Diamond Offshore: Proceed With Caution

| About: Diamond Offshore (DO)

While reading the article 10 Stock to Buy Now in the recent edition of Fortune magazine, I was intrigued by Diamond Offshore (NYSE:DO), one of the companies mentioned in the article. As a subscriber pointed out last month, traditional energy companies are conspicuously missing from our model portfolio and when I came across Diamond Offshore, I decided to explore the company further to see if it would be a good fit. Without reiterating what was written in the article, let me discuss a couple of additional thoughts about the company.

Apart from the triple digit earnings growth mentioned in the article, Diamond Offshore also has excellent operating and profit margins of 43.1% and 32.15%. However the price of the stock seems to be highly sensitive to oil prices, as seen by the more than 4% drop on January 3rd in reaction to a 4.5% drop in the price of crude oil.

DO 1-yr chart

Given that Diamond has already booked out rigs at high prices for 2007, 2008 and beyond, the stock should respond to higher earnings in the longer term and I see drops in the stock price in response to drops in oil prices as a buying opportunity. Over the last few months oil and gas prices have been very volatile and so it may be prudent to start a small position in Diamond and then add to this position over a period of time.

Diamond Offshore does have close to a billion dollars in debt on its balance sheet, but it also has $788.5 million in cash and short-term investments. As you can see from the balance sheet, the company appears to be devoting capital towards the purchase of property and equipment each quarter. Given the shortage of drilling rigs and the high profit margins the company enjoys, it makes a lot of sense to invest in additional equipment instead of paying down debt during this period of high growth.

Apart from volatility in oil prices, the other key risks to watch out for with Diamond Offshore is the possibility of intense tropical storms due to global warming that could affect offshore drilling operations. Environmentalists and many members of congress are also not supportive of offshore drilling because of the potential for oil spills and other discharges into the ocean that can affect marine life. In light of the fact that Congress recently gave its go ahead on offshore drilling in an area of the Gulf of Mexico that is estimated to hold 1.26 billion barrels of crude oil, the political risk of a ban on offshore drilling appears remote at this point.

The Good:

  • Diamond Offshore's earnings are expected to rise 178% in 2006 and this highly profitable company could offer a special dividend like it did last year.
  • Offshore drilling rigs are in short supply and Diamond has already contracted its rigs out for 2007, 2008 and beyond.
  • Diamond Offshore's forward P/E is 8.36 and the recent pullback in the stock price may present a good buying opportunity.
  • The Bad:

  • Offshore drilling is heavily opposed by environmentalists as it carries the risk of oil spills and tainted beaches if done too close to shore.
  • Global climate changes could bring about severe storms like hurricane Katrina and impact safe offshore drilling.
  • Diamond's stock price is highly correlated with the price of crude oil in the short-term and crude oil has been trending downwards over the last few months.
  • The Numbers:

    P/S: 5.37
    Cash: $688.18 million
    P/E: 18.08
    Long Term Debt: $965.8 million