Diamond Offshore: Uncovering Value

Includes: DO, L
by: Hester

If you are a value investor, then you are a contrarian. You have to be, the two just go together. When a stock becomes unpopular, or faces short term/temporary problems, even great businesses will see their stocks plummet. These stocks are anologous to diamonds in the rough.

A diamond that has recently been dropped into the rough is Diamond Offshore (NYSE:DO) (bad puns intended). DO is an offshore oil and gas drilling contractor, which operates offshore semisubmersible drilling rigs and jackup rigs.

Business Quality

I typically don't like to invest in cyclical, capital intensive companies. However, DO is different than most companies in their industry. They have steady free cash flow, with great prospects for the future. DO is also an excellent business, with a giant moat, one of the biggest moats of any company I've owned. They possess many competitive advantages, one of them being asset size.

This is a very large barrier to entry for anybody wanting get into the offshore drilling business. There are plenty of people that can start an internet company or a clothing company almost overnight, but I don't know a lot of people who can start an offshore drilling company overnight. A brand new offshore rig will probably cost you $600-$700 million. Even a used, fully operation rig will cost at the very least $100-$200 million dollars, and that is just for one. DO currently has 47 rigs. Even if you or your company has $150 million laying around, good luck securing a contract with a reputable oil/gas company. Why would ExxonMobil (NYSE:XOM) hire you when they can hire somebody they trust, who has been drilling for years.

Another advantage they have is technology. Technology suppliers for Diamond Offshore have to stay on the cutting edge in order to keep DO as a customer. This leads to continually better and cheaper technology for DO that allows them to do things that improve their business and profits, like drilling deeper and increase efficiency.

Diamond Offshore also a very large and respected company. They have been in business for years and have been working with the world's largest oil/gas companies for decades. These relationships are important as well. All of these competitive advantages help guard against new competitors, but these advantages are all shared by DO's largest competitors. However, DO has a few advantages over their direct competitors.

Tisch Family: A Value Approach

No discussion of DO would be complete without discussing Loew's Corp (ticker: L), as they own about half of DO. Loews has been run by the Tisch family for decades. They are value investors who basically try to buy entire businesses or assets at distress prices when they are out of favor.

This relationship is critical to DO. Under current management, with guidance from the Tisch family, DO reinvests in their business just like a value investor would. 2/3 of corporate acqusitions don't work out, because most managers don't have a value philosophy. Diamond Offshore/Loews does. They only buy or upgrade new rigs when they can at cheap or distressed prices.

Offshore drilling is a very cyclical industry, but DO benefits from this greatly. The offshore drilling "herd" usually spends most of their growth capital expenditures (i.e., they grow their business) during boom times, when oil is high, equipment is expensive, and the economy is good. These companies usually gorge on debt and buy overpriced equipment.

DO does the opposite during boom times. They lock in contracts for as long as possible (which helps smooth normally cyclical earnings). This is evidenced by the huge backlog they have carried during the recession, which is currently over $9 billion. Instead of growing their business by buying new, overpriced equipment, they just pass their profits on to shareholders in the form of dividends. During a bust cycle, most drillers don't buy any equipment and may even sell at distressed prices to pay off debt. This is where DO swoops in and buys a dollar worth of equipment for 60 or 70 cents.

The economic business cycle for DO is akin to farming. The bust cycle is spring, where DO purchases the seeds (equipment/upgrades) and plants. During the boom cycle DO sits back and reaps their harvest (profits) and passes the harvest on to shareholders (dividends). This management attribute is a huge advantage for DO.

Another advantage is having L as a sort of parent. L is well capitalized and currently has over 2 billion dollars in net cash on their balance sheet. If DO ever needs access to capital, they don't necessarily have to rely on the kindness of strangers (the capital markets). DO could always draw on Loews if they really needs the capital.


