ENSCO: Drilling Deep for Value

By Christopher C. Williams, Barron’s

Oil and gas producers are scoring major finds farther offshore than ever before. That, and rising energy prices, are good news for companies like Ensco, the world’s second-largest offshore driller, with 70 rigs and six more under construction. The London-based company drills in deepwater basins throughout the world, from the North Sea to the Southern Hemisphere to the “golden triangle” bounded by the Gulf of Mexico, the west coast of Africa, and Brazil.

Ensco (ticker: ESV) could be one of the most compelling plays on the growing demand for deepwater drilling. Its shares have rallied more than 28% in the past 12 months, to a recent $61.50, and could keep climbing to $70. Add a 2.4% dividend yield, and shareholders could see a total return of more than 15% in the next year.

Ensco’s advance was abetted last year by its readmission to the Standard & Poor’s 500, after a three-year absence from the index during which it traded in the U.S. via American depositary shares. It converted last May to ordinary shares.

As deepwater drillers go, Ensco is value-priced. Shares trade for 8.7 times this year’s expected earnings of $7.03 share, and enterprise value (market value plus net debt) is seven times estimated 2013 earnings before interest, taxes, depreciation, and amortization of $2.6 billion. Both multiples are below those of rival Transocean (RIG), the industry’s largest participant and the subject of a positive Barron’s profile last month (“Ready to Rise From the Depths,” Dec. 3, 2012).

Ensco arguably deserves a richer multiple of 10 times future earnings, given its industry-leading free-cash-flow yield of 6%, a highly regarded management team, and a young fleet of deepwater rigs. “The risk-reward [trade-off] is still favorable for Ensco,” says Shinwoo Kim, an analyst at T. Rowe Price, which owns the shares.

Ensco was founded in Houston in 1975 as an operator of jackup rigs in the Gulf of Mexico. The company moved its headquarters to London in late 2009, partly to take advantage of Britain’s lower corporate tax rate, now 24%, compared with a 35% rate in the U.S. Its enviable position in the oil patch owes largely to a $7 billion bet made in 2011 on deepwater drilling; Ensco purchased Pride Petroleum in May of that year, gaining Pride’s technologically advanced drillships and exposure to drilling off the coasts of Brazil and West Africa.

In last year’s third quarter, deepwater drilling generated 56% of revenue, or $629 million, helped by the Pride deal. Average day rates increased by 3% in the period, to $402,489, while capacity utilization totaled 90%. The jackup segment chipped in 34% of sales, although mid-water drilling, plagued by oversupply and lower day rates, was a drag.

Driven by higher day rates and new rigs, Ensco is expected to report full-year earnings of $1.2 billion, or $5.39 a share, on revenue of $4.3 billion. This year earnings could rise 30%, on an 18% jump in sales, to $5.1 billion.

In addition to earnings growth, Ensco boasts a healthy balance sheet, with debt equal to 29% of total capital. Free cash flow — an estimated $850 million in 2012 — is more than enough to service debt and fund an increase in the company’s $1.50-a-share annual dividend. Brad Handler, an analyst at Jefferies who recently upgraded Ensco to Buy from Hold, expects the company to double its dividend in the next four years.

Even James Swent, Ensco’s chief financial officer, thinks the shares hold appeal for both growth and income investors. He notes the company invested $1.6 billion in 2012 to upgrade its fleet, while also increasing its dividend payout by 7% during the year. “We are in the enviable position of being able to grow through internally generated cash flow and pay a dividend to shareholders,” he says.

Ensco operates a fleet of 15 rigs that can drill at water depths of 7,500 feet or greater. On average, the rigs are three years old, compared with a nine-year average at Transocean. Customers pay for the newer rigs because they have the technological sophistication and safety features to more effectively access reserves in harder-to-get-to reservoirs. Swent notes that Ensco’s move over time to standardize the technology and design across many of its rigs has given it a competitive advantage in less downtime and quicker regulatory certification.

Drillers like Ensco are getting upward of $600,000 a day for their ultradeepwater rigs, compared with $400,000 two years ago. The company also operates 40 premium jackup rigs, the largest active fleet in the business, which command day rates of $104,000 on average. The premium rigs drill in shallower waters, but can drill deeper than regular jackups. Swent says its oil-company customeres can earn a good return on drilling even if oil falls to $70 a barrel from a current $93.

Some analysts warn that day rates — and profit margins — might fall across the industry in 2014, as new rigs come on line, surpassing demand. One skeptic, Mike Urban of Deutsche Bank, downgraded several drillers in November, including Ensco, to Hold from Buy. “While we generally see the market absorbing new-build deepwater capacity, there may be a mismatch in timing of demand versus supply growth,” he wrote in a client report.

Swent says most of the rigs coming on line in the next few years “are accounted for,” and that “supply and demand is reasonably in balance.” You don’t have to drill too deep to see the source of his confidence: Ensco’s $9 billion in order backlog. That should keep earnings — and the shares — well above water for the next few years.