To Buy or Not to Buy?

In the offshore drilling industry, industry factors dominate sentiments and if oil moves lower, stocks in the industry will invariably move lower (irrespective of company fundamentals).

I have discussed few fundamentally strong stocks that have provided medium-term investing or trading opportunities since the offshore drilling industry has seen difficult times.

I maintain that stance and whenever an individual stock declines sharply, there is an opportunity to make some quick gains. The key factor is to invest (even for near term) in a company that has strong fundamentals.

This article will discuss Diamond Offshore (DO, Financial), which is a fundamentally strong stock in the offshore industry but has declined sharply by 36.2% year to date. Current levels are appealing for near to medium-term gains.

Diamond Offshore bottomed out at $10.2 on July 7, and the stock is trading 10.6% higher at $11.3. This is a small example of my point of quick trading gains with a safe buffer of strong fundamentals.

Strong backlog support

For the first quarter, Diamond Offshore reported revenue of $374 million and EBITDA of $143 million, which translates into EBITDA margin of 38%. Clearly, revenue has declined on a year-on-year basis, and EBITDA margin has also compressed. Diamond Offshore continues to report decent numbers, and this is entirely backed by their existing backlog.

Just to put things into perspective, Diamond Offshore has an order backlog of $1.1 billion for the remainder of fiscal 2017, a backlog of $1.1 billion for fiscal 2018 and a backlog of $842 million for fiscal 2019.

One can conclude with some conviction that even if the backlog remains at current levels for the next two to three quarters, Diamond Offshore is well positioned to navigate the crisis.

The key point is that cash flows will sustain even in challenging times, and it’s important to note that Diamond Offshore has no speculative new rigs for delivery. This will ensure that even with relatively depressed cash flows, the company’s free cash flow remains positive.

Another important point worth mentioning is that the offshore industry can see some recovery in fiscal 2018. Therefore, I expect the backlog for fiscal 2018 and fiscal 2019 to swell from current levels and have a positive impact on the stock and the company’s credit health.

Strong fundamentals

One of the key factors to consider Diamond Offshore as an attractive near to medium-term investment opportunity is the company’s fundamentals. The following fundamental factors are worth noting:

1. Diamond Offshore reported total debt of $2.0 billion as of the first quarter; for the same period, the value of the company’s drilling properties was $5.6 billion. This translates into an attractive loan-to-value of 35%.
2. For the first quarter, the company’s debt to capitalization was 34% with net debt to capitalization of 33%. This provides ample financial flexibility and ensures that the balance sheet remains stress free.
3. Even as the company’s EBITDA declined, Diamond Offshore reported operating cash flow of $99 million for the first quarter and free cash flow of $70 million for the same period. In the coming quarters, I expect positive FCF to sustain, and that will help Diamond Offshore in building cash buffer or deleveraging.
4. For the first quarter, the company’s interest expense (net of capitalized interest) was $28 million. Considering annualized EBITDA of $570 million and annualized interest expense of $112 million, Diamond Offshore has a comfortable EBITDA interest coverage ratio of 5.0. Even if the EBITDA is relatively lower in the coming quarters, the company’s EBITDA interest coverage for the year is likely to remain above 4.0.

Considering these fundamental factors, it is clear that Diamond Offshore is well positioned and I see the company’s credit metrics improving in the coming quarters. While the key factor to note will be timing and pace of recovery for the industry, the stock looks good for near-term gains after a sharp selloff.

Conclusion

Oil has been trading in a narrow range of $45 to $50 per barrel, but I remain positive on the outlook for crude oil for the remainder of fiscal 2017 and fiscal 2018. The production cut agreement stands for OPEC and non-OPEC members and that should have a positive impact on oil price with a lag.

Further, geo-political tensions support oil prices and as India and China grow, the demand for oil will sustain. Therefore, from a 3-5 year horizon, I do see the offshore industry coming back to good times.

Disclosure: No positions in the stock.