Several weeks ago I wrote an article about my favorite offshore oil driller Seadrill (NYSE:SDRL). In it I argued that the company was massively undervalued and represented an extraordinary long-term opportunity for capital gains and high income. Several commenters told me about one of Seadrill's competitors and how they believed it to be the gold standard in the offshore oil drilling industry. Their comments peaked my interest and the more I researched their recommendation the more I believe they are correct.
Ensco PLC (NYSE:ESV) is the world's second largest offshore oil driller by fleet size. It owns 74 rigs with another 6 under construction. The company has transformed itself into the second youngest rig fleet at just 3.8 years old. This compares very favorably to Seadrill's 3.1 years and Diamond Offshore's (NYSE:DO) 22 years. Ensco is focusing exclusively on high margin floaters and harsh environment Jack-up rigs. Over the last 4 years the company has sold 13 of its older and less profitable rigs for a combined gain of $80 million. The proceeds were used to fund a massive new rig construction program that will have spent $5 billion from 2010-2016 on 18 new state of the art rigs. Thirteen of these are floaters (the most profitable form of oil rig) and five are harsh environmental jack-ups. As part of its growth effort in 2011, the company spent $7.6 billion to acquire rival Pride International (NYSE:PDE) which more than doubled Ensco's fleet of floaters from 13 to 29. Today the company operates in three segments.
Floaters: 63% of revenues, 29 rigs in the fleet, three under construction.
These are ultra deep-Water drillships and semi-submersibles. They are the most advanced oil rigs in the world and are capable of drilling up to 40,000 feet under the seafloor in 12,500 feet of water. The floaters are the most expensive to build but the most profitable, commanding day rates as high as $650,000/day and usually paying for themselves in just five years (average life span is 30 years).
Jack-ups: 35.1% of revenues, 44 rigs in the fleet, 3 under construction
These are harsh environmental rigs that can only operate in 400 feet of water.
Rig Management: 1.9% of revenues
This branch of the company manages oil rigs for third parties. Sales in 2013 were $59.2 million.
The recent spending on new rigs is coming to a close with 2013 cap-ex of $1.8 billion declining to no new rig spending in 2016 as Ensco absorbs and processes its new rigs. This is expected to free up $4 billion in free cash flow over the next three years. This money will go toward paying down the debt taken on to acquire Pride International as well as growing the dividend.
Catalysts For Growth:
Some facts to consider:
-In 1990, 25% of the world's oil production came from offshore, by 2020 it will grow to 34%.
- Today Ultra-Deepwater drilling produces 1 million barrels/day. By 2020 this is expected to increase to 5 million barrels/day.
- To meet the demand for ultra-deepwater drillships in 2020, 189 more UDW rigs need to be built by 2020, through for 2015 only 45 are scheduled to be delivered. This means that long-term demand will outstrip supply, driving up day rates.
- 55% of Jack-ups and 37% of floaters are over 30-years-old and will soon be retired.
- In 2013, there were 500 UDW wells drilled. In 2025 that number is projected to grow to 1,250.
- Since 2012, 57% of all new oil discoveries have been offshore in water deeper than 5,000 feet.
- According to the latest investor presentation, there have been 70+ offshore oil discoveries/year since 2009.
- By 2050 global demand for oil will increase by 110% to 190 million barrels/day.
- Past 2020 a minimum of 30% of new oil production will be from offshore.
- This means that by 2050 the production of Ultra-Deepwater oil will have to increase over 17 fold at a minimum. This represents a minimum growth rate of 8% CAGR over the next 37 years.
The mega trend in offshore oil drilling is one that is likely to continue for decades to come. The extra 100 million barrels/day of oil production will overwhelmingly come from offshore as onshore wells become exhausted. Offshore oil drillers such as Ensco who have the size, scale and expertise to safely operate in Ultra-Deepwater and harsh environments will likely prosper tremendously and long-term investors with them.
Recently analysts from Barclays and Citigroup downgraded several offshore oil drillers citing concerns over short-term oversupply and falling utilization and day rates. While true that utilization and day rates have declined for competitors Diamond Offshore and Transocean (NYSE:RIG), this has not been the case for new and more modern fleets such as those owned by Seadrill and Ensco. Specifically here are some recent contracts procured by Ensco.
- Two rigs - ENSCO 68 and 81 - received new contracts from Chevron (NYSE:CVX) at higher day rates than before.
- Activity in the Gulf of Mexico is strong, with ConocoPhillips (NYSE:COP) signing a three-year contract at $550,000/day for rig DS-9.
- Recently Talos signed a three-year contract at $530,000/day for the rig ENSCO 8502.
- North Sea "demand continues to exceed supply," as seen with rig Ensco 122 recently signing on for a two-year contract in the low $230,000s/day.
- 2013, year-over-year 19% increase in average floater day rate, up to $438,000/day.
As one can see from these recent contracts, the weakness that competitors such as Diamond Offshore and Transocean are facing in 2014 is not being felt by Ensco or Seadrill, drillers with young, modern fleets.
1. Scale: Ensco has 47 customers in 22 countries on 6 continents. This diversifies its risk in case one customer gets in trouble or goes bankrupt such as the recent bankruptcy of Brazilian oil company OGX.
