By The Valuentum Team
The offshore drilling industry is driven by hydrocarbon demand and spending by oil and gas companies, and the group has traditionally been subject to intense price competition and volatility. Such has been the case in recent quarters, and Diamond Offshore (NYSE:DO) was forced to suspend its dividend as a result of the material pressure on earnings. Prior to the elimination of the payout, Diamond Offshore's Dividend Cushion ratio was a very concerning -5.7 (negative 5.7).
We continue to be very cautious with any operator so tied to the cyclicality of the energy markets. Though the move to eliminate its dividend has scarred Diamond Offshore's image to income investors everywhere, the move was a prudent one as far as the health of the business and cash preservation are concerned. As oil and gas companies continue to cut back on capital spending, demand for Diamond Offshore's services will continue to be pressured.
Even though Diamond Offshore has a strong balance sheet compared to its peers, it is certainly not optimal, especially for a firm tied to such a cyclical market. We're simply uninterested in the firm's shares at the moment. Diamond Offshore currently registers a 6 on the Valuentum Buying Index.
Diamond Offshore's Investment Considerations
• Diamond Offshore is a global offshore oil and gas drilling contractor with a fleet of more than 40 offshore drilling rigs, consisting of about 30 semisubmersibles and a number of jack-ups and drillships. The average age of its fleet is the highest among peers (~17 years). The company is ~52% owned by Loews.
• The company continues to navigate difficult waters. Management expects minimal contracting activity to continue, and most business is of shorter duration terms. Day rates for potential new fixtures are also under pressure, and cancellations are happening in contracts that allow such termination.
• Diamond Offshore has paid ~$5.7+ billion in dividends since 2006. On a per share basis, total regular and special dividends have amounted to $41+ per share. The firm garners a high credit rating thanks in part to its strategic partnership with Loews (NYSE:L). However, it was recently forced to suspend its dividend to add to cost savings. This came about a year after scrapping its annual special dividend.
• We're big fans of the firm's balance sheet relative to peers, though we're not exactly excited about it. The supply of newbuild rigs coming online in the next few years may pressure performance, and the uncertainty surrounding E&P spending in light of volatile energy prices remains significant.
• No contracts are ever guaranteed. For example, Petrobras (NYSE:PBR) reached an agreement in mid-2015 with Diamond Offshore to terminate deals covering a rig and drillship ahead of their original end dates. The loss to revenue backlog in this case was ~$100 million.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Diamond Offshore's 3-year historical return on invested capital (without goodwill) is 11.6%, which is above the estimate of its cost of capital of 8.3%. As such, we assign the firm a ValueCreation™ rating of GOOD.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.
Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
In the chart below, we show the probable path of Diamond Offshore's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. We assign the firm a neutral Economic Castle rating.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Diamond Offshore's free cash flow margin has averaged about -4.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Diamond Offshore, cash flow from operations decreased about 24% from levels registered two years ago, while capital expenditures expanded about 190% over the same time period.
In 2015, Diamond Offshore reported cash from operations of $736 million and capital expenditures of ~$831 million, resulting in free cash flow of -$94 million (negative $94 million). Though this is a concerning figure, it is a material improvement from 2014 levels.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Diamond Offshore is worth $22 per share with a fair value range of $18-$26. Shares are currently trading at ~$24, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
We're expecting another year of significant top-line erosion for Diamond Offshore in 2016, consistent with consensus estimates, due to continued reductions in oil and gas producers capital spending budgets. We anticipate this weakness extending into 2017, though the declines will be tempered. Earnings are not projected to recover in the near term, as the firm's operating leverage cuts both ways through the course of the economic cycle. Our expectations for capital spending are similar to that of our revenue projections in that they are tied to the price of crude oil. As the price of oil recovers, the firm should become more confident in investing
Our model reflects a compound annual revenue growth rate of -9.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of -5.4%. Our model reflects a 5-year projected average operating margin of 13%, which is below Diamond Offshore's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For Diamond Offshore, we use a 8.3% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $22 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Diamond Offshore. We think the firm is attractive below $18 per share (the green line), but quite expensive above $26 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Diamond Offshore's fair value at this point in time to be about $22 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Diamond Offshore's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $30 per share in Year 3 represents our existing fair value per share of $22 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.