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We downgraded our recommendation for Diamond Offshore Drilling Inc. (DO - Analyst Report) to Underperform from Neutral on Nov 21, 2013. We remain bearish at this stage based on a volatile oil and gas price scenario, geopolitical risks related to international operations, the uneven mid-water markets and expectations of a gradual decline in mid-water rates. Diamond carries a Zacks Rank #3 (Hold).

Why Downgrade?

Diamond, a major contract driller, expects delayed start-up of newbuilds, increased downtime for some of its rigs as well as higher operating costs in 2013 to affect 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.

During the third quarter, Diamond’s earnings and revenues declined 4.7% and 3.2% year over year, respectively. The decline was mainly due to cash flow issues with customers. Any delay or inability to manage these matters in time as well as failure to handle repositioning of the rigs will adversely impact the company’s profitability.

During the third quarter of 2013, Diamond faced further shipyard delays on all of the five rigs, which were scheduled for delivery in 2014. The delay has affected all of its yard projects. Any further delay in its rig delivery will affect investor sentiment and thus the share price.

We believe that the company lacks visible catalysts, which are important for the offshore driller to renew its fleet in order to improve its position in an extremely competitive marketplace. Although management has taken commendable steps to upgrade the fleet, Diamond retains a substantial amount of older moored floaters.

However, Diamond Offshore Drilling has solid fundamentals with significant free cash flow potential and a clean balance sheet, which enhances the possibility of further share buybacks and special dividends in the years ahead.

Other Stocks to Consider

While we prefer to remain on the sidelines for Diamond, Zacks Ranked #1 (Strong Buy) stocks – SM Energy Company (SM - Analyst Report), Western Gas Partners LP (WES - Snapshot Report) and Abraxas Petroleum Corp. (AXAS - Snapshot Report) – could be good buying options for the short term.

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