Investors who follow the drilling rigs are probably familiar with the tight supply-and-demand situation that's been driving up shares of Diamond Offshore Drilling (NYSE:DO), along with those of competitors Transocean (NYSE:RIG) and TODCO (NYSE:THE). (I've written about these companies here, here, and here, respectively. If you want more, fellow Fool Stephen Simpson has written about TODCO here and Transocean here.)
The situation the industry finds itself in helped Diamond Offshore deliver a heck of a good report for the fourth quarter and full year of 2005. For the quarter, sales increased 55% over last year, and earnings per diluted share shot up by 767% to beat analyst estimates by $0.17. Earnings for the year hit $1.91 per diluted share, versus a $0.06 loss in 2004, and management indicated that 2006 looks to be another great year.
The short version of the industry's story of late goes like this: A few years ago, the drilling business was not so good. Dayrates (the price to rent a rig and a crew for a day) were low, and no one was adding rig capacity. As oil prices rose, demand for rigs exceeded supply. That caused dayrates to jump. Current earnings, however, are still restrained by long-term contracts at the old dayrates. As these old contracts expire, the new contracts will be upped to current market rates. As a result, earnings are exploding, and the explosion will continue at least until the rigs are repriced at today's current, higher rates.
Beyond having a booming business, Diamond Offshore shares the wealth with stockholders. In addition to its $0.125 quarterly dividend, Diamond Offshore announced last month that a $1.50 special dividend will be paid on March 1 to shareholders of record on Feb. 3. Furthermore, management has indicated that it will declare additional special dividends as long as the cash continues to pour into the coffers.
When Diamond Offshore delivered the gold in its third quarter back in October, I said that shares were not exactly cheap. But that didn't stop them from advancing by another 40%. If you think the party is over now, consider the following: The consensus estimate for 2006 is $5.17 a share -- 170% growth over 2005.
To figure out whether shares still have some upside, we have to consider that drilling is a cyclical business. As such, the million-dollar question is: "Where are we in the cycle?" At the bottom of the cycle, valuations look extremely high because the earnings portion of the price-to-earnings ratio is very low. At the top of the cycle, valuations look extremely low because earnings increase dramatically, but the price levels off with the expectation that the company's growth phase has ended.
I'm willing to bet the cycle still has a few more years of growth, and I will be holding my shares. For those without an existing position, I have to believe that Diamond Offshore's shares will be available at a better (i.e., lower) price some time in the coming months, given that volatility in the drilling sector is even greater than in the overall oil patch. Of course, I held a similar view when I wrote about Diamond Offshore back in October, and I am still waiting for that stock pullback to occur.
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Fool contributor Robert Aronen owns shares of Diamond Offshore and Transocean but of no other company mentioned in this article. The Motley Fool has an ironclad disclosure policy.
