Diamond Offshore: A Tough Road To Recovery

Summary

• Diamond Offshore reported a net profit of $19.3 million or $0.14 per share for the first quarter of 2018. Total revenues were $295.51 million.
• The company expects slightly higher contract drilling expense in Q2 2018 between $210 million and $215 million.
• The stock is retracing now and I recommend a cautious accumulation under $16, assuming future bullish oil prices.

Image: Drillship Ocean Endeavor.

Investment Thesis

Diamond Offshore (NYSE:DO) is a dilemma from an investor's perspective due to the contradictory character of its business model. While the company has managed to survive years of struggling and shows a solid balance sheet with room to maneuver, it did not use this substantial advantage to handle these tough economic times to rejuvenate at a discount its shrinking and aging rig fleet. However, I consider the stock as a good investment due to an appealing valuation. The stock is retracing now and I recommend a cautious accumulation under $16, assuming future bullish oil prices.

CEO Marc Edwards is still procrastinating and refuses to act decisively about the need to fix the company's aging rig fleet, thinking that the offshore drilling industry may get even worse and will offer better "distressed" deals this year. However, it is not what we are experiencing at all in the Industry.

Oil majors are starting to spend money again in exploration CapEx and tendering activity is slowly increasing. Good assets have been grabbed fast directly at the shipyard (West Mira, West Rigel, etc.) with discounted sale prices lately.

Transocean (RIG) and Ensco (ESV) have been quick to recognize that this market is offering buying opportunities and acquired some good assets at a significant discount. I think Diamond Offshore should consider a merger, but I do not see a firm commitment from the company, yet. The clock is ticking.

DO data by YCharts

After listening to the last conference call, I concluded that offshore drillers could be at the bottom, but it will be a slow recovery which will take months to translate into meaningful business improvement. The question for Diamond Offshore is to adapt and have a fair share of the recovery.

Diamond Offshore - Balance Sheet history. The raw numbers

Diamond Offshore	1Q'15	2Q'15	3Q'15	4Q'15	1Q'16	2Q'16	3Q'16	4Q'16	1Q'17	2Q'17	3Q'17	4Q'17	1Q'18
Total Revenues in $ Million	620.1	634.0	609.7	555.6	470.5	388.8	349.2	391.9	374.2	399.3	366.0	346.2	295.5
Net Income in $ Million	−255.7	90.4	136.4	−245.4	87.4	−589.9	13.9	116.1	23.5	16.0	10.8	−31.9	19.3
EBITDA $ Million	−125.8	254.8	299.2	−222.4	213.0	−536.9	140.3	187.1	145.3	106.2	108.0	217.5	85.0
Profit margin % (0 if loss)	0	14.3%	22.4%	0	18.6%	0	4.0%	29.6%	6.3%	4.0%	3.0%	0	6.5%
EPS diluted in $/share	−1.86	0.66	0.99	−1.79	0.64	−4.30	0.10	0.84	0.17	0.12	0.08	−0.23	0.14
Cash from operations in $ Million	160.6	40.3	265.8	269.8	241.3	64.1	186.5	154.6	98.7	78.2	189.8	127.2	83.8
Capital Expenditure in $ Million	197.0	489.1	72.2	72.3	58.1	475.3	64.8	54.4	29.5	42.4	28.8	38.9	31.5
Free Cash Flow in $ Million	−36.5	−448.8	193.6	197.4	183.2	−411.2	121.7	100.1	69.2	35.8	161.0	88.3	52.3
Cash and short term investments $ Million	199	112	155	131	134	103	81	156	123	161	277	376	430
Long term Debt in $ Million	2,245	2,620	2,488	2,266	1,980	2,308	2,163	2,085	1,981	1,981	1,972	1,972	1,973
Dividend per share in $	0.125	0.125	0.125	0.125	0	0	0	0	0	0	0	0	0
Shares outstanding (diluted) in Million	137.15	137.20	137.20	137.16	137.21	137.17	137.25	137.17	137.25	137.23	137.24	137.23	137.50

Click to enlarge

Note: Most of the data indicated above come from Morningstar and company filings

Trends and Charts: Revenues, Earnings Details, Free Cash Flow and Backlog discussion

1 - Quarterly revenues

Diamond Offshore reported a net profit of $19.3 million or $0.14 per share for the first quarter of 2018. First-quarter results included a favorable non-cash tax adjustment related to tax reform further restructuring costs and a gain from the sale of a cold stacked rig Victory. Excluding these two items, Diamond had an adjusted net loss of $21 million or negative $0.16 per share.

