American businesses aren't adding jobs at a meaningful pace, with the Labor Department reporting last Friday that nonfarm payrolls increased by only 113,000 in January. Factoring in the 75,000 created in December, the last two months represented the weakest two-month period of job growth in three years, the cold weather notwithstanding. The official unemployment rate did drop a tenth of a percentage point to 6.6%, which is the lowest since October 2008, but that's of little comfort to the millions of Americans who have simply given up looking for a job and the tens of millions that aren't seeing their incomes grow, even as taxes, fees, healthcare costs, heating bills, etcetera, are rising. Disconcertingly, too, factory activity dropped in January to the lowest level in eight months, perhaps indicating the 3%-plus GDP (gross domestic product) growth in last year's second half was bolstered considerably by inventory building, which wouldn't bode well for economic growth in 2014.
Somber statistics, of the type detailed above, didn't seem to matter much in 2013, when Wall Street drove the stock market straight up, arguably on the adrenaline triggered by prolific central bank money printing. Investor behavior six weeks into the new year strongly suggests things could be very different in 2014, however. Equities are down for the year and volatility has spiked considerably, with the Volatility Index (VIX), also known as the "fear" gauge, already having surpassed the high of all of last year. In a mere 27 trading sessions, investors have had to endure seven declines of more than 100 points in the Dow Jones Industrial Average, including two in which the venerable index gave up more than 300 points.
It's difficult to know how the Federal Reserve is going to react if economic activity doesn't accelerate, emerging market turmoil persists, and/or stocks continue to gyrate downward. But, as noted in previous reports, government entities have exhausted much of their stimulative powers and stock market gains in the year ahead, if any, will probably have to come the old-fashioned way; the individual companies will have to earn their way to price appreciation. All that said, we like the idea of dividend yield in an environment of high uncertainty and steep valuations. As such, the stock we're recommending here is Ensco plc (ESV).
Ensco plc, the second-largest offshore contract drilling company in the world, raised its quarterly dividend distribution by 33% (to $0.50 a share) 12 months ago, lifting the indicated yield then to 3.6%. Citing a "strong balance sheet, $11 billion in contracted revenue backlog and positive outlook for future earnings and cash flow growth," the England-based concern increased the quarterly payout by another 50% three months ago. That hike boosted the annual yield to 5.3%. Following almost three straight months of downward pressure, investors who buy the stock at today's closing price can lock in an extraordinarily attractive dividend yield of at least 5.9%, which is in the top 5% of all the stocks in the Standard & Poor's 500 index. So, the critical questions to be addressed prior to making a commitment are: First, is the dividend safe and sustainable? Second, can the payout be raised further in the future? And third, what are the prospects for capital appreciation, to augment the dividend yield?
Ensco transformed itself in mid-2011 through the $7.4 billion acquisition of a rival, Pride International. The transaction added substantial debt to the balance sheet, along with a relatively large number of shares to the stock base, but profits and cash flow have also expanded considerably since then. Per-share earnings rebounded almost 70% in 2012 and probably rose by more than 17% (to $6.15) in the recently-concluded year; December-quarter and full-year results are scheduled to be announced on February 20th. Moreover, the aforementioned backlog and the prevailing business environment augur well for even better results in 2014 and beyond; our bottom-line estimates for this year and next are $6.60 and $7.60, respectively. Significantly, too, despite the increase in indebtedness, the company's finances remain sound, with debt representing a relatively modest (and easily manageable) 27.3% of total capital as of September 30, 2013. That's not all, the driller's aggressive fleet expansion program is slated to wind down over the next five or six quarters, which should result in considerable "free cash flow," which in turn, not only provides a larger cushion for the current dividend distribution, but lays the foundation for increases in the payout, share repurchases, and/or the rapid pay-down of debt.
ESV shares certainly aren't without risk, however, sensitive to both vacillations in energy prices and fluctuations in global economic activity. The company's top and bottom lines are also vulnerable to supply/demand dynamics in drilling rigs, an issue that may explain, in part, the drilling sector's relative weakness in recent months. All in all, though, we think Ensco is well-positioned to navigate the treacherous waters ahead and expect its shares, which are trading at low valuations, to deliver very attractive total returns over the next three to five years - consisting of an annual dividend yield of about 6% and a near doubling in the stock price.
