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Diamond Offshore Offers Value Amid Gulf of Mexico Regulatory Chaos January 4, 2011

The official moratorium on deepwater drilling in the U.S. Gulf of Mexico was lifted in October 2010, but has been replaced with what can only be described as a quasi moratorium as new permits continue to languish in a byzantine approval process that has frustrated the industry.  Investors and industry participants have every reason to be confused.  On Monday, The Wall Street Journal reported that major players did not expect new permits to be issued until late 2011 or 2012.  This was followed today by another article in the Journal indicating that certain projects could receive a go-ahead within weeks. It seems like the Obama Administration either does not know how to proceed or an internal power struggle is taking place as competing  interest groups influence policy.

Regardless of the reasons behind the quasi moratorium, the end result has been an atmosphere of extreme uncertainty for oil and gas industry executives and for investors.  However, if a silver lining can be found in this situation, it is that investors willing to do the work may be able to identify opportunities in the sector that have escaped those who are preoccupied with the ongoing regulatory chaos.

Contract Drillers

In the wake of the Deepwater Horizon disaster, we profiled several companies in the business of providing offshore contract drilling services.  For those who are unfamiliar with offshore oil rigs, please refer to our article on Noble Corporation from June 2010.  In addition to Noble, we provided a series of articles on Ensco, Atwood Oceanics, and Diamond Offshore.  We did not provide a profile on Transocean, owner of the Deepwater Horizon rig, due to a desire to eliminate risks specifically associated with the oil spill itself.  The following chart provides comparative returns on the contract drillers since July 15, 2010, the date of our profile of Diamond Offshore (click on the image for a larger view):

The companies in this group have all rallied significantly over the past six months with one notable exception:  Diamond Offshore is essentially flat from the time of our initial profile on the company.  Mr. Market clearly does not like Diamond Offshore, but has he spotted a real concern that justified this lack of participation in the rally or is the disparity a potential opportunity?

Diamond Offshore Reduces Gulf of Mexico Exposure

We encourage readers to review the original profile on Diamond Offshore from July.  At the time, we were impressed with the company in terms of the operational results and quality of the rig fleet but had concerns regarding the fact that the vast majority of revenues were attributed to high specification floaters of the type used in deepwater activities.  Another concern involved the percentage of revenues attributable to activities in the Gulf of Mexico.  Although the company had already started to reposition rigs to other parts of the world, it seemed that the company still had a higher risk profile compared to Ensco and Noble Corporation.

In the original profile, we presented an exhibit showing that 32 percent of 2009 revenues originated in the Gulf of Mexico.  The following exhibit provides the same pie chart for the first nine months of 2010:

As we can see, revenues attributable to the Gulf of Mexico are now 21 percent of the total with revenues from South America dramatically climbing from 20 percent to 38 percent of revenues.  As we will see shortly, management has done an excellent job reducing exposure to the Gulf of Mexico since the Deepwater Horizon disaster but the process of moving rigs, particularly high specification floaters, to other parts of the world started in early 2009, as discussed in Diamond Offshore’s Q3 2010 10-Q Report:

Revenue generated by our high−specification floaters operating in the GOM decreased $353.7 million during the first nine months of 2010 compared to the same period in 2009, primarily due to the relocation of seven of our high−specification rigs to international markets. Since early 2009, we have transferred three rigs to the South America market, three to the Europe/Africa/Mediterranean market and one to the Australia/Asia/Middle East market. The effect of these rigs exiting the GOM was a net $325.3 million reduction in revenue for the first nine months of 2010 compared to the same period in 2009, inclusive of a $30.7 million contract termination fee from a previous customer of the Ocean Endeavor in 2010.  (page 33)

In our original profile of the company in July, we presented an exhibit listing all of the rigs located in the Gulf of Mexico.  The following exhibit shows the original status of each rig as of June 30 compared with the location and use of the rig as of December 15, 2010:

Management has been able to shift three rigs to other parts of the world where they are currently in revenue generating status.  Only five rigs remain in the Gulf of Mexico.  The most significant issue at this point is the status of the Ocean Monarch which has been contracted to a customer that claimed force majeure due to the moratorium and the matter is the subject of a lawsuit.

Diamond Offshore has also significantly reduced exposure to the Gulf of Mexico in terms of the composition of the company’s $7.5 billion backlog, as reported in the latest 10-Q (pages 22-23).  The exhibit below shows the backlog for Q4 2010, 2011, 2012, and 2013-2016 by region.  Total backlog for the Gulf of Mexico over the entire period is only 7.5 percent of total backlog:

Based on the data presented above, it seems quite clear that management has taken proactive steps to shift resources out of the Gulf of Mexico into other areas of the world.

Diamond Offshore 2010 Performance

Obviously, the fact that rigs have been moving out of the Gulf of Mexico is not reason for celebration when considered in isolation.  The company needs to find productive work for these rigs in other parts of the world.  How has performance in 2010 compared to the company’s operating results in prior years?

