Ensco's Second Quarter 2014 Results Are Not As Bad As They First Appear

Aug. 4.14 | About: Ensco PLC (ESV)

Summary

Ensco's reported net income showed a significant drop compared to the prior year quarter.

This net income drop was primarily due to a $1.5 non-cash writedown. Excluding this, the company actually showed solid growth.

Ensco has noticed that E&P companies greatly prefer newer, modern rigs so the company is selling off some of its older rigs in order to reposition itself.

Ensco has been experiencing challenges in the market for floating midwater rigs.

The company has the potential for forward growth due to new rigs coming online.

Offshore drilling giant Ensco plc (NYSE:ESV) announced its second quarter 2014 results on Wednesday, July 30, 2014. Analysts seemed to be somewhat ambivalent following the results as the company failed to hit revenue estimates. However, Ensco's earnings were a completely different story, as the company's earnings beat estimates when impairments during the quarter are excluded. Regardless of analysts' opinions, there are certainly some things in the report that investors in the company should be pleased about.

As my long-time readers are likely aware of, it is my usual practice to share the highlights from a company's earnings report when I do a review of them before analyzing the results in depth. This is because these highlights provide a background for the remainder of this report and help to frame the resultant discussion. Therefore, here are the highlights from Ensco's second quarter 2014 results:

  • Ensco reported total revenues of $1.203 billion, representing a 6% increase from the approximately $1.13 billion of revenue that Ensco reported in the second quarter of 2013.
  • Ensco took a $1.5 billion non-cash impairment charge in the quarter, which resulted in a significant adverse impact on Ensco's second quarter earnings.
  • Ensco reported a loss of $1.1727 billion in the second quarter of 2014. This represents a tremendous 429% decline compared to the prior year quarter.
  • Ensco reported a loss of $5.07 per share. This is a significant decrease from the $1.55 earnings per share that Ensco achieved in the prior year quarter.

As was mentioned in the highlights, the reason for the large year-over-year change in Ensco's net income was the $1.5 billion writedown that Ensco took in the quarter. the reason for this writedown is that Ensco's management believes that the conditions currently present in the midwater floater drilling segment are sufficiently challenging that eight of its rigs deserve a lower valuation than what Ensco had previously been carrying them at. It is important for investors to note though that this writedown was a non-cash expense and as such does not represent any actual cash that left the company. Thus, neither the writedown nor the reported quarterly loss had a direct impact on the company's current or future cash position.

One other factor to consider is the performance of Ensco's continuing operations during the quarter. If the writedown is excluded from Ensco's results, then the company's net income would have been much more in line with the prior year quarter. If the company's writedown is excluded from its results then Ensco's continuing operations would have achieved an earnings per share of $1.58 in the second quarter of 2014. The same operations achieved an earnings per share of $1.48 in the prior year quarter. Thus, those operations that Ensco will be carrying forward into future quarters actually grew year-over-year. This bodes well for the future should these operations be able to continue this growth going forward.

In addition to the year-over-year earnings growth from its continuing operations, Ensco also managed to grow the cash that its operations generated compared to the prior year quarter. In the second quarter of 2014, Ensco generated total operating cash flows of $572.7 million. This represents a 47.1% increase over the $389.2 million that the company generated in the prior year quarter. It also represents a 37.5% increase over the $416.6 million of operating cash flow that Ensco generated in the first quarter of 2014. This is, in some ways, much more important than the change in net income because it tells investors how much cash the company's operations actually produced after all expenses (except for capital expenditures). As such, this figure is much more relevant than net income to analyzing the company's ability to maintain and grow its operations, as well as pay its dividend.

In addition to the writedown that Ensco took in the second quarter, the company took steps to high-grade its fleet. To this end, Ensco will be selling five floating rigs (four of which were among the eight that incurred the writedowns in the period) that have an average age of 32 years. In so doing, the company will be reducing the average age of its floater fleet to just nine years. This is a move that will help Ensco be more competitive with companies such as Seadrill (NYSE:SDRL), which already has a much newer fleet than Ensco, and Noble (NYSE:NE), which is also reducing the average age of its fleet through the transfer of several older assets to Paragon Offshore. Although Ensco is already consistently rated the number one company in the industry in terms of customer satisfaction, this move will help the company attract more customers as it will now have one of the newest fleets in the industry. This asset sale also shows that Ensco has been observing one of the same trends that other offshore drilling companies have reported in that oil and gas companies have been showing a marked preference to contract modern drilling units over vintage ones.

