Peter Lynch often said that when he found one company he liked, it often led to others in the same industry. I recently profiled Transocean (NYSE:RIG) as a company benefiting from deepwater oil exploration. My research naturally led me to their competitor, Diamond Offshore Drilling (NYSE:DO). Not surprisingly, the market forces boosting Transocean are also aiding Diamond Offshore; oil companies are exploring and developing properties farther from shore, deeper under the ocean.
In many respects, Diamond Offshore is a smaller version of Transocean. Its business is basically the same -- renting out drilling rigs to oil and natural gas companies on a dayrate basis. Diamond Offshore's fleet consists of 29 semi-submersible rigs, 14 jack-ups, and one drillship. Its fleet is not as advanced as Transocean's, but the company is continually upgrading its capabilities. Four units are considered "fifth-generation" rigs capable of the toughest duties. Due to increased exploration activity, dayrates and utilization are up. This has led to a big turnaround in earnings, from losses in 2003 and 2004 to an estimated $1.76 per share in 2005, with a whopping $4.47 per share forecast for 2006.
Normally, I'm skeptical of using estimates for an investment thesis. In this case, though, Diamond Offshore has a $2.8 billion backlog, 89% of their rigs are committed for the remainder of 2005, and 52% of their capacity is committed for 2006. The earnings still need to materialize, but a huge backlog is a pretty good place to start. For another perspective on valuing Transocean and Diamond, take a look at Dan Bloom's piece here.
Where shareholders are concerned, Diamond Offshore is not too bad (as we Minnesotans say when giving a compliment). Since 1998, buybacks have retired 8.7% of its outstanding shares. Unlike Transocean, Diamond Offshore continued to pay dividends through the downturn in 2002 and 2003, and recently upped the quarterly dividend to $0.125 per share.
In addition, Diamond Offshore took advantage of that downturn to buy deepwater drilling rigs on the cheap. Part of their strategy to expand earnings and capability is to upgrade existing rigs instead of buying new ones. For example, they are in the process of upgrading the Ocean Endeavor for 10,000-ft. drilling capability. This project will cost $250 million, as opposed to $400 million for a new rig, with a shorter lead time and nearly double the return on investment. Share buybacks, dividends in good times and bad, and smart use of capital -- not bad at all.
Currently trading around $59, with a P/E of 90, Diamond Offshore is priced for perfection. As hurricane Katrina just demonstrated by displacing Diamond Offshore's "Ocean Warwick" jack-up rig by 66 miles (and most likely taking it out of commission for quite a while), there are significant risks inherent to the business. To compensate for the risk, I will be looking to purchase either at a future discounted price, or when earnings have caught up to the valuation. For now, Diamond Offshore will remain on my watch list.
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Robert Aronen does not own shares in any company mentioned, but is now hoping for a back-to-school sale on both Transocean and Diamond Offshore. Please feel free to share your comments with him at [email protected].
