I've maintained an investment in Ensco (ESV) since 2005.
By 2005, it was obvious even to inattentive observers (and I was an attentive one, doing research in energy in general and in the Peak Oil issue in particular - and I was an early investor in long-term CL (WTI futures) contracts, even when they were still traded in the NYMEX pit instead of in an electronic platform) that the times of cheap oil were gone forever.
The inability to go on increasing oil production capacity in the already well-explored on-shore fields of the world was a given. And those are the cheap fields, where liquid crude oil flows out of the Hearth by itself. They represented (and still do) most of the world's oil production, but most of them (and arguably all of the biggest and best) had been explored for a long time already and were (and still are) being progressively depleted.
At the same time, as production was stalling (and still is, even on the present "shale miracle" days), the continued increase in worldwide desire to consume petroleum (an exponential curve that basically started 150 years ago) was reinforced by evolutions in China, India, and other countries.
This combination meant that oil prices were inevitably going to have to increase, and then to remain high. No more transient periods of $10 sweet crude, no more long-term averages of $20 inflation-corrected prices. That new reality justified (and even forced) a strong increase in the exploration of unconventional oil resources, from Canadian "tar sands", Orinoco bitumen, oil in shale formations (yes, it was explored back then, too!) to deeper, more expensive, offshore.
So, thinking like this, I compared oceanic drilling companies, selected ESV for a more careful study of the company's fundamentals, and was totally convinced. ESV was a cheap gem and would probably be a great investment. I entered ESV around $50.
For a couple of years, ESV's stock did well but nothing out of the ordinary. Then, by early 2008, crude oil price got clearly ahead of itself. I closed my long positions in long-term crude futures, and even got some (very limited) short positions on shorter time-frame futures.
ESV was riding the wave (see the attached chart from Yahoo Finance), and even before its maximum (around $80), I had reduced somewhat my position.
Then, in late 2008, both crude and every company related to its production crashed hard.
ESV, still presenting relatively good operational fundamentals, dropped extremely fast to a low of around $24! That represented a PER of 3 in a solid company with profits and very low debt!
As it dropped below around $40, I started to load up in it. Following the principles of every real fundamental investor, I was happy with those prices and kept reinforcing my investment step by step, even managing to buy some stock below $25.
I recommended ESV to my family, friends, wrote about in forums, etc. For the first time in my investment career, I risked some leverage, investing about 110% to 120% of my funds in ESV. It seemed to me to be one of the best opportunities of my (already relatively long) investment career. (The dot and the little grabby hand shown at that low point of the chart mark my stance at that time.)
And so it was.
From the lows of around $24, it recovered nicely (and relatively fast) to around $60.
Then, it suffered another blow: The Macondo accident in the GOM. ESV was not involved, but it was badly affected by the subsequent drilling ban (not enough to stop being profitable, but still severely affected). It was obviously a temporary thing, but it was still painful. However, obviously by the time of that accident ESV was no longer dirt-cheap, so I had already reduced my exposure to around 50% of my investments.
ESV changed its headquarters from Texas to London to become a UK company. That was rather surprising, but it was ok. Most of the competition was headquartered in Europe, and the experienced, trusty, effective management explained that it would reduce a little bit its taxes and facilitate worldwide marketing. Good.
And ESV acquired Pride International, another drilling company (mainly with focus in deep-offshore drillships and some activity in Brazil's pre-salt). In regard to that, and in spite of the management explanations (mainly greater scale, complementary fleets, and the promises of efficiency gains with the merging of the activities), I did not particularly like the acquisition since I was afraid ESV would lose (or give up…) its well-proven efficiency and its traditionally conservative, extremely solid approach.
For the first time ESV got real debt, and real goodwill, in its books. Also, management compensation (traditionally quite reasonable in ESV, especially considering the quality of the persons involved) grew a bit too much for my liking. However, with time, the merger proved reasonably successful, at least up until now.
And so, we reach the present.
ESV is suffering a significant drop in share price.
It is still my biggest single stock investment, at about 30% of my holdings.
Forgetting attempts to do technical analysis and short-term market timing (something that I don't think is consistently possible/effective, although I have a PhD around that stuff…), is this drop in share price justified by the fundamentals of the company (or of the ocean drilling activity in general)? Or is this the start of another significant market inefficiency that we, savvy investors, can grab with both hands (to profit handsomely)?
Those are very good questions. I had no answer for them, so (after a relatively long spell of just following the most relevant company news, browsing the financial reports, and reading the Seeking Alpha articles about it) I went back to the basics to re-evaluate ESV.
To start, I tried to nail more exactly the recent negative points that are the direct drivers of the share price drop.
