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Microsoft’s Depressed Stock Price Attracts Flock of Value Investors August 31, 2010

This is the sixth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

At the turn of the century, few observers could have possibly foreseen that Microsoft would become a favorite bargain purchase for value investors in 2010.  The dot com boom was in the process of peaking and any company even vaguely associated with software or technology traded at stratospheric multiples of earnings.

Microsoft was certainly no exception.  The company earned $0.85 per share in fiscal 2000 and traded at well over fifty times earnings when Steve Ballmer assumed the CEO position in January of that year.  While the company has increased profits at a moderate clip and reached earnings per share of $2.10 in fiscal 2010, the stock price is now at well under half of the peak levels seen in 2000 and is firmly in “value” territory trading at ten times trailing earnings when adjusted for excess cash on the balance sheet.

Bargain Valuation Not Unnoticed

Microsoft’s bargain valuation has not gone unnoticed among value investors who have flocked to the stock in recent months.  Some of the prominent investors with significant positions in Microsoft include Arnold Van Den Berg, Wally Weitz, David Einhorn, Bill Miller, and Whitney Tilson.  (For a list of fund managers currently holding Microsoft stock, click on this link to view Dataroma’s database.)

Of course, the fact that many value investors have positions in Microsoft does not mean that it is intelligent to blindly follow but it is intelligent to use the positions of successful investors to generate ideas for further independent research.  In the case of Microsoft, the value becomes quickly apparent with a brief review of the key facts.

From Cutting Edge to Stodgy in Ten Years …

We presented much of the bullish case for Microsoft in a recent article regarding Steve Ballmer and will not repeat all of the details here.  To sum up the past decade, Microsoft continued to deliver strong results but suffered a downward revision in valuation so extreme as to deliver negative returns for investors who purchased stock a decade ago.  Earnings advanced from $0.85 to $2.10 over the ten year period which amounts to a compound annual growth rate of 9.5 percent.  During the decade, the company introduced a regular quarterly dividend and paid a one-time $3.00 per share special dividend in 2004.  Profit margins have declined over the ten year period but net profit margin of 30 percent in fiscal 2010 still signals the presence of a very strong franchise. (Download Value Line’s report on Microsoft for more useful statistics.  The report is one of Value Line’s Free Dow 30 stock reports.)

The main problem facing the company is the inability of management to profitably break into a new line of business beyond the core Windows and Office franchises.  Mr. Ballmer is facing a great deal of criticism regarding the failure of Microsoft to break into an entirely new line of business that will deliver new profit streams and potentially mitigate an eventual decline in the core Windows and Office franchises.

One cannot help but compare Microsoft’s performance to Apple Computer particularly given the fact that Apple recently overtook Microsoft in terms of market capitalization.  Steve Jobs has succeeded in creating entirely new categories of products such as the iPod and iPad and he revolutionized the mobile phone industry with the iPhone.  Meanwhile, Microsoft has introduced lukewarm products like the Zune music player and disastrous products like the Kin mobile phone that was taken off the market only months after its introduction earlier this year.  Even successful products like the XBox have not resulted in large sources of profit compared to the company’s core Windows and Office business.  Microsoft has obviously failed to break into new areas successfully and, as a result, the company has taken on a stodgy image.

But Count the Cash …

Despite the well publicized difficulties facing Microsoft, the company continues to generate significant cash flow and had approximately $36.8 billion of cash and cash equivalents as of June 30, 2010 ($4.12 per diluted share).  The company generated over $22 billion of free cash flow for fiscal 2010, paid $4.6 billion in dividends, and used $11.3 billion for share repurchases.  Microsoft is clearly still a cash flow machine. At a recent price of $23.47 and a market capitalization of $203 billion, the overall valuation of the company is clearly depressed.

Microsoft is even cheaper than the “headline” price/earnings ratio suggests when one considers the excess cash on the balance sheet.  The exact amount of excess cash is open to debate, but it appears that at least half of the cash on the balance sheet could be safely distributed to shareholders.  Adjusted for excess cash, Microsoft trades at ten times trailing earnings and less than nine times estimated fiscal 2011 earnings of $2.40 per share.

If someone had told you in August 2000 that Microsoft would be available for under nine times forward earnings one day, it is unlikely that you would have believed them.

Cloud Risks Are Exaggerated

Cloud computing is a long term threat that could erode Microsoft’s Windows and Office franchises over time.  Products such as Google Docs have gained some traction, but Microsoft still controls well over 90 percent of the office market.  The slow moving conservative nature of most information technology departments all but guarantees that Microsoft will retain a very large share in both operating system and office sales for many years to come even if cloud based solutions begin to take more share.