Ensco plc is the second-largest provider of offshore contract drilling services to the international oil and gas industry. The company owns and operates an offshore drilling rig fleet of 75 rigs, including six new rigs that are under construction. They include 10 drillships, 19 semisubmersible rigs, and 46 independent leg jackups, with operations spanning approximately 20 countries on six continents, and in nearly every major deep-water and shallow-water basin around the world. The regions include major markets in Southeast Asia, Australia, the North Sea, the Mediterranean, the U.S. Gulf of Mexico, Mexico, and the Middle East. They also include the fastest-growing floater markets in Brazil and West Africa, where some of the world's most prolific geology resides. Ensco's ultra-deepwater fleet is the newest in the industry and its premium jackup fleet is the largest of any offshore drilling company. Under construction are three technologically-advanced drillships and three ultra-premium harsh environment jackup rigs, all of which are part of management's long-standing strategy of continually expanding and improving the fleet.
The large contract driller was formed in 1975 as a Texas corporation and was known as Ensco Delaware until December 2009, when it completed a corporate reorganization, incorporated under English law, and assumed the current appellation. It remains subject to U.S. Securities and Exchange Commission reporting requirements, however, and continues to report consolidated financial results in U.S. dollars and in accordance with U.S. generally accepted accounting principles (GAAP). Ensco provides its services to major international, government-owned, and independent oil and gas companies. During 2012, the company's five largest customers accounted for 48% of aggregate revenues, with the largest, Petrobras of Brazil, representing 24% of the total. Non-U.S. operations accounted for 70%, 73%, and 75% of total revenues in 2012, 2011, and 2010, respectively. Drilling services, which include a drilling rig and rig crews, are provided on a "day rate" contract basis. As of February 1, 2013, Ensco had approximately 9,000 employees, the vast majority working on rigs and compensated on an hourly basis.
The company's business consists of three operating segments: Floaters, which include the drillships and semisubmersible rigs; Jackups; and Other, which consists of management services on rigs owned by third-parties. Floaters and Jackups provide one service, contract drilling. A significant number of the drilling contracts are of a long-term nature. Accordingly, an increase or decline in demand for contract drilling services generally affects operating results and cash flows gradually over future periods as long-term contracts expire and new contracts and/or options are priced at prevailing market rates.
Floaters (63.0% of 2012 revenue and 63.9% of operating income)
Floaters consist of 29 drillships and semisubmersible rigs that are capable of drilling in water depths exceeding 1,000 feet; 23 are capable of drilling in excess of 4,500 feet of water. Segment revenues and operating profits totaled 2.7 billion and $1.1 billion in 2012, respectively, compared with just $1.5 billion and $512 million in the previous year. Results were buoyed considerably by a full-year's contribution from Pride International, which added five drillships and 11 semisubmersibles. The top and bottom lines were also aided by improvements in both average day rates, which increased from $339,017 to $358,336 (up 5.7%), and floater utilization, which rose seven percentage points to 87%. (Rig utilization is derived by dividing the number of days under contract by the number of days in the period.)
The Floaters segment continued to perform well in 2013, with revenues 14.5% ahead of the year-earlier pace after nine months and totaling $2.3 billion; they were up 9.9% (to $788 million) in the September quarter. Rig utilization was six percentage points lower at 83%, but that was due exclusively to nonoperational items associated with several units. Average day rates, meantime, were $416,201 in the third quarter and $397,698 year-to-date, versus $362,197 and $354,695 in the comparable 2012 periods.
Jackups (35.1%; 34.9%)
The Jackups segment consists of 46 units that drill in waters not exceeding 400 feet in depth. It contributed $1.5 billion to Ensco's top line in 2012, 24.5% more than in 2011. The business also added $601 million to operating profits in 2012, up from $423 million in the prior year. Financial results were driven by broad-based improvements in demand, which lifted both average day rates - up 8.1% to $106,212 - and jackup utilization rates - nine percentage points to 89%. (Demand for drilling rigs was limited during most of 2010 but tender activity increased during 2011, resulting in material progress the following year.)
The Jackups segment continued to perform well in 2013, too, with revenues surging 20.7% (to $460 million) in the third quarter and 14.1% (to $1.3 billion) in the year's first nine months. Rig utilization expanded three percentage points in the September interim, reaching 90%, but were two percentage points lower (at 87%) for the nine-month period. Nevertheless, operating income rose nicely for both the three- and nine-month periods, bolstered by improvements of $16,894 (to $125,434) and $17,220 (to $121,560) in average day rates, respectively. In all, Jackups added 18.3% more (or $82 million) year-over-year to operating profits in 2013's first three quarters.
