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Diamond Offshore (NYSE:DO) is a major worldwide driller of offshore oil and gas wells. Non-US revenues are approximately 50%. Anadarko (NYSE:APC) and Petrobras (NYSE:PBR) accounted for about 9.4% and 9.2% of 2008 revenues respectively.

Earnings surged with rising oil prices from 2005 through 2008. Most of DO’s fleet is contracted through 2009 at high day rates so the recent drop in crude pricing will not be reflected in DO’s earnings this year.

Here are the per share numbers for the past four years as reported by Value Line. Dividends reflect both the regular and special payments actually paid in the years indicated.

Year ….. Sales …... C/F …… EPS ….. Div …… B.V. ….. Avg. P/E

2005 …. 9.47 …… 3.28 ….... 1.76 ….. 0.38 …. 14.38 ……. 30.3x

2006 ….15.88 ……7.02 …… 5.12 ….. 2.00 …. 17.95 ……. 15.4x

2007 ….18.49 ……8.21 …… 6.54 ….. 5.75 …. 20.72 ……. 15.1x

2008 ….25.50 …...11.50 ……9.43 ….. 6.13 …. 24.10 ……. 11.6x

Consensus estimates for 2009 are now running $10.55 – $10.58/share. The Q1 dividend is $2.00 (including the special) and goes ex-div on Feb. 11th.

At yesterday’s close of $65.56, these shares now trade at just 6.95x last year’s earnings and about 6.2x 2009 estimates. Actual calendar year dividends of $5.75 and $6.13 were paid in 2007 and 2008. With $2.00 already declared this year, I’d expect at least $5.00 in 2009 - a likely yield of at least $7.6%.

Diamond Offshore has a good balance sheet. At YE 2008 it held $736.6 million in cash against total debt of $503.3 million. Best of all, only $9.2 million comes due within the next five years.

Like all cyclical stocks DO is unlikely to command a high multiple on what may turn out to be peak earnings this year and next. I’m looking for about 8 times the $10.55 - $11 EPS expected both in 2009 and 2010 for a target price of $84 - $92 /share. That’s about a 30% move from the current quote.

Is that reasonable? Diamond shares hit peak prices of $97.90, $149.30 and $147.80 in 2006-2007-2008 so my goal does not seem far fetched.

Those of you who are regular readers of my articles know I like to use options to make for better returns than just buy and hold. Here is my options-augmented play for those who like DO shares.

………………………………………. Cash Outlay ………… Cash Inflow

Buy 100 shares @ $65.56 …………….$6,556

Sell 1 Jan. $65 call @ $13.60 ………………………………….. $1,360

Sell 1 Jan. $65 put @ $13.80 ………………………………….. $1,380

Net Cash Out-of-Pocket …………… $3,816

On expiration date (Jan. 15, 2010):

If Diamond Offshore shares are $65 or higher (as they are today):

  • Your $65 call will be exercised.
  • Your shares will be sold for $6,500.
  • Your $65 put will expire worthless (a good thing for you as a seller).
  • You will have collected about $500 in dividends.
  • You will have no further option obligations.

You will have about $7,000 cash for your original outlay of $3,816.

That’s a $3,184 net profit in < one year on shares which did not even have to go up.

What’s the Risk?

Should Diamond Offshore stay below $65 /share you would be forced to buy an additional 100 shares and would need to lay out another $6,500.

  • Your $65 call would expire worthless.
  • Your $65 put would be exercised (that’s why you were forced to buy the extra 100 shares).
  • You would now own 200 shares of DO stock.
  • Your total cash outlay would now be the original $3,816 plus the $6,500 = $10,316 (excluding dividends).

Your break-even would be as follows:

  • On the original shares it’s the purchase price of $65.56 less the $13.60 call premium = 51.96 /share.
  • On the exercised put it’s the $65 strike price less the $13.80 put premium = $51.20 /share.

Your overall net cost would be the average of those two prices = $51.58 /share.

Nobody can guarantee that DO shares won’t fall below $51.58 by next January. I can tell you, however, that these shares have not changed hands at that low a price since 2005 (when EPS came in at $1.76 versus last year’s $9.43).

Diamond Offshore shares could drop by up to 21% without causing a loss on this trade as described.

Disclosure: Author is long DO shares and short DO options.

Source: Diamond Offshore: Likely to Drill Higher