While Microsoft was initially slow to respond to the cloud computing threat, the company has not ignored the risks entirely.  Office Web Apps and related online services are intended to directly address the threat from solutions like Google Docs.  While Microsoft may not be entirely successful in retaining share on the cloud, many risk averse companies could be convinced to stick with a known quantity.  Making a move from desktop based Office products to Microsoft’s web solutions could be seen as a more conservative approach for IT managers concerned with career risk issues.

Tablets Beyond iPads

With three million iPads sold through June 30, Apple has proven that the tablet computer has finally arrived, but it would be a mistake to assume that Apple will “own” this market.  One very surprising aspect of the iPad’s introduction, apparently even to Apple executives, has been the adoption of the device in business environments.  The Wall Street Journal recently reported that businesses are adding the iPad as a rapid clip.  Some executives are using the iPad as a substitute for laptop computers for tasks such as email, reading documents, and even giving presentations.

One of the possible reasons behind Microsoft’s recent stock price weakness is the fear that the iPad will erode sales of traditional laptop computers running Windows.  However, it is very likely that business users have adopted the iPad as a supplement to their laptops rather than as a replacement. In addition, new tablets running Windows and Android will be released in the very near future.

There are some doubts regarding whether tablets are well suited to run Microsoft’s Windows operating system.  Although Windows 7 does have touch screen capabilities, will it provide a good user experience in the tablet form factor?  One potential solution may be the upcoming Windows Phone 7 software which is scheduled for release in October.  Windows Phone 7 has received some positive reviews (click here for one example) and may be better suited for tablet devices.

While no one can predict the market shares different players will have in tablet devices once the market matures, it is very likely that Microsoft will generate significant market share given the strength of Windows Phone 7 and the relationships the company has with corporate users.

Summary

Microsoft is one of the “least loved” companies in America today.  Investors have become disillusioned by the company’s failure to break into highly profitable lines of business beyond the core Windows and Office franchises.  The emergence of highly successful products such as the iPad have generated fears that Microsoft’s moat in operating system software may be facing a more rapid decline than previously assumed.  From an intangible perspective, Microsoft is simply no longer in fashion.

Despite the negative headwinds and many real challenges facing Microsoft, the company does not deserve to trade at current depressed valuations based on its demonstrated earnings power and formidable cash flow.  Windows and Office still have dominant markets shares and enjoy high margins that validate the presence of a significant moat.  The current corporate refresh cycle will help generate record earnings for fiscal 2011 and the company is not standing still in cloud computing, mobile phones, or tablets.  A company with this profile does not deserve to trade for nine times likely fiscal 2011 earnings.

Whitney Tilson summed up the bullish case very well in a recent presentation (pdf).  Mr. Tilson assumes fiscal 2011 earnings per share of $2.40 and assigns various multiples to arrive at a valuation (adjusted for cash/share of approximately $4).  At a modest 10x multiple, Microsoft should trade at approximately $28 per share which would imply an upside of nearly 20 percent from current levels.  A more reasonable 12x multiple would imply a share price of approximately $33 for an upside of 40 percent.  In addition, the company has a 2.2 percent dividend.  Barring an unprecedented collapse in Microsoft’s earning power over the next few years, the risk of permanent impairment of capital seems remote given the company’s current valuation.

Disclosure:  The author of this article initiated a position in Microsoft Corporation today at an average cost $23.67. This article is for entertainment and informational purposes only;  do your own research before making any investment decisions.

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A Closer Look at Noble Corporation’s Q2 Results July 20, 2010

Noble Corporation recently announced second quarter 2010 earnings of $218 million, or $0.85 per share.  The results were negatively impacted by a combination of lower utilization for the overall fleet and sharply lower average dayrates.  As a result, contract drilling revenues dropped to $687.5 million for the second quarter compared to $808.6 million for the first quarter.  Second quarter 2009 contract drilling revenues were $868.2 million.

We profiled Noble in some detail in early June when the shares traded at approximately $28.  After significant volatility in trading today, Noble shares closed up 4.6 percent at $32.06 on the earnings news despite failing to meet analyst estimates.  In this article, we will take a closer look at Noble’s quarterly results with particular attention devoted to trends on dayrates and Noble’s changing mix of revenues by rig type.

