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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.

Source: Diamond Offshore and Noble Corp: Drilling Profits