Even as oil prices recover, there is an increasing probability that the offshore industry will remain depressed through 2017. In particular, day rates might decline when contracts are renegotiated and companies see EBITDA margins other than lower rig utilization shrink.
This might sound gloomy, but there are companies in the offshore industry that have strong fundamentals and are well positioned to navigate the crisis. I see the sustained bearish outlook in the industry as an opportunity to buy these stocks, one of which is Diamond Offshore (DO, Financial).
For the third quarter, Diamond Offshore reported revenue of $349 million compared to third-quarter 2015 revenue of $610 million. For the same period, the EBITDA was $139 million as compared to $304 million for the prior-year comparable period. While revenue and EBITDA declined meaningfully, this factor was discounted in the stock. With new orders not flowing, the rig utilization has declined, resulting in weak results.
However, my focus remains on the current backlog and the results the backlog will deliver in the next four to five quarters. As industry conditions gradually improve, the backlog is likely to be different in 2018. The key analysis would be to see if Diamond Offshore can maintain current fundamentals in the coming quarters. If this holds true, the stock is likely to trend higher.
For the next 15 months (fourth quarter 2016 and fiscal 2017), Diamond Offshore has a total order backlog of $1.889 billion. For the third quarter, the company reported EBITDA margin of 40% and if the margin is assumed to sustain through the next five quarters, Diamond Offshore has an EBITDA potential of $755 million. This would also imply an operating cash flow in excess of $500 million for the same period.
The reason for doing this analysis is that Diamond Offshore has completed its new rig program and there is no major capital expenditure coming in 2017. Therefore, with potential operating cash flow in excess of $500 million and with minimal maintenance capital expenditure, Diamond Offshore is likely to be free cash flow positive for the next 15 months.
With industry conditions remaining depressed, excess cash will be deployed to reduce debt even with Diamond Offshore having no near-term debt maturity. The company has an order backlog of $1.1 billion for 2018. I expect the order backlog to improve in the next 15 months, and this will ensure that 2018 remains a good year for Diamond Offshore from a fundamental perspective.
Considering these positives, I expect the stock to trend higher in the foreseeable future. It is important to note that the stock has witnessed deep correction since July 2016 and current levels are attractive from a 12- to 15-month investment horizon.
However, amid these positives, there are bound to be some concerns. In 2017 and 2018, I expect EBITDA margin compression to sustain as new rig contracts are likely to come with a lower day rate as compared to the period of peak offshore drilling activity. Therefore, cash flows are likely to remain weak even if the order backlog swells.
From an oil price perspective, I see better days ahead for the energy industry and oil is likely to trend higher considering the point that there can be a potential deal on output freeze by OPEC and Russia in the coming months.
Diamond Offshore is a quality name in the industry and I don’t see further downside for the stock. With current order backlog, the company is well positioned to generate enough cash flows to ensure that company fundamentals improve even as industry conditions remain challenging.
Disclosure: No positions in the stock.