Revenue Trends by Rig Type

It is helpful to examine Noble’s revenue by rig type over the past ten quarters to get a feel for the dayrate and utilization trends.  The exhibit below provides average rig utilization, operating days, average dayrates, and contract drilling revenue for each rig type (click on the image to enlarge it).

Several facts are readily apparent from reviewing the data in the exhibit:

  • Jackup revenues are clearly in a declining trend due to a combination of lower utilization and eroding dayrates.  The average dayrate in the second quarter was $96,677, far lower than the dayrates in the $140,000 to $160,000 range that prevailed during 2008 and the first three quarters of 2009.
  • During 2009, semisubmersible rigs capable of drilling in waters over 6,000 feet produced higher revenues that largely offset the decline in jackup fleet revenues.  However, dayrates for these rigs have been under pressure during the second quarter.
  • Overall fleet utilization has dropped from 94 percent to 80 percent over the ten quarter period.

The following chart shows the revenue contribution of each rig type in a more visually intuitive format and clearly highlights the diminishing contribution of the jackup fleet and the growing importance of sophisticated semisubmersible rigs:

Drilling down to the revenue for the second quarter, the chart below shows the contribution of each rig type to overall contract drilling revenues:

Clearly, the negative sentiment surrounding the Deepwater  Horizon disaster and the Federal Government’s regulatory response has taken a toll on Noble’s second quarter results, but it is also important to note that the decline in overall revenues actually began in earnest during the first quarter prior to any hint of difficulties in the Gulf of Mexico.  The notable change in the second quarter is the precipitous drop in average dayrates for both advanced semisubmersible units and jackups.

Despite the negative trends that have taken shape so far this year, Noble posted net income of $589 million, or $2.28 per share, for the first half.  During the first half, the company generated slightly over $1 billion in net cash from operating activities while investing $490.7 million in new construction and other capital expenditures.  Also, at the end of the quarter, Noble announced the acquisition of Frontier Drilling and a significant agreement with Shell.

Outlook

Noble held a conference call (available for replay at this link through July 27, or read the transcript) for investors today and most of the questions in the Q&A session were related to the outlook for dayrates and utilization in the wake of the negative regulatory climate caused by the Deepwater Horizon disaster. The company also released a fleet status report (pdf) on July 8.

While the company has been able to secure additional work for several jackup units around the world, it is notable that the extensions generally have lower dayrates.  With the exception of the Noble Roy Butler in Mexico and the Noble Hans Deul in the North Sea, all of the newly announced contracts for jackup rigs are at lower dayrates than the contracts they replace.  In some cases, the new dayrates are dramatically lower:  For example, the Noble Gene Rosser in Mexico was on a dayrate of $171,000 until June 19 and was recently extended through December 2010 at a dayrate of $80,000.

The deepwater situation in the Gulf of Mexico remains uncertain due to the moratorium as well as questions regarding the higher cost structure that will inevitably come from tighter regulations if operations are allowed to resume.  The good news is that Noble has been able to negotiate standby agreements with most customers.  The bad news is that the standby dayrates are substantially lower than operational dayrates and appear to limit the ability of the company to relocate rigs to other parts of the world.  Additionally, the company is involved in litigation with Anadarko over a force majeure dispute regarding the Noble Amos Runner.  While the litigation is in progress, Noble is not collecting the $440,000 dayrate for the Amos Runner, although some recovery might be possible in the event of a favorable court ruling.

Summary

There is no doubt that Noble Corporation has suffered along with the rest of the offshore contract drilling industry due to the regulatory uncertainty in the Gulf of Mexico and what appears to be a general trend toward lower dayrates particularly in the jackup fleet.  However, despite these setbacks, the company remains highly profitable and was able to leverage a strong balance sheet in an opportunistic acquisition of Frontier that doubles contracted backlog going forward.  This acquisition should close by the end of July.

Whether Noble represents a good investment at current prices depends greatly on the investor’s time horizon and tolerance for price fluctuations in the short run.  The $8.2 billion market capitalization of the company compares favorably to free cash flow that is likely to exceed $1 billion this year.  With an eventual recovery in dayrates and the contribution of the Frontier acquisition, free cash flow should eventually exceed the peak levels of 2009.

While the most prominent risk to the bullish thesis at the moment is the regulatory climate, the larger economic risk would be associated with a period of sustained low oil prices that would make deepwater exploration uneconomical.  However, with energy use in the developing world growing rapidly (For example, China recently surpassed the United States in energy usage), it seems highly unlikely to expect oil prices to drop significantly over the next five to ten years.

