Diamond Offshore Drilling (DO) has had a terrific year with the stock rallying 18%. This rally has been volatile but the undeniable trend has been upwards. The recent surge in stock and energy prices has left many potential investors wondering if they should invest into the company. Through this analysis, I present the case that potential investors should avoid Diamond.
What the Market Values
Prior to investing in any security, an analyst should isolate a few key drivers of share price. If he or she is able to identify what the market has historically attached value to, then the analyst will be poised to intelligently invest in the security. Two items which have historically driven Diamond have been return on assets and return on equity. Return on assets is a ratio which measures the efficiency of the organization to use its assets to generate revenues. Return on equity measures the effectiveness of management utilizing direct shareholder investment to produce profit for the firm. The chart below shows 10 years of data for the return on assets, return on equity, and the market value of Diamond.
It can clearly be seen that return on assets, return on equity, and market capitalization are closely related. As Diamond has become better at utilizing assets and shareholder equity to produce revenues, the market has been willing to pay more for the organization. This makes perfect sense in that a more efficient and effective organization is better able to deliver profits to investors.
Throughout the past 10 years, the clear relationship of market cap, return on assets, and return on equity can be seen. Beginning in 2004, the firm recovered from a temporary period of losing quarters and for the next 4 years it increasingly utilized assets and shareholder equity more efficiently to generate profits. During this time period, the market responded to this bettering of performance by rewarding the firm with an increase in $12 billion of market cap. This increased the value of the firm by over 400%! In 2009 however, firm efficiency began to slowly decline and it has been declining since. The market has priced in decreases in the return on assets and return on equity progressively and over the past 3 years, the firm has shed nearly $6 billion in shareholder value.
Many investors have noticed the decrease in share price over the past 3 years. This decrease coupled with an increase in energy prices has led many to question if Diamond Offshore may be a valuable investment. I don't think so. The market has clearly shown what it values in Diamond and that is efficiency and effectiveness and for the past 3 years, the firm has steadily lost these qualities. The current levels of return on assets and return on equity are good, but the market is interested in the future value of these ratios and not necessarily the present value. It can clearly be seen that the firm has been returning less on an asset and equity basis and the market has priced the stock accordingly.
With this decrease in efficiency, the firm is bound to suffer. As Diamond decreases in its effectiveness and efficiency, competitors can gradually encroach into its territory and claw revenues from the firm. This can clearly be seen in the chart below.
The chart shows the revenue growth in Diamond on a quarterly basis for the past 10 years. The trend in Diamond has been that of a firm on the decline for the past 5 years. Sure the firm was growing at rates of 50% in 2007, but each quarter witnessed slower and slower growth until the firm actually began contracting in 2010 and 2012.
Declining revenues coupled with a decrease in returns on assets and equity leads me to doubt the value of Diamond. The ratios and current levels of revenue are not so bad as to warrant a "short" signal (yet), but they do show that there truly is nothing so glamorous as to merit initiating a new long position. When searching for an investment opportunity, we should seek to isolate a catalyst that drives share price and capitalize on opportunities centered on that catalyst. Diamond simply does not have the catalyst necessary for new investment.
My opinion on Diamond is two-fold. If you are interested in investing in a good company that is growing, look elsewhere. If you are a current shareholder, keep your mouse hovered over the "sell" button. There simply isn't a reason to be a long-term investor in this organization - the long-term fundamentals warn against it. This said, I believe that we should identify reasonable points at which we should begin looking to exit any existing Diamond positions. The chart and annotation below contain my opinion on the matter.
For the past two years, the market has struggled with the $70 per share range. Price was supported here in mid-2011 for a few months. Following this time of support, price fell through $70 per share and in October of 2011, the market began a process in which it has been unable to close above this point. For the past 5 quarters, the market has been unable to end a month above $70 per share and it has been range-bound since.
Since the market is at the top of its yearly range, I believe that now is a good time to sell shares of Diamond. When the market has historically tested the $70 level, price has subsequently fallen around 25% to $53 per share. This said, I believe investors who are holding Diamond are easily risking 25% or more to maintain their position.
My personal belief is that Diamond Offshore Drilling has more downside in the near future. For the past 3 years, the firm has been shedding efficiency of returns and for the past 5 years revenues have been declining. I believe this picture represents a fundamental flaw within the organization that has consistently driven share price lower for the past 5 years. I see it has entirely possibly and reasonable that this decline in shareholder value will continue. This said, if prices fall out of the current trading range, I view $53 as an excellent potential short entry to capitalize on further downside in Diamond.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.