Diamond Offshore: Credit Metrics Analysis Post 1Q16

| About: Diamond Offshore (DO)

Summary

Diamond Offshore has strong credit metrics that will sustain through 2016 and 2017.

I expect the company to continue deleveraging with minimal capital expenditure requirements.

EBITDA margin compression likely after existing contracts are renegotiated, but current backlog ensures strong cash flow visibility.

Even as difficult times for the offshore drilling industry sustain, Diamond Offshore (NYSE:DO) has witnessed strong recovery from a stock upside perspective with the stock having surged by 58% from YTD16 lows of $15.55. Even after the big rally, I remain positive on the stock from a credit perspective and this article will discuss the positive triggers that will help maintain bullish momentum for the stock.

With the discussion to follow, the key conclusion is that Diamond Offshore bottomed out in January 2016 and investors can expect sustained upside in the next 12-24 months. The key upside trigger for Diamond Offshore is a front-end loaded order backlog that not only provides strong cash flow visibility, but also ensures that the company's credit profile remains robust through challenging times.

I must mention at the onset that when Seadrill (NYSE:SDRL) reported 1Q16 results, the company's management was of the view that industry recovery is unlikely through 2016 and potentially through 2017. If this holds true, challenges will sustain in the coming quarters. However, for quality names in the industry, buying on dips is a good idea. The very fact that Diamond Offshore has returned 58% from lows of 2016 underscores my point that big returns can come even from depressed sectors.

Coming to the key analysis, the following points back my view that Diamond Offshore has a robust credit health and the company's financial position will remain strong in the coming 12-24 months.

First, Diamond Offshore reported total debt of $2.3 billion as of December 2015. However, by March 2016, the company's total debt declined to $2.0 billion. The company is already in the process of deleveraging and this is the right way forward with industry challenges to sustain. Further, as of March 2016, Diamond Offshore had debt to capitalization of just 32%, providing the company with strong financial flexibility.

Second, for 1Q16, Diamond Offshore reported revenue of $470 million and EBITDA of $215 million, translating into EBITDA margin of 45%. Considering the order backlog of $1.2 billion for the remainder of 2016 and assuming the same EBITDA margin of 45%, the annual EBITDA is likely to be $748 million. Considering current debt levels, the company's leverage (debt to EBITDA) comes to 2.6, which is not aggressive. Further, even considering 2015 cash interest expense of $110 million, the EBITDA interest coverage ratio comes to 6.8. Clearly, Diamond Offshore is in a strong position to service debt comfortably through 2016.

Third, Diamond Offshore has an order backlog (1Q16 report) of $1,473 million for 2017. Assuming that there is no backlog addition and assuming the same EBITDA margin of 45%, the company is likely to report EBITDA of $660 million for 2017. While I expect deleveraging to lower cash interest cost, I will still consider cash interest expense of around $100 million for 2017 and this implies EBITDA interest coverage of 6.6. With smooth debt servicing visibility even for 2017, I expect the company's overall credit health to remain robust.

Fourth, Diamond Offshore has just one new rig for delivery with the company expecting investment expenditure of $620 million for the remainder of 2016. For 2017, the company's capital expenditure will be only towards maintenance and modification. Therefore, with limited investment plans, I expect Diamond Offshore to generate free cash flow in the coming quarters and this will further the cause of deleveraging. I must add here that beyond 2017, Diamond Offshore has an order backlog of $1.1 billion for 2018 and this ensures steady cash inflow for reducing debt or building a strong cash buffer.

With these credit positives in consideration, I believe that Diamond Offshore is well positioned to navigate the crisis. More importantly, the company is likely to emerge from the crisis with a strong balance sheet and enough financial flexibility to grow at a robust pace in good times.

In my current analysis, these positive factors dominate, but there are points of concern and I would like to briefly discuss these points.

First, global economic growth remains sluggish and I don't see strong demand growth for oil consumption in the foreseeable future. Therefore, even if supply side factors are favourable for oil, the sluggish demand can translate into oil prices remaining largely sideways. This can extend the pain for offshore drillers.

Second, the current backlog offers healthy day rates, but as increasing number of rigs go off-contract, I expect day rates to decline and EBITDA margin to compress. While offshore drilling stocks might have discounted this concern, there is still little clarity on the extent of impact on credit metrics coming from EBITDA margin compression.

In conclusion, I am cautiously optimistic on offshore drilling stocks with robust fundamentals and Diamond Offshore is clearly one of the best choices in the industry. After the big rally from lows in YTD16, the stock has been in a consolidation zone and I believe that this is a good opportunity to consider some exposure to the stock. If broad markets correct and the stock decline on negative sentiments, I see this as an opportunity to further increase exposure.

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.