Pressure on Drillers Is Over-Played; Diamond Offshore Primed

Diamond Offshore (NYSE: DO) is an owner and operator of 41 offshore drilling rigs. Company's primary business is in providing drilling platforms to the offshore oil & gas industry, which is becoming ever growing part of the global oil production.

These platforms take up to three years to construct and can cost upwards of $700 million. While oil & gas companies have a fleet of their own platforms, they depend on off-shore drillers like Diamond Offshore to provide equipment for early stage and marginal fields. In exchange for their services off-shore drillers get compensated up to $600,000 per day. Depending on the platform and regional supply/demand balance, return on investment for off-shore drillers ranges between 10 and 20% per annum - well above current cost of capital.

Industry Overview
In the last 10 years, day rates went up dramatically on the back of increasing demand for driller services. Eager to take advantage of increased interest, drillers ordered significant amounts of new ships. New builds are starting to go into operations, and sell-side analysts, concerned about oversupply, are predicting significant declines in day rates and profitability of off-shore drillers. These concerns led to a significant sell-off. Current valuations are more than two standard deviations below long term average on Price to Cash Flow Basis.

We feel that the threat of falling day-rates is way overplayed. Since 2011 number of marketed rigs, globally, increased by around 15% without significant negative impact on either utilization rates or average contract prices. In the next few years, a large number of new offshore rigs are expected to be delivered, but the magnitude of change is not significant in comparison to last few years.

We find current day rates are supported by oil prices. From the point of view of the oil & gas producer, rig contract is a decision that guarantees a certain amount of production at a certain prices over a certain period. They consider the cost of contracting the rig in light of the revenues that they expect to receive. Since 2000, rig day rates have increased by approximately 350%, which is the same percentage increase as the global oil price. As a percent of revenues, the expenses associated with drill-rig contracts remained stable.

Company Position
We find Diamond Offshore to be one of the most attractively priced companies in an under owned industry. Analysts hate the company and are focusing on expiring contracts and age of the fleet. What we feel they are missing is a company with strongest balance sheet in the sector, the best record of returns on capital employed, and improving earnings outlook.

Capital Expenditure Program
In the last three years, Diamond spent $1.2b on pre-payments for the ships that will only start contributing to profitability in 2014. As these ships go into production over next three years, they can add up to $700m in annual cash flow. 2013 EBITDA was $1,185 million.

From the point of view of capital expenditures, Diamond Offshore has a track record of turning its weaknesses into strength. As an owner of a number of drill rigs that are more than 30 years old, Diamond has figured out a way to refurbish these ships and in the process create much value. A good example is conversion Ocean Patriot platform that was originally built in 1983 and is currently being renovated at a cost of $120 million in order to be placed in service, in North Sea, at rates exceeding $400,000 per day. The rig is already under long term contract with Shell and required Capital Expenditure will pay back for itself in little more than a year.

Revenue Outlook
Even without taking into account new drilling rigs, we expect the company's results to improve. Many of Diamond Offshore's rigs are on the tail end of long term contracts. As the table below shows, current market rates are on average 30% higher than what Diamond was able to get in 2013. Drilling rigs are valued both for their specifications and personnel. Companies that market rigs do not just rent them out to the highest bidder; they operate them as well. Diamond has a history of delivering projects on time and on budget that helps them with booking prospective projects at market rates. The company's 2014 contracts show improved pricing compared to last year.

Ownership
Diamond Offshore is majority owned by Loews Corp, a value driven diversified holding company. Their influence over the company is visible in strong dividend track record ($36 in total dividends since 2006 vs. current stock price of $48), low leverage and industry leading Returns on Capital Employed.

Valuation
We believe that Diamond Offshore is an undervalued asset with significant upside from current prices. The Company is currently trading at 6.2x EV/EBITDA that is in-line with the historical average for the sector. However the market is not taking into account extra earnings that will be delivered starting in 2014 as a result of new ships going into service.

We've estimated future cash flows of the company based on current average market day rates and conservative utilization rates. Our DCF suggests that Diamond Offshore is worth around $60 per share. A cash flow model with estimated dividend payments and exit in 2019 at 6x EV/EBITDA (long-term industry average) suggests that a long term holder can earn in excess of 15% per year on their Diamond Offshore investment.

Disclaimer
Steve Gorelik is a portfolio manager for Firebird Management LLC ("Firebird"). This report was prepared based upon information from sources that are believed to be reliable. However, neither Mr. Gorelik nor Firebird make any representation or warranty as to the accuracy or completeness of the information contained in this report. This report may include estimates and projections. No representation is made as to the accuracy of such estimates or projections or that such projections will be realized. Mr. Gorelik and Firebird have no obligation to update or keep current any information or projections contained in this report. Firebird is registered as an investment adviser with the U.S. Securities and Exchange Commission. Mr. Gorelik and Firebird's principals own interest in Diamond Offshore.