Markets Are Pricing Ensco To Sink, But Its Ability To Stay Afloat Spells Potential For Equity Upside

| About: Ensco PLC (ESV)


At $7.46 per share, ESV’s 17.7% Adjusted ROA and 0.8x Adjusted P/B drive an 11.8x Adjusted P/E, which set it up as an interesting cross-capital idea given its fundamentals.

Investors appear concerned about ESV’s ability to navigate challenging macroeconomic conditions in the energy market, with credit markets particularly concerned about the firm’s balance sheet and liquidity.

Not only are concerns about ESV’s profitability overblown, the firm also boasts a robust recovery rate, substantial cash balances, and a multi-year debt runway for navigating any credit issues.

Ensco plc (NYSE:ESV) is in the Oil and Gas Drilling & Exploration subindustry of the Energy sector. Its stock price is $7.46 as of September 9, 2016, with a market capitalization of $2.2bn. Ensco is traded on the NASDAQ exchange with headquarters in London, United Kingdom.

To better analyze the company's performance and valuation, we used the database, as it is difficult to make investment decisions without using performance and valuation metrics that have been adjusted for distortions and inconsistencies in financial statement reporting under both GAAP and IFRS. (For more detail, please follow this link.)

After careful analysis of both historical trends, as well as current valuations and analyst estimates, we believe the embedded expectations of ESV make it a very interesting cross-capital idea.

At $7.46 per share, Ensco has embedded expectations of future performance that are excessively low relative to historical performance.

Based on the firm's stock price of $7.46, market valuations are pricing in ESV to see Adjusted ROA decline to 4%-5% over the next five years, with neutral 5-year CAGR (compound annual growth rate).

Click to enlarge

What the market is thinking and why

Ensco provides offshore contract drilling services to the worldwide oil and gas industry through three segments: Floaters, Jackups, and Other. The firm owns and operates the second largest fleet in the world, with 68 offshore drilling rigs.

Ensco's stock price has been hit dramatically since the oil downturn began in late 2014. While drilling and exploration companies of all kinds have been negatively impacted by the downturn, offshore rig lessors have taken the biggest hit. Offshore rigs tend to be the highest levered of their drilling peers, and cannot easily alter operations to reduce costs and de-leverage. Also, thanks to the cost of some of the larger rigs and the more complicated environments they operate in, they can sometimes be at the higher end of the cost curve, pressuring demand. Additionally, in an oversupplied market, E&P customers are in an excellent negotiating position to drive down day rates, further impacting the revenues of offshore drillers.

On top of macroeconomic concerns, investors have been further spooked by the explosion in Ensco's CDS and cash bond market spreads, with their CDS trading at 573bps as of this writing, and their 2021 4.700% bond trading with a cash bond YTW of 8.009%. With these kinds of credit market spreads, markets appear to be pricing in a 10% 5-year chance of default, raising significant concerns for equity investors.

Why the market is wrong

While it is certainly true that any macroeconomic weakness in the energy market will impact all participants, especially drilling companies, market expectations in this scenario are clearly overblown. In spite of the downturn in oil prices, ESV has been able to continually improve profitability, with Adjusted ROA climbing from 10.9% in 2013 to 17% in 2014 and 17.7% in 2015. By shrinking their balance sheet, selling off underperforming assets and old rigs, ESV's management has been able to improve their profitability and clean up their operations. The firm is going to see Adjusted ROA fall due to the market environment, but it is unlikely to sustain at such low levels permanently, as markets are expecting.

Moreover, concerns about ESV's operational profitability aside, we can also see that liquidity and bankruptcy concerns are overblown as well. ESV's management has taken a number of steps to shore up their balance sheet and ensure they have substantial financial liquidity. Last quarter, the firm raised an additional $586mn in a share offering, which they used to repurchase $861mn in senior notes at a 28% discount, plus another $79mn at a 21% discount. Furthermore, they scrapped an additional five floaters and two jackups, which were each over 30 years old. These actions have ensured that the firm has substantial operational liquidity and a leaner fleet.

