Ensco: Consolidation Reduces Risk

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About: Ensco PLC (ESV), Includes: NE, ORIG, RDC, RIG
by: Stone Fox Capital

Summary

Ensco and Rowan agree to an all-stock merger.

The biggest immediate benefit of the merger is $150 million in synergies in 2020.

The industry consolidation will help the sector recover, but the sector faces substantial risk due to land drilling.

My thesis remains bullish, but the combined company is still positioned for a loss in 2020.

My investment thesis has remained consistently bullish on Ensco (ESV) due to an expected rebound in the offshore drilling market. A big plus to the thesis is the recent industry consolidation that will reduce a large portion of the major players in the sector. The merger with Rowan (RDC) is another big step in the process and keeps us bullish on Ensco despite the recent rally to yearly highs.

Image Source: Ensco/Rowan merger presentation

Consolidation Helps

Industry consolidation is undeniably positive. Fewer players will reduce competition for limited contracts in the future.

Partly for this reason, Ensco and Rowan agreed to merge. Rowan shareholders will receive 2.215 Ensco shares for each Rowan share. Ensco shareholders will control roughly 60% of the new company.

Ensco buying Atwood Oceanics hasn't been completely bullish for the company due to a lack of deepwater contracts for the industry, but the last two deals in the sector cuts the competition for deepwater work. The combination of Transocean (RIG) and Ocean Rig UDW (ORIG) creates the sector leader while Ensco combining with Rowan creates a strong second position in the floater market. As well, the company will have a leadership position in the jack-up market due to the strength of Rowan in the later segment.

Source: Ensco/Rowan merger presentation

As one can see from the above chart, neither Atwood Oceanics or Ocean Rig are listed anymore on the floater side and Rowan will come off the list soon. The market is quickly consolidating into 3 or 4 quality players.

Further breakdown of the floater segment places Ensco and Transocean as the clear leaders in the high-spec drillships at 11 and 12 rigs, respectively. As well, the harsh environment jack-ups segement has Ensco as the clear leader over Maersk and Noble (NE).

Doesn't Resolve Sector Risk

The major issue with the offshore drilling sector is that industry consolidation doesn't solve the demand issue. Shale drilling has possibly changed the industry forever so that deepwater drilling might not match the peak levels of the past.

Unlike the airline industry that has seen massive increases in profits since the industry consolidated to three legacy players, the offshore drilling sector isn't guaranteed to get better due to the competition from land drilling. Demand was never the issue in airlines so limiting supply and competitive pressures solved that industry problem.

The company suggests the new Ensco only has about $2.7 billion in backlog, excluding the unconsolidated ARO Drilling JV of Rowan. The analyst estimates for 2019 revenues is at nearly $2.4 billion.

Though these numbers don't exactly add up considering the backlog consists of remaining revenues in 2018, the key to the story is that lack of backlog beyond 2019. As this slide from the high-spec drillships highlights, very little backlog exists beyond 2019 with only the Ensco DS-10 having a contract that extends into 2021.

Source: Ensco/Rowan merger presentation

A key part of the deal is another $150 million in synergies making the combined company closer to breakeven in this tough operating environment. Analysts forecast both companies individually generating substantial losses in 2019 and 2020.

Chart ESV EPS Estimates for Next Fiscal Year data by YCharts

Based on these predicted losses, Ensco with 437 million shares outstanding would lose ~$300 million next year and Rowan with 127 million shares outstanding would lose $260 million. The combined company would have 718 million shares and lose $560 million before the synergies. The new Ensco would cut the loss to $410 million based on the $150 million synergy estimate in 2020.

A loss of about $0.57 per share is still a substantial amount.

Takeaway

The key investor takeaway is that consolidation helps the long-term prospects, but the company is still hampered by a weak recovery in the offshore drilling market. The consolidation should improve day rates and reduce the sector rush for newbuilds as the market improves, but a ton of work needs to take place before the risk is removed from owning Ensco.

My thesis has long agreed with this comment from ISI analyst James West, but a lot of risk still exist:

offshore drillers are where the doubles, triples and more can be found.

Disclaimer: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.

Disclosure: I am/we are long ESV.

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.