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In my article "Diamond Offshore Drilling: Brazil, Pre-Salt And Growth" I took a look at a broader scope of Diamond Offshore Drilling (NYSE:DO). In the article, we established positive potential for Diamond Offshore in the pre-salt region off the coast of Brazil. On a negative point, the article also indicated that there was a declining trend in the company's profitability.

As we have established that the company is focusing on Brazil and has declining profitability over the past couple of years, the next step is to look at the company's debt. As Diamond Offshore is in a highly competitive business and is bidding for contracts against other companies such as Noble Corporation (NYSE:NE) and Transocean (NYSE:RIG) it is imperative that the company is spending to keep up with the most advance equipment in the business. To help stay competitive, Diamond Offshore recently ordered two deepwater semisubmersibles and one more ultra-deepwater drillship by the name Ocean BlackLion. As these acquisitions come at a steep cost, it is crucial for the investor to make sure the company's debt side is in reasonable shape.

In the article below, I will calculate important ratios in understanding the amount of debt and liabilities the company has incurred. From this analysis, we will understand more about the company's debt, liabilities and financial risk.

Debt Ratios

1. Total Debt = Long-Term Debt + Short-Term Debt

Total debt is the sum of long-term debt, which is debt that is due in one year or more, and short-term debt, which is any debt due within one year.

  • 2008 - $503 million + $0 million = $503 million
  • 2009 - $1.495 billion + $4 million = $1.499 billion
  • 2010 - $1.496 billion + $0 million = $1.496 billion
  • 2011 - $1.496 billion + $0 million = $1.496 billion
  • 2012 - $1.496 billion + $0 million = $1.496 billion

Diamond Offshore's total debt has increased over the past five years, but over the past four years, the trend has been flat. In 2009, Diamond Offshore posted a total debt of $1.499 billion while in 2012, the company posted a total debt of $1.496 billion. This signifies an decrease of .2% over the past 4 years.

2. Total Liabilities

Liabilities are a company's legal debts or obligations that arise during the course of business operations, so debts are one type of liability, but not all liabilities. Total liabilities are the combination of long-term liabilities, which are the liabilities that are due in one year or more, and short-term or current liabilities, which are any liabilities due within one year.

  • 2008 - $1.590 billion
  • 2009 - $2.634 billion
  • 2010 - $2.865 billion
  • 2011 - $2.631 billion
  • 2012 - $2.659 billion

Over the past five years, Diamond Offshore's liabilities have also increased but also like the total debt, the liabilities have remained relatively flat over the past four years. In 2008, Enbridge reported liabilities of $18.083 billion while in 2012, Enbridge reported liabilities at $36.672 billion. This marks an increase of 102.80%.

In analyzing Diamond Offshore's total debt and liabilities, we can see that the company currently has a total debt of $1.496 billion and liabilities at $2.659 billion. From the numbers above, we can see that over the past four years Diamond Offshore's total debt and liabilities have remained relatively flat. As Diamond Offshore currently has a total debt of $1.496 billion, liabilities of $2.659 billion, the next step will reveal if the company has the ability to pay them.

1. Total Debt to Total Assets Ratio = Total Debt / Total Assets

This is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. It is calculated by adding short-term and long-term debt and then dividing by the company's total assets.

A debt ratio of greater than 1 indicates that a company has more total debt than assets. Meanwhile, a debt ratio of less than 1 indicates that a company has more assets than total debt. Used along with other measures of financial health, the total debt to total assets ratio can help investors determine a company's level of risk.

  • 2010 - $1.496 billion / $6.727 billion = .22
  • 2011 - $1.496 billion / $6.964 billion = .21
  • 2012 - $1.496 billion / $7.235 billion = .21

Diamond Offshore currently has a total debt to total assets ratio of .21. As the total debt to total assets ratio has decreased over the past three years, this indicates a slight decrease in risk to the company. Because the ratio numbers are diminishing and well below 1 and indicates a diminishing amount of risk to the shareholder.

4. Debt ratio = Total Liabilities / Total Assets

Total liabilities divided by total assets. The debt ratio shows the proportion of a company's assets that is financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity. If the ratio is greater than 0.5, most of the company's assets are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged." A company with a high-debt ratio or that is "highly leveraged" could be in danger if creditors start to demand repayment of debt.

  • 2010 - $2.865 billion / $6.727 billion = .43
  • 2011 - $2.631 billion / $6.964 billion = .38
  • 2012 - $2.659 billion / $7.235 billion = .37

In looking at Diamond Offshore's total liabilities to total assets ratio over the past three years, we can see that this ratio has also decreased. The ratio has decreased from .43 in 2010 to .37 in 2012. As the ratios are below the 0.50 mark, this indicates that Diamond Offshore has not financed the company's assets through debt. As the number has decreased, so has the risk to the company.

5. Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity

The debt-to-equity ratio is another leverage ratio that compares a company's total liabilities with its total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and obligators have committed to the company versus what the shareholders have committed.

A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in the company reporting volatile earnings. In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations, and therefore is considered a riskier investment.

  • 2010 - $2.865 billion / $3.862 billion = .74
  • 2011 - $2.631 billion / $4.333 billion = .61
  • 2012 - $2.659 billion / $4.576 billion = .58

Compared with 2010, Diamond Offshore's debt-to-equity ratio has decreased. The ratio has decreased from .74 to .58. As the ratio is currently below 1, this indicates shareholders have more invested than suppliers, lenders, creditors and obligators. .58 indicates a low amount of risk for the company. As the ratio is below 1 and considered low, so is the risk for the company.

