Deepwater Drillers Offer Deep Value

Occasionally, industry fundamentals are good enough and valuations attractive enough that they create enticing investments in several sector participants. The volatility in oil prices has affected all businesses relating to oil, and the recent pullback in the deepwater drillers offers ample opportunity.

In the offshore drilling space, two dominant players include Transocean (RIG Quote) and Diamond Offshore Drilling (DO Quote).

Transocean has the largest fleet of offshore drilling rigs, and the volatility in oil prices has not hurt the company's overall business. The total contracted backlog stands at $40 billion, and given the high demand for these rigs, these contracts are secure. Transocean produces eye-popping net margins approaching 45% and a return on equity (ROE) of nearly 40%, while changing hands at a P/E of 7.83 and a forward P/E of 7.46 (at publication time).

Diamond Offshore operates a fleet of 44 rigs all over the world, and the numbers are equally as impressive -- 35% profit margins, 37% ROE, and a forward P/E of about 9.12. Both companies have seen share prices decline by over 30% in recent months.

A more pure-play opportunity on the ultra-deepwater market is Ensco (ESV Quote), which owns 12% of the available fleet with seven more rigs on the way. Ensco's core focus is in on water depths exceeding 7,500 feet. It's a much smaller company relative to Transocean and Diamond Offshore, with a market cap of $8.5 billion, but its margins are just as impressive. Ensco has no net debt and generates tons of free cash flow.

The ROI of these deepwater rigs is phenomenal. Since 2005, Ensco has taken delivery of four rigs at an average cost of $350 million. In 2005, the average dayrate was around $260,000; last year, the company contracted a rig out for $510,000 a day. Again, these contracts have durations from two to four years. At the low end of the dayrate, the ROI is in the midteens; at the high end, the ROI approaches 21% to 22%. Over time, turning a dollar of investment into $1.20 in returns creates tremendous value that will be reflected in the stock price.

Deepwater drilling rigs are utilized all over the world, and the industry backlog and continued strength in dayrates suggest healthy long-term demand for these specialized rigs.

This was originally published on RealMoney on September 23, 2008. For more information about subscribing to RealMoney, please click here.

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