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By Henry Hoffman

Ensco plc (ESV) is a global offshore driller, based in London, that has seen its shares pull back in stride with other offshore companies following the Macondo accident and recent decline in oil prices. Uniquely, Ensco takes a barbell approach, focusing almost exclusively of the high-end shallow water jackups and ultra-deepwater semisubmerisibles. Ensco has historically been a shallow water driller and is currently second in the high-end jackup space with 39 Jackups, comprising 11% of the global premium jackup fleet. High-end jackups are capable of drilling in deeper and more extreme conditions. ESV currently has 4 ultra deepwater rigs, and another 4 under construction. With a strategy of continually upgrading its jackup fleet, and recently entering the ultra-deepwater market, ESV has one of the youngest fleets among peers. Ensco’s story remains in the midst of a strategic change from a shallow water driller with half of its revenues in the GOM, to a global shallow and ultra-deepwater driller. Already, ESV’s GOM jackup exposure has been reduced to 20% of total jackup revenues.

Of Ensco’s eight ultra-deepwater Semi-Submersibles, seven are for up to 8,500’ depth and the other is classified as 7,500’. This build out has been a $3 Billion plus investment, of which only $1B remains unpaid. Ensco has as a market cap of just $5.9B, and their new ultra deepwater fleet will constitute a leading 12% market share of the global ultra-deepwater semi fleet. By 2012, ultra deepwater should account for roughly half of Ensco’s revenues and contribute earnings of $4+/share. Primary risks to this business include weak day rates and Petrobras plans to build 28 rigs, thus flooding the ultra-deepwater rig supply.

In reaction to the Macondo oil disaster and weak jackup day rates Ensco shares are down 15% since April 20th to $41 and briefly traded below $34 in early June at the height of the uncertainty surrounding offshore drilling in the GOM. However, Ensco has no direct involvement in the accident and we believe downside in shares is limited as Ensco has $1.2B in cash, only 4% leverage (vs 23% for its offshore peers), and a tangible book value of $38. Furthermore, the company has been repurchasing shares and recently increased the quarterly dividend to $0.35/share from $0.025/share.

Historically, the offshore group trades at a premium enterprise value to replacement value, yet ESV’s fleet has a replacement value of $9B, and a market cap of $5.9B with $1B in net cash, giving the company an industry low EV/replacement value ratio of 0.54x, as the market has not rewarded them for their huge capital investments to build out the ultra-deepwater fleet. Additionally, management has been prudent stewards of capital earning favorable returns on investment. Ensco has consistently earned higher operating margins than peers, averaging 62% over the last 5 years vs its peer group average of 47%. These high margins make the contract backlog of $2.8B even more attractive taken in combination with company’s Swiss subsidiary structure provides low effective tax rates of 16-17%.

ESV shares trade at 8x consensus 2012 earnings of $5, a premium to its peer its peer group at 7.4x. However, as previously demonstrated in 2006 – 2008, ESV can earn in excess of $5/share on just its jackup fleet in a strong demand environment. The company’s barbell approach and relatively fewer contracted rigs make them one of the most levered players to swings in day rates, which can cause earnings to fluctuate dramatically. However, a strong balance sheet and valuations close to tangible book value should limit the downside, while a strong demand environment provides potential earnings easily over $8/share in an upside scenario, giving ESV shares attractive upside promise.

Peer Group Valuation Metrics

Price

Market Cap

2011 P/E

2012 P/E

Net Debt/Mkt Cap

EV/RV

DO

59.27

8,240

8.5x

9.4x

8.8%

1.0x

NE

30.81

7,883

6.4x

6.4x

-4.2%

0.7x

PDE

23.14

4,065

8.0x

6.9x

21.4%

0.9x

RIG

51.42

16,402

6.4x

6.8x

51.9%

1.1x

AVG

7.3x

7.4x

19.5%

0.9x

ESV

41.07

5,871

9.6x

8.3x

-16.6%

0.5x

*Thomson One mean estimates

**JPM replacement value (RV) estimates

Disclosure: Long ESV in hedged strategy, Long RIG

Source: Ensco's Favorable Risk / Reward Tradeoff