Is Long Ensco Rowan A Good Oil Play Now And For How Long?

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About: Ensco Rowan plc (ESV), Includes: DO, NE, RIG, SDRL
by: Kit Research
Summary

Using our financial model, ESV equity is worth nothing at today's day rates.

ESV equity is worth almost 10x today's prices if day rates recover till 2023.

Key to an investment in ESV is a balanced portfolio.

Purpose

The purpose of this analysis is to understand the likely range of Ensco Rowan (ESV)’s current and future share price using our investing framework. Our investing framework is based on two key factors; magnitude and likelihood.

The magnitude component produces a range of ESV’s share price under various potential market conditions. Likelihood, is the probability of these market conditions materialising.

Our analysis will discuss both these factors and recommend a probable range of ESV’s share price.

Introduction

The offshore drilling industry has consolidated in the last 2 years are is left with a few key players. Transocean (RIG), Ensco Rowan, Noble Corporation (NE), Diamond Offshore (DO) and Seadrill (SDRL) being the key remaining players. ESV is a result of a merger between Ensco Plc (Ensco) and Rowan Companies Plc (Rowan) in April 2019. For accounting purposes of the merger, Ensco were deemed the acquirers. Rowan shareholders received 2.75 Ensco shares for each share held. As a result of this, legacy Ensco and Rowan shareholders hold approximately 55% an d 45% of shares outstanding in the combined company, ESV. The stock of ESV was then consolidated through a 4:1 reverse stock split, leaving 197.5m shares outstanding.

ESV’s core fleet consists of 16 drillships, 12 semi submersibles and 53 jackup. As part of the Rowan merger, the combined company also holds a 50% interest in ARO Drilling, a joint venture (JV) with Saudi Aramco. 7 jackups have been contributed (ownership transferred) to the JV and 9 jackups are currently leased to ARO Drilling.

Only one rig, the Rowan Gorilla IV, is held for sale. Given that the rig was built in 1986 and is currently cold stacked, the reactivation cost alone is likely to put off any potential suitors. Therefore, we hold the view that this rig will likely be scrapped.

Fleet aging analysis

We begin with an analysis of ESV’s fleet age. ESV’s floaters and semisubmersibles are relatively modern as all drillships were made in 2010 or later and the majority of semisubmersibles were made in 2008 with the exception of 2 rigs built in 1982 and 1999; being Ensco 5004 and Ensco 5006 respectively. The status of non-contracted rigs is as described in table 1 and 2 below.

Status

Rigs

Warm stacked

Rowan Reliance, Ensco DS-11, Ensco DS-6

Cold stacked

Ensco DS-5, Ensco DS-3

Under construction

Ensco DS-13, Ensco DS-14

(Table 1: Drillship status – source KWY Research)

Status

Rigs

Warm stacked

Ensco MS-1

Cold stacked

Ensco 8506, Ensco 8502, Ensco 8501, Ensco 8500

(Table 2: Semisubmersible status – source KWY Research)

ESV’s jackups are more diverse in age compared to drillships and semisubmersibles with build years ranging from 1976 to as recent as 2019. 11 jackups are aged over 25 years as of 2019 (See Apendix 1). However, 10 out of these 11 jackups have won contract extensions spanning 2019 despite the recent downturn.

(Appendix 1 – source KWY Research)

Rig ages are central to our financial model assumptions as we believe that older rigs are less competitive, especially those over 25 years and get scrapped even as the industry recovers.

Magnitude

Our analysis first begins by laying out various future scenarios followed by discussions around the impact of these scenarios on ESV’s Enterprise Value. We then select a suitable multiple to produce reasonable range of ESV’s share prices over the next 5 years.

In our financial model, we have introduced 4 probable scenarios driven primarily by day rates and utilisation that might play out in the next 5 years.

We have grouped ESV’s rigs into 3 categories:

  • Core fleet – Rigs which are 25 years and younger
  • Old fleet – Rigs older than 25 years
  • ARO fleet – Rigs leased to ARO Drilling JV with Saudi Aramco

The core fleet has been modelled by applying the following day rates and utilisation (refer to Appendix 2 for detailed breakdown):

  • Base Case – Day rates and utilisation for each rig class remain unchanged from today’s average
  • Bull Case 1 – Day rates and utilisation grows gradually between 5-15% per annum
  • Bull Case 2 – Day rates and utilisation grows more aggresively between 5-20% per annum
  • Bull Case 3 – Day rates grow aggressively between 10-25% per annum whilst utilisation grows between 5% and 30% per annum

Note that Appendix 2 below shows that in the most optimistic scenario (Bull Case 3), ESV ends 2023 with effective utilisation close to 100% and day rates similar to that of early 2014, before the crash in WTI/Brent prices. We take the view that the day rates assumed reflect the upper bound in future market conditions in the next 5 years.

(Appendix 2: Day rates and utilisation scenarios – source KWY Research)

For the old fleet the day rates are the same as that of the core fleet however, we have assumed that only the following rigs are active during each of the following 4 scenarios:

Our base case assumes that no contract extensions are handed out to all old rigs once contracts roll off at the end of 2019. This is an extreme but possible scenario. We have also erred on the side of caution in our bull cases and have baked in the assumption that the rig count would halve every 2 years after 2019 as the old fleet is retired.