2. Strong Balance Sheet: Ensco has a current ratio of 1.47 and a leverage ratio of 28%. Ensco is the 2nd least levered offshore driller. This gives protection to both the company and the dividend in case of unanticipated trouble such as the recent OGX bankruptcy. The loss of income from the 2 rigs operated by OGX isn't a threat to the company's ability to service its debt (debt interest coverage of 3.57).
3. Large Backlog: Ensco has a $11 billion contract backlog that covers 2 years of revenues and from which dividends can continue to be paid during a rough patch.
4. Young, state of the art, highly profitable fleet: During the first 10 years of its life, a floater has operating margins of 65%. Ensco's fleet is an average of 3.8 years old. Only Seadrill's 3.1 year old fleet is younger. In addition to higher utilization rates, (due to less maintenance) demand for young, 6th generation rigs continues to be high. The state of the art rigs in Ensco's fleet possesses the latest safety equipment, which all oil companies want after the BP oil spill disaster.
5. Top in industry customer satisfaction: Ensco has been the top offshore driller in customer satisfaction for 3 consecutive years. This focus on serving customers results in loyal customers and repeat business. In addition Ensco has an obsessive focus on safety and strives to achieve record low accident rates every year. After the BP oil disaster, safety records are one of the first things potential customers look at in a driller.
6. Top Income Margins in Industry: Management is able to generate industry best, 29% net margins, despite its strong investment in new rigs and its obsession with customer service and safety. Few companies can achieve this optimal blend.
Valuation and Long-Term Projected Performance:
The recent weakness in the offshore drilling market has resulted in Ensco being incredibly undervalued. To show the extent of the mispricing I'll use three different methods.
First I'll use a discounted cash flow analysis with the following assumptions:
- current EPS: $6.07
- 5 year EPS growth rate: 10.36%
- 10 year growth rate after that: 10% (due to the mega trend in offshore drilling)
- discount rate: 9%, (historical CAGR of stock market from 1871-2013)
Under these conditions Ensco is trading at a remarkable 48% discount to its fair value of $99.44.
Another way we can model the fair value of Ensco is by modeling the growth in its earnings and dividend and then applying likely historical valuations and yields.
This table attempts to model different growth scenarios for Ensco's earnings and dividend over the next 10 years. I start by using the analyst estimated 2016 earnings of $7.25/share. Next I used the consensus estimate of 10.36% EPS growth through 2018. This coincides with the projected short-term weakness in the industry. 2018-2023 is likely to see strong growth in the offshore drilling industry as Ultra-Deepwater production is forced to ramp up quickly to meet rising global oil demand.
I model two scenarios. The first, a continued 10% growth rate in EPS. The second, a faster 15% growth rate. To get a projected five-year price target I use the historical four-year average PE ratio of 12.62 and assume regression to the mean within 5 years. To the projected share price I add the anticipated five years of dividends to get a total share value. I then discount this by the same 9% used earlier to determine the fair price and current discount. Finally, I use the projected total share value to determine the expected 5 and 10 year returns.
With dividends, I model two scenarios as well. A 10% growth rate and a 15% growth rate. The first growth rate is based on the assumption that the massive increase in free cash flow will allow the continued strong growth of the dividend. The second growth rate takes into account the possible acceleration of growth past 2018 as the industry comes out of its trough and assumes the dividend will grow at the pace of earnings.
|Year||Dividend (10% growth)||Dividend (15% growth)||EPS||EPS (15% growth)|
|2018 Price Projection||87.846||104.940375||102.3471267952||117.70043|
|Total stock value||106.1613||125.16751875||120.6624267952||137.92757375|
|Total return CAGR||1.15369707861236||1.19233875823853||1.18361994597237||1.21571383254544|
|Total Return with Dividend Reinvestment||16.2%||20.2%||19.3%||22.7%|
|Avg Current Discount in 2014||32%||Avg Total Return CAGR||18.63%|
|2023 price projection||141.4||211.072577515195||164.831071174938||205.858787697687|
|Total Share Value||189.212273803||271.983732229353||212.643344977938||266.769942411846|
|Total Return CAGR||1.138005114874||1.18005840473946||1.15136838945327||1.17777818056471|
|Total Return CAGR with Dividend Reinvestment||14.49%||18.9%||15.9%||18.7%|
|Avg Current Discount in 2014||43%||Avg Total Return CAGR||16.2%|
As seen in the table, based on likely 5 year projections Ensco is trading at a discount of 25%-42% with an average of 31%. Anticipated returns are between 15.4%-21.6% CAGR assuming dividend reinvestment.
Looking out 10 years, we see that Ensco is even more undervalued by an average of 43%. The anticipated 10-year total returns are between 13.8-17.8% CAGR - again assuming dividend reinvestment. Comparing this to the stock market's 9% CAGR, (11.1% with dividend reinvestment) we see that Ensco is likely to greatly outperform the general market. This is not surprising given the deep discount to fair value at which the shares are currently trading.
After researching this competitor to Seadrill I must concede that Ensco does seem to have many advantages over that company and all others in its industry. When you combine Ensco's best-in-class customer service, safety record, its strong backlog and safe balance sheet this spells strong dividend growth and capital appreciation for many years to come. Given the current massive undervaluation of its shares I do not hesitate to recommend Ensco as a "Strong Buy Now" to interested investors.
Disclosure: I am long SDRL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.