The Long Case for Ensco International

Dec.12.07 | About: Ensco PLC (ESV)

Ensco International (NYSE:ESV) is an offshore oil/gas driller. Their fleet consists of 46 rigs (44 jackup rigs, 1 semi-submersible and 1 barge rig). Ensco also have 4 semi-submersible rigs under construction and scheduled for delivery from Q2 2008 through 2010.

Valuation

  • Intrinsic Value: $70 - $84 per share
  • Accumulation Range: $55 or better

On surface examination, this stock looks cheap. According to Morningstar, Ensco has a TTM P/E of 8.5 and a forward P/E under 7. Yahoo Finance shows a PEG ratio of 0.26, which is one of Peter Lynch's preferred metrics.

Digging deeper seems to confirm the attractiveness of this stock. Consensus estimates put earnings growth at 30% for the next five years. Being conservative, we will assume 10% growth or a third of analyst estimates. Using TTM FCF ($625M after capex of $531M) as the base, we get a rough 5-yr DCF value at $84 per share. The company is estimating $550M capex in 2008 but also nearly 400 less shipyard days which should lead to increased OCF. Lowering FCF to $520M gives us a value of $70 per share. If the company increases OCF and earnings growth is closer to analyst estimates than my conservative number, this stock will look even cheaper.

Additionally, the company measures very well using the Greenblatt metrics of earnings yield (14.7%) and ROIC (31%), TTM. Operationally, the company has been hitting on all cylinders -- increasing net income faster than asset growth, buying back shares and increasing margins. Their low debt levels should insulate them from any credit market turmoil.

The Skinny

Generally, I've been resistant toward investing in the oil-service industry. Most of the companies generate little in the way of "owner's earnings" - what Warren Buffett defined as the cash that could be taken out of the business without impairing the operation. Most oil-service companies generated lots of cash during boom periods but most of it goes toward reinvestment as they ramp up capacity. Once capacity is ramped up, the boom is over and the cash dries up. And so the cycle goes.

So what's "different this time?" Peak oil.

The market seems to have accepted the fact that the IOCs (international oil companies - ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), BP (NYSE:BP), Royal Dutch Shell (NYSE:RDS.A), Total (NYSE:TOT), etc.) face major challenges in replenishing reserves. In fact, many analysts have noted that this task is so daunting for the IOCs that they have demurred and instead, spend vast sums of money buying back their own shares rather than undertake new drilling in harsh conditions. But with oil prices so high and increasingly larger blocks of area off-limits to them due to nationalism and environmentalism, the major oil companies will have no choice but to ramp up exploration programs or else liquidate their business.

I have always preferred the upstream companies over the service companies due to the tangible nature of the oil assets. But increasingly, operating conditions for all companies, IOC or NOC, are becoming increasingly hostile.

"Free-market" companies face more challenging conditions and terms -- and not just in countries like Venezuela or Kazakhstan. Alberta province proposed increasing royalties on oil and gas production. The US just increased royalty terms on leases in the Gulf of Mexico. So even as oil companies have to deal with the immense costs and technical obstacles associated with extracting oil from tar sands or in hurricane-prone waters, the government is lowering investment returns, thus increasing total risk for these projects.

The NOCs face their own set of peculiar circumstances. Some of them, like Petrochina and Petrobras, have exclusive access to promising prospects. But due to their state-owned situation, it is far from certain that they will be allowed to operate in a way to maximize profits. Their respective governments highly regulate the prices that can be charged in the domestic markets. Chinese refiners often operate at a loss and are compensated via state subsidies. Ultimately, promising oil reserves are worth only as much as the revenue generated from their sale - no matter how scarce the commodity may be.

This leads us to Ensco. Being an oil driller, they are not exposed to ever-shifting regulatory environments - the exploration companies bear that risk. But unlike many oil service companies, Ensco generates solid free cash flow with good visibility out at least the next few years. They have a $3.4B backlog after 2007 and one deepwater rig that probably will get contracted well before its scheduled delivery.

Ensco has heavy exposure to international markets, with 75% of revenues in 2007 outside the Americas. They also have a very good operational and strategic track record and even managed to make money during the last cycle downturn.

Keep in mind that according to numbers from the IEA, oil production may have peaked in summer 2005. If peak oil is truly upon us, Ensco will do great business in the years ahead but without many of the risks the oil companies will have to face.

Performance Measurements

  • Maintain or increase OCF/FCF levels.
  • Keep timeline on the ENSCO 8500 rigs: E8500 in 2Q 08, E8501 in 1Q 09, 8502 in 4Q 09, E8503 in 3Q 10
  • Generate top+bottom line growth of at least 10%.
  • Continue growing backlog YOY.
  • Keep expenses in check (contract drilling expense in 4Q 07 expected @ +1%)
  • Continue entry into new markets (Pemex, Saudi Arabia, Tunisia)
  • Keep shipyard days to minimum (~45 days expected in 08)

This is an excerpt edited specifically for Seeking Alpha. You can find a more thorough detail of risks, upside, probabilities and management here.

Disclosure: Author has a long position in ESV