Click to enlarge

As we can see in the chart above, ESV's cash flows would fall short of operating obligations by $67mn-$100mn from 2016-2019, a 7%-18% shortfall, before exceeding operating obligations by $73mn each year after, a 7% buffer. Nonetheless, given the firm's current $1.8bn cash balance, their combined cash flows and cash on hand would be sufficient to service all obligations, including debt maturities, through 2020. However, with a $767m debt maturity headwall in 2021, the firm will experience a $569m shortfall relative to all obligations, a cash crunch that they will need to take action to avoid. As a positive, the company's Net/Gross PP&E ratio is currently 86%, meaning that the firm has very new assets. With maintenance capex at $565m a year, they are likely able to reduce capex in one or several years between now and 2021 to help navigate this shortfall. Also, the firm's robust 140% recovery rate on unsecured debt, driven by positive net working capital levels and strong PP&E backing, should allow them to access credit markets and refinance without issue. Moreover, the firm's multi-year runway before facing this liquidity crunch should allow them ample time to explore alternative methods of raising capital.

Target price range suggests significant upside potential

Given our fundamental analysis, as well as an understanding of prior historical performance and current market conditions, we see the possibility for a number of scenarios:

In our worst-case scenario, Adjusted ROA falls to historical lows at a mere 4% while the firm continues to grow Adjusted Assets at 5% annually. While at such depressed valuations (where asset values begin to offer a floor to prices), this scenario would suggest equity downside of 63% with a target price of just $2.78.

In our low-end estimation, Adjusted ROA falls to historical lows again, at just 4%, but the firm shrinks assets at 5% annually, a more likely scenario, as ESV's management has shown that they know when to aggressively grow and shrink their balance sheet. While again the firm would remain at incredibly depressed valuations, which should in theory offer a floor to prices, this scenario would suggest equity downside of 21%, with a target price of $5.92. It may sound counter-intuitive that they would create more value by shrinking than growing, but by shrinking a below cost-of-capital business, as opposed to investing more money into it, management would be able to release capital for investors to deploy elsewhere, saving investors' money.

In our first base-case scenario, Adjusted ROA rebounds over time to historical averages, and sell-side analyst projected levels, at 10%, accompanied by 5% Adjusted Asset shrinkage. This scenario would suggest equity upside of 220%, with a target price of $23.89, near early 2015 price levels, and with valuations returning to 2011-2013 levels, at a 1.7x Adjusted P/B.

In our second base-case scenario, and in our opinion the most likely, Adjusted ROA rebounds to historical averages at 10%, but accompanied by 5% Adjusted Asset growth. Considering the firm has historically seen Adjusted ROA range from 4%-23%, with consistent 3%-14% Adjusted Asset growth when ROA' warrants investing, this scenario appears quite reasonable. Moreover, this scenario would suggest equity upside of 304%, with a target price of $30.16, near late 2014/early 2015 price levels, and with valuations again returning to 2011-2013 levels, at a 1.8x Adjusted P/B.

In our best-case scenario, which, considering the historical cyclicality of the firm's profits, seems less likely, Adjusted ROA returns to slightly below 2015 current levels, at 15%, with sustained 5% Asset growth. This scenario would suggest equity upside of 610%, with a target price of $53.97, near 2013 price levels, but still below historical highs, and with valuations expanding to historical highs at a 2.8x Adjusted P/B.

The catalyst to the market revising its expectations of company performance

Given that market concerns about ESV center around two issues, the catalyst for the market revising its expectations is fairly straightforward. First, market expectations for continued weakness in oil markets need to moderate. Once markets believe that the oil supply glut is over, and that oil markets will be able to sustain prices over $40-$50 a barrel, concerns about declining profitability and liquidity should subside. Second, as was previously mentioned, the market needs to regain faith in the operational liquidity and balance sheet health of ESV. Given management's intelligent actions to bolster their balance sheet, raise cash, and sell off underperforming assets, the company is clearly well positioned to weather any extended downturn. Once credit markets come to this realization, and adjust accordingly, equity investors should follow suit. Finally, investors should follow two things: oil prices and ESV credit spreads. Once sustainable upward (or downward in the case of credit spreads) movement has been seen in both, investors will know that the time is right.

Final summary statement about the company, situation, and upside

As a global leader in offshore drilling services and leasing, ESV is an excellent company with a history of strong fundamental performance. However, markets have been scared away by the downturn in oil prices, fearing it will lead to substantial declines in revenues and profitability, and possible liquidity issues, with credit spreads exploding toward bankruptcy levels. However, these concerns ignore the recent actions taken by ESV's management to shore up their balance sheet, pay down debt, and ensure they have substantial operational liquidity. Given these actions, and the enormous potential for equity upside as credit fears subside and operational performance continues to exceed expectations, ESV is clearly well positioned for outperformance.

Note: This analysis was conducted by Fabrizio Di Martino, Sofia Pineda Bedolla, Juan Pablo Covacevich, and Rafael Ferraro Cook. It was conducted in a seminar program taught by Valens Research.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.