Contract drilling revenues were $288 million during the quarter, down 15% compared to the fourth quarter of 2017. The company expects slightly higher contract drilling expense in Q2 2018 between $210 million and $215 million.

2 - Free cash flow

DO has generated $337.40 million in FCF ("TTM") in 2017 with $52.3 million this quarter alone. That is quite an achievement looking at the offshore drilling struggle.

Thus, DO passes the FCF test.

3- Quarterly Backlog history and discussion

Note: The Ocean Endeavor work is not in the $2.2 billion. That backlog number is as of the end of the quarter, and the Endeavor gig was announced subsequently.

We notice that the backlog has been going down regularly since 2015, and it is difficult to predict a bottom for the company despite a better oil price environment.

In fact, the fleet status shown in detail below clearly indicates a situation of apparent weakness, in my opinion, that may last longer than previously expected, unless the company decides to act firmly and move towards a merger to revamp the company's weak fleet. I favor a merger because the company needs a serious revamping.

Marc Edwards, the CEO, said in the conference call:

Now turning to our contracting activity. We are pleased to announce that we have secured additional work for the Ocean Apex and the Ocean BlackRhino. And we have been awarded the multi-year Penguins work for the ocean Endeavor in the North Sea. As we shared on our last call, Diamond entered into an option period earlier this year with Woodside for the Ocean Apex. Woodside has elected to exercise the option and the rig will begin work in the second quarter of 2019.

As to the Ocean Endeavor, we have been awarded a 12 plus two option well contract that will keep the rig working for at least two years. We will accelerate startup activities to prepare the rig to commence work in the first half of 2019.

Total backlog is now $2.2 billion, which is down another $0.2 billion from last quarter. The company recorded a small gain related to the sale of Ocean Victory which was previously classified as held for sale.

The company indicated that the dynamically positioned floater category is still facing many headwinds, whereby the supply-demand gap is still wide, though it has narrowed from the lows of 2017. Marc Edwards thinks that the industry may be close to approaching a bottom in both utilization and pricing alike. However, he is skeptical about a quick pricing recovery.

On the other side, in the moored segment, signs of a recovery are more prominent as the company continues to see an increase in tendering activity. The North Sea market particularly has tightened and opportunities to start modestly pushing pricing, not just in the harsh environment segment, are apparent.

Note: As CapEx guidance, the company is expecting maintenance capital costs of approximately $220 million for the full year 2018.

4 - Net Debt

Net debt is now $1.543 billion with a net debt-to-EBITDA ratio of 2.99 which is good and means that the company can repay its net debt in about three years based on its EBITDA ("TTM"). It is one of the best ratios in the offshore drilling industry and a sign of financial strength.

Commentary and Technical Analysis

Diamond Offshore presents a questionable business model for investors as I explained succinctly in my introduction.

On the one hand, Diamond Offshore is offering a rock-solid balance sheet, but on the other side, the fleet presents many weaknesses, and the company will have to address them sooner or later if it wants to support the company's cash flow needs in the future.

The weak company fleet is a disadvantage in this very competitive market, and DO needs to use its strong balance sheet to solve this dangerous imbalance. I have been saying this since January 2017, and I was hoping that Marc Edwards starts to move in that right direction, but his actions and comments lately are not encouraging.

Technical analysis

DO is forming a typical ascending triangle pattern with a line resistance formed by a double bottom at nearly $20 (Sell flag) and rising line support at about $15 (Buy flag). I see first support at $16 (Weak Buy flag) now, at which point it is a good idea to accumulate again DO. However, it is critical to adopt a strategy that integrates the price of oil. If the oil price momentum continues strong, the retracement will be smaller. I recommend a Hold right now for DO.

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Analyst’s 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.