On Wednesday, February 24, 2016, offshore drilling giant Ensco (NYSE:ESV) announced its fourth quarter 2015 results. Overall, these results were disappointing but they were not as bad as the headline numbers might lead one to believe. As with many other companies in the industry, Ensco has been greatly affected by the tremendous decline in oil prices that has taken place over the past two years and this is clearly evident in the company's results. Fortunately, the company is taking steps to improve its ability to weather the challenges facing it.
As my long-time readers are no doubt already aware, it is my standard practice to share the highlights from a company's earnings report before delving into an analysis of these results. This is because these highlights provide background for the remainder of the article and provide a framework for the resultant analysis. Therefore, here are the highlights from Ensco's fourth quarter 2015 results:
- Ensco brought in total revenues of $828 million in the quarter. This represents a substantial decline from the $1.16 billion that the company brought in during the prior year quarter.
- The company reported an operating loss of approximately $2.51 billion in the quarter.
- Ensco reported contract drilling expenses totaling $415 million. This represents a significant decline from the $514 million that the company spent in the prior year quarter.
- The company reported a loss on impairment of $2.744 billion. This compares to $3.515 billion in the prior year quarter.
- Ensco reported total impairments of approximately $2.9 billion in the quarter.
- The company reported a net loss of $2.472 billion in the quarter. This compares to a net loss of $3.452 billion in the prior year quarter.
It has become something of a recurring theme over the past few years for offshore drilling contractors to report outsized losses in the final quarter of the year. These losses are, without fail, caused by one-time non-cash transactions. That was very much the case here. During the fourth quarter, Ensco was forced to write down the value of several of its rigs, taking a $2.584 billion loss in the process. In addition to this loss, Ensco was also forced to take a $276 million impairment charge against its goodwill, bringing the company's goodwill down to zero. It is important to note that both of these charges were non-cash transactions. No money actually left the company as a result of these charges. If these impairment charges are excluded, then Ensco would have turned a profit in the quarter.
It is not exactly a secret that the oil and gas industry is very capital intensive. The offshore drilling industry is no exception. After all, the construction of an ultra-deepwater drilling rig can cost between $600 and $700 million. The capital intensive nature of the industry combined with the overall weakness in the industry strained Ensco's free cash flow during the year, which is somewhat concerning. This is because of the definition of free cash flow. Investopedia defines free cash flow thusly,
"Free cash flow is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (NYSE:FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, its tough to develop new products, make acquisitions, pay dividends, and reduce debt. FCF is calculated as: EBIT(1 - Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditures. It can also be calculated by taking operating cash flow and subtracting capital expenditures."
Thus, free cash flow is essentially the money that Ensco can use to improve its liquidity or pay dividends to its shareholders. During the 2015 fiscal year, Ensco had an operating cash flow of $1.6979 billion and had total capital expenditures of $1.6195 billion. This gives the company a free cash flow of $78.4 million. During the year, Ensco paid a total of $141.2 million in dividends to its shareholders. Therefore, the company failed to generate sufficient cash to pay its dividend and so had to take on debt to be able to afford it. Given the challenges plaguing the industry, it is unlikely that Ensco will be able to continue to do this (although the company's capital expenditures will likely also decline going forward).
However, the lack of free cash flow was not the primary reason why Ensco reduced its dividend to $0.01 per share per quarter from $0.15 per share per quarter. Instead, the company made this move for the same reason that peer companies Seadrill (NYSE:SDRL) and Seadrill Partners (NYSE:SDLP), among others, reduced or eliminated their dividends over the past few years. This reason is that offshore drilling contractors as a whole need to preserve their cash in order to weather what is perhaps the most challenging market that the industry has ever faced. Fortunately, Ensco does have one significant advantage over the other two aforementioned companies: its debt level is much lower. As of December 31, 2015, Ensco had no current or short-term debt and $5.8951 billion in long-term debt. The company had a total of $6.5172 billion in shareholders' equity as of the same date. This gives the company a total debt-to-equity ratio of 0.9045. While this is certainly much higher than Ensco has had in the past, primarily due to the significant writedowns that the company has taken over the past two years, it is still a much better ratio than many other drillers have.
Unfortunately, as Ensco's fleet status report shows, the company has a large number of rigs coming off of their current contracts during 2016 without replacement contracts for the rigs to begin work on once their current contracts expire. If Ensco fails to secure new contracts for these rigs, which is a very real possibility given the current state of the offshore market, then the company's revenues will be under powerful downward pressure throughout the year. This makes the improved liquidity afforded by the dividend cut all the more vital to the company's ability to weather the downturn.
Fortunately, the contract status of Ensco's ultra-deepwater fleet is much stronger than that of its jack-up fleet, owing largely to the much longer contracts that these rigs were awarded during the previous industry upcycle. As the fleet status report shows, at least some of these reasons have contracts extending into 2017 or 2018, although a not insignificant number will see their contracts expire in 2016. Given that these rigs are by far the most profitable in the company's fleet, the rigs whose contracts will remain in place over the next two years will provide some support to the firm's finances, although it will still likely experience notable revenue declines in 2016.
Disclosure: I am/we are 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.