Investment overview
Among offshore drilling stocks, I have consistently maintained a positive view of Diamond Offshore Drilling Inc. (DO, Financial). While the stock has declined 15% in the last year, I see this sideways to lower movement as a good opportunity to accumulate for the medium to long term.
After reporting fourth-quarter and full-year 2016 results, the outlook for the stock remains bright for fiscal 2017. The stock has declined to $16.25 from December 2016 highs of $21.08. This correction is an opportunity to buy as the company is likely to deliver decent numbers through 2017.
Before discussing company-specific factors that will serve as upside triggers, I want to mention that I am bullish on oil through 2017 and positive sentiments for the energy industry will also contribute to stock upside. The OPEC and non-OPEC members are in compliance with the production cuts, which is good for narrowing the demand-supply gap. Further, as tensions with Iran escalate again, oil is likely to remain firm.
Strong backlog support
For the year ended Dec. 31, 2016, Diamond Offshore reported revenue of $1.6 billion. For the same period, the company had an order backlog of $3.6 billion, which implies 2.25 years of revenue visibility based on fiscal 2016 revenue. As the industry continues to face challenging times, the revenue visibility is robust and will ensure that the company’s financial health remains strong.
Further, as of third-quarter 2016, the company’s order backlog for fiscal 2017 was $1.5 billion. Assuming minimal backlog additions for 2017, Diamond Offshore is likely to report revenue in excess of $1.6 billion for the year. Therefore, after a slump in revenue in 2016 as compared to 2015, revenue is likely to stabilize.
It is also important to note the company has an order backlog of $1.1 billion for 2018. I expect industry recovery to gain traction from the second half of 2017, which will ensure fiscal 2018's backlog is healthier compared to 2017.
The key point here is that industry conditions have bottomed out and recovery might be gradual, but there are better days ahead for Diamond Offshore.
Decent EBITDA outlook
With revenue of $1.6 billion for fiscal 2016, Diamond Offshore reported EBITDA of $706 million, implying an EBITDA margin of 44%. Further, the company reported operating cash flow of $647 million, implying an EBITDA cash conversion ratio of 92%. As a result of these strong numbers, debt servicing was smooth in 2016 and the company also paid for capital expenditure throughout the year using internal cash flows.
For 2017, if it is assumed the EBITDA margin remains stable at 44%, I am expecting EBITDA to be in the range of $700 to $750 million on a conservative basis. The assumption is conservative because it assumes no backlog additions during the year. Therefore, it would not be surprising to see EBITDA in excess of $800 million if positive sentiments continue for the industry.
The bottom line here is that Diamond Offshore will report decent numbers for fiscal 2017, which will ensure the stock does not see negative action unless there is another drastic reversal in oil prices.
Strong fundamentals
Diamond Offshore has strong fundamentals when compared to other struggling drillers like Seadrill Ltd. (SDRL, Financial), which is currently undergoing restructuring. The company’s fundamentals will remain strong in 2017 and potentially improve.
Diamond Offshore reported operating cash flow of $646 million in 2016, but with $652 million in capital expenditure, the company’s cash flow was completely used for the year. With the same operating cash flow visibility for 2017 and minimal capital expenditure expectations (no speculative rig deliveries) however, I expect the company’s cash position to swell during the year. As of December 2016, Diamond Offshore had a cash buffer of $156 million, which is likely to increase in the next 12 months. I expect the cash buffer to be used for deleveraging, which will improve the company’s fundamentals.
Another important point is the company had cash interests of $54.4 million for the first nine months of the year, implying annual cash outflow of $70 million. Even if EBITDA for 2017 is at $700 million, Diamond Offshore has EBITDA interest coverage of 10 times. Based on this, there are minimal concerns for the company’s creditors and as industry conditions gradually improve, so will its credit health.
Conclusion
Considering these factors, Diamond Offshore is certainly worth considering at current levels. The company’s fundamentals are strong and a robust backlog will ensure its financial health remains strong.
The company has a quality fleet that will be well positioned for industry recovery. Although EBITDA margins may remain under pressure (relative to peak activity prior to crisis), the company’s cost control will partially offset the decline in day rates.
Overall, Diamond Offshore is a value pick and I expect the stock to perform well in the next 12 months after being largely sideways for the past year.
Disclosure: No position in the stocks discussed.
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