Description

Diamond Offshore Drilling (“Diamond”) is a global offshore oil and gas driller operating at bottom-of-cycle market conditions. Diamond equity is off approximately -75% over the past 3-years principally due to (1) oil prices and ongoing skepticism that oil will recover above $50 / barrel and (2) a widespread belief that onshore oil supply will be more-than-adequate in maintaining a global S/D balance and effectively making offshore development unnecessary. Current valuations levels for Diamond are at all-time low levels as the market assumes Diamond’s business model is broken with oil prices <$50 and consensus estimates assume no recovery before 2020. In contrast to the market, we believe that Diamond’s business model is cost competitive even at an oil price of $50 / barrel and that the recently announced OPEC supply reductions significantly improve the magnitude and timing of an oil price recovery. Without meaningful additional OPEC supply, the oil markets will balance in 2017, as demand growth and non-OPEC production declines continue.

Diamond is best positioned to benefit from a cyclical upturn in oil over the next 2-years and the downside is limited: muted consensus expectations, a pristine balance sheet with the least amount of debt and best liquidity of its offshore peers, supportive majority stakeholder (Loews owns ~53%), valuation support with the stock trading at ~0.7x book value versus a historical average of >2x and strong FCF characteristics as Diamond trades at >10% FCF yield on trough earnings power (and >20% under normalized assumptions). Diamond equity offers asymmetric returns of 50 – 100% upside and less than -15% downside ($15 / share was the floor in the stock in early 2016 when oil touched ~$28 / barrel). Additionally, it’s worth noting that Diamond’s debt trades at healthy yields of less than 7.5% on its 2043 notes (BB+, Ba2 ratings by S&P and Moody’s) while the equity trades at a low-teens FCF yield on 2017E and 2018E trough market conditions and >20% on “normalized” making the equity the most attractive risk-reward in the capital structure. On a fundamental basis, Diamond equity is compelling for several reasons, most notably:

1.      Offshore rig industry operating at bottom-of-cycle conditions with an under-appreciated multi-year cyclical recovery ahead: Demand for offshore drilling has fallen by ~50%. Additionally, another proxy for demand is backlog which has dropped ~70% from peak 2014 levels to current levels! Supply of offshore drilling vessels has been cut by >30% and an additional ~15% of supply is expected to be removed over the next 12-months. As a result of bottom-of-cycle conditions, expectations of future day-rates are at historically all-time low levels.

2.      Recent evidence of OPEC supply discipline is too difficult to ignore: Offshore investors have been caught flat-footed believing oil will stay lower for longer. OPEC policy changes from increasing production toward capping it is significant, as the reason the oil markets remained in surplus in 2015 and 2016 was mainly due to OPEC increased production. Without meaningful additional OPEC supply, this balancing will occur in 2017, as demand growth and non-OPEC production declines continue. While the market will debate enforcement of supply curtailments, the OPEC announcement was significant in changing around the trajectory of oil prices making it timely to focus on offshore equities that have asymmetric pay-outs.

3.      Misperception that offshore drilling is “broken”: Offshore represents ~30% of total supply and deepwater close to ~12%. There is a widespread belief that onshore supply will provide more-than-adequate outlet for balancing global S/D. In contrast to this view, we believe US offshore will remain pertinent as there will be a significant supply deficit in the next few years. When you marry the reality of the decline curve (3 – 4MM bbl/day) with the fact that world oil demand continues to grow (>1MM bbl/day) and the fact that OPEC is curtailing supply in the near-term (upwards of ~1MM bbl/day assuming 6-month supply reduction), the world needs an oil price at a level that supports sufficient ongoing drilling to overcome decline rates and to meet that growth. Onshore supply will be insufficient in bridging this gap.

4.      Diamond has under-appreciated earnings power leading to a cheap valuation: Diamond generated >$2Bln of EBITDA in 2009 (prior peak) versus $457MM expected in 2018E (trough). Diamond trades at 6.3x using LTM EBITDA, ~0.7x BV and >10% FCF yield and closer to ~4x EBITDA on "normalized EBITDA" of ~$1Bln (factoring in the next few years of FCF generation) which provides more than adequate cushion to a 6x "mid-cycle" multiple and >1x BV. Moreover, Diamond’s FCF profile is attractive and it will generate >$250MM of FCF per annum during bottom-of-cycle conditions (low-teens FCF yield) and has more-than-adequate liquidity of >$1.2Bln.

