Massif Capital - Diamond Offshore Drilling Inc.

Summary

• Diamond has been a painful investment for our portfolio.
• We invested too early in the cycle for offshore equipment, and the trough of the cycle has been extended beyond our modeled scenarios.
• We will aim to reduce our average cost between 20% and 30%. Once done, we expect to exit the position with a 10%-15% annualized return three to four years from now.

The following segment was excerpted from this fund letter published by Massif Capital.

Diamond Offshore (NYSE:DO) (Long): Diamond has been a painful investment for our portfolio. We invested too early in the cycle for offshore equipment, and the trough of the cycle has been extended beyond our modeled scenarios. Capacity utilization throughout the industry has suffered, which has created an extended drag on lower day-rates for forward contracts. We would note though that capacity utilization remains high at Diamond, it is the only driller with a fully contracted fleet of drill ships. One of the challenges the industry faces is that a shrinking contracted backlog at most drillers has negative implications on balance sheets and credit ratings. Diamond does not face this issue. The firm has even been able to counter-cyclically increase capital expenditures this year, largely for two rig reactivations, which we view as a net-positive, while their cash position has deteriorated. As a result, their balance sheet remains the strongest in the industry.

The firm has no debt maturities until 2023, and they have access to $1.2 billion under a credit facility. There are no liquidity issues, and all their drill-ships have long-term contracts. A decline in capital expenditures in 2020 should improve their cash position, yet we believe it will likely be offset by their final legacy contracts rolling off the books at the end of this year. The forward strategy is clear. The firm will sit through the trough of the offshore market cycle with ~$300,000-day rates, far above the current spot price averages, and try to capture the upside in the moored rig segment, a rig segment that Diamond has little competition in. Critically, the company can financially implement this strategy and is not dependent on a quick pace of recovery, as some of their peers may be.

At today's prices, our potential expected return has increased substantially, and we expect to average down to capture this reality. Our industry rig tender database indicates that utilization has picked up in several critical markets. Competitive utilization across the industry has increased ten percentage points over the calendar year. Should this trend continue, we expect day rates to appreciate. When we see evidence that the offshore market has turned a corner, specifically sustained utilization rates above 80% with further recovery in day rates, we will look to add to our position. We will aim to reduce our average cost between 20% and 30%. Once done, we expect to exit the position with a 10%-15% annualized return three to four years from now.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.