Description

We believe shorting Diamond Offshore equity (DO) is very compelling at this point. DO is a popular short – it was written up on VIC by jessie993 in June 2013, and short interest is currently 25%. The short thesis on offshore drillers in general was also discussed at length on the messages under the NE post from Apr 2013. The reason DO is particularly timely today as a short is the stock has outperformed its direct peers by over 30% over the last two weeks as stock lent out was recalled and the stock squeezed. We’ve seen some borrow open up in the last couple of days, and if you can get your hands on some, we believe near-term catalysts will likely take DO at least 30% lower within a couple of months.

The short thesis for DO is straight forward, and jessie993 did a good job of laying it out in his post. DO operates a fleet of mostly old, tired offshore rigs that are likely to get displaced in the current environment of very weak demand for offshore exploration assets. This was already the case a few months ago and the collapse in oil prices makes it even worse, with even the most modern newbuild rigs like ATW’s Admiral and Archer unable to find any work at all in the near-term.

In this context, we believe most rigs in DO’s fleet will roll off their contract and never work again. Even if demand is decent three years from now, there will be such plentiful supply of superior rigs at attractive dayrates that most of DO’s current fleet will not be competitive. The impact of this is is still far from reflected in DO’s earnings estimates: we believe 2015 EBITDA will likely come in around $940mm, while consensus is at $1.19bn. For 2016, where DO has less contract coverage, consensus is at $1.04bn, but we believe EBITDA likely gets cut in half to under $500mm.

The critical point is, DO’s average fleet is so old that the current 11x EV/EBITDA multiple on 16 EBITDA is not on trough cyclical earnings, because we believe most of DO’s 2G, 3G and 4G floaters won’t work ever again after their current contracts expire.

Many buy-side specialists are probably on board this thesis. So what makes the trade work? We believe two things in the short-term:

·         First, DO’s special dividend ($0.75/quarter) is likely to be suspended, and the company will likely announce it in February with 4Q earnings. DO wants to take advantage of the downturn to renovate its fleet and buy modern assets on the cheap. To do that, it will need liquidity, and paying out $490mm in dividends in 2015 while it will generate zero FCF on our numbers doesn’t help. We expect DO to probably keep paying the regular $0.125 quarterly dividend, which would take the divvy yield on the stock from the current 10.5% to 1.5%.

·         Second, DO might have outperformed in the last couple of weeks because it screens as having the best balance sheet in the space, at only 1.2x net debt to 2015 consensus EBITDA. This will soon change, as DO is due to spend over $1bn in capex in 4Q14 as it makes the final payment on a couple of newbuild rigs. This will take DO to being 2.0x levered overnight when they report 4Q14 (and trading at 12x EV/16 EBITDA).

One could even argue that the dividend cut thesis is well circulated, but this was much the case for energy companies like SDRL and COS CN that have gotten crushed after announcing a dividend cut in the past few weeks. We’re in fact told that part of DO’s outperformance in the past couple of weeks might be due to dividend funds taking money out of SDRL and into DO. The amount of retail money pursuing high-dividend stocks in this ZIRP world is not to be underestimated.

Finally, getting the borrow. The stock’s ripped in good measure due to shorts being recalled and a tight borrow over the past two weeks. Tough to say when the squeeze ends, but the fact that some borrow opened up in the past couple of days might be a hint. The same dynamics occurred in October when oil took its first big leg down, and DO reverted to the mean rather quickly. A 20%+ annualized borrow is steep, but with 30% downside within 2-3 months and 50% within a year (as offshore markets keep deteriorating) makes it worth it in our opinion.

Catalyst

• Dividend cut and $900mm higher net debt reported with 4Q earnings in Feb 2015.