Diamond Offshore Drilling: Ideal for Income Investors

Most investors head for the hills when a stock is hit by analyst downgrades.  As for me, I want a closer look.  Value frequently materializes after an exodus.
I see value following the investor exodus from Diamond Offshore Drilling (NYSE: DO), whose business is readily gleaned from its name: Diamond provides offshore drilling rigs — in deep and shallow waters — to large integrated energy companies. Clients include Royal Dutch Shell (NYSE: RDS.a), BP (NYSE: BP), Petrobras (NYSE: PBR), and PEMEX.
Diamond is a long-time holding in the High Yield Wealth portfolio.  To be honest, it has been the rare disappointment.  Diamond’s shares have simply failed to gain traction. Worse, its shares have actually backslid in recent months, and not in an inconsequential amount.  Diamond’s price graph is hardly cause for celebration.
Then again, Diamond Offshore Drilling’s price graph is hardly cause for despair.  Indeed, I see opportunity.
As a price-appreciation investment, Diamond has left much to be desired.  As an income investment, it has continually performed. The company continues to pump out $3.50 per share in annual dividends.  At today’s lower price, that translates to a lush 7.4% yield – one of the highest in the sector.
So why is Diamond’s share price depressed?  Issues cover the macro and the micro.
On the macro side, overcapacity is a concern. Offshore drillers have aggressively expanded in recent years.  Diamond’s fleet has increased nearly 41%, going to 45 rigs from 32. Concurrently, a few large oil companies have hinted at plans to reduce capital expenditures. Rising supply coupled with falling demand has analysts sucking their thumbs and whining over the possibility of lower dayrates and lower rig-utilization rates.
On the micro side, Diamond Offshore Drilling has suffered setbacks in Brazil, which accounts for more than 30% of its annual revenue. Specifically, two of Diamond’s rigs were contracted to the Brazilian oil service company OGX, which filed for bankruptcy in October 2013.  Diamond took a $75 million hit in the third quarter of 2013 related to OGX non-payments.
These concerns have lead to a cascade of downgrades, most of which hit the market over the past month. Investors, in turn, responded with a hard sell. Diamond’s shares are down over 16% year to date.
Time to buy. I say that because Diamond’s shares are oversold – WAY OVERSOLD.
For one, Diamond Offshore Drilling continues to make money and cover the dividend.  EPS in 2013 posted at $3.95, which is a disappointment and a 23.8% reduction from EPS of $5.18 posted in 2012. Still, it was enough to cover the dividend.  What’s more, EPS is expected to recover to  $4.50 in 2014.
In other words, circumstances are better than recent share performance would lead investors to believe.  Indeed, I believe they are even better than most analysts believe.
I expect Diamond will continue to make money, and make it at a growing rate in the future. Even with the aforementioned issues, Diamond’s backlog is around $9 billion, nearly three years of revenue, and provides sufficient visibility on the company’s financial performance.
What’s more, long-term growth in worldwide oil demand is unlikely to abate, and the low-hanging fruit is already taken.
According to the 2013 World Energy Outlook, the total world oil supply in 2012 was
87.1 million barrels a day (MBD), an increase of 11.9MBD over the 75.2 MBD produced in 2000. Less than one-third of this increase was in the form of conventional crude oil – the easy stuff pumped directly out of the ground. More than two-thirds was what the International Energy Agency calls “unconventional crude” (light-tight oil, oil sands, and deep/ultra-deepwater oil) or natural-gas liquids.
The long-term outlook for offshore drilling is clear: Oil companies will need to invest more to extract oil, whether they want to or not. That will keep drilling contractors like Diamond Offshore Drilling busy.
In the meantime, investors can pick up shares of a premier offshore drilling contractor with a yield of 7.4% that trades at a mere 10.5 times 2014 EPS estimates.

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