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We reaffirmed our Neutral recommendation on major contract driller Diamond Offshore Drilling Inc. (DO - Analyst Report), on May 22, 2013. In the recently reported first quarter, stable performance of the company was backed by lower contract drilling expenses and interest overhead. The company currently holds a Zacks Rank #3, which is equivalent to a short-term Hold rating.

Why Maintained?

Houston, Texas-based Diamond Offshore Drilling is a major contract driller, providing comprehensive offshore drilling services to the global energy industry. The company’s drilling fleet of 46 consists of 32 semi-submersibles, 13 jackups and a dynamically positioned drillship.

Diamond Offshore currently has three drillships on order, two of which are expected to be delivered late in the second and fourth quarters of 2013. The third drillship is expected to be delivered at the end of the second quarter of 2014. The company’s rigs operate in the Gulf of Mexico (GoM), the U.K. North Sea, South America, Africa, Australia and Southeast Asia.

We continue to have a favorable view on Diamond Offshore based on its leverage to the global deepwater markets, attractive yield and solid backlog position. Going forward the driller will likely present investors with solid fundamentals with significant free cash flow potential and a clean balance sheet, which would enhance the possibility of further share buybacks and/or special dividends.

Diamond is aiming to increase its footprint in emerging markets (such as Brazil, Australia and West Africa) to reap benefits from the recent discoveries of deepwater fields. Again, the gradual improvement in the drilling market in the Gulf of Mexico (especially after the deepwater drilling ban was lifted), along with better bidding activity, will prove beneficial for a contract drilling company like Diamond Offshore.

However going forward, Diamond expects higher downtime and operating costs in 2013, which are likely to affect the company’s profitability. Further, the company's decision to reclassify four cold-stacked rigs as held for sale is likely to restrict the capacity for upgrades as was in the case of Ocean Apex and Ocean Onyx.

Also, Diamond is an offshore drilling company, which relies heavily on the volume of capital expenditure coming from the exploration and production sector. With the oil and gas price volatility prevalent currently, this puts downward pressure on the activity level of the companies.

Finally, we are cautious due to a number of headwinds that all offshore drillers face, including the execution risk on the newbuilds, the downtime related to its rigs as well as unexpected maintenance or damage from hurricanes, which could likely lower rig utilization. The company revealed recently that the Ocean Endeavor and Ocean Patriot will undergo preparation and maintenance before commencing its new contract.

Other Stocks to Consider

There are other stocks in the sector that however appear more rewarding. These include CNOOC Ltd. (CEO - Analyst Report), Enerplus Corporation (ERF - Snapshot Report) and Compagnie G (CGG - Snapshot Report), which are expected to perform impressively over the next few months and carry a Zacks Rank #1 (Strong Buy).

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