DO typically trades at a p/e of between 15-20. It is warranted, considering DO's past growth and business quality. Revenue has grown at about 24% and 31% over the last 10 and 5 years respectively, and cash from operations have grown 28% and 29% over 10 and 5 years respectively. DO is currently trading at a p/e of about 6.7, but there are some modifications that need to be made. First, I add the debt to the market cap and subtract cash/short term investments to get the enterprise value. Also, depreciation is lower than maintenance capex. Management, in a recent conference call, said they expect about $510 million in maintenance capex per year going forward, so I'll take $600 million maintenance capex (to be conservative). Depreciation/amortization and a few other non cash charges equals only about $400 million. $600 - $400 million equals $200 million, so that is the amount I will take off of earnings to account for the lower depreciation. After these necessary modifications to earnings are made the p/e comes out to just over 8. At this price you are getting any growth for free. The long term return on stocks is about 10%, and the earnings yield on DO is about 12.5%. As long as DO creates at least 1 dollar of value for every dollar retained, investors in DO can expect to outperform over the long term as long as earnings can be maintained at these levels. If they grow anywhere near where they have in the past, then buyers at these levels have a huge margin of safety. I believe DO will continue to grow at a decent rate.

Tailwinds for Continued Growth

A great potential growth driver is access to deeper water. Over the years DO's average drilling depth has gotten deeper and deeper. The amount of rigs that are capable of operating in water of 3,500 feet or more have gone from 3 to 14. The average nominal depth rating on their high specialization submersibles has gone from 5,780 feet to 7,400 feet. Why is deeper better? Most drillers operate shallow Jackup rigs. These are cheaper, but they can only drill up to 400 feet. The competition is fierce in this area, and reserves are getting more and more depleted each year. Only 11% of DO's revenue comes from jackups. Most competitors' rigs derive a high percentage of revenue from jackups. Going into deeper water exposes DO to untapped reserves, and substantially less competition.

Another growth driver is increased oil demand. Talking long term, I believe oil demand will rise substantially in emerging market countries, and I believe we will eventually see US and other countries have increased demand. Fortunately for DO, but perhaps unfortunately for society, we are as dependant on oil and gas as ever, and I think it is fair to say that it will be a long time before all of us will be running our cars on solar or wind generated power. Higher oil prices/demand should produce higher day rates and higher rig utilization rates that would add to profits as well.

The Recent Headwinds

The Obama administration recently announced that they are extending a moratorium on permits for new offshore drilling. They also unexpectedly halted all drilling of deepwater wells, but at the time I am writing this we don't know for how long. This magnified the near term uncertainty for offshore drillers. In addition to this and the BP spill, the general market sell off, and the fact that Diamond Offshore recently had an accident on one of their drillers where two people died, the market has sent DO's stock down faster than a sinking oil rig.

The BP/Transocean oil spill itself isn't a direct risk to DO, but it is indirectly a risk because it leads to increased regulation. There are different regulatory actions that would effect DO. A short term ban on deepwater offshore drilling has happened, and as long as it is short term, long term investors at these prices will be rewarded when the ban is lifted and business returns to normal. A permanent/long term ban on deepwater offshore drilling (highly unlikely in my opinion) would be just a short term problem as well. DO would be effected at first, but the American demand that was previously satisfied by the supply created from deepwater drilling would not disappear. DO would have to relocate rigs to different parts of the world, which is a long and unprofitable process. However, the American demand for oil would likely stay constant and the supply will have to come from somewhere, so Diamond's drilling that is lost in the gulf would likely be made up for in other parts of the world that would provide the supply to meet America's demand.

DO has also been minimizing their exposure to the Gulf of Mexico since 2005. In a worst case scenario, if all Gulf of Mexico revenue/profits were lost and all the rigs were coldstacked, then DO would still probably be trading at a p/e of around 11-12. For a high quality company with plenty of growth potential, that is a pretty good worst case scenario.

If you are willing to look out a few years in valuing this business (as opposed to looking out a few quarters like the market does), then the short term problems shouldn't dissuade you from picking up this great company at a great price.

Disclosure: Author is long DO and short DO puts

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