Wednesday, July 28, 2010

Ensco International: Guilty by Association (with BP)

On a selective basis, controversial situations that are in the news offer the potential for great value investments. These are also known as headline risk situations, since they often beg the question "Don't you read the papers?" But it is precisely because of this uncertainty that many investors automatically sell these companies and create the potential for high returns for value investors. Mr. Market discounts the share price of such companies to reflect a perception of risk much greater than the probable economic risk of the company's long-term fundamentals.

You cannot help but notice that the Gulf of Mexico oil spill has been in the news on a daily basis since the BP Deepwater accident. BP has been the target of criticism, deservedly, since then. The future of BP is definitely at risk, and the extent of its liabilities are hard to estimate. The accident is one of the worst environmental disasters causing extensive damage to marine life and wildlife habitats as well as Gulf's fishing and tourism industries. However, along with BP, many other companies in the sector have been sold off and a few of them indiscrimately. I have taken a long position in one such indiscrimately sold off company, Ensco International. Before I go on, I want to clarify that my investment in this sector does not mean that I do not condone BP's actions or that I am trying to minimize the accident.


Business Overview:
Ensco International is a global offshore drilling contract company. It provides offshore drilling services to the international oil and gas industry. Its operations are concentrated in the geographic regions of Asia Pacific (which includes Asia, Middle East and Australia), Europe and Africa, and North and South America. Its offshore rig fleet included 39 jackup rigs, 4 ultra-deepwater semisubmersible rigs and one barge rig. Additionally, it has 4 ultra-deepwater semisubmersible rigs under construction.

Its business model is very simple. It provides drilling services on a "day rate" contract basis. Under day rate contracts, it provides a drilling rig and a drilling crew and receives a fixed amount for drilling a well. Its customers bear substantially all of the ancillary costs of drilling the well and supporting drilling operations, as well as the economic success of the well. In addition, the customers may pay all or a portion of the cost of moving the equipment and the personnel to and from the well site.

Its strategy has been to focus on the ultra-deepwater semisubmersible rig and premium jack-up rig operations and deemphasize other assets and operations considered to be non-core. It sold off its marine transportation service vessel fleet, all its platform rigs, and all but one barge rigs in the past seven years.

Financials:
The table below shows items from the Income statement for 2007-2009 separated out by the two segments - ultra deepwater semisubmersible for deepwater operations and jackup rigs for shallow-water operations.


The BP oil accident occurred during one of its deep-water operations, and there is significant uncertainty on these kinds of operations. In the case of Ensco, deep-water operations have grown from 4% to 13% of total revenue. In fact, Ensco has invested a large amount of its capital over the last five years growing its fleet to support these operations (from one semisubmersible in 2004 to four in 2009 and four more expected to be delivered in the later of 2010 to 2012). Having said that, as of 2009, majority of its revenue and operating income resulted from its shallow-water operations through its premium jack-up rigs. Also, notice that its gross margins (as well as net) have been compressed since 2007. I will discuss the economics of pricing later in this article.

Lets turn to the cash flow statement for 2007-2009. Ensco has been a strong generator of cash. It has used this cash to (i) add to its fleet (ii) retire debt and return capital to shareholders in the form of dividends and share repurchases and (iii) to make enhancements and maintenance of existing fleet.


One can argue that including rig enhancements in the free cash flow calculation is not strictly necessary, but it is conservative to do so. Such enhancements are required to keep the rigs marketable as "premium" rigs and thus command the margins that Ensco has been delivering.

The company has an extremely strong financial position. This is important in an industry where demand for its products is ultimately tied to the price of oil (rig demand depends on drilling activity which in turn depends on the current and future outlook of oil prices). In a hypothetical deflationary global macro environment where drilling activity could possibly slow down and "day rates" get compressed to historical low levels for an "extended" period of time (although I think this seems unlikely as I explain later), a drilling contract company's financial position could start deteriorating because of a high cash burn rate. In such an unlikely scenario, Ensco is probably the last one to be affected because of its strong position relative to the other players.



In addition to the above, Ensco has off-balance contractual obligations of 482.4 million in 2010 and 644.5 million in 2011-2012 related to construction of new rigs, but it can easily fund these obligations mostly from its  cash & cash equivalents and if needed from its future operating cash flows. It does not need access to capital markets to meet these obligations.

Business Environment:
There are two key metrics - average day rates and rig utilization - that are key to understanding the economics of this business.
  • Rig utilization is derived by dividing the number of days under contract by the number of days in a period.
  • Days under contract equals the total number of days that rigs have earned a day rate, including days associated with compensated downtime and mobilizations. For newly constructed or acquired rigs, the number of days in the period begins upon commencement of drilling operations for rigs with a contract or when the rig becomes available for drilling operations for rigs without a contract.
  • Average day rates are derived by dividing contract drilling revenues, adjusted to exclude certain types of non-recurring reimbursable revenues and lump sum revenues, by the aggregate number of contract days, adjusted to exclude contract days associated with certain mobilizations, demobilizations, shipyard contracts and standby contracts.
Lets look at Rig Utilization and Average Day Rate trends for Ensco from 2005 to June 2010:



These trends were not limited to Ensco but were evident industry-wide. When crude oil and natural gas prices were record high during 2007, drilling activity was at full capacity thus causing industry-wide rig utilization and average day rates to peak. Contract drillers responded to this heightened drilling activity by ordering a large number of new rigs to be delivered in 2008-2010. With the onset of global recession and the fall of oil prices from its record high, drilling activity slowed down abruptly causing an increase in supply of uncontracted rigs thus putting tremendous pressure on day rates. 


