Diamond Offshore: A Buy On Bad News

| About: Diamond Offshore (DO)

Over the past five years Diamond Offshore Inc, (NYSE:DO) has shown a declining trend in profitability. One of the reasons for the decline in profitability is its aging fleet. According to Outfoxthestreet.com, Diamond Offshore has the oldest fleet amongst its competitors. As of 2011, Diamond Offshore's average fleet age was 31 years.

Amid Diamond Offshore's efforts to manage its costs, the company is now using this time to invest in its fleet as part of a long-term strategy. Recently, Diamond Offshore was awarded a three-year contract for Shell's (NYSE:RDS.A) North Sea operations. Due to the contract, Diamond Offshore is upgrading the Ocean Patriot. As part of its long-term strategy, in 2012 Diamond Offshore entered a contract with Hundai Heavy Industries (OTC:HYHZF) for the construction of four ultra-deepwater drillships, which will be delivered in 2013 and 2014 respectively. Recently, Diamond Offshore entered contracts for construction of the Ocean Onyx and the Ocean Apex. All of these construction projects and upgrades to their assets will give the company the ability to increase market share and profitability as well as providing its customers with some of the most advanced and reliable rigs in the business, but they will come at a cost.

Over the past five years Diamond Offshore has spent a significant amount of its cash flow from operations on capital expenditures. Listed below are the reported capital expenditures from 2008 to 2012. Please note these numbers include rig purchases.

Capital Expenditures or CAPEX are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment.

  • 2008 - $667 million
  • 2009 - $1.369 billion
  • 2010 - $434 million
  • 2011 - $775 million
  • 2012 - $702 million

As the list above indicates, over the past five years Diamond Offshore has spent an average of $789 million per year on capital expenditures.

Even though Diamond Offshore has spent a large amount of its cash flow from operations on CAPEX over the past five years, Diamond Offshore has managed to report positive free cash at the end of each reporting period.

Operating Cash Flow - Capital Expenditures = Free Cash Flow

  • 2008 - $1.620 billion - $667 million = $953 million
  • 2009 - $1.517 billion - $1.369 million = $148 million
  • 2010 - $1.282 billion - $434 million = $848 million
  • 2011 - $1.420 billion - $775 million = $645 million
  • 2012 - $1.311 billion - $702 million = $609 million

But in 2013, Diamond Offshore is expecting a large increase in capital spending. To finance the construction projects and upgrades listed at the beginning of the article, Diamond Offshore is expecting to spend $1.75 billion on capital expenditures in 2013. As stated in the 10-k, Diamond Offshore is expecting to fund these capital expenditures from next year's operating cash flow and cash reserves.

As of the end of 2012, Diamond Offshore had $335 million in cash and $1.150 billion in short-term investment, thus equaling $1.486 billion in cash and short-term investments.

Total Cash and Short-Term Investments

  • 2008 - $736.64 million
  • 2009 - $777.27 million
  • 2010 - $1.077 billion
  • 2011 - $1.236 billion
  • 2012 - $1.486 billion

As cash and short-term investments have been increasing over the past five years this indicates a strengthening of the company's financial health. The advantage of short-term investments is that they earn interest and can easily be turned into cash for expenses such as capital expenditures.

As Diamond Offshore is looking to spend $1.75 billion on its construction projects and currently has total cash and short-term investments at $1.486 billion, the company does have the ability to access a $750 million Revolving Credit if needed. In September of 2012, Diamond Offshore entered an agreement with Wells Fargo Bank (NYSE:WFC) for $750 million senior unsecured revolving credit, which will mature in September 2017. If needed this agreement could help the company support its operations and growth.

As Diamond Offshore might need to access debt in 2013 to support operations and growth, it would be important to look at management's historical return on capital employed.

Return on capital employed = EBIT / (Total Assets - Current Liabilities)

This ratio indicates the efficiency and profitability of a company's capital investments. The higher the percentage the better.

ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice-versa. A good ROCE is one that is greater than the rate at which the company borrows.

  • 2010 = $1.427 billion / $6.101 billion = 23.39%
  • 2011 = $1.252 billion / $6.537 billion = 19.15%
  • 2012 = $964 million / $6.749 billion = 14.28%

According to the list above, all of Diamond Offshore's calculated return on capital employed ratios are higher than the rate at which it has borrowed. According to my article "Diamond Offshore: Increasing Value Without Adding Debt" the company currently has a current cost of debt at 5.15%, cost of equity of 6.68% and WACC of 6.07%. The current ROCE of 14.28% is well above the company's WACC of 6.07%. This implies that management is earning more cash on its capital employed than it spent to borrow the cash.

2013 looks to be a year of financial transition for Diamond Offshore Drilling. If Diamond Offshore wants to stay competitive, the company must upgrade and purchase newer assets. These newer assets will come at a steep cost. In 2013, Diamond Offshore is estimating capital spending to be $1.75 billion on new construction and upgrades. As the company currently has $1.486 billion in cash and short-term investments this could mean the company might need to access the debt agreement with Wells Fargo for $750 million. 2013 could be a year of short-term pain for long-term gain as the upgrades and construction contracts will provide greater profit margins, thus creating more cash in the long term. Over the past five years management has proven that it is able to make money on its investments as Diamond Offshore has created more capital on its investments than it has spent on borrowing.

Over the next year, I expect that Diamond Offshore will report zero-to-negative free cash flow and a decline in cash and short-term investments. These two metrics have historically been two strong points where the company's finances have been very positive. As the company is expecting to spend $1.75 billion in capital expenditures this year, this could mean that Diamond Offshore might need to issue debt. If all of these short-term negatives get reported and create negative press around the company's finances, this could prove to be a buying opportunity as the company's new assets should provide an increase in future profitability.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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