Wednesday, 22 March 2017

Diamond Offshore Drilling - A cyclical value idea (NYSE:DO)

I have held some shares in Diamond Offshore (NYSE:DO) since 2014. Unfortunately. The reason being they seemed quite good value back then despite the breather in the oil market. Looking for value one does tend to sometimes jump in too early in the cycle as I had not foreseen such a prolonged drop in oil prices. 

Diamond Offshore is an oil rig leasing company who commission and operate rigs for a variety of oil majors and minors across the world. Historically they have a large fleet of relatively shallow water rigs for drilling in the Gulf of Mexico and associated areas. But more recently DO have invested heavily in ultra deep-water floating rigs. This was presumably in response the oil price boom from 2006 onwards where many offshore deep-water discoveries appeared more economically viable as oil headed north of $100 (both in 2007 and 2011). DO therefore commissioned a number a rather expensive rigs to be able to respond to market demand as this was the time of offshore Brazil discoveries, Shell drilling the arctic etc. Ultimately it is a good business plan as oil will only get harder to find and extract over the future forcing companies to drill in deeper and deeper waters. However the collapse in the oil price in 2014 has led to a major capex drop across the industry as unconventional oils become economically nonviable. Hence DO has a lot of nice new rigs and nobody wants to borrow them to drill!

This is an industry wide problem for oil services and in particular offshore services because of the onshore shale oil boom in the US. It appeared that with OPEC cuts oil prices might rise but the increased competitiveness of US shale costs mean that for now at least they can expand production onshore for less risk and less cost than offshore. The glut of oil building in the US is thus weighing on global prices and keeping deep sea oil under the sea. The majors will cut expenses and a drilling services company like DO is left high and dry - they are very leveraged to the cycle - more so than the integrated majors who can fall back on low cost production and refining.

It doesn't help that basically the huge glut of rigs across the industry is creating an overcapacity problem. Therefore DO is facing similar pricing power problems that one finds in the shipping industry. Ultimately then the fate of the stock price performance relies on a significant rise in crude oil prices, most likely past the $60 point before they can get more demand and increase both utilization and rates on the rigs. Presently a number of rigs are 'cold stacked' and this can lead to them being more difficult to recommission later so DO are running many rigs at breakeven or even below breakeven costs to keep them 'hot' and thus attractive for commissioning. 

So the first thing I ask myself as an equity investor is; will this company survive? My take is; yes, probably. 

The company made the error (in hindsight) of leveraging up by $1.5bn (to $2bn net debt) in the good period (2009-2013) and paying out special dividends totalling $3.3bn in that period. Of course cash flow generation was good, the oil market was tight so all this probably seemed like a good idea. But alas the depressed oil price has brought down cashflow generation and DO lost their investment grade rating. However with Free Cash Flow generation now the order of the day the company has managed to break even FCF in 2016 with 2017 looking to be cash generative as they have finished the major capex to complete their last ultra deepwater rig 'Ocean GreatWhite' in 2016. 

How to lever up at the wrong time - you are meant to enhance ROE!

If revenues can hold up around the present level (currently >70% revenue is ultra deepwater) then with effective cost control the company should be able to begin paying down debt. Debt maturities are low risk given that only $500m of debentures are due in the next 5 years (2019 note) and the residual $1.5bn is due in the period 2023-2043. However gearing is high by historical standards with debt at 51.4% of equity and I make net debt 2.8x EBITDAX. (For comparison in 2008 before they geared the balance sheet it was 5% and 0.08x - a shrewd policy for a cyclical operational leveraged company - which was unfortunately abandoned. Anyway the debt metrics look manageable at this point provided the revenues don't deteriorate much further. It is hard to see any capex going ahead now except maintenance so the company can be run for cash. So it should survive. 

For what it is worth DO is controlled by Loews Corporation which is a conglomerate whose other interests include insurance, gas pipelines and hotels. They may also be able to provide a backstop to DO should they need it - but I am a little suspicious as it was probably Loews who leveraged up the company in the first place to extract the dividends. For what it is worth Loews has substantially outperformed DO but rather under performed the S&P in the past 5 years:

Google Finance

Now does this leave any value for equity holders? I think again; yes. I was definitely too early to this one having lost > 50% of the value of the shares I bought (around $35-45) and I bought on the way down from $65. 

Now the stock definitely has value if we try and adjust for the cycle. For instance Return on Assets over the past 10 years has averaged 10.8% - now those are some boom years, and some bust years. But even discounting a long run ROA to 6% with an asset base of $6bn this company should be generating a normalised profit of $367m per year. Now if you put a conservative value of 10x on those earnings you have a stock worth $26.80 a share. Now yes there are various adjustments to consider given the use of ROA. But it gives you a picture of the massive excess capacity they currently have. 

This stock is definitely trading below intrinsic value. You can buy it for 0.56x book value ($27.33 a share) even after $1.6bn of impairments on rigs over the past 3 years. Most of that asset value must be tied up in the ultra deep-water rigs (assets are not disclosed by type) - but we know the GreatWhite cost around $500m and DO has 7 more submersibles built since 2000 - so maybe these are worth $3bn in total - now add on the 4 drill-ships all built since 2014 and that is the other $2.5bn. This means I think one is getting 6 deep-water, 5 mid water and a bunch of jack up rigs effectively for $500m. Now that said all 4 drill ships are currently in use in the Gulf of Mexico but only 4/8 deep water rigs are in use (the newer 4) so further impairments could be on the cards. But even so I perceive a margin of safety here. [Note DO have around $250m at risk on 2 rigs in Brazil as Petrobras wants to terminate the contracts - however these are held up in a Brazilian court - which knowing Brazil means by the time they settle the oil price may have recovered.]

So the remaining question is; when? If the earning power is there but the market is dead it doesn't matter what the value is. DO needs the cycle to turn and the current US resurgence in shale is keeping global prices depressed. However shale oil attrition in the wells is a major issue. It is unclear for how much longer costs can stay down in Shale. At some point the capital cycle of chronic under-investment in the wider industry has to turn and given the 3 year stretch of depressed earnings at DO I would argue it may turn soon, and the stock will rise ahead of that shift.

Now my intuition tells me we may be closer to this than one thinks - just because of all the news flow  about booming US onshore production, OPEC, Hedgies dumping their long oil commodity positions etc. 

Things change. But the value investor has time on his side - I don't think DO will go bust - I think it is bottom fishing time. I may be wrong but I think cyclically this could be a good time to add to my position. At least to dilute my book cost base!

Disclosure: I have an established modest long position in NYSE:DO. These are opinions only, not investment advice. If in doubt read my disclaimer.

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