6. Capitalization Ratio = LT Debt / LT Debt + Shareholders' Equity

(LT Debt = Long-Term Debt)

The capitalization ratio tells the investors the extent to which the company is using its equity to support operations and growth. This ratio helps in the assessment of risk. Companies with a high capitalization ratio are considered to be risky because they are at a risk of insolvency if they fail to repay their debt on time. Companies with a high capitalization ratio may also find it difficult to get more loans in the future.

  • 2010 - $1.496 billion / $5.358 billion = .28
  • 2011 - $1.496 billion / $5.829 billion = .26
  • 2012 - $1.496 billion / $6.072 billion = .25

Over the past three years, Diamond Offshore's capitalization ratio has increased from .28 to .25. This implies that the company has more equity compared with its long-term debt. As this is the case, the company has more equity to support its operations and add growth through. As the ratio is decreasing, financially this implies a slight decrease in risk to the company.

7. Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt

This coverage ratio compares a company's operating cash flow with its total debt. This ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations. The higher the percentage ratio, the better the company's ability to carry its total debt. The larger the ratio, the better a company can weather rough economic conditions.

  • 2010 - $1.282 billion / $1.496 billion = 0.86
  • 2011 - $1.420 billion / $1.496 billion = 0.95
  • 2012 - $1.311 billion / $1.496 billion = 0.88

As the current cash flow to total debt ratio is below 1, this implies that Diamond Offshore does not have the ability to cover its total debt with its yearly cash flow from operations.

Based on the five debt ratios listed above, we can see that Diamond Offshore has a limited amount of risk regarding the company's debt and liabilities. The above ratios state that there has been a slight decrease in all the company's debt levels compared to the company's assets over the past 3 years. Currently, the company is showing a decreasing amount of risk from a debt point of view. As this is the case, this indicates a measure of financial strength. The next step will reveal how much the company will pay for the debt incurred.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

8. Cost of debt (before tax) = Corporate Bond rate of company's bond rating.

  • S&P rated Diamond Offshore bonds "A-"
  • 5.15% Senior Notes Rate of "A-" = 5.15%
  • Current cost of Debt as of May 3rd 2013 = 5.15%

According to the S&P rating guide, the "A-" rating is - "Strong capacity to meet financial commitments but somewhat susceptible to adverse economic conditions and changes in circumstances." Enbridge has a rating that meets this description.

9. Current tax rate = (Income Tax total / Income before Tax)

  • 2010 - $381 million / $1.336 billion = 28.52%
  • 2011 - $217 million / $1.179 billion = 18.41%
  • 2012 - $198 million / $918 million = 21.57%

2010 - 2012 3-year average = 22.83%

From 2010 - 2012, Diamond Offshore has averaged tax rate of 22.83%.

10. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 - Tax Rate)

The effective rate that a company pays on its current debt after tax.

  • .0515 x (1 - .2283) = Cost of debt after tax

The cost of debt after tax for Diamond Offshore is 3.97%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return - Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors (for example, shareholders) to compensate for the risk they undertake by investing in their company.

  • Risk Free Rate = U.S. 10-year bond = 1.74% (Bloomberg)
  • Average Market Return 1950 - 2012 = 7%
  • Beta = (MSN Money) Diamond Offshore's Beta = 0.94

Risk Free Rate + Beta Equity (Average Market Return - Risk Free Rate)

  • 1.74 + 0.94 (7- 1.74)
  • 1.74 + 0.94 x 5.26
  • 1.74 + 4.94 = 6.68%

Currently, Diamond Offshore has a Cost of Equity or R Equity of 6.68%, so investors should expect to get a return of 6.68% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

(Please note that this is the CAPM approach to finding the cost of equity. Inherently, there are some flaws with this approach and that the numbers are very "general." This approach is based off of the S&P average return from 1950 - 2012 at 7%, the U.S. 10-year bond for the risk-free rate, which is susceptible to daily change and Google Finance beta.)

Weighted Average Cost of Capital or WACC

The WACC calculation is a calculation of a company's cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 22.83%

Cost of Debt (before tax) or R debt = 5.15%

Cost of Equity or R equity = 6.68%

Debt (Total Liabilities) for 2012 or D = $2.659 billion

Stock Price = $70.05 (May 3rd, 2013)

Outstanding Shares = 130.03 million

Equity = Stock price x Outstanding Shares or E = $9.108 billion

Debt + Equity or D+E = $11.767 billion

WACC = R = (1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 - .2283) x .0515 x ($2.659/$11.767) + .0668 ($9.108/$11.767)

.7717 x .0515 x .226 + .0668 x .774

.009 + .0517

= 6.07%

A current PEG ratio of 1.11 based on an EPS average growth rate from the past year and two years forward indicates that based on the next few years estimates, the stock is currently slightly overvalued.

Based on the information, buying at a price of $63.00 would indicate fair value.

Chart sourced by FINVIZ

Summary

The above analysis reveals that Diamond Offshore is a solid company on the debt side. All of the metrics listed above are indicating financial strength as Diamond Offshore is able to add assets and increase its competitiveness without taking on additional debt. This information is confirmed by a strong rating by S&P. S&P has given the company a rating of "A-" with a "stable outlook". From a value point of view, the current peg ratio of 1.11 states that the stock is slightly overvalued. If the stock falls in the low $60's, this would indicate an excellent buying opportunity. Based on the evidence presented above, Diamond Offshore is in excellent financial shape from a debt point of view. Diamond Offshore has the ability to pay for its debts, has a relatively low cost of debt at 5.15% and has a product that is in demand.

Source: Diamond Offshore: Increasing Value Without Adding Debt