As for the ARO Drilling fleet, we have assumed a continuous utilisation rate of 100% at existing day rates through to 2023.With these assumptions, our model computes the hypothetical EBITDA and consequently EV/EBITDA (refer to Appendix 3). As part of our assumptions, leverage ratios are assumed to remain unchanged through to 2023. In addition to that, EV has been calculated based on the post-merger debt value of $7.53b, cash and cash equivalents of $1.48b and an equity value of $2.38b based on a share price of $12.08 and consolidated outstanding shares of 197.54m.

(Appendix 3: EBITDA and EV/EBITDA – source KWY Research)

Note that our projected 2019 EBITDA is $118.68m lower than ESV’s post-merger 2018 EBITDA of $311.77m. The driver behind this variance is that we’ve used a more conservative utilisation rate for our base case. Despite our conservative assumptions, it is apparent that ESV has a strong torque to increases in day rates and utilisation. Assuming utilisation and day rates return to pre-2014 levels, EBITDA would see a significant uplift to $6,999.63m in 2023.

Now that we have a range of EBITDA’s, we then examine the OSD drilling industry’s EV/EBITDA multiple in the last 25 years, it is reasonable to assume an average EV/EBITDA valuation multiple of 10 based on the Appendix 4 below.

(Appendix 4: OSD EV/EBITDA multiple – source Ycharts)

To draw the magnitude section to a close, a range of 9-10 EV/EBITDA produces the following range of equity valuations on a per share basis:

Note that if the market remains at today’s levels (Base Case), ESV’s equity is effectively worthless even till 2023. Based on our analysis, it appears that the market is currently pricing ESV based on a 2021 recovery in line with Bull Case 1. This gives us a fair value range between $9.63-$14.10 per share.

However, we cannot ignore the fact that if market conditions pick-up and maintain buoyant to 2023, even a tame recovery per Bull Case 1 would see ESV’s shares valued between $27.47 and $33.92 per share. In the case of Bull Case 2 which is a more aggressive recovery, share prices may shoot up to between $80.42 and $92.76 per share.

Likelihood

Since Ensco’s acquisition of Atwood and merger with Rowan, it has really transformed itself into a leader in the space. It is evident from Appendix 5 below that ESV is the largest and most diversified operator, owning both floater and jackup fleets. Note that Transocean is a floater fleet pure play.

(Appendix 5 – source Ensco Investor Presentation)

Operating across both jackup and floater fleets will allow ESV to comprehensively understand the needs of its customers. This can be achieved by obtaining insight as to whether customers are more conservative and investing in shallow water projects (via jackups) or whether customers are being aggressive and investing in deep water projects (via floater rigs). With information on the type of projects that its customers are investing CAPEX in, ESV can leverage on this information to maximise its revenue.

Being arguably the largest player in the industry also grants ESV a stronger bargaining position with its customers which increases the likelihood of ESV outperforming on day rates compared to its peers.

Day rates and utilisation tend to lag WTI/Brent prices, therefore we think this makes WTI/Brent prices a great risk management tool when analysing ESV. Refer to Appendix 6 below showing how significantly OSD stocks have lagged the WTI benchmark.

(Appendix 6: OSD sector price performance vs crude oil)

However, note that this is largely due to the fact that day rates and utilisation have lagged the crude oil rally by a large margin (refer to Appendix 7 below).

We believe it is very likely that day rates and utilisation will see growth as long as crude oil prices remain supportive.

However, the question really lies in the durability of the current market rally in oil prices. From a macro perspective, reports from Wall Street including hedge fund research companies such as Hedgeye are pointing towards a late cycle market. What does this mean? This typically is means that the market has 12-24 months before a recession. The magnitude of which is impossible to guess.

Recommendation

The macro consensus view described above may very well be wrong, in which case, ESV could offer tremendous upside per our model. Referring to Appendix 8 below, we believe that should WTI and Brent hold the $66.00 and $59.78 supports (Key Support Level 1) respectively, then we will monitor ESV’s shares closely for a bottoming in price action.

Per our model, should Key Support Level 1 hold for both WTI and Brent, we would initiate a long position between our entry range of $9.63 and $14.10 with a conservative upside to our target range of $27.47 and $33.92. However, if crude oil prices pick up more aggressively in line with Bull Case 2 and maintains that position in the next 5 years, an upside range between $80.42 and $92.76 by 2023 is a reasonable target.

(Appendix 8: Crude and Brent support levels)

However, should crude oil prices breakdown from Key Support Level 1, we would monitor closely if it holds the final support level (Key Support Level 2) of approximately $54/barrel for both WTI and Brent. If it holds, we would initiate a long position in ESV at the bottom of $9.63 and $14.10 range. Should oil prices break below the Key Support level 2 level, we won’t take any positions in the offshore drilling sector in following 6-12 months as it would be a reliable indicator that the late cycle has played out and the market is headed towards a recession. In a recessionary environment, the OSD industry would be a classic value trap.

Given ESV’s tremendous torque to higher oil prices, our research shows that there is a strong financial foundation backing a long position in ESV as an ideal trade to express a long oil thesis. However, given the high volatility and risks involved, it would be wise to keep a tight stop loss and to treat this position as a speculative position rather than a core position from a value perspective.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ESV over 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.