Oil price dynamics suggest the possibility of a decline in the price of oil.  Upward price momentum in oil has slowed since January of this year.  Oil has been rangebound since April.  The recent levelling off in the price of oil could be a pause (after which oil would then resume its upward climb) or it could signal the start of a correction.  Using Fibonacci retracement analysis as a guide and the June 2017 low of $42.05 and June 2018 high of $75.07 as the low and high water marks, oil could conceivably fall back to between $55 and $62 in a normal correction.

If a correction is in store, its severity and duration would likely influence the timing and quality of a rebound in offshore activity.  A short-lived correction might not have much impact on the trajectory of an offshore recovery.  On the other hand, a more severe and long-lasting correction obviously would.  One determining factor would likely be the trend in global economic activity.

For now, though, and without a crystal ball on the price of oil and global economic growth, investors (and creditors) will probably focus predominantly on the historical performance trends of the offshore drillers.

Recent Financial Performance.  Diamond Offshore’s quarterly financial performance has deteriorated steadily over the past few years.  Its revenues have declined each year since 2009.  While operating income has fluctuated in recent years, due to large impairment charges taken in 2015 and 2016, its EBITDA has been positive but declining steadily.  Despite the decline in EBITDA, the company has up until recently generated enough operating cash flow, even after capital expenditures, to cover its debt service obligations.  Capital expenditures were large in 2014 and 2015, due to its acquisitions of drillships and deepwater semisubmersibles, but they have come down sharply since then.

The declines in revenues and EBITDA mirror the shrinkage in its fleet.  Diamond’s actively deployed rigs declined from 13 in 2015 to 10 currently.  At the same time, average day rates for floaters have declined from around $415,000 in 2015 to just over $320,000 in the 2018 second quarter.  Although management has maintained a sharp focus on reducing costs, the decline in revenues has been too swift to preserve profitability.  As a result, adjusted EPS, which backs out impairment charges among other costs, turned negative in the 2017 fourth quarter and has been increasingly so in the first two quarters of 2018.  For the 2018 first half, Diamond reported adjusted EPS of negative $0.50.

As the business has continued its decline, Diamond has had to strike a balance between preserving the flexibility to meet an increase in demand and the need to minimize operating costs.  In the 2017 fourth quarter, however, it acknowledged that it had to act again to reduce its cost structure by restructuring its operations (and in the process, laying off more staff).  At this point, the Street is looking for the 2018 first half losses to continue (or possibly get a little worse) in the second half with little, if any, improvement in 2019.

Credit Rating Downgrade.  The deterioration in the company’s financial performance has been duly noted by the credit rating agencies, Moody’s and Standard & Poor’s, both of which downgraded Diamond’s unsecured debt rating to B2 (from Ba3) and B (from B+), respectively.  Both agencies continue to be negative in their outlook for the company.

Signs of Increasing Offshore Activity for Diamond.  Despite this troubling deterioration in Diamond’s financial performance, there was at least one ray of hope in the quarter:  the company’s contract drilling backlog increased for the first time in years from $2.177 billion to $2.211 billion.

One quarter’s change does not establish a new trend and Diamond warns investors against assuming that its contract billing backlog will be converted dollar-for-dollar into revenues.   Nevertheless, there is a strong correlation between changes in the backlog and changes in revenues.  The small, almost negligible, increase in backlog in 18Q2, combined with forecasts and trends in regional offshore drilling activity does suggest that the business is beginning to rebound (with the help of higher oil prices).

There also has been a modest pick-up in activity that coincides with the slight increase in contract drilling backlog.  The company announced agreements with BP and Anadarko related to two of its four drillships.  Anadarko extended the contract on one of its two drillships, but arranged to cancel its contract on the other, the Ocean Blackhornet, in June 2019.  BP has agreed to step in and contract the Blackhornet for two years.  It also has agreed to contract a yet unnamed drillship in 2020.

The other two Diamond drillships are contracted to Hess Corporation.  Hess’s contracts expire in 2020 with extension options; but the agreement with BP apparently anticipates that Hess will not renew on at least one of its drillships.

Diamond has also agreed to allow BP to terminate its lease on the Ocean GreatWhite,  a modern, ultra-deepwater semisubmersible, a year ahead of schedule.  That rig, which had been deployed to Malaysia is now on its way to the North Sea, where it should find a new customer.

In addition, Shell has signed a contract for the Ocean Endeavor, an 11-year old ultra-deepwater semisubmersible, which had been cold-stacked in Italy.  With the signing of the Endeavor, Diamond has four more cold-stacked rigs, two ultra-deepwater and two deepwater semisubmersibles.  Two other rigs that were listed as warm-stacked in Diamond’s 2017 10-K are now under contract to Exxon and Chevron.  Day rates for these and other recent contracts have not been disclosed.

Estimating Update Potential.  The upside potential for Diamond can be estimated by considering the potential contribution from putting its idle rigs back to work and also from a potential improvement in day rates (which would likely be achieved over time, as contracts roll-off and are renewed (unless there are provisions in the contracts that provide for re-pricing).

For the four rigs that are currently cold-stacked, I assume contract rates of $300,000 per day for the two ultra-deepwater rigs and $200,000 per day for the two deepwater rigs.  (Those rates seem reasonable given contract signings previously disclosed by Diamond, but current day rates remain somewhat of a mystery.)

Assuming 100% utilization, that works out to additional annual revenues of $365 million.  Adding this $365 million to Diamond’s 2017 revenues of $1.45 billion, I project potential revenues for Diamond of about $1.8 billion.  (Although the Ocean GreatWhite, which was formerly leased to BP is now idle, its revenues were included in the 2017 total, so this analysis does not anticipate any additional revenues from contracting out that rig.)

