It’s Time to Sell This Popular Oil Stock

Although energy stocks have been hot as a group — already jumping nearly 13% so far in 2012 — individual performance is all over the board, ranging from double-digit gains to double-digit losses. And just because a stock is up a lot doesn’t mean it’s worth getting excited about.

In fact, there’s one energy stock I’d like to warn you about.

This well-known company, an offshore driller with 46 rigs that are contracted out to large oil and gas companies around the world, has seen its stock rise about 25% in 2012.

But I’m not impressed.

If you take a closer look, then you’ll see this company hasn’t invested adequately for the future — a short-sighted approach that’s about to come home to roost.

The company I’m referring to: Diamond Offshore Drilling Inc. (NYSE: DO).

As I see it, Diamond Offshore has gotten itself into a fix by focusing too much on dividend payments and not enough on equipment upgrades. From 2008 to 2011, for example, the combined dividend payout was nearly $23 a share — a total of about $3.2 billion. This consisted mainly of “special dividends” or one-time payments over and above the scheduled dividend, which amounted to $2.00 a share from 2008 to 2011 for a total scheduled payout of $278 million during those four years.

During the same period, the company put about $2.3 billion — 28% less than it paid in dividends — toward capital investments such as upgrading existing rigs and buying new ones. This obviously wasn’t enough. Diamond Offshore now has one of the oldest fleets in the offshore drilling industry, with an average rig age of nearly 30 years.

The company opted against extensive equipment upgrades and new purchases during the past few years because it believed returns on such investments would be too low in a recessionary economy. But now the economy is picking up, oil prices are rising and deepwater drilling activity is increasing.

Management may be wishing it had put a lot more cash toward capital improvements instead of special dividends. But it didn’t, and now it’s stuck with one of the least competitive rig fleets in the world. To make things worse, it may be a few years before the company can aggressively invest in upgrades, since many of its rigs are tied up in long-term contracts that don’t expire until 2015.

The future looks pretty grim for the company. Analysts estimate revenue, which has grown 29% annually in the past five years, may only rise at a 3.5% pace in the next three to five years, as Diamond Offshore has difficulty in winning new contracts because of its aged fleet.

Earnings growth is expected to plunge from 20% to a mere 2.5%. At these rates, annual revenue would increase to barely $4 billion, from a recent $3.2 billion, while per share earnings would rise from $6.92 to $7.83 between 2011 and 2016. Yearly cash flow growth is expected to suffer, too, possibly tumbling to 3%, from the average 43% posted during the prior five years.

Action to Take –> Since Diamond Offshore has been neglecting capital investment, it will have to spend that much more aggressively in coming years if it wants to regain competitiveness. Combine this with the major slowdown in cash flow growth that analysts are projecting, and I think the company is at risk for cutting special dividends. This would make the stock much less attractive as an income source and probably do serious damage to its valuation, since many investors may be prompted to dump shares and seek better payouts elsewhere.

Diamond Offshore’s price-to-earnings (P/E) ratio of 10 is markedly lower than its historic P/E of 11.4. I see this as a reflection of the company’s reduced competitiveness, not as a sign it might be a good value stock. Indeed, now is a good time to consider selling or shorting the stock.

If you’re looking for an alternative to Diamond Offshore, then consider Transocean Ltd. (NYSE: RIG). It’s still undervalued in the wake of the Gulf of Mexico oil spill, yet there’s little indication the company will be responsible for much of the estimated $20 billion in cleanup costs and fines associated with the spill. Plus, with 135 rigs, it’s a much bigger player in the offshore drilling industry — including the lucrative ultra-deepwater segment, where it outnumbers Diamond Offshore in rigs by 20 to 4.