Although oil prices have stabilized, incremental drilling activity is expected to stay limited. Also, it is reported that 41 newbuild jackup rigs are currently under construction, over half of which are scheduled to be delivered for delivery during the remainder of 2010. The majority of jackup rigs scheduled to be delivered during 2010 are not contracted. It is unlikely that the market in general or any geographic region in particular will be able to fully absorb newbuild jackup rig deliveries in the near-term, especially in consideration of the existing oversupply of jackup rigs. This may cause average day rates and rig utilization to continue to soften going forward. Semisubmersible rig supply also continues to increase as a result of newbuild construction programs. It has been reported that 29 newbuild semisubmersible rigs are currently under construction, approximately half of which are scheduled for delivery during the remainder of 2010. The majority of semisubmersible rigs scheduled for delivery during 2010 are contracted. But, based on the current level of uncertainty regarding deepwater drilling in the U.S. Gulf of Mexico, it is quite likely that the newbuild semisubmersible rigs will not be absorbed into the global market without a significant effect on utilization and day rates.


Valuation
First we value the company using an income approach starting with reported data for 2009. We then make adjustments to 2009 data to come up with mid cycle, worst case, and peak cycle earnings.


It is evident that in all the above cases, the stock is trading at a very reasonable earnings multiple of 4-10x. Notice that the worst case scenario is quite drastic - cold stacking all semisubmersible rigs and net income from jackup rigs 30% lower than 2009.  This scenario is very unlikely for the following reason - Even though there is near-term uncertainty on deepwater exploration, it seems unlikely that there will be a permanent moratorium worldwide. Deepwater exploration and production are important if the western nations want to reduce their dependence on the OPEC. Also, in the light of the current findings of the BP oil spill, it seems likely that the accident was a result of human error and hence likelihood of such spills can be reduced in the future through stronger regulations on safety measures. But, even if the worst case scenario for deepwater drilling materializes, the worst case scenario for jackup rigs seems implausible. Eventually the day rates for jackup rigs will stabilize to a higher level (2011-2012). So, in the worst case scenario jackup rig utilization and day rates may get compressed for another a year or two, but then stabilize to a higher level. Ensco has the financial strength to live through such a scenario. Besides, such a scenario may get rid of the smaller  contract drillers that took on leverage during the peak of the cycle helping the day rate stabilization process. At the current level (Jun 28, 2010) the margin of safety is large enough to protect our position on the downside even in the worst case scenario. I will not bother analyzing the upside, because "if we take care of the downside, the upside will take care of itself". 

We can also value the company using a book value approach. We start with the book value at the end of 2009 and subtract the goodwill to come up with the tangible book value. This gives us a per share book value of 36.16$. However, property and equipment is accounted for at a historical cost less accumulated depreciation. But, remember that the company has been pouring money from 2005 to 2009 (20% of its total cash flow from operations) for making rig enhancements and maintenance of the rigs. Thus, the book value of property and equipment is somewhat understated. We add the total capital expenditure that the company for enhancements and maintenance to come up with adjusted tangible book value. This gives us a per share book value of 42.57$. 


Here is another evidence to show that the value for rigs is understated on the books. (i) In April 2010, Ensco sold one of its jackup rigs, Ensco 57 built in 1982 upgraded in 2003 max water depth of 300' and drilling depth of 25,000', for 47.1 million but its book value was much lower at 29.2 million. (ii) In March 2010, Ensco sold two jackup rigs, Ensco 50 built in 1983 upgraded in 1998 max water depth of 300' drilling depth of 25,000' and Ensco 51 built in 1981 upgraded in 2002 max water depth of 300' drilling depth of 25,000', for an aggregate of 94.7 million but its book value was much lower at 60.8 million.

Yet, another way to look at company's valuation is offered by the value investor David Einhorn at Greenlight Capital (who owns greater than 5% of Ensco) in his July 16, 2010 letter to shareholders:
Ensco plc (ESV) is an offshore contract oil drilling company operating a large fleet of shallow-water jack-up rigs and a small but new fleet of deep water rigs.  The Deepwater Horizon oil spill and resulting 6-month drilling moratorium in the Gulf of Mexico caused significant share price declines throughout the sector.  ESV was not involved in the horrible accident, which should not materially impact the company’s long-term potential.  ESV has approximately $7 per share in net cash and a tangible book value of $37.50 per share.  The shallow water drilling business, which is unaffected by the drilling moratorium, generates $4.00 per share in unlevered mid-cycle earnings and $8.00 per share in peak earnings.  At the Partnerships’ average cost of $39.41 per share, we appear to be getting the shallow water fleet at a low value and the deepwater fleet (in which ESV has thus far invested over $15 per share to build and should add $2.00 and $4.00 to mid-cycle and peak EPS respectively) for free.  ESV shares ended the quarter at $39.28 each
Credits: Ravi Nagarajan, author of www.rationalwalk.com, brought this idea to my attention through his article Ensco International Profile & Analysis on June 12, 2010.

Resources:
Disclosure: The author has a long position in Ensco (ESV). This presentation is for information purposes only. Do your own research before taking any action regarding any security mentioned in this article.

2 comments:

  1. One can argue that including rig enhancements in the free cash flow calculation is not strictly necessary, but it is conservative to do so.
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