I recently discussed my offshore drilling stock pick for 2016 when I elaborated on why Rowan Companies (RDC, Financial) is a good company with strong fundamentals among offshore drilling stocks. On a relative basis, I am more bullish on Rowan Companies, but Diamond Offshore (DO, Financial) is also a quality stock, and the company’s credit profile is likely to remain strong through 2016.
If the stock performance for Diamond Offshore is considered for the last year, the stock has declined by 43% as compared to Rowan Companies declining only by 29% for the same period. However, the following point is important to note – Diamond Offshore was trading at $21.41 on July 24, 2015.
Five months down the line, the stock is trading at $21.1. In other words, the stock movement has largely been sideways even as oil prices continue to touch multiyear lows. The stock has bottomed out and should trend higher from current levels once oil starts trending higher. My view is strengthened by the company’s valuation of 4.79 (TTM EV/EBITDA), which is attractive and in line with Rowan Companies TTM EV/EBITDA valuation of 4.64.
Coming to the factors that will ensure that Diamond Offshore maintains a healthy credit profile in 2016, the company’s debt to capitalization as of Sept. 30, 2015 was 31%, placing Diamond Offshore among the less leveraged companies in the offshore drilling sector.
The most critical factor that will keep Diamond Offshore's stock performance strong in 2016 along with a robust credit profile is the company’s order backlog for the year. Currently, Diamond Offshore has an order backlog of $1.7 billion, and the total revenue for 2016 should be in the range of $1.8 billion to $2.1 billion (depending on further contracts). Even if the revenue is assumed at around $2 billion, Diamond Offshore will be generating approximately $500 million in operating cash flows.
When I discussed Rowan Companies, I mention that the company has no new rig orders, and that is one of the major positives from a free cash flow and balance sheet perspective. For Diamond Offshore, the outlook is bright on that front with one new rig for delivery in 2016. The remaining capital expenditure for the rig was expected to be $540 million as of Sept. 30, 2015. Considering the cash flow outlook for 2016, Diamond Offshore will not need to leverage further for its last new rig commitment. This is a big positive for Rowan Companies and Diamond Offshore when compared with Seadrill (SDRL, Financial), which still has significant new rig delivery commitments.
From a liquidity buffer perspective, Diamond Offshore has $1.5 billion in undrawn revolving credit facility and $141 million in cash and equivalents as of 3Q15. With low debt to capitalization, the company should utilize its credit facility in 2016 and increase its cash holdings through approximately $500 million in OCF visibility.
While these positives ensure that Diamond Offshore will have a strong 2016, continued weakness in oil prices is a major risk factor when looking beyond 2016. As an offsetting factor, Diamond Offshore has an order backlog of $1.5 billion for 2017. Therefore, the front-end loaded order backlog provides cash cushion in challenging times.
Considering these key positive factors, Diamond Offshore should be among the first offshore drilling stocks to trend higher meaningfully once oil prices start showing sustained recovery. The important point to note here is that sentiments are as depressed as possible, and current valuations will be difficult to get when recovery starts. Therefore, it makes sense to consider small exposure to quality names in the sector with a two- to three-year investment horizon.
Disclosure: No positions in the stock