My pro forma “full rig utilization” model also assumes operating margins of 24.4%, which is higher than Diamond’s average 2014-2017 operating margin (excluding impairment charges, restructuring costs and gains/losses on asset sales) of 20.8%, but most of the improvement is due to a reduction in depreciation as a percent of revenues from the four-year average of 21.0% to 17.7%, which is justified by the company’s large impairment charges taken in 2015 and 2016 and on a dollar basis is in line with the current run rate.  Similarly, my assumptions produce a pro forma EBITDA margin of just over 42%, which is consistent with the company’s 2014-2017 average EBITDA margin.

From there after interest expense and taxes (at an assumed tax rate of 39%), my model produces a pro forma EPS target of $1.50 per share.  EBITDA, under this model, is about $775 million.

With that baseline level of profitability, I derive a target valuation for Diamond 7.7 times EBITDA which equates to an enterprise value of $6.0 billion.  With roughly $2 billion of debt outstanding, the target equity valuation would be $4 billion, which is just over Diamond’s current equity book value of $3.7 billion.  Given its 137 million shares outstanding, my target price on the stock is $29 per share, which represents a P/E multiple of 19.3 times.  At the current price of $17.25, Diamond’s stock trades at 64% of its book value of $27.00.  My target share price represents a potential gain of nearly 70%.

Despite the stock’s large discount from its current book value, I calculate that Diamond’s current ratio of enterprise value to rolling 12-month EBITDA is 11.0 times.  (That is based up an enterprise value of $4.35 billion and rolling 12-month EBITDA of $394 million.)  It is obvious (at least in my view) that its current share price already anticipates some improvement in both the offshore market and Diamond’s financial performance.

Yet. with a demonstrated trend of lower revenues and now operating losses and as reflected in the recent downgrades and continued negative outlooks given by the rating agencies to Diamond’s unsecured debt, there is still potential downside in the company’s financial performance, especially if oil prices enter a correction in the next few months.  For that reason, investors should at least take note of the potential downside risk on the stock.

Liquidity.  At June 30, Diamond had $419 million of cash and marketable securities on its balance sheet and, I believe, full availability under its $1.5 billion credit facility.  The company faces no debt maturities until 2023.  Under the terms of its outstanding $1.97 billion of public-traded senior unsecured notes, Diamond can issue only a limited amount of secured debt.  Thus, the credit facility is unsecured.

A quick scan of the fifth amended bank credit agreement, which was entered into in August 2016, shows only one negative covenant that could impact availability: a maximum debt-to-total capitalization ratio of 60%.  Capitalization, as defined in the agreement, is debt plus tangible net worth but Diamond does not appear to have any intangible assets.

By my calculations, Diamond would have to incur $1.4 billion of additional losses before its bank credit availability would begin to be restricted.  To put this in perspective, consensus estimates anticipate that the company will record additional losses of $250 million to the end of 2019.  Diamond also booked after tax impairment charges of about $693 million in 2015 and $535 million in 2016.

Investment Alternatives.  Given its strong liquidity position, Diamond does not appear to be in immediate danger of failing to meet its financial obligations.  Although it is possible that a near-term setback in the price of oil could delay the recovery and increase the company’s losses, it does appear that offshore market will recover eventually, probably within the next two or three years.

The simplest way to invest in Diamond would be to buy the stock; but investors who do so would have to accept the possibility of near-term downside risk.

Income-oriented investors should consider the company’s outstanding publicly-traded high yield bonds.  The best choice, in my view is the 7.875% Notes due August 15, 2025.  This was Diamond’s most recent debt offering, issued in August 2017, so it is also likely to be the most actively-traded issue.  The 7 7/8s recently traded at 102.88 (on Sept. 12) to yield 7.32%, which represented a spread of 439 basis points over Treasurys.

That yield and spread is roughly comparable to two other longer-term outstanding debt issues – the 5.7% Notes due October 15, 2039, which traded at 78 to yield 7.85% at a 478 basis point spread, and the 4.875% Notes due November 1, 2043, which traded at 71 to yield 7.44% at a 432 basis point spread.  Investors who are more worried about the downside risk of a bankruptcy filing might want to consider the 4 7/8s, because they trade at a lower dollar price.

To round out Diamond’s public debt issues, the company also has the 3.45% Notes due November 1, 2023, which recently traded at 87.2 to yield 6.43% or 354 basis points over Treasurys.

Investors who seek to limit downside equity risk might consider Diamond’s outstanding options, but Diamond’s options are not cheap. For example, with the stock trading at $17.25 today (Sept. 13), an investor could buy the January 2020 $17.50-$22.50 call spread, paying $3.63 for the January 2020 $17.50 calls and collecting $1.95 for selling the January 2020 $22.50 calls.  The net cost of trade would be $1.68, excluding commissions, or $168 for one contract.  That compares with a cost of $1,725, excluding commissions, for buying 100 shares of stock.  The trade breaks even if the stock reaches $18.88 at expiration, up 9.8% from the current price.  If the stock reaches $22.50 by expiration, up 31% from the current share price, the profit would be $3.62 or 2.2 times the cost of the trade.

To further reduce the cost of the trade, an investor may want to consider selling a downside put.  For example, the sale of the January 2020 $10.0 puts on Sept. 13 would bring in another $0.76, which would reduce the cost of the trade to $0.92 and improve the maximum payout to 4-to-1.  However, the put seller would have to be comfortable owning Diamond shares at $10.00, if the stock falls below that strike price at expiration.  Although selling that downside put would cut the cost of the trade, it would work against the goal of limiting downside risk.

September 13, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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