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Summary

  • Ensco recent earnings announcement was met with much disappointment.
  • Ensco is looking to divest itself of older rigs which will dramatically reduce the average age of its existing fleet.
  • Management is cautious due to the coming oversupply in the market.

One of the hardest decisions facing an investor is how to handle a position that has moved against you. The most difficult portion for most is the "pain" of admitting defeat and selling a position. The thought "If I just hold a little longer, things will turn around and I will have a profit to show for my efforts". Sadly, most times the decline continues leading to even larger losses before the investor gives up and sells. Such is the dilemma I recently faced with Ensco (NYSE:ESV). The article below will detail my decision to sell ESV, with a brief overview of the company I replaced them with in my portfolio.

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Before I initiate a position in a company, I develop a thesis as to why this particular investment should be included in my portfolio. When I originally purchased ESV, my thesis revolved around two factors. The first factor was the overly generous dividend paid out by the company. ESV dividend at the time was above 5% which in my view helped compensate for the risk in holding the shares.

The second thesis revolved around the share buyback program the company had authorized. The share reduction plan has yet to be initiated, with the company taking some steps to make that a reality. The following quote attributed to James Swent CFO of ESV from the recent conference call, neatly sums up the capital spending priorities of the company.

Our current outlook for 2014 capital spending is approximately $1.7 billion. Through June 30, capital spending totaled $630 million, so the balance for the remainder of the year is $1.1 billion. The full year estimate includes $800 million in newbuild CapEx, including the final payment for ENSCO 122, as well as a milestone payment for ENSCO DS-10 and the initial payments for ENSCO 140 and 141, plus $570 million for rig enhancement projects and $330 million for sustaining projects. As a reminder, approximately $200 million of our rig enhancement CapEx will be funded by our customers. We project newbuild CapEx in 2015 will increase to approximately $1.6 billion and then drop significantly to $400 million in 2016 as we deliver our final rigs under construction. Therefore, for the balance of 2014 and 2015, cash flows from operations will be dedicated primarily to milestone payments for newbuild rigs that will support future growth and the dividend, as I mentioned on our prior conference calls.

I was heartened to see the company sees future dividend growth as important yet the enthusiasm waned after the following comments made by Carl Trowell the CEO of the company. He was speaking about some of the headwinds the company currently faces with respect to customer spending.

In terms of the deepwater market, a significant number of new drillships and semis are being built, and customers have tightened CapEx spending, which, together, are pressuring the supply/demand dynamics. Therefore, it's hard to predict the length and depth of the current downturn in the floater market. There are a series of positive factors, however, that should support growing demand in the mid to long term. They include robust commodity price levels, coupled with positive global GDP forecast; a significant number of deepwater discoveries yet to move to appraisal and development drilling; continued customer participation in offshore lease sales, including new frontier areas; and while rates of return have trended down for E&P companies, most IOCs have production levels beneath those of 2010 and reduced offshore rig rates will likely trigger return to drilling as the imperative to replace production increases.

After reading the following blurb, one would question why would the company continue to commit so much capital towards new equiptment. I actually believe this is a prudent move, as ESV move towards "high grading" their fleet has allowed them to keep contract price levels up. ESV is looking to divest their older, less capable rigs and move to a more modern fleet. The following quote from the CEO speaks to this reality.

The other side of high-grading is divesting older, less capable rigs. And during the second quarter, we completed a granular market review and an in-depth analysis of our fleet. We concluded that we will sell 5 of our floaters, which are now included in discontinued operations. Four of these rigs, with an average age of 37 years, had a loss on impairment. The rigs we intend to divest are mostly older mid-water semisubs that we believe do not have a place in our long-term fleet structure. After this action, our remaining floater fleet will have an average age of just 9 years. We also wrote down the value of 4 additional floaters that remain in continuing operations to reflect our current assessment of the market. Jay will go through the details of the $1.5 billion impairment charge we took this quarter for these 8 rigs.

To add to the uncertainty here, their is a large number of equiptment being built throughout the world. I suspected the established players would look to retire some of their older equiptment which is playing out as expected. The wildcard here is the amount being built by firms who aren't operating today. The following quote from the CEO speaks to this reality.

In terms of the deepwater market, a significant number of new drillships and semis are being built, and customers have tightened CapEx spending, which, together, are pressuring the supply/demand dynamics. Therefore, it's hard to predict the length and depth of the current downturn in the floater market. There are a series of positive factors, however, that should support growing demand in the mid to long term. They include robust commodity price levels, coupled with positive global GDP forecast; a significant number of deepwater discoveries yet to move to appraisal and development drilling; continued customer participation in offshore lease sales, including new frontier areas; and while rates of return have trended down for E&P companies, most IOCs have production levels beneath those of 2010 and reduced offshore rig rates will likely trigger return to drilling as the imperative to replace production increases.

The fear here is a glut of supply coming to market which would lead to lower day rates across the industry. Mr. Trowell certainly addressed this issue with particular candor which can be seen from the quote below.

There are, however, a large number of jackups being built around the world, and we need to be cognizant of this new supply. It is worth noting that more than half of the jackup rigs being built have been ordered by firms that are not operating even 1 rig today on the open water. Therefore, it's unclear when and how these rigs will come to market and whether they'll be sold and if so, to whom, given that many of the established drillers already have active newbuild programs in place.

After reviewing the entire conference call, I decided to sell my position in ESV and redeploy the funds into Walgreen (WAG) as detailed in the following article. ESV is a well run company with one of the newer fleets in the market. The problem facing the company is two fold. The first is the glut of supply coming into the market. While this isn't a new found phenomena, it does put pressure on the existing players. I expected some of the older rigs to be de-commissioned and the newer models to take their place.

The second problem is the continued slow down in capital being allocated towards deep water exploration. Currently from my review of some of the oil majors, the trend is towards a reduction in their cap ex budgets. I suspect the trend will reverse at some point however it will more than likely be a 2016. At this time, I am unwilling to continue to hold the shares. I would like to thank you for reading and I look forward to your comments.

Disclosure: The author is long WAG. 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.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.

Source: Ensco PLC Offers A Sobering Look At The Dynamics Affecting Its Core Markets