In our original profile of the company, we presented a detailed exhibit showing operating data for 2007, 2008, and 2009.  In order to get a sense of whether the company’s contract drilling margins are holding up, we need to update this exhibit to examine the first nine months of 2010 and see how the results compare against the first nine months of 2009.  The following exhibit provides this data (click on the  image for a larger view):

Have results fallen off the cliff in the first nine months of 2010?  This does not appear to be the case based on the data.  While margins are compressed for all rig classes compared to the same period in 2009, we can see that management was able to reposition rigs in a manner that significantly mitigated a 45 percent drop in contract drilling revenues in the Gulf of Mexico.  Overall contract drilling revenues were  down under 10 percent thanks to a significant increase in activity in Brazil in 2010 compared to 2009.  While margins were  under pressure, all things considered, the company seems to have navigated turbulent times quite well.

Net income per share was $5.13 for the first nine months of 2010 compared to $7.91 for the first nine months of 2009.  The company continues to generate significant free cash flow and has continued a policy of distributing much of the free cash flow to shareholders in the form of special quarterly dividends, as we can see in the following exhibit (click on the image for a larger view):

Management seems to be bullish on future demand for high specification rigs capable of deepwater operations.  On January 3, the company issued a press release announcing an order for a $590 million drillship capable of ultra-deepwater operations with an option for a second ship exercisable at any time before the end of the first quarter of 2011.  CEO Larry Dickerson had the following to say about the new order:

Diamond Offshore President and Chief Executive Officer Larry Dickerson said: “The addition of a new drillship to our fleet is part of a continuing effort to enhance our ultra-deepwater capabilities at attractive capital costs. Including our opportunistic acquisitions of the Ocean Courage and Ocean Valor in 2009, we have now purchased, ordered or upgraded six 10,000-foot ultra-deepwater units over the last four years. New drillship construction costs have declined substantially from peak pricing. As a result, we believe this new drillship will provide returns consistent with our long history of value creation for the Company and our stockholders.”

Summary

As investors, we must make decisions based on imperfect information amid uncertainty.  The situation in the Gulf of Mexico is about as uncertain as possible and, despite rallies in some contract drilling companies, the overall group is still trading at depressed valuations.  This is particularly true in the case of Diamond Offshore given the stock’s lack of participation in the sector’s rally over the past six months.

While Diamond Offshore has a heavy exposure to deepwater exploration worldwide, the company has diligently reduced exposure in the Gulf of Mexico and operating results for the first nine months of 2010 were strong, all things considered.  While the percentage of backlog attributable to Brazil is a potential risk, it still seems preferable to enduring high exposure to a very uncertain Gulf of Mexico policy environment.

If we annualize free cash flow for the first nine months of 2010, we arrive at a figure of approximately $850 million.  Shares are currently trading only slightly more than ten times the depressed free cash flow levels of 2010. Diamond Offshore is controlled by Loews Corporation which owns 50.4 percent of shares outstanding.  Loews has long been known for intelligent deployment of capital to wholly owned and partly owned subsidiaries.  As we can see from deployment of free cash flow in the past, Loews has been willing to either  opportunistically deploy free cash flow toward expansion capex or return cash to shareholders through special dividends.  As a result of future volatility in dividend payments and timing, it may be best to own Diamond Offshore in a non-taxable account.

Disclosure:  The author recently purchased shares of Diamond Offshore and also owns shares of Noble Corporation.

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Diamond Offshore Represents Interesting Play on Deepwater Revival July 15, 2010

Diamond Offshore

This is the fifth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

One of the central tenets of value investing is that one must always insist on a large margin of safety before allocating capital.  When investor sentiment is favorable toward an industry or a company, prices of securities are usually bid up to a level where everything must go according to plan in order to achieve expected investment returns.  On the other hand, negative sentiment can sometimes, but not always, offer an investor opportunities to make commitments offering high returns and low downside risk.

In this article, we profile Diamond Offshore, one of the leading companies in the deepwater drilling industry.  In previous articles, we focused on two companies in the offshore drilling industry with lower risk profiles.  Both Noble Corporation and Ensco plc have exposure to deepwater drilling in the Gulf of Mexico but also have significant international operations along with large fleets of jackup rigs that are designed for less controversial shallow water drilling.

The main reason that Diamond Offshore was not profiled in the past is because the company is far more exposed to deepwater drilling and could face more regulatory uncertainty as a result.  The goal of the articles on Noble and Ensco was to identify companies that had enough diversity in operations, both in terms of shallow water and international operations, to successfully deal with an extended (or even permanent)  U.S. moratorium on deepwater drilling.  With this caveat, let us briefly examine Diamond Offshore’s business.