Let's list them, starting with the most important:
ESV (and its peers) have been subjected to a flurry of downgrades from analysts. Those downgrades have all been motivated by the expected oversupply of new drilling rigs that are coming "online", and the associated change from a situation where the oceanic drillers could charge high rates and basically chose the best customers, in the most favorable regions to the inverse situation, where the clients may choose between a vast offer of recent, effective rigs/drillships, most of them well-suited for the tasks at hand, offered by desperate drillers that just can't cold stack newly-built, non-amortized assets.
This is a real problem. The oceanic drilling industry is traditionally cyclical, and it seems clear that at present it is on the verge of a significant period of relative oversupply. That is not just a "promise" for future years. It is already showing in the results of some companies in the 4th quarter of 2013 (for example, in Noble's (NE) results and guidance).
It is almost assured that it will also show in ESV's 4th quarter results, since the number of "zero rate" days in many of its "Floaters" was quite high. (See the entries for "ENSCO DS-3", "ENSCO DS-5", "ENSCO 8502", "ENSCO 8506", "ENSCO 7500", "ENSCO 6002", "ENSCO 6003", and "ENSCO 6004" all in the first 2 pages of the Fleet Status Report of January 2014.) This new-built rig oversupply problem seems to be compounded by some weakness in some of the most relevant deep offshore drilling regions - notably in Brazil (where, by the way, the bankruptcy of Eike Batista's OGX should also directly affect the 4th quarter of Ensco).
In my opinion, the present (limited) weakness in demand will not last, but the oversupply of new rigs/drillships will mean 2 or 3 years of worse results for oceanic drillers. This problem will mainly be solved by 3 factors: very limited new rig construction during the next several years, natural growth of the market, and retirement of some older, lower-performance rigs. Fortunately, ESV is in one of best positions in the industry to withstand this downturn in the drilling industry (more on that below).
To illustrate with a very recent (but typical) downgrade by Raymond James and its motivations, please open this short summary. Notes on this downgrade: 1. I agree with the EPS compression they predict (18%) - I even expect a slightly greater reduction of EPS (see below). 2. I fully agree with their statement that this is a transient, cyclical, downturn and that in the long-term, oceanic drilling has a bright future. 3. I agree with the fleets reduction that they estimate. This is a point where ESV is very well-placed due to its efficient, recent fleet that it keeps updated with constant upgrades. (When ESV sells some older rigs, that usually generates book profits…) 4. I agree with the prediction that the soft spot in oceanic drilling should last for some 2 or 3 years. (The demand should pick up well before that, but the oversupply of rigs coming online will keep the contracted rates depressed for some 2 to 3 years.)
Bad (and strange) developments in the situation of some specific "floaters".
Comparing the two last Fleet Status Reports (FSR) (available on ESV's website), it is obvious that there were very recent unpleasant developments with the contracts of 2 relevant semi-submersible rigs. These rigs are among the most valuable of ESV's fleet, and so these developments cause concern both because of what they mean and also because by themselves they will have a significant impact in the first quarter of 2014.
These rigs are the "ENSCO 8503" and the "ENSCO7500".
The first of these, "ENSCO 8503", located in the GOM, appears listed in the December 2013 FSR as working for Cobalt, earning a daily rate in the lows $550,000, plus $54 000 per day of additional reimbursements, and a listed "availability" date (typically, this would be the contract termination date) of May 14. Unfortunately, this most valuable rig appears listed as non-contracted in the January 2014 FSR, earning a "Zero rate for aproxim. 85 days in 1Q14" (this is basically a loss of $600,000 for each day of the 1Q2014).
The second of these, "ENSCO 7500", located in Brazil, appears listed both in the December and in the January FSR as working for Petrobras. However, in the December FSR, it appears listed as earning in the lows $320,000 (plus $20,000) per day, with a contract lasting until Aug. 14. In the January FSR, the situation is changed, and it is now described as "Based upon mutual agreement with the customer, zero rate beginning in Jan. 14 for the remainder of the contract term" (and the contract term is still listed as Aug.14). Apparently, this is some kind of compensation to the client for something that remains unspecified. Naturally this alone represents a significant loss for ESV, in this case extending during the 3 first quarters of 2014. I would like to have more information about this strange development. Perhaps some analyst will ask the right questions in the next conference call and we all can be enlightened about it...
Personnel changes in the company.
Obviously, personnel changes are not always negative, but in the case of Dan Rabun's retirement, it is hard to see it as positive or even neutral. He has been ESV's CEO for years, and besides losing an effective operation leadership, his retirement again raises a prospect of changes in general policies of the company - and in my view, if it happens, it will almost certainly be negative.
