Diamond Offshore and Noble Corp: Drilling Profits

Investing in the offshore drilling sector has been my preferred method of gaining exposure to the oil and natural gas industry and profiting from the rising commodity prices. Offshore drilling contracts are generally long term and therefore provide the companies with some level of visibility into future earnings.

Further the business can be extremely profitable across a wide range of oil prices and, to a certain extent, is not dependant on the daily variation in the price of oil and gas.

In this article, I will compare the valuations of the two major contract drilling companies, namely Diamond Offshore Drilling Inc. (DO) and Noble Corporation (NE).

Another major offshore driller, Transocean (RIG) (debt to equity ratio = 0.72), was not considered in this analysis as it did not meet my low debt requirements.

The table that follows presents the fleet composition of the two companies.

Fleet Composition

Type	DO	NE
Semisubmersible Rigs	30	13
Submersible Rigs	0	3
Drillships	1	4
Jackup Rigs	15	43
Total	46	63

Diamond Offshore and Transocean (77 floaters) have one of the largest deepwater drilling fleets (semisubmersible rigs) in the world. Analysts expect the deepwater drilling sector to grow faster than the overall oil and natural gas drilling sector which should benefit these companies.

The table that follows provides the company fundamentals for Diamond Offshore and Noble Corp.

Company Fundamentals

	DO	NE
Market Cap (Billions)	$12.12	$9.22
Sales (Billions)	$3.64	$3.48
Income (Billions)	$1.37	$1.59
Net Profit Margin	37.6%	45.7%
Return on Assets	28%	23.6%
P/E	8.90	5.90
Projected 5 Year Growth Rate	20%	10%
Current Ratio	2.29	2.61
LT Debt to Cap	0.15	0.13
Institutional Ownership	95%	25%
% Price Change YTD*	48%	60%

The EPS estimates for the two companies are shown the table that follows:

Earnings Estimate

	DO	NE
TTM EPS	$9.84	$6.02
2010 Average Analyst EPS Estimate	$9.80	$5.50
My 2010 EPS Estimate (Conservative)	$9.50	$5.35

Using the data from the last four financial years, relative valuation was performed for the two companies and the obtained fair value is shown the table below.

Fair Value

	DO			NE
	Existing	Average	Fair Value	Existing	Average	Fair Value
P/E	8.86	20.78	$214	5.98	16.36	$104
P/S	3.33	5.92	$155	2.64	4.78	$64
(P/E) / (P/E – Peers)	1.34	1.24	$84	0.91	0.87	$36
(P/E) / (P/E – S&P 500)	0.50	0.94	$170	0.34	0.73	$82

The Call:

Diamond Offshore

I am initiating coverage of DO with a HOLD rating and a 12-month price target of $95. At these levels, DO would be trading at a P/E of 10 representing a 50% discount to its historic levels, but at a premium to its offshore drilling peers. This premium is warranted owing the projected growth rate and the dividend offered by DO. The company has been declaring a quarterly dividend of $1.88 a share yielding 8% a year.

Noble Corporation

I am initiating coverage of NE with a BUY rating and a 12-month price target of $45 derived by applying a multiple of seven to my 2010 EPS estimate. At these levels, NE would be trading on par with its peers.

Disclosure: The author was long DO at the time of posting.

Comments

[DONE_SONZ:]

Ensco (ESV) Not as large of a fleet as the other three,but all of their deepwater fleet is brand new.Alot of rigs out there are over 30 years old.

Jun 08 07:06 AM

[biomedlives:]

Because it has a much lower percentage of jackups in its fleet, I prefer DO to NE.

Jun 08 09:38 AM

[huber:]

Good analysis Nadeem.

I would have a question.

In the two years of 2004 and 2005 Diamond significantly outperformed Noble:

Prices January 2, 2004 January 3, 2006 Change
NE 17.80 37.31 110%
DO 20.48 72.83 255%

I think the earnings do not justify this difference:

Earnings 2003 2004 2005 2006
NE 0.63 0.54 1.08 2.66
DO -0.37 -0.06 1.91 5.12

What is the reason for this?
I would appreciate your opinion.

Aug 11 05:51 AM

[Nadeem Moulvi:]

Thanks huber.

Unfortunately, I was not following those companies during the time period you mentioned. So I can only venture a guess. There can be several reasons for this outperformance.

As you can see, the DO's earnings shot up from 2003 to 2006. The expectation for future growth was probably responsible for the price differential.

Aug 11 06:28 AM