Ensco's shallow-water jackup fleet exhibited significantly improved performance in the latest quarter compared to the year ago quarter. The first evidence of this can be found in the fact that this segment of the fleet generated much higher revenues than in the prior year quarter. In the second quarter of 2014, Ensco's jackup revenues were $466 million, representing a 19% increase over the prior year quarter. There were three reasons for this increase. The first is that the average dayrate of a jackup rig in Ensco's fleet climbed from $120,000 to $132,000 over the past year. It is worth noting that this does not mean that the dayrates for new jackup contracts are climbing as it can also represent older rigs coming off of contract and being sold, scrapped, or otherwise leaving Ensco's fleet. However, with that said, jackup dayrates have been relatively steady over the past year but this cannot be determined simply by looking at the average dayrate across Ensco's jackup fleet. In addition to the increase in average dayrate across the company's jackup fleet, Ensco also saw one of its new jackup rigs, the ENSCO 120, spend its first full quarter in operation. Since offshore drilling rigs are compensated based on the number of days that they spend in operation, the fact that this rig spent more time in operation during the second quarter than in the previous one (or in the prior year quarter) resulted in it generating more revenue than it did in any prior quarter. Ensco also had another rig, the ENSCO 121, begin operating during the quarter which also boosted revenue but it did not spend the entire quarter in operation. Thus, the third quarter of 2014 will be the first quarter in which the rigs operates for the full quarter and thus it will result in this rig producing more revenue than what it did in the most recent one.

Ensco also has some additional near-term forward growth prospects due to the addition of another new jackup rig, the ENSCO 122, to its fleet. This rig will begin work on its first contract in the fourth quarter at a dayrate of approximately $230,000. As the rig will not begin operating until the fourth quarter of 2014, it will not be able to contribute to the company's results until that time but once it begins operations, it will boost Ensco's revenues by the total amount of its dayrate. The addition of this rig to Ensco's fleet may also prove accretive to Ensco's first quarter 2015 revenues as this may be the first quarter in which the rig operates for the full quarter depending on exactly when it begins operating in the fourth quarter.

Ensco also saw a few improvements in the year-over-year performance of its floater fleet. As was seen in its jackup fleet, Ensco's floater fleet saw revenue growth from $717 million to $721 million year-over-year. Here too, the company did see its average dayrate increase from $430,000 in the prior year quarter to $479,000 in the most recent one. Once again though, this does not mean that the dayrate that is being awarded to newly contracted rigs is also increasing. In fact, dayrates for modern, ultra-deepwater rigs have fallen from the levels that they were at last year.

As is the case with many other offshore drilling companies, Ensco provided an overview of the macroeconomic conditions that are currently affecting the offshore drilling industry. Overall, the company seemed pessimistic, stating that conditions have become "quite challenging" in the market for floating rigs, such as drillships and semisubmersible rigs. This is, after all, the reason why Ensco took the $1.5 billion writedown in the second quarter. However, it is important to note that Ensco's management did not state that the market for ultra-deepwater rigs has become more challenging. In fact, the results announcement states the opposite -- that the company is seeing growing future demand in the deepwater and ultra-deepwater segments. Instead, Ensco specifically stated that the market for floating rigs, particularly older midwater rigs, has become more challenging. This supports my longstanding conviction that the oil and gas companies that contract with contractors such as Ensco for the use of offshore drilling rigs have a marked preference for modern, high-specification units. This also means that companies such as Seadrill and Pacific Drilling (NYSE:PACD), which do not have any older midwater rigs, are unlikely to take similar writedowns when they report their second quarter results.

Disclosure: The author is long SDRL, PACD. 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.