In terms of earnings numbers, I believe the 2015 estimate of $8.66 is too high because: (1) the street’s day-rate assumptions on older rigs are too aggressive, (2) the utilization assumptions on older rigs too aggressive, (3) the capex numbers are too light and (4) the operating costs are too low as the street is not modeling enough industry cost inflation.  My estimate is $7.05 and I think it will trade at 8x that numbers as the secular issues by then will be fully evident.  Not least, DO will be unable to cover its dividend in 2015.  Recently this yield has been funded by levering up the balance sheet through sales of investment securities and assumptions of debt.  The company has begun to invest in new rigs but the market will come to realize that these investments will replace rather than grow earnings.

This is a good stock to own when day-rates are rising and the market is fully in an upturn precisely because it is the “tail of the dog” but from here in a stable to declining industry environment (i.e. offshore rig contractor industry), DO (and RIG) are most vulnerable.

Background:

Diamond Offshore ("DO") traces its history to 1953 when Ocean Drilling & Exploration Company designed the first submersible drilling rig.  Its modern form began in 1989 when Jim Tisch began buying drilling rigs at distressed prices in the 1980’s and acquired Diamond M drilling.  Diamond was a wholly-owned subsidiary of Loews Corp until 1995 when 30% of the company was sold in a public offering.  Loews continues to be the majority shareholder with 50% of the company.

Fleet Description:

DO has the oldest rig fleet among public drillers for both jackups and floaters.  In addition, the majority of its floaters are older moored designs rather than modern dynamically positioned ("DP") vessels.  As drilling conditions become more challenging and safety standards increase, these moored rigs will become increasingly uncompetitive.  17 of its “standard semi’’s” are 2^nd to 3^rd generation rigs and all of its jackups are standard (i.e. not high specification).  When people speak of the global rig count needing refurbishment and being too old, they are basically talking about rigs of this age and specification.

Point 1: Ultra-deepwater Date-rates About to Plateau (at best)

Supply/Demand expressed as total “rig years” available (new builds but contract rollovers) vs. the next 10 quarters of demand (10 because it takes about 2.5 years to build a rig) that can be seen via ODS-petrodata which is the industry source for all supply/demand data.  Typically, the demand represents about 75% of what ends up contracted. The rest are through private negotiations.  Many in industry say that this cycle has a unique feature in that a larger portion of demand is seeking rigs through private negotiations. 

This shows why things really picked up in early 2012 and from there why I am concerned.  “Spare capacity” of rigs is increasing based on the publically available data. 

Point 2: Newbuild Economics for Ultra-deepwater Rigs

Industry is being heavily incentivized to build new rigs based on attractive economics.  With each newbuild, more pressure is put on older generation rigs that simply can’t compete especially as the incremental well is being drilled in harsher environments and deeper waters.  Here is a sample year 1 returns illustration assuming $650mm for a new build deepwater rig.

 More recently, I’ve heard about Chinese yards offering 5% or less cash down with the balance of the capital cost due at delivery which not only enhances the return but reduces the risk for spec builders.  Channel checks suggest that the Chinese yards are operating at 20-30% of capacity.  The implication is that day-rates could actually deflate 10-20% with the incentive to build remaining.  With current financing rates, shipyard availability, and healthy day-rates, the fact that the replacement cost of a newbuild, high-spec deepwater rig is below the NPV of a newbuild rig is unsustainable.  The unit economic analysis above failes to capture a couple of dynamics that I think are major headwinds to the offshore drilling contractor business model:

• Day-rates are earned based on uptime of the rig. So the E&P only pays for the rig when it is available to drill.  However, the opex per day is borne by the contractor based on total days that it is not stacked.  This is why downtime is so important.  DO has done a better job on this metric largely for the wrong reason: its rigs are moored (will discuss below) and older which ironically allowed it to have better uptime.  I will discuss why this dynamic will turn into a headwind below.
• Also, day-rate follow the supply/demand cycle for rigs. However, opex tends to go up every year.  So through the cycle, what we have seen is EBITDA per rig lag day-rate per rig and as the midwater and older rig fleet has more difficulty pushing day-rate, this headwind will endure.

Point 3: DO’s Exposure is Precarious: Moored vs. Dynamically Positioned Rigs

There are basically 2 types of technologies that “position/anchor a rig”.  Modern rigs are generally “dynamically positioned.” This technology involves thrusters on the sides of the rig and via computerized systems the thrusters are employed when necessary to keep the rig positioned accurately.  In addition, weather and wind information is transmitted to the computer on board helping the rig to maintain position proactively and reactively.  These rigs are typically much cheaper to operate and handle rough seas better.  However, they were traditionally much more stable in rough waters.  However, many of newly built DP rigs have some type of mooring capability and can now handle rougher water.  In addition, a moored rig requires vessels to place the rig’s anchors and to tow the rig from one location to another.  These vessels are also needed for additional storage given that the deck’s of the legacy moored rigs are much smaller.  The increased space on newly built rigs allow for more storage of drill pipe, back up systems including backup blow out preventers, down hole tools, trees, and other related materials needed in the drilling process.  It's tough to show the economic difference between the two types of rigs to the operators but the overall point is the for a significant portion of DO's fleet, their "target addressable" market is shrinking and this is increasing over time due to where we are drilling and where the industry is going from a safety/redundancy perspective.

To sum up, I think a chart of what industry day-rates have done in this cycle speaks volumes.  I cant paste a chart here but what we've seen is the average ultra-deepwater day-rate climb from a trough of around $350k/d to well north of $600k/d from 2009 to late last year while mid-water day-rates  have hovered around $300k/d so the "spread" between the two has grown wider in an upcycle and as the big new build cycle enters the delivery phase this year and next, I believe that spread will see continued pressure and will result in older fleets ceding more and more share.  The average mid-water rates have failed to make a new cycle high and the spread to the average deepwater rigs is almost $100k/d higher than in the previous cycle. 

In terms of earnings, to be clear, DO is building 5-6 new ships that will add over $3/share in good quality EPS.  The issue is the street is basically assuming these are entirely additive and I believe reality will be significant cost and utilization pressure of the legacy fleet.  The street is north $8.50 in EPS for 2015 when the new builds are almost fully contributing and I am at $6.50.  Further, I have the company finally but still barely covering its dividend in 2015 when the new builds can contribute whereas some of the company's peers will be in positions to pay out increasing safe and high dividends due to their better mix of assets. 

DO is well managed and has done a good job of returning capital to shareholders.  However, this story is going to change over the next 2-3 years as you the asset mix and quality thereof are not things that can be managed out of without shifting capital allocation strategies and making hard sacrifices.

Another way of seeing the structural issues here is via the margin performance:

 There is some cyclicality here but more powerful is the structural move down.  Id also say that optically the company is over-earnings and reports returns that are mis-leading.  Many of their assets were built in the 1970s and 1980s.  As such they have been depreciated heavily and while it's true that management has done a great job of milking returns out of these assets, their private market value is almost zero and to replicate these earnings in a sustainable fashion would take much more capital than the balance sheet implies.

(The model here is pretty complex as I built it up rig by rig so for details into how I get to my estimates or any other part of the earnings or balance sheet model, please feel free to post question on the Q&A or if anyone has any ideas on how to post the model on a website or something, please share and I'd be happy to do so.)