Diamond Offshore: Analysts Must Adjust Estimates Downward

Diamond Offshore (DO) is the premier offshore drilling company that has benefited from the rise in crude prices. Unfortunately, crude oil has fallen dramatically and those high dayrates will be a thing of the past. This is evident in similar industry companies such as Dryships (DRYS), whose dayrates have fallen dramatically as demand is sapped and there is overbuilding of ships. Fortunately, the offshore drillers have not built as many new drill ships, as the time and cost causes a lag time.

The risks of cancellation are not as prevalent as the break-up fees and dissolution of the contract will undermine the cost effectiveness of such moves. Furthermore, none of the integrated oils want to dismiss the few players in the sector and cause stricter restriction on their company with future rig contracts.

The major companies such as BP (BP) and Chevron (CVX) will just wait until the contract comes due and will negotiate lower dayrates, as the current high dayrates are making them lose money on the drilling of the oil. Therefore, once the inevitable contracts rollover, the downside risks to stocks such as Diamond Offshore is tremendous as they will showcase the ultra premium offshore platforms losing their edge. The steel companies are prime examples of how lower pricing causes the street and growth managers to drop a stock precipitously.

I can envision it right now on CNBC: "Breaking News - deep water driller Diamond Offshore just negotiated their premier Ocean Star with rates half of what they once were." Then, a stock that was projecting earning $11.46 in 2009 and $12.92 in 2010, will soon have its estimates cut in half in a matter of days, just as U.S. Steel (X) was supposed to earn $22 in 2009 and most likely will earn closer to the top-down analysis of $1.85.

Investors need to be prepared for coming earnings estimates revisions as the bottom-up analysts are always slow to adjust their numbers downward.

Disclosures: Long U.S. Steel (X). No current positions in DO, BP, CVX, DRYS

Comments

[CM in MA:]

Scott, point taken that DO will probably have EPS estimates taken down. Here are my random thoughts about DO for investors with a long time horizon if DO does decline following any revisions (disclosure: long DO for nearly ten years).

- Coming out of the last recession, DO had negative EPS making EPS multiples a useless metric for a buy point. At that time, DO traded at a low of roughly 3x sales. Chop projected sales in half (too aggressive in my opinion) and one gets a range at the low of $36-$45 at a 3x sales multiple.

- Remember where this company came from. It took its current form through the purchase of distressed assets by Jim Tisch. The Tisch family knows value, and when listening to the conference calls (I do) it comes through that these guys are preparing to get stronger during any future downturns. They didn't follow the merger path after Transocean / Global Santa Fe because they didn't see any significant savings based strictly on size. They haven't chased new builds aggressively. They are waiting and prepared for a downturn.

- The special dividend, now at $7.50 annually, is paid out in quarterly increments providing flexibility to the payouts. The term nature of the contracts in place will provide sufficient cash flow to either continue the special dividend (if only at a reduced level) or, if eliminated, permit that cash to be redirected to buying additional rigs from marginal and/or leveraged companies. This would be in keeping with the company's value-oriented history.

- As with any company with high fixed costs, when times are good the cash flows right to the bottom line. This company rewards shareholders with special dividends, thereby allowing them to quickly recoup part or all of their initial investment while still holding shares. They also are conservative in using cash to take on additional capacity, only doing so when they are certain the long-term profit prospects look good.

So, sure the shares may come down in price. Per your last sentence, investors need to be prepared. That would mean be prepared to pick up shares in a well run company with good prospects. A new investor in DO might not pick the bottom, but they will be highly rewarded when oil goes higher.

2008 Dec 09 08:45 AM

[Tom Armistead:]

Agree with CM's analysis, reduce sales estimates and apply the P/S ratio from the previous low point.

2008 Dec 09 10:08 AM

[Crude Oil T...:]

Don't look for the drillers to suffer long term. As inflation roars back this time around, the dollar will drop at a dramatic rate. Sending crude through the roof. This could happen as early as spring of 09 so don't look for the drillers to lag for years to come. The American consumer could only dream.


Great post!

2008 Dec 09 12:19 PM

[Mad Hedge F...:]

The diamond market has crashed. Recession plagued wholesalers and retailers in the US, which account for half of world demand, are glutted with stagnant inventory, and have watched helplessly as prices dropped a third from the 2007 peak. De Beers has shuttered its Botswana mine, which supplied a quarter of the world’s rough sparklers. Diamonds account for a third of the African country’s GDP and 80% of its foreign exchange income, and now Standard and Poor’s is threatening a sovereign ratings downgrade. Was there ever a better time to drop down on one knee and make that marriage proposal?

Mar 13 05:48 PM