2023-11-18 07:50:20 ET
Summary
- Diamond Offshore's shares have risen 27% in the past year due to a recovery in demand for offshore rigs and a cleaned-up balance sheet after bankruptcy.
- The company reported a sequential decline in revenue and adjusted EBITDA in its latest quarter due to the completion of a rig contract.
- Diamond Offshore's short backlog exposes it to both upside and downside risks in the recontracting environment, but the current market conditions suggest potential upside for the company.
Shares of Diamond Offshore (DO) have been a solid performer over the past year, rising by about 27% as the company benefits from a recovery in demand for offshore rigs after years of little investment. Its 2020 bankruptcy has also cleaned up its balance sheet, and it has taken further steps during the past quarter to enhance its financial strength. DO is positioned for ongoing recovery in dayrates, creating further upside in the stock, if the favorable supply/demand dynamics persist.
In the company's third quarter , Diamond reported an adjusted loss of $1.36 per share as revenue declined sequentially to $245 million from $282 million. This sequential decline was largely driven by the fact one of its eleven owned rigs completed its contract and was brought into the shipyard for post-contract maintenance work. Accordingly, adjusted EBITDA of $28 million was down from $36 million last quarter.
This has been a bit of a transition year for DO. It has still had contracts struck when dayrates were much lower, capping revenue. As these contracts are lapsing, DO is able to sign new ones at higher rates. Indeed, its dayrate was up from $299k to $306k sequentially. With most of a rig's cost fixed, incremental dayrates flow directly to the bottom line. This is why Q4 EBITDA should rise to $50-$60 million as revenue jumps to about $270 million, the highest of the year. Offsetting this, cap-ex is likely to come in at the high end of the range with Q4's free cash flow expected to be similar to Q3's negative $48 million. For the year, cap-ex will be about $135 million with 2023 EBITDA of $135-$145 million.
During 2023, Diamond has had to do major periodic surveys on five of its rigs-this figure should decline to two next year. As a consequence, days off contract should decline from 450 to 100 next year. This more normalized operating environment should have two benefits. First, cap-ex spending should decline materially, by at least one-third. At the same time, revenue and cash flow will benefit from increasing effective utilization. When not facing regulatory-required surveys, Diamond's fleet is performing quite well with a revenue efficiency of 95% in the quarter. These two factors could support up to $100 million in extra free cash flow next year relative to 2023.
During the quarter, Diamond also issued $550 million in debt at 8.5% from a previous 9.9% weighted average cost, saving about $7 million a year in interest. This essentially completes its post-bankruptcy financial transformation with the company carrying just $400 million of net debt. It also has no maturities now until 2030, giving it significant financial flexibility and no further exposure to the current elevated interest rate environment.
During the quarter, Diamond also signed $240 million in new contracts on its rigs,. As a consequence, it now has a $1.64 billion backlog, up $62 million from June 30. As you can see though, this backlog is relatively short-dated with about 70% of it used up by the end of 2024, after which point less than a quarter of available-rig days are signed.
This provides both upside and downside risk. On the downside, this relatively short lifespan of its backlog means if the environment were to get materially worse (i.e. oil prices fall significantly due to a recession), DO could struggle to recontract all of its rigs and face a meaningful decline in revenue. On the flip side, it will have significant recontacting opportunities to sign customers at the higher dayrates we now have, providing upside to cash flow. Essentially, DO's short backlog makes it more exposed to the present recontracting environment, either good or bad.
At this moment in time, it looks to be a positive. It just signed a 30-day contract for $ 15.4 million , or about $513k, the highest level in nearly a decade . I suspect most offshore rig companies wished all of their contracts could mature today, and they could restrike at the current market level. Of course, these long-term contracts exist to provide necessary revenue certainty in what can be a very cyclical market. As you can see below, I've estimated its contracted effective day rate by year, based on its revenue committed and days used. These are substantially below market levels, and so if market conditions today persist, DO should be able to recontract the rigs at a revenue and EBITDA accretive level, similar to this week's contracting announcement.
Now, given Diamond's exposure to recontracting in H2 2024 and H1 2025, it is important to consider fundamentals. I would also emphasize that DO can sign contracts today that will take effect next year when these rigs are available, similar to the $15 million contract. It becomes a question of how soon oil producers are willing to commit and lock-up rig capacity. We should not expect DO to recontract a day before a contract ends, it will likely be weeks if not months in advance, particularly if a rig will be moving geographies.
Thinking about the offshore rig market, the supply side is quite simple. There is no new supply. It takes several years to build an offshore rig. So, for a rig to come online today, construction would have begun in 2020. Back then, many of the drillers were filing for bankruptcy, after years of excess capacity and debt came to a head when COVID crushed oil prices. There are also no rigs under construction. Noble ( NE ) estimates dayrates would need to reach $650k to make a newbuild program economic, still well above the current ~500k market level. As such, no new construction is imminent, meaning new offshore rigs are unlikely to hit the market before 2027 at the soonest. It will likely be even longer
With the supply side poised to stay tight for the forecastable horizon, the question becomes what the demand side is. Schlumberger (SLB) expects the 2022-2025 period should see $200 billion invested in deepwater-up 90% from 2016-2019 levels. This forecast is consistent with what companies have planned. Guyana is a major growth market with Exxon Mobil (XOM) proposing yet another project worth over $12 billion that will run through 2030. Chevron's (CVX) acquisition of Hess (HES) is also motivated in part by the opportunity in Guyana. Brazil plans to invest $200 billion in infrastructure with increased exploration activity by Petrobras (PBR) a major contributor, which will further add to PBR's demand for rigs.
This comes against a backdrop where Russia and Saudi Arabia have announced they are extended their oil production cuts through year-end. The Israeli-Gaza war is a sad reminder that much of the world's oil supply comes from a geographically fragile region. I would also emphasize that oil demand is still rising, with the International Energy Agency forecasting a ~5% rise by the end of 2028.
Now, of course in a recession, oil demand tends to fall, and prices likely will fall in tandem. Right now, a recession does not seem likely with Target ( TGT ) showing that consumers are still spending. Even Chinese data has taken a bit of a turn to the upside. If this environment continues, we should see the company ramp up EBITDA in 2024 beyond Q4's $200 million run-rate as it recontracts at higher rates. Just given less downtime and assuming a 10% uplift on recontracting, DO can generate $250-275 million in EBITDA, which should generate $100 million in free cash flow, assuming cap-ex moderates to $100 million.
At its current share price, DO has a 7.7% free cash flow yield. This is a discount vs peers like Noble, given Diamond's older fleet as well as the fact its shorter backlog exposes it more to a potential cyclical downturn. Given the fundamentals in the offshore market and my view a recession is unlikely, I think this short backlog is more likely to lead to upside than downside risk, but for investors more cautious on the outlook, they should be aware of this, making DO less attractive.
With this cash flow, Diamond is well positioned to begin paying shareholders via a dividend or buyback by the end of 2024. I would view fair value as 8x forward EBITDA, given the cyclicality of the business and potential for cash flow growth beyond 2024 as it recontracts more rigs. That provides a $2 billion enterprise value, or $1.6 billion stock value after its $400 million in net debt. That provides 20% upside to $15, which I believe can be realized over the next year as the company begins to pivot to rewarding shareholders.
For further details see:
Diamond Offshore: Recontracting Provides Upside Potential Despite Risks