Disclosure:  The author owns shares of Noble Corporation.

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Diamond Offshore Represents Interesting Play on Deepwater Revival July 15, 2010

Diamond Offshore

This is the fifth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

One of the central tenets of value investing is that one must always insist on a large margin of safety before allocating capital.  When investor sentiment is favorable toward an industry or a company, prices of securities are usually bid up to a level where everything must go according to plan in order to achieve expected investment returns.  On the other hand, negative sentiment can sometimes, but not always, offer an investor opportunities to make commitments offering high returns and low downside risk.

In this article, we profile Diamond Offshore, one of the leading companies in the deepwater drilling industry.  In previous articles, we focused on two companies in the offshore drilling industry with lower risk profiles.  Both Noble Corporation and Ensco plc have exposure to deepwater drilling in the Gulf of Mexico but also have significant international operations along with large fleets of jackup rigs that are designed for less controversial shallow water drilling.

The main reason that Diamond Offshore was not profiled in the past is because the company is far more exposed to deepwater drilling and could face more regulatory uncertainty as a result.  The goal of the articles on Noble and Ensco was to identify companies that had enough diversity in operations, both in terms of shallow water and international operations, to successfully deal with an extended (or even permanent)  U.S. moratorium on deepwater drilling.  With this caveat, let us briefly examine Diamond Offshore’s business.

Overview

Diamond Offshore is one of the leading global providers of contract drilling services and operates a fleet of 47 offshore rigs comprised of 32 semisubmersible rigs capable of deepwater operations, 14 jackup rigs designed for shallow water drilling, and one drillship.  The company is well diversified by region with 68 percent of 2009 contract drilling revenues originating from outside the United States.  Revenues are heavily tilted in favor of deepwater operations with only 12.9 percent of 2009 revenues coming from the jackup fleet.  For a brief primer on the differences between rig types, please refer to our previous article on Noble Corporation. The following exhibit presents a snapshot of Diamond Offshore’s valuation as of July 15, 2010.

In contrast to Ensco and Noble which both trade at small premiums to tangible book value, Diamond Offshore commands a larger premium which is most likely due to the long term projected earnings power generated by a more advanced fleet capable of the higher dayrates that deepwater operations command.

The company has a small regular dividend but has been paying out large special dividends in recent years.  The total dividend paid in 2009 was $8 per share.  As we can see from the exhibit below, the company has been generating in excess of $1.1 billion of free cash flow over the past two years and has distributed much of this to shareholders.  Debt levels appear manageable at approximately 29 percent of total capital, although debt was increased by approximately $1 billion during 2009 to fund expansion capex.

Operating Data Snapshot:  2007 to 2009

Although Diamond Offshore operates in a single segment, the company provides more data than many competitors regarding the composition of revenues, expenses, and operating income between rig type and region.  The exhibit below is a reorganization of the data presented within the company’s MD&A section of the 2009 10-K report.  Please click on the image to enlarge it.

The exhibit breaks down operating data for contract drilling by rig type and then by geographic region.  Both high specification floaters and intermediate semisubmersibles are generally designed for deepwater activities, although in some cases they may be repurposed for shallow water drilling.  All jackup rigs are limited to shallow water drilling.  The vast majority of the company’s revenues and operating profits can be attributed to rigs designed for deepwater operations.

Gulf of Mexico Exposure

The chart below shows the breakdown of 2009 contract drilling revenues by region and includes revenues from all rig types.  The segment that is broken out shows that 32 percent of total contract drilling revenues are from operations in the United States Gulf of Mexico.

Within the U.S. Gulf of Mexico, the vast majority of 2009 revenues were attributed to rigs capable of deepwater operations.

Only 5 percent of revenues from the Gulf of Mexico were from jackup rigs and the vast majority were from high specification floaters representing some of the most advanced rigs in Diamond Offshore’s fleet.

According to the June 30, 2010 fleet status report, Diamond Offshore currently has nine rigs in the Gulf of Mexico.  Five of the rigs are semisubmersible units.  On July 12, the company announced that Ocean Confidence, one of the semisubmersible rigs, would immediately redeploy to the Republic of Congo.  The following exhibit provides a summary of the latest information regarding the Gulf of Mexico fleet.