Another very relevant personnel change is the replacement of the Marketing VP. Kevin Robert, the previous Marketing VP, came to ESV in 2011 with the acquisition of Pride, and now "has left the company to pursue other interests". His replacement by David Hensel (who has been working for ENSCO from 2003 and must be very well known by the administration) is possibly positive. However, David Hensel has been in charge of the "North and South America Business Unit" since May 2011, and that is the region where the strange developments with the contracts of the 2 rigs describe above happened recently.
Having dealt with the most obvious negative points, let's discuss some financial indicators of this (still) very interesting and promising company.
Below, I present a table with some important fundamental indicators, including both ESV's historical results and some personal predictions.
Notes to the table:
- "Last price", "Market Cap", and PER estimates are dated, of course. They are from February 4, 2014.
- The dark blue values in the table were collected from ESV's SEC filings.
- Light gray values to the left show values from the "old ESV", pre-merger with Pride International.
- The red value for EPS in 2011 represents a value with little meaning. The number of shares and "perimeter of incorporation" changed so much during the last quarter of 2011, that presenting a single value for EPS in that year can't represent much of the reality.
- Lighter blue values to the right are my "educated guesses" for future results.
- The values for the columns of the 4th quarter of 2013 and for the full year of 2013 will be known on 20 February.
In my opinion, this summary table illustrates quite well the extremely solid past performance of ESV.
Of particular note (since they are the single most important point for every fundamental investor) are the yearly EPS values. They remain quite stable over all the years presented in the table, with a low value of slightly above $3 for 2011 (an atypical year because of the consolidation changes and costs related to the acquisition and merger with Pride, and also a year strongly affected by the Macondo accident in the GOM). But to fully appreciate this stability, we could (and should) look into more data... In 2009 (the year when ESV's shares reached the low $20s !!!), the ESP was $5.48. In 2008 (the year when crude reached a peak above $140 per barrel), the EPS was $8.02. In 2007 (a good year, with crude price quite high), ESV's EPS was $6.69.
So, there is no arguing with this: ESV has always been able to carry on with good, stable profits even in the worst conditions.
Another very interesting point illustrated in the table is the evolution of the debt. After the very significant increase due to Pride's acquisition, in 2011, it is being reduced with such regularity as to cause concern to a casual observer… How can a company in a competitive, Capex-heavy business present this kind of evolution without falsifying the accounts? Simple: ESV keeps paying for its significant investments with its operational cash flow, and keeps just enough cash to pay for the (relatively regular) Capex outflows without a need to change/increase debt. The extremely stable reduction of debt, quarter after quarter, is a show of the kind of management that we, long-term ESV investors, don't want to lose with Dan Rabun's retirement…
A final point about the historic values in the table: It is rare for a company to show such a good accordance between stated profits, overall dividends paid, and evolution of the stockholders' equity. With ESV, everything balances perfectly! This happens to such a degree that a seasoned investor (used to studying this kind of thing over many companies) must feel some unease. Either almost every other company does sloppy accounting, or someone in ESV invents simple and too-clean numbers - falsifying things using a naïve linear approach... Or, perhaps, in ESV they do things exactly as they should be done! (Note for those that don't follow this company: Every indication fits. The answer is that it really does things so cleanly by-the-book that it looks strange when we are accustomed to other standards…)
Now for the right side of the table. My predictions for future ESV's results are based on several things: Past quarterly performance, analysis of the Rig Status Reports, publicly available relevant news (remember Eike Batista's bankruptcy?), management-stated expectations, analysts' estimates - as listed mainly on Yahoo Finance. Note: Those analysts' estimates are usual quite close to the mark (past performance is also shown in the link above). However, for the next few quarters, my estimates are lower.
To simplify, let's focus just on EPS, the most relevant of the predicted values. As of February 4, the analysts' predictions for the 4th quarter 2013 point to an EPS of $1.61. That would be great for ESV (and for us, investors), but it would be at the level of the $1.62 EPS of the 3th quarter. I believe that the $1.61 estimate does not fully incorporate the available news - in particular, concerning the number of zero rate days in some rigs and OGX bankruptcy. Now, being a long-term fundamental investor, I tend to evaluate companies conservatively (the usual "margin of safety" thing…), and that includes being conservative when predicting expected company results. So, maybe my prediction is somewhat below the median of the distribution of the real probabilities of ESV's 4th quarter results - meaning that there is a greater probability of the actual results exceeding my prediction than falling below it. But my prediction is still an honest attempt to be as close as possible to the center (and of the higher point) of a relatively wide probability distribution. It is not a value that I throw up expecting ESV to beat it, so that it looks better in the picture. Part of the explanation for higher analyst estimates must be attributed to the fact that most of the estimates in Yahoo's table already date from several months, and so fail to incorporate some more recent news. That said, I would still be happy if they proved more accurate than me, and if ESV's 4th quarter result proves to be close to $1.61.
