Diamond Offshore: Street Looks Past Results

Summary

• Diamond Offshore beat expectations, but I believe only cost and cash management is worth (timidly) celebrating.
• The long-awaited inflection point in the offshore drilling space, at least in what pertains to observable financial impact, seems to be out of sight.
• Absent irrefutable signs of macro improvement, I still find investing in offshore drilling too risky for my taste.

Earnings season continues for offshore drillers, with Diamond Offshore (NYSE:DO) topping revenues and earnings expectations this Monday morning. But despite the beat and the immediate positive market reaction to the numbers (the stock was up 13% pre-market at one point), I see few reasons for Diamond to celebrate profusely, particularly on the business development front. The long-awaited inflection point in the offshore drilling space, at least in my opinion and in what pertains to observable financial impact, seems to be still out of sight.

Source: Oil Guru

Diamond Offshore by the numbers

Revenues of $366.0 million built up on last quarter's momentum, when Diamond delivered the first YOY top-line improvement since the start of the downcycle. But the nearly 5% growth over 2016 levels arrived just about in line with expectations. Adjusted EPS of $0.25 was five cents above consensus, as contained opex and a better effective tax rate helped to offset some loss of drilling efficiency.

Cost and cash management, in fact, were the main highlights of the quarter, in my view. G&A ticked up sequentially, but non-cash expenses associated with depreciation (as Diamond's rig fleet continues to shrink and adapt to market realities) helped to soften the blow of declines above the gross profit line.

Drilling costs came in richer sequentially, pressuring drilling margins that reached only 45.9% this quarter vs. 50.9% in 2Q17. The deterioration is unfortunate, given Diamond's progress at driving efficiency gains into margins last quarter. But with higher-margin projects being replaced by new contracts that are likely to be barely above cash breakeven, I would be too optimistic to expect profitability to improve considerably and sustainably in the immediate future.

See summarized P&L below, for both 3Q17 and the previous quarter.Source: DM Martins Research, using data from company reports

Looking at Diamond's recently released fleet status update, not much has changed in terms of new business to support renewed optimism for the future. Sure, additional work secured on both the floater and jackup sides this quarter are always welcome, but they were unsurprisingly short-term in nature and likely inked for very low dayrates - drillers don't even bother disclosing the price tag on their services anymore. I believe contract activity this quarter had more of a headline than a meaningful financial or operational impact to the company.

Very importantly and on a more positive note, cash generation was quite robust, as the graph below illustrates. The main driver seems to have been a sizable pullback in working capital of over $65 million in 3Q17, underscoring the company's conservative approach to managing its capital - last quarter, Diamond retired five rigs to save on future reactivation costs. Now, the company's net debt position is the most favorable it has been since the beginning of the crude oil bear, in 2014, which might be the most meaningful metric coming out of the quarter's results worth timidly celebrating.

Source: DM Martins Research, using data from company's reports

Thoughts on Diamond stock

Diamond Offshore continues to squeeze all it can from a sector that fails to improve substantially. Contract extensions are rolling in, but possibly at terms that are unlikely to fuel investor optimism once the initial excitement wears off. As a result, I would be surprised to see DO maintain its initial, positive reaction to the print in the next few days and weeks, absent new developments not disclosed in the company's earnings release. On the plus side, DO remains rather affordable (see graph and table below), particularly in the context of solid cash generation and responsible cost containment.

DO EV to EBITDA (Forward) data by YCharts

Ticker/Company	Fwd EV/EBITDA	P/Tang. Book	TTM FCF Yield
Diamond - DO	6.8x	0.60x	15.1%
Transocean (RIG)	6.8x	0.29x	20.4%
Ensco (ESV)	9.3x	0.28x	-15.2%
Noble (NE)	10.5x	0.18x	-4.8%
Rowan (RDC)	6.5x	0.33x	30.8%

Click to enlarge

Source: table compiled by DM Martins Research, data from YCharts

I still find investing in offshore drilling too risky for my taste. Only if or once the tides begin to turn (a bump in crude oil prices well above $50/barrel would help greatly) and the industry sees signs of substantial improvement would I expect DO to reverse course and offset a good chunk of its sharp losses of the past couple of years.

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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.