Other (1.9%; 1.2%)
Ensco's smallest business segment consists of management services provided for rigs owned by third-parties. Revenues from this unit totaled only $82.8 million in 2012 and $52.4 million in 2011, while operating income was $21.7 million and $9.5 million, respectively. Both measures were off slightly in 2013's first three quarters, totaling $59.2 million and $12.4 million, down from $62.5 million and $16.6 million in the prior year's comparable period. The declines reflect the completion of certain contracts.
On May 31, 2011, Ensco plc completed its $7.4 billion acquisition of former offshore drilling rival, Pride International, paying $2.8 billion in cash and 85.8 million shares of its own stock, which were then priced at $53.32 each. Factoring in the debt already on Pride's balance sheet, Ensco closed out 2011 with debt of $4.9 billion, far above the $240 million with which it began the year. The driller also finished the year with 61.6% (or 88 million) more shares outstanding. On the flip side, the merger transformed the England-headquartered concern's rig fleet, dramatically increasing top-line contributions from high-end floaters, which now account for roughly 70% of company-wide revenues, up from a little more than 40% prior to the transaction. Moreover, in addition to substantially boosting the top line, Pride has diversified and expanded Ensco's geographic scale in terms of contracting out its rigs. Significantly, too, the combination provides economies of scale in purchasing, rig construction, and shore-based operations. And most important, in the first full year since the acquisition, Ensco plc earned $5.23 a share, 69.8% more than in 2011, on a 51.3% (to $4.3 billion) jump in revenues; in the year before the merger, revenues totaled just $1.7 billion. Fleet-wide utilization rose eight percentage points to 88% and the average day rate increased $32,000 to $193,000.
Costly Expansion of the Fleet
Ensco has a long-established history of strategically "high-grading" its jackup rig fleet by investing in new equipment while expanding the size and quality of its floater rig fleet. During the five-year period ended December 31, 2012, the company invested $3.6 billion in the construction of new drilling rigs. In 2013, it spent an estimated $1.3 billion for new-build rigs, above and beyond the money allocated for rig enhancement ($300 million) and maintenance ($250 million) programs. Looking forward, management expects to spend another $1.3 billion in 2014 and $600 million in 2015 on the six rigs that are now under construction - three ultra-deepwater drillships and three premium jackups.
Over the past four years, Ensco has taken delivery of 12 high-performance rigs, including five Samsung DP3 ultra-deepwater drillships, five ENSCO 8500 Series ultra-deepwater semisubmersibles, and two ENSCO 120 Series ultra-premium harsh environment jackups. Over the same period, the company sold 13 rigs, with the proceeds being reinvested in the new rigs. Significantly, the new rigs are usually ordered in response to strong demand and invariably contracted out even before delivery. ENSCO 8505, for example, an ultra-deepwater semisubmersible, was delivered in January and began work under a shared drilling contract for Anadarko, Apache, and Noble Energy in the U.S. Gulf of Mexico. ENSCO DS-6, an ultra-deepwater drillship, was delivered in January and contracted to work for BP in Angola for a five-year term that added more than $1 billion to the backlog. And ENSCO 8506 was delivered in June and contracted to work for Anadarko in the U.S. Gulf of Mexico for two and-a-half years.
Earnings Rebounding Strongly
Ensco's bottom line soared 22% in 2008, reaching a record high of $8.19 a share, fueled by surging crude oil prices that almost touched $150 a barrel. Earnings fell sharply in the subsequent three years, however, as the global economy struggled, hydrocarbon quotations slumped, and the Macondo well accident in the Gulf of Mexico severely inhibited operators' ability to secure drilling permits from the U.S. Department of the Interior. Share net fell to $3.08 in 2011. Fortunately for the drillers, permit issuance for both shallow-water and deepwater started to improve that year and picked up markedly during the following year. As such, demand for floaters and jackups increased, as did day rates. That's not all, drilling activity accelerated in most regions of the world.