5.      Downside support: Downside supported by strong balance sheet, attractive FCF under trough market conditions, and robust fleet asset value: minimal downside risk given trading at ~0.7x BV and has more-than-adequate liquidity profile. Additionally, Diamond has a highly supportive majority equity stakeholder in Loews and will likely be supportive in the future as Diamond is a "cycle bet" on the offshore drilling industry.

6.      Multiple ways to win in the equity: Diamond is hated amongst sell-side analysts and there is skepticism that the offshore industry will be relevant in the future. Accordingly, not much needs to go right for the stock to do quite well, including: (1) price / book value multiple expands from its current all-time low levels based on improved sentiment as the cycle recovery story unfolds (~0.7x current multiple for Diamond shifts to 1 – 1.5x BV equates to >75%); (2) earnings power estimates shift higher as the market currently assumes 2019E EBITDA will be -80% below Diamond’s prior peak levels and very little upside is “priced in” from this 2019E trough earnings power; and (3) timing of the recovery accelerates to 2018 (market currently assumes a 2020+ recovery).

Valuation:

Diamond generated >$2Bln of EBITDA in 2009 (prior peak) versus $457MM expected in 2018E (trough). Diamond trades at 6.3x using LTM EBITDA, ~0.7x BV and ~12% FCF yield, and closer to ~4x EBITDA on "normalized EBITDA". Diamond will generate >$250MM of FCF in trough-like conditions and has more-than-adequate liquidity of >$1.2Bln. Diamond also has a highly supportive majority equity stakeholder in Loews

Diamond has ~137MM shares outstanding and book value / share of ~$26.50. Given the attractive characteristics of the Diamond business model with a multi-year cyclical recovery ahead, applying a >1x BV multiple and ~6x EBITDA multiple to normalized earnings power is conservative (it’s worth noting that Diamond historically traded well in excess of >2x BV over the 2000 – 2014 timeframe and >6x EBITDA).  If we factor in FCF generation over the next 3-years, this would suggest a FV of $30 - $40 / share (or >50% - 100% upside).

Controversies + Divergence:

Diamond (and the entire offshore driller industry) is out-of-favor as there is still a great deal of skepticism that offshore will be relevant unless oil sustainably stays >$60 - $70 / barrel.

The market does not appreciate the benefit of having best-in-class balance sheet at this point in the cycle – if concerns persist, Diamond will have a war-chest to acquire distressed assets, and conversely if the cyclical upturn occurs in the next 2-years, Diamond will be a beneficiary of this upturn with ample liquidity to make accretive investments.

Additionally, most energy investors are momentum driven and focused on the n-term trajectory of oil. Having a longer time frame and ability to patiently wait through a few quarters is a significant advantage. Currently, the market views 2020 – 2025 as the recovery timeframe for offshore rig companies, whereas we view 2018 – 2020 as the recovery. As investors grow more comfortable that offshore drillers are in the beginning stages of a cycle recovery, longer-term patient capital will be attracted to the space

Catalysts to unlock value:

1.      Oil price recovery – timing / magnitude underappreciated by market: Bottom-of-cycle conditions with recent evidence of supply discipline by OPEC (material announcement that might accelerate S/D balance)

2.      Oil companies providing clarity on spending outlook: Any clarity by the end-market customers that spending is stabilizing and outlook is improving would serve as a material catalyst for both exploration (seismic industry) and development (offshore drillers)

3.      Capital allocation disclosure: Diamond has significant liquidity and has the ability to be opportunistic in the current environment. Any clarity on Loews’ thought process around this investment (majority owner and have gone on record that they are supportive of the investment) would be a material co-specific catalyst 

Catalyst

 Oil price recovery – timing / magnitude underappreciated by market: Bottom-of-cycle conditions with recent evidence of supply discipline by OPEC (material announcement that might accelerate S/D balance) 

2.      Oil companies providing clarity on spending outlook: Any clarity by the end-market customers that spending is stabilizing and outlook is improving would serve as a material catalyst for both exploration (seismic industry) and development (offshore drillers) 

3.      Capital allocation disclosure: Diamond has significant liquidity and has the ability to be opportunistic in the current environment. Any clarity on Loews’ thought process around this investment (majority owner and have gone on record that they are supportive of the investment) would be a material co-specific catalyst