Diamond Offshore: Market Sentiment Is Shifting, Rare Opportunity Is Ending

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 |  Includes: DO, PBR
by: Hester

Earlier in the year, at the end of May, I wrote a bullish article on Diamond Offshore (NYSE:DO). At the time, shares of Diamond were getting crushed, as the hysteria over the BP spill was in full swing, with many speculating that BP would go bankrupt. The offshore drilling industry was just starting to go under a microscope by regulators. The drilling moratorium was just a twinkle in Ken Salazar's eye. People refused to go near drilling stocks because of regulatory uncertainty, possible increased insurance costs, the risk of another spill, and most importantly, the general dislike of the sector.

It has been nearly five months since all of this, and most of the reasons to sell are nearly gone. The moratorium and regulatory scrutiny is basically over. Insurance costs will be passed on to customers. The BP spill has ended, it is out of the news, and cleanup is moving swiftly. The risk of another spill is the exact same as before the BP spill (which is low), but perception of the risk is lowered. The general dislike and hatred of anything in the sector is slowly ending. The opportunity to purchase great companies at ridiculous prices is may be ending.

Yet, DO is trading at basically the same price as when my article came out and when I started buying. The stock price took a big plunge, from high $60's per share to mid $50's, after the article when people were speculating that Diamond had a spill themselves. However, anybody who took the time to listen to management or actually read past the headlines knew it was a non issue, and the stock eventually recovered to where it is now. So even though these issues are ending, today's buyers are offered a rare opportunity to buy one of the highest quality oil drillers in the world, at just 10 times earnings.

QUALITY

10 times earnings (or Enterprise value/EBIT-normal tax rate in this case) is what I consider a fair price for a mediocre/average company with little (below GDP) or no growth. Diamond Offshore is neither of these. Diamond is a well respected driller with excellent management and great capital allocation (which is paramount in offshore drilling). For a more detailed description of Diamond's advantages, refer to my previous article. Diamond has also grown both revenue and earnings at a very impressive clip over the last decade. The future is just as bright.

FUTURE GROWTH

Oil is in high demand and will be in even higher demand in the future. Emerging markets will drive the bulk of the demand, as the globe becomes more civilized. Giant countries like India and China will move towards a higher standard of living, which will entail more oil consumption. Diamond has a strong global footprint in nearly every continent, is well respected, and is well positioned to take advantage of this growth.

Emerging market prospects are illustrated beautifully by Petrobras (NYSE:PBR). Recently, they did a record $79 billion dollar share offering, which is just part of their $224 BILLION exploration program. Petrobras and Diamond have excellent relations. Diamond's drillship Ocean Clipper made a big discovery for Petrobras a couple years ago, and Petrobras has repeatedly expressed demand for Diamond's rigs. Earlier in the year PBR awarded 3 new rig contracts to Diamond.

There is an old saying that the surest way to get rich during a gold rush is to sell picks and shovels to the miners. Diamond offshore and other Petrobras oil drillers appear to be the "picks and shovels" way to play the ambitious exploration project of Petrobras, as Diamond will win whether Petrobras finds a lot of oil or not. For now, Brazil provides an area of strong long term demand for any additional rigs that come off contract or are acquired.

Diamond also has another avenue of growth that few other drillers have. It is gains on rig transactions. Diamond Offshore operates like good value investors. They only buy rigs when they are out of favor, when steel is cheap, or when a bankrupt company is desperate to unload. Although they acquire these rigs to rent out and aspire to make the most money in that fashion, they occasionally make money just buying and selling rigs.

Consider the recent transaction they made with Ensco (NYSE:ESV). They bought the rig on the cheap, putting about $150 million into it. They operated the rig for about two years, and generated about $100 million in EBITDA off of it and then sold the rig to Ensco for $186 million. That is a pretty nice profit in such a short period of time.

Diamond Offshore has the ability to purchase rigs on the cheap, and they now have a large source of global demand for their rigs. Sentiment is shifting, the opportunity might not last for long.

Disclosure: Long Do. No position in PBR