In regard to estimates for 2014, again I think the Yahoo table is showing outdated estimates. I believe the analysts' estimate for the 1st quarter is probably quite good (just slightly above mine), but I don't understand how the expectations for the rest of the year recover so much after the first quarter. The weakness in the offshore rig market is clear, as illustrated and discussed in the presentations of the 2013 results of other drilling companies. I don't expect the 1st quarter of 2014 to be the lower point of this weakness. I agree that ESV's first quarter will be directly affected by specific rig contract problems, but find it hard to predict much better results for the rest of the year. So, I merely maintain the expected 1st quarter result (the only quarter that can, at the moment, be "calculated" with a reasonable approximation) for the rest of 2014. Again, I would be happy if the analysts' predictions prove to closer to the mark than mine.
The previous table is also a good basis to start discussing ESV's strengths. Let's list them:
As previously discussed, ESV's past evolution is stable, very solid, and quite positive. Since the acquisition of Pride International, the yearly results have been growing. This would go on if the offshore rig market stayed unchanged. However, realistically, a drilling market downturn would happen sooner or later in this kind of traditionally cyclical activity.
The results that I predict for ESV (even if pessimistic when compared with the average of analysts' predictions) still represent a relatively limited compression of profits during 2014. Since my predicted results for 2014 are already quite conservative (at the level of the worst what happened in the previous downturns of 2009, with the oil price crash, and in 2011, with the GOM accident and drilling ban) I see no reasons to expect things to get still worse in 2015 and 2016.
So, even if ESV's results turn out as weak as I expect, its present valuation will still represent a PER of around 10 - even at the bottom results of a cyclical market downturn!
And the high dividends, expected to remain at $3/year, will remain comfortably covered (something that not all of ESV's competition may expect to happen - unlike most, ESV combines high yield with a relatively low payout ratio).
Like Raymond James (see the link above), I expect the offshore drilling market to again improve in 2-3 years - once the new rigs presently contracted stop arriving in the market, and once the appropriate fleet adjustments (mainly cold stacking and/or selling older less efficient rigs) are done.
Considering that new rigs will probably not be built for a while, and that in the long term, the offshore drilling has a very promising future (discussing that would be another long story, but basically the Peak Oil remains real, alive, and well, and the deep sea is one of the last promising oil prospects…), there is every reason to expect ESV's results to improve again around 2016 or 2017. That is still a good time frame for a long-term fundamental investment in a company. (Yes, I'm the kind of investor that expects to keep a stock for many many years…)
ESV can be expected to be one of the least-affected oceanic drillers during this transient rig oversupply and market downturn.
ESV has one of the lowest financial leverages; it has one of the largest and best diversified fleets; it has a well-distributed, balanced, worldwide client base; and its rigs/drillships are among the most modern and efficient. I could present here direct evidence of those points, but I think that anyone interested in ESV should go look into this nice (and convincing, and still very recent) Investor Presentation. It is compact and pleasing, and it contains a summary of all those points (see, among others, the slides 4, 5, 14, ...), and of several other relevant issues. Even if clearly "institutional", this "investor presentation" should leave everyone presently invested in ESV with a cozy, positive feeling…
Stock values oscillate (the old "Mr. Market" thing…). That is good for serious fundamental investors that are able to evaluate companies and are able to maintain long-term presence. Doing things right, we should be (and we are!) able to profit from excessive oscillations - those that lower specific stock prices into unreasonable low valuations, or rise them to unreasonable highs.
At present, ESV seems to be one of those cases of an unreasonable low valuation. It is (still) NOT at EXTREME unreasonable low levels (as it was in 2009), but for someone following it closely and willing to invest for the long term, it (already) seems to present a very good relation between expected risk and expected returns.
If I was out of this stock and had done the re-analysis I did in the last few days, I would certainly acquire now an initial position in ESV. However, in my case, since I already have a very significant exposition to ESV, I am only reinforcing that exposition with extreme care. I have just added a very small number of shares below $50, but basically I'm waiting for the 2013 results and (even more) for the conference call that will follow their presentation. I hope some good questions are asked, and I hope that the management will offer some useful forward guidance so that I am able to validate my expectations for 2014 - or to correct them, even if only slightly, because these kinds of estimates must be continuously under revision…