Given steadily rising rig utilization and average day rates, plus an expanding fleet, Ensco posted year-over-year top- and bottom-line advances of 51.3% and 69.8% in 2012, respectively; the numbers were certainly enhanced by the acquisition discussed above. Moreover, with just the final quarter still left untallied, the driller's per-share earnings probably gained another 17.6% (to $6.15) in the recently-concluded year, on an estimated 15.2% increase (to $4.95 billion) in revenues. Looking forward, we think earnings in 2014 and 2015 will approximate $6.60 and $7.60 a share, respectively. The company's contract drilling backlog, which reflects firm commitments, was $11 billion at the end of last September. Emerging market dislocations are a near-term concern, as underscored by the problems associated with delinquent Brazilian customer OGX Petroleo e Gas Participacoes S.A., but demand remains reasonably healthy in every arena, including the Gulf of Mexico, West Africa, Brazil, Asia Pacific, the North Sea, and the Mediterranean; in last year's third quarter, Ensco did not recognize revenues for drilling services provided to OGX and also booked an $11 million provision for doubtful accounts. That said, earnings expectations for 2014 have eased in recent weeks.
Free Cash Flow Should Grow Considerably
Ensco plc has spent heavily the last several years on acquisitions and building new rigs. Indeed, cash outflow on the Pride deal and capital expenditures likely totaled more than $5.2 billion in the past three years. Given last year's two hikes in the quarterly dividend distribution and commitments already on the books for ongoing construction activity ($1.3 billion), cash outlays will most likely exceed internally generated cash flow in 2014, as they did in each of the previous three years. The budget for new-build programs drops dramatically in 2015, however, while at the same time, new rigs should be adding to revenues and cash flow. In all, we estimate free cash flow, that is cash available after meeting all cap ex and dividend requirements, will approximate $860 million that year. Moreover, we think free cash flow will total roughly $3.2 billion in the outer three years of our three- to five-year projection horizon, even assuming another modest hike in the dividend payout in a couple of years. This would afford management substantial financial flexibility in terms of retiring debt, buying back shares, and/or boosting dividends even more than we currently project.
Stock Under Pressure, Though
The price of ESV shares is down 19.6% from a year ago and is 23.2% below the 52-week high of $65.82. Moreover, trading at just $50.52 a share, it's off almost 40% from the all-time high set in mid-2008 and at levels first seen more than nine years ago. With the stock falling 11.5% since the company announced a 50% hike in the quarterly dividend distribution, on November 5, 2013, the yield is now 5.9%, compared with 5.3% on the day of the announcement.
It's always difficult to know the precise reasons for an individual stock's short-term weakness (or vigor). But the stock market's year-to-date retreat is undoubtedly a contributing factor. Concerns about emerging markets are probably hurting, too, with negative implications for oil prices, which are critical to rig rates, and worries about clients like OGX. Also adding to the negative sentiment, vis-à-vis the drilling sector, are worries no doubt about overcapacity, with rivals like Transocean (RIG) and Seadrill (SDRL) taking advantage of cheap money to expand their own fleets. Weighing on investors' minds, too, probably, is soaring oil production in the United States, which could have a depressing impact on crude oil prices.
The Bottom Line
Considering the scope and nature of Ensco's business, revenues and earnings will most likely fluctuate considerably from year to year, keeping stockholders somewhat on edge. Increasing demand for oil will lift prices, capacity utilization, and day rates, all of which will eventually lead to increased drilling capacity and pressures on rates and margins. At some point, though, the dynamics will swing again in favor of the drillers. All that said, expanding oil production in the United States has had minimal impact on oil prices, at least thus far, perhaps reflecting the fact that beyond our borders, oil is getting harder and harder to find. Indeed, an ever-growing share of oil discoveries is being made in ultra-deep waters and in other harsh environments. It's also important to note that the Saudis are the world's swing producers and aren't likely to sit still if prices were to fall too far. These dynamics augur well for contract drillers that offer the capabilities to operate in those inhospitable environments, notably Ensco.
In the meantime, valuations that are at levels seldom seen in the company's history, even as it's posting solid financial results and boasts a 10-digit revenue backlog, strongly suggests ESV shares are worthy of consideration for both the near and long term. At today's closing price, the stock sells at 7.7-times our earnings estimate for 2014 and offers one of the best dividend yields in the Standard & Poor's 500 Index. As well, a discount to book value, roughly 75% of it consisting of the tangible variety, affords the shares with additional downside support. The road over the next three to five years will undoubtedly be bumpy, not just for Ensco, but we think ESV shares will perform far better than most over that long haul, possibly even doubling in price. Importantly, too, investors will receive a very generous (and secure, in our view) dividend yield while waiting for the capital gains.