Ensco: Q4 2017 Results Analysis

Summary

• Ensco's Q4 2017 results were quite disappointing, particularly when compared to those of its peers.
• The company completed the Atwood acquisition in October, which had the result of growing the company's fleet and should enhance its money making capability in future quarters.
• Revenues declined while expenses increased.
• Some of the company's profitability decline was due to non-recurring and non-cash items, however free cash flow also declined year-over-year.
• The industry has been recovering but Ensco has not benefited to the same degree as other drillers and needs to correct this situation.

On Monday, February 26, 2018, offshore drilling giant Ensco plc (ESV) announced its fourth quarter 2017 results. These results were rather disappointing as the company saw its net profit last year swing to a net loss in the most recent quarter. This is particularly true since it comes at a time when other large drilling firms such as Noble (NE) have seen their results improve year-over-year. However, it was certainly not all bad news and there are certainly things to like here, notably the fleet expansion that the company saw via the Atwood Oceanics acquisition.

As my long-time readers are no doubt already well aware, it is my usual practice to share the highlights from a company's earnings results before delving into an analysis of those results. This is because these highlights serve to 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 2017 results:

• Ensco had total revenue of $454 million in the fourth quarter of 2017. This compares unfavorably to the $505 million that the company brought in during the prior year quarter.
• The company incurred total contract drilling expenses of $334 million in the quarter. In the prior year quarter, the company had $289 million of contract drilling expenses so these increased by 15.6%.
• The company's floater fleet had total operational utilization of 97% and its jackup fleet achieved operational utilization of 98%. Both of these figures are in line with the year-ago numbers.
• Ensco completed the acquisition of Atwood Oceanics.
• The company reported a net loss of $207.1 million in the fourth quarter of 2017, which works out to $0.49 per basic and diluted share. This compares unfavorably to the $39 million in net income that the company had in the fourth quarter of 2016.

The first thing that someone perusing these highlights is likely to notice is that the company's revenue decreased by $51 million year-over-year. The primary reason for this was a decline in average fleetwide dayrates. In the fourth quarter of 2017, Ensco had an average fleetwide dayrate of $157,000 as opposed to $177,000 in the fourth quarter of 2016. This may seem confusing since, as I have stated numerous times in the past, dayrates generally do not change after a contract has begun. The reason why average fleetwide dayrates can decline is that some of the company's older, high-paying contracts were completed during the year and the new contracts that replaced them (for those rigs that had replacement contracts) were at lesser dayrates. Thus, the fleetwide average came down year-over-year. This had the effect of reducing the company's revenues.

Perhaps the most important event that occurred for Ensco in the fourth quarter was the completion of the Atwood Oceanics acquisition. Ensco first announced the definitive merger agreement back in May. According to the arrangement at the time, the stockholders of Atwood Oceanics would receive 1.60 shares of Ensco stock for every share of Atwood Oceanics owned. At the time, shares of Ensco were trading hands at $6.70, so 1.60 shares would have a value of $10.72. This would also dilute the original owners of Ensco to the point where the original Ensco owners would have a 69% stake in the combined company. The deal was ultimately consummated on October 6, 2017 under these terms. However, the stock price never hit such a level again prior to the completion of the merger so Atwood shareholders ultimately received less for their shares, but this is fairly typical with non-cash acquisitions.

This acquisition increased Ensco's size dramatically. Atwood previously had a quite capable and modern fleet of six ultra-deepwater floaters and five high-specification jackups which naturally now belong to the combined company. The addition of these rigs added $23 million to the company's revenues in the quarter. It also had the effect of increasing the company's rig costs by $53 million and added $7 million in one-time costs to execute the transaction. Admittedly, the fact that these new rigs increased the company's costs by more than revenues increased is rather problematic, but Ensco is looking toward the future with this deal.

In numerous past articles published over this past year, I stated that the offshore drilling industry has begun to recover, albeit slowly. Ensco itself has noted this fact as well. Furthermore, as has been the case since at least the Great Recession, the exploration & production companies that make up the customers of the industry have expressed a marked preference for modern rigs. There are a few reasons for this but essentially these rigs have improved performance and safety features compared to older ones. The addition of Atwood's rigs to the fleet increases the number of such rigs that the company can market as the market continues to recover which should ultimately result in larger profits (and improved efficiencies) than if the companies stayed separate.

As I mentioned in the highlights, Ensco saw the profit that it earned in the fourth quarter of 2016 turn into a loss in the most recent quarter. One of the reasons for this was that the company incurred a $183 million non-cash impairment charge during the quarter. We have seen these kinds of expenses on the income statements of many drillers over the past few years and they are typically caused by the fair market value of offshore drilling rigs declining. Ensco does not state which rigs were the cause of this impairment charge in its press release (it mentioned the ENSCO 5005 in the earnings call but also stated that the charge was not specifically due to the retirement of that rig), only that it was two non-core floaters, so we can assume that the charge was caused by a decline in value of two of the company's older rigs. It is a non-cash charge, of course; an accounting figure that is required to account for a decrease in the value of the rigs as listed on Ensco's balance sheet. It is also worth noting that the company had a $140 million gain (listed under other income) due to the Atwood acquisition that offset some of this loss.

I have long felt that cash flow is a better measure of a company's profitability that net income. Specifically free cash flow, which is also one of Warren Buffett's favorite measures of profitability. Free cash flow is essentially the money left over after a company pays all its operating and capital expenses. In the fourth quarter of 2017, Ensco had a free cash flow of -$22.8 million compared to $15.9 million in the prior year quarter. Thus, we can see that by this measure too, Ensco's profitability declined year-over-year. In this case though, the causes were primarily the decline in revenues along with the increase in expenses. This is obviously a negative development for the company.

In conclusion, the expansion of the fleet that came with the Atwood acquisition could prove positive for the company as the industry continues its recovery. Otherwise this was a disappointing quarter for Ensco and the company has some work to do to turn around its declining revenues and profitability.

Analyst’s 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.