ENSCO INTL (ESV) Q3 2008 Update

All results US$ unless otherwise noted:

  • Through nine months of 2008, operating cash flow (OCF) came in at $743M, down 12% YoY from $844M.  As noted previously,the company registered very large cash outlays for accrued taxes and other liabilities as well as its ARS fiasco.
  • In the current credit crunch, Ensco’s solid balance sheet is precious (even if the stock hasn’t been rewarded for it).  The company has more cash than debt, with only $20M in annual debt expense and half of their minimal long-term debt (0.06 debt/equity) doesn’t come due until 2027.  No worries about Ensco’s ability to survive a sustained downturn in the energy markets.
  • Nothing terribly interesting lurking in the income statement.  Margins remained sky-high during Q3 (operating margin @ 58%, net margin @ 47%).  The company took a small $20M hit due to the loss of ENSCO 74 in the wake of Hurricane Ike, which should be covered by an insurance payment in Q4.

In light of the global financial crisis, the emphasis for earnings isn’t so much past results but the outlook going forward .  In this respect, Ensco’s outlook was interesting in the dichotomy that management presented.  As one would expect in an unprecedented global crisis, management struck a very cautious note — reducing their outlook on the Asia-Pacific region due to new rigs coming on market, unofficially suspending their share buyback, not aggressively pursuing industry consolidation and just emphasizing a very conservative approach going forward.  But when pressed on the details, CEO Rabun and his team presented strong underlying fundamentals which haven’t been overly affected by either the massive drop in energy prices nor the credit crisis:

  • Management estimates 85% of ESV customers are investment grade or national oil companies which are projected to continue their capital drilling programs despite recent market events.
  • 2008 is fully contracted except for 1 rig.
  • Despite a possible surplus of rigs and discount bidding in the Asia-Pacific region, the company’s high-spec rigs hasn’t seen any softening to date in demand or pricing.
  • When one analyst mentioned the slowing North Sea drilling market, management countered that North Sea was probably their strongest market, with all rigs projected under contract through 2009.
    • North Sea contracts generally have 120/180 day termination notice clauses so while it’s not set in stone, there is some visibility on this.
  • The Gulf of Mexico is seeing increased utilization and firming day rates as past weakness prompted an exodus of premium rigs out of the region.  Operators are also contracting high-end jackups for longer terms.
    • The company also hit the lowest bid for 2 jackups for PEMEX and awaiting word on that tender.

On the conference call, management reminded analysts that 2009 would see a substantial increase in deepwater rig revenues as the 8500 and 8501 come online at dayrates $275k & $355k while the ENSCO 7500 resets to $550k per day.  Rabun also shed some light on details of the company’s deepwater strategy.  While the company will look at acquisition opportunities presented by the credit crunch, ENSCO strongly prefers building out their deepwater segment for various reasons.  Their rigs are custom spec (for example, they are non-propelled and need to be towed to location which reduces headcount during the span of the contract) and operations are more efficient if they only have to worry about one spec in the fleet.  Their contracts with the shipyard are non-cancellable so the 3 remaining rigs without a contract will be built regardless of what happens in the markets.  Management was somewhat coy but it sounded to me as if they would prefer to take advantage to move up the timeline on the builds rather than look at buying assets.

The market slaughtered ESV along with nearly every other stock but in my view, it’s overdone.  The visibility into 2009 earnings is strong, especially with the deepwater segment more than tripling revenues by my quick math.  The company releases a monthly rig report so if markets soften considerably, investors will know sooner than the next earnings report.

It’s possible that the market will revalue everything with lower multiples but I value companies based on the future value of free cash flows, not on what P/E multiple I think the market will pay.  From this standpoint, deflation only makes ESV more valuable as future cash is discounted at a lower risk rate.  I should also point out that ESV is in the middle of a massive $3B deepwater rig capital build and related outlays should decrease gradually from here.  Management projects maintenance capex to be around $150M annually.  Compare that to $743M OCF through the 9 months of 2008 and it’s obvious that ESV is a cash cow now and especially once the capex program normalizes but with the added earnings power in the deepwater segment. Combined with its solid balance sheet, it would take one hell of a global depression to significantly threaten the company.  If we get inflation instead, I’d expect to see higher commodity prices and a good environment for ESV.

My only complaint is the company’s paltry dividend and their buy-high stock repurchase program (seems like many companies buy high and stop buying when the shares are discounted).  If the markets are repricing risk, it’d be nice to see management take more forceful action to reward shareholders, perhaps along the lines of special dividend payments like Diamond Offshore (DO).

I’ve already established a full position in ESV but if I got to do it over again, I would probably look first at long-dated call spreads at these levels instead of buying the stock due to its lousy dividend.

2008 Guidance:

  • Q4 revenues -3% from Q3
  • Contract drilling expense up 4% from Q3
  • Full year effective tax rate 18-19%
  • CapEx: $820M, $166M in Q4 ($670M in new deepwater rig builds, $40M rig enhancements, $110M sustaining projects)

Performance Measurements :

  • Hit guidance — especially on contract drilling expense and shipyard days.
  • Manage revenue stream in energy market downturn.
  • Maintain backlog near current levels ($3.8B as of YE 2007).
  • OCF run rate to revert back to 2007 levels (~40-50% of revenues, 9 months 2008: 41%) .
  • Uncertain Asia-Pacific market, strong in North Sea, stabilization in GOM and new entries into Iran, UAE, PEMEX, etc.
  • Hold the line on 8500 series roll-out.

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