Overview

Diamond Offshore is one of the leading global providers of contract drilling services and operates a fleet of 47 offshore rigs comprised of 32 semisubmersible rigs capable of deepwater operations, 14 jackup rigs designed for shallow water drilling, and one drillship.  The company is well diversified by region with 68 percent of 2009 contract drilling revenues originating from outside the United States.  Revenues are heavily tilted in favor of deepwater operations with only 12.9 percent of 2009 revenues coming from the jackup fleet.  For a brief primer on the differences between rig types, please refer to our previous article on Noble Corporation. The following exhibit presents a snapshot of Diamond Offshore’s valuation as of July 15, 2010.

In contrast to Ensco and Noble which both trade at small premiums to tangible book value, Diamond Offshore commands a larger premium which is most likely due to the long term projected earnings power generated by a more advanced fleet capable of the higher dayrates that deepwater operations command.

The company has a small regular dividend but has been paying out large special dividends in recent years.  The total dividend paid in 2009 was $8 per share.  As we can see from the exhibit below, the company has been generating in excess of $1.1 billion of free cash flow over the past two years and has distributed much of this to shareholders.  Debt levels appear manageable at approximately 29 percent of total capital, although debt was increased by approximately $1 billion during 2009 to fund expansion capex.

Operating Data Snapshot:  2007 to 2009

Although Diamond Offshore operates in a single segment, the company provides more data than many competitors regarding the composition of revenues, expenses, and operating income between rig type and region.  The exhibit below is a reorganization of the data presented within the company’s MD&A section of the 2009 10-K report.  Please click on the image to enlarge it.

The exhibit breaks down operating data for contract drilling by rig type and then by geographic region.  Both high specification floaters and intermediate semisubmersibles are generally designed for deepwater activities, although in some cases they may be repurposed for shallow water drilling.  All jackup rigs are limited to shallow water drilling.  The vast majority of the company’s revenues and operating profits can be attributed to rigs designed for deepwater operations.

Gulf of Mexico Exposure

The chart below shows the breakdown of 2009 contract drilling revenues by region and includes revenues from all rig types.  The segment that is broken out shows that 32 percent of total contract drilling revenues are from operations in the United States Gulf of Mexico.

Within the U.S. Gulf of Mexico, the vast majority of 2009 revenues were attributed to rigs capable of deepwater operations.

Only 5 percent of revenues from the Gulf of Mexico were from jackup rigs and the vast majority were from high specification floaters representing some of the most advanced rigs in Diamond Offshore’s fleet.

According to the June 30, 2010 fleet status report, Diamond Offshore currently has nine rigs in the Gulf of Mexico.  Five of the rigs are semisubmersible units.  On July 12, the company announced that Ocean Confidence, one of the semisubmersible rigs, would immediately redeploy to the Republic of Congo.  The following exhibit provides a summary of the latest information regarding the Gulf of Mexico fleet.

As we can see, several customers have invoked force majeure in an attempt to exit or modify existing contracts.  Presumably, this is due to the Obama Administration’s moratorium on deepwater drilling although it is notable that the Ocean Titan is on a standby rate of zero dollars due to regulatory difficulties even though it is a jackup rig.  The relocation of Ocean Confidence out of the Gulf of Mexico could presage similar actions for other rigs if regulatory difficulties continue.  However, relocation can be expensive and time consuming and there is a possibility that mass relocations of rigs from the U.S. Gulf of Mexico could depress dayrates elsewhere in the world.

Summary

In contrast to our previous studies of Noble Corporation and Ensco, it seems clear that Diamond Offshore carries more business risk due to the higher concentration of revenues in deepwater activities in the U.S. Gulf of Mexico.  These risks may be mitigated to some extent through the relocation of assets to other parts of the world and negotiations with customers.  However, it is clear that investors in Diamond Offshore have a great deal to lose if the deepwater moratorium is extended or made permanent.

At the current valuation, Diamond Offshore certainly appears inexpensive compared to the market prices that prevailed before the Deepwater Horizon disaster.  However, Noble Corporation seems far cheaper both in terms of multiples of earnings and free cash flow as well as the price to tangible book ratio.  A similar observation can be made regarding Ensco.

It must be acknowledged that Diamond Offshore’s fleet may legitimately command a premium valuation compared to Noble and Ensco in a world where deepwater exploration is robust and premiums are placed on advanced semisubmersible rigs. However, the flip side is that they are more exposed to adverse regulatory developments in deepwater.  An investment in Diamond Offshore may turn out well at current market prices and may even offer more upside potential than Noble or Ensco, but much depends on a reasonably quick return to deepwater exploration in the Gulf of Mexico.

Resources

Diamond Offshore 2009 10-K
Diamond Offshore 2010 Q1 10-Q
Diamond Offshore Fleet Status Report as of June 30, 2010 (Excel)
Press Release on Ocean Confidence Relocation

Disclosure:  No position in Diamond Offshore or Ensco.  Long Noble Corporation.

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