Ensco Seems Primed For 20% 5-Year Annual Returns

| About: Ensco PLC (ESV)


Ensco historically trades at 8-9x cash flow; currently, the company is on sale for 6.3x cash flow.

The company is still growing earnings substantially due to Floater growth and high profit margins with ultra-deepwater operations.

Furthermore, the company pays a $3 dividend, which is a nice cushion against the stock's historically strong volatility that could understandably scare some investors away.

Ensco (NYSE:ESV), the offshore contract drilling company, is quite cheap right now, trading at only a price of $53 per share. This is a company that, in times of normal business operating conditions, tends to have a sustained valuation in the range of 8-9x cash flow per share.

When it was producing $3 in cash flow per share in the early 2000s, the price per share averaged around $25 per share. By the time the cash flow per share increased to over $6 per share by 2006, the company was trading in the $48-$54 range regularly.

The catch, though, with owning shares of this company is that Ensco experiences significant volatility during difficult operating conditions when cash flow declines, and investors get worried and send the price of the stock down into undervaluation territory. The most dramatic example came during the 2008-2009 financial crisis (what energy company wasn't deeply undervalued then?) when cash flow fell in half and the price collapsed from the $80s to the $20s. That kind of volatility is not welcoming to everyone, especially when it is accompanied by cash flow reports indicating 50% declines in profitability.

For current investors, there is an opportunity that exists because Ensco is still growing quite fast (its ten-year earnings per share growth rate is 17.5%) but because of investor concern about oversupply in the rig industry, the price of the stock has found itself lower than what you'd expect during a period of somewhat normal business conditions in the industry.

On a relative basis, I'd think about it this way. There are plenty of companies that you can identify as growing north of 10% over the medium term. The trickier part, particularly here in 2014, is finding a company trading at a discount to fair value so you can benefit from P/E expansion as well. That's where Ensco sets itself apart: the two ways to create wealth-both through earnings growth and P/E expansion.

If we use trailing figures in the interest of conservatism, we can see that Ensco has produced $8.30 per share in cash flow over the course of 2013. If the company experiences valuation expansion to trade at 8-9x its usual cash flow, then this suggests that the company should be trading at $66.40 to $74.70 due to a proper valuation adjustment. That is an expected price change in the range of 25% to 40% just from the transition to fair value, without factoring in the company's future growth as well.

When we look to growth, there is a lot to be excited about there as well. On the Floaters side, the company noted in its most recent annual report:

During 2013, Floater revenues increased by $401.7 million, or 15%, as compared to the prior year. The increase in revenues was primarily due to commencement of ENSCO 8506 and ENSCO DS-6 drilling operations during the first quarter of 2013 and commencement of ENSCO 8505 drilling operations during the second quarter of 2012. To a lesser extent, the increase in revenues was attributable to an increase in average day rates for various rigs in our Floater fleet.

Not only does the company have eight rigs under construction, but it also has three ultra-deepwater fleets under construction as well. That's where the company is able to earn very high profit margins; typically, its operating profit margins are around 48%, and stand to inch the company's profitability numbers in the coming years.

Within the next three or four years, it seems entirely possible that Ensco's cash flow per share figures could hit $10 per share. My assumption is that the revenue growth of 15% tapers down a bit to 13%, and is offset by the higher margins received from the additions to its ultra-deepwater rig fleets.

As an investor, assuming business conditions remain reasonable, I would be interested in the intersection of growth towards $10 per share in cash flow mixed with a valuation that drifts upward toward 8-9x cash flow.

That doesn't even factor in the dividend, which at $3 per share, is significant and causes the company to yield over 5.5%. It provides a very clear path for Ensco to deliver returns in the 20% ballpark over the coming three to five years. You've got the nice dividend. You've got the undervaluation that can create value as the stock price readjusts towards its 8-9x cash flow typical range. And then you have the substantial growth with Floaters and the high profit margins offered by ultra-deepwater rig fleets. If cash flow hits $10 per share, you'd have a typical valuation in the $80 to $90 range, plus the accrual of the $3 dividend. For those reasons, Ensco is not a bad place to look.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.