The Outlook for Diamond Offshore Drilling Does Not Convince Investors

On March 31, Arnold Van Den Berg added Texas-based Diamond Offshore Drilling Inc. (DO, Financial), a global offshore oil and gas drilling contractor. It is engaged in providing contract drilling services. Through its fleet, the company provides a range of services in both the floater market (ultra-deepwater, deepwater and mid-water) as well as the non-floater, or jack-up, market.

In this article, let's take a look at this oil driller and try to explain to investors the reasons this is an apparently appealing investment for that guru, while for other investors the worst is still to come.

Emerging Markets

The company provides offshore drilling services to a customer base that includes independent oil and gas companies and government-owned oil companies. As of Dec. 31 2012, the company had a fleet of 44 offshore drilling rigs, consisting of 32 semisubmersibles, seven jack-ups and five drill ships, four of which are under construction. Diamond plans to focus on regions such as Brazil, Australia and West Africa. The aim is to reap benefits from the recent discoveries of deepwater fields. Since 2007, Diamond Offshore has acquired or placed orders for 11 deepwater and ultra-deepwater units.

In December 2010 and January 2011, the company entered into contracts to construct two new builds ultra deep water drill ships for a combined $1.2 billion. Further, the firm agreed to construct a third such drillship for $610 million, due in 2014, and a fourth, due in late 2014. Finally, in May 2013, it agreed to build a fifth ultra deep water unit, a semisubmersible, due in November 2015, for a total capital cost of $755 million. This fifth rig has been underwritten with a three-year contract with BP (BP 43, Hold) for $585,000 per day, off the coast of South Australia. The latest new build projects will continue the process of renewing the fleet to meet customers’ future requirements.

Excellent Financial Health

As of Sept. 30, 2013, the firm had approximately $469 million in cash (and cash equivalents), and a long-term debt of $1.246 billion. The company's current quick ratio of 3.44 is very high and demonstrates very strong liquidity. This significant cash flow and the clean balance sheet in terms of debt increase the possibility of further share buybacks and special dividends in the near future. We have to remember that since 2006, in addition to its regular dividend, Diamond has regularly been paying a special dividend. For the fourth quarter of 2013, Diamond declared a regular dividend of $0.125 and a special dividend of $0.75, a total of $0.875 per share.

Volume of Capital Expenditure

As an offshore drilling company, Diamond relies heavily on the volume of capital expenditure coming from the exploration and production sector. Also, Diamond Offshore's cost structure will come under further pressure, as it plans to double capital expenditures on fleet upgrades in 2014. Finally, the reduced deepwater drilling activity and lower (or volatile) oil and natural gas prices put downward pressure on the activity level of the companies.

Analyst Recommendation

The firm is currently Zacks Rank # 3–Hold, and it also has a longer-term recommendation of “Neutral.” A Hold rating indicates that the stock, over the next one to three months, will perform at an annualized rate of 10.56%, very similar to the S&P 500. For investors looking for a Zacks Rank # 1–Strong Buy, Helmerich & Payne Inc. (HP, Financial) and Pioneer Energy Services Corp. (PES, Financial) could be options.

Relative Valuation, Earnings and ROE

In terms of valuation, the stock sells at a trailing P/E of 12.3x, trading at a discount compared to the industry mean. Due to its decline in revenue, earnings per share (EPS) have decreased by 40.2% in the most recent quarter compared to the same quarter a year ago. In the next graph we include the stock price because EPS often lead the stock price movement. As we can appreciate in the chart, the price performance as well as EPS had a downward trend over the last five years.

Finally, I always like to see one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity. The ratio has decreased from the same quarter one year prior. This is a clear sign of weakness within the company.

Let´s compare the current ratio with the peer group in the next table:

Diamond Offshore has a current ratio of 11.83% which is higher than those registered by Pioneer Energy Services Corp., Ensco Plc (ESV, Financial), Hercules Offshore Inc. (HERO, Financial), Nabors Industries Ltd. (NBR, Financial) and Noble Corporation Plc). For investors looking for a higher ROE, Atwood Oceanics Inc. (ATW, Financial) is a good option.

Final Comment

As outlined in this article, we see longer-term growth opportunities due to the expansion in international expansion. However, the firm currently retains a substantial amount of older moored floaters which we see as a major risk in a highly competitive landscape. Finally, the firm's EPS as well as ROE’s non-growth are demonstrating the company´s weaknesses. Therefore, I feel bearish about this company’s future profitability.

Although Arnold Van Den Berg (Trades, Portfolio) has invested in the stock in the first quarter of 2014, I would recommend staying away from Diamond at the time, mainly on account of its somewhat uncertain prospects and its stock price decline.

Disclosure: Victor Selva holds no position in any stocks mentioned.