As we can see, several customers have invoked force majeure in an attempt to exit or modify existing contracts.  Presumably, this is due to the Obama Administration’s moratorium on deepwater drilling although it is notable that the Ocean Titan is on a standby rate of zero dollars due to regulatory difficulties even though it is a jackup rig.  The relocation of Ocean Confidence out of the Gulf of Mexico could presage similar actions for other rigs if regulatory difficulties continue.  However, relocation can be expensive and time consuming and there is a possibility that mass relocations of rigs from the U.S. Gulf of Mexico could depress dayrates elsewhere in the world.

Summary

In contrast to our previous studies of Noble Corporation and Ensco, it seems clear that Diamond Offshore carries more business risk due to the higher concentration of revenues in deepwater activities in the U.S. Gulf of Mexico.  These risks may be mitigated to some extent through the relocation of assets to other parts of the world and negotiations with customers.  However, it is clear that investors in Diamond Offshore have a great deal to lose if the deepwater moratorium is extended or made permanent.

At the current valuation, Diamond Offshore certainly appears inexpensive compared to the market prices that prevailed before the Deepwater Horizon disaster.  However, Noble Corporation seems far cheaper both in terms of multiples of earnings and free cash flow as well as the price to tangible book ratio.  A similar observation can be made regarding Ensco.

It must be acknowledged that Diamond Offshore’s fleet may legitimately command a premium valuation compared to Noble and Ensco in a world where deepwater exploration is robust and premiums are placed on advanced semisubmersible rigs. However, the flip side is that they are more exposed to adverse regulatory developments in deepwater.  An investment in Diamond Offshore may turn out well at current market prices and may even offer more upside potential than Noble or Ensco, but much depends on a reasonably quick return to deepwater exploration in the Gulf of Mexico.

Resources

Diamond Offshore 2009 10-K
Diamond Offshore 2010 Q1 10-Q
Diamond Offshore Fleet Status Report as of June 30, 2010 (Excel)
Press Release on Ocean Confidence Relocation

Disclosure:  No position in Diamond Offshore or Ensco.  Long Noble Corporation.

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Noble’s Acquisition of Frontier Highlights Importance of Clean Balance Sheet June 30, 2010

Frontier Drilling

Earlier this week, Noble Corporation announced that it has entered into an agreement to acquire Frontier Drilling in a cash transaction valued at $2.16 billion.  Frontier is a privately held independent drilling company with a fleet of three dynamically positioned drillships, two conventionally moored drillships, one deepwater semisubmersible drilling rig, and one dynamically positioned floating production, storage, and offloading (FPSO) vessel. In addition, Noble has entered into an agreement with Shell that favorably impacts backlog.

We profiled Noble Corporation in early June as part of the series of articles covering “unpopular” larger companies.  The series was inspired by Benjamin Graham’s approach of considering larger companies with financial strength as a potential source of investment ideas when such companies are generally out of favor.  Few industry sectors have been more out of favor than the offshore drilling industry in light of the Deepwater Horizon disaster.  At the time of our initial analysis, Noble appeared to be statistically cheap and conservatively financed.  The clean balance sheet has now presented management with the opportunity to purchase assets at distressed prices.

Terms of Frontier Acquisition

Noble will finance the $2.16 billion acquisition with a combination of cash on hand, use of an existing bank credit facility, and a new $800 million bridge credit facility.  Noble will secure permanent financing to replace the bridge loan and revolving credit facility.  Management anticipates that total debt will be approximately $3 billion at the end of 2010 with a debt to capital ratio of approximately 28 percent.  This is a significant increase from the 10 percent debt to capital ratio as of March 31, 2010 but management is confident that acquisition debt could be fully repaid within three years.  The transaction is expected to be accretive to cash flow immediately and to earnings starting in 2011.

Agreement with Shell

Approximately 95 percent of Frontier’s backlog is with Shell and Noble has separately entered into agreements with Shell that are complimentary to the Frontier transaction.  Noble entered into ten year contracts with Shell for the Noble Globetrotter newbuild rig as well as one additional newbuild.  Each will have a fixed $410,000 dayrate for the first five years with a potential 15 percent bonus based on certain key performance indicators.  The dayrate over the subsequent five years will be based on a market index.

Noble also extended the contract for Noble Jim Thompson for three years at a $336,200 dayrate following the current contract expiration on March 1, 2011.  Noble Jim Thompson is currently in the Gulf of Mexico leased to Shell at a $505,000 dayrate so the extension terms are not as favorable.  However, Shell has agreed to suspend contracts during the moratorium in the Gulf at a reduced dayrate and contracts will be extended day for day once the moratorium is lifted. No force majeure early termination provision will exist for the newbuilds.

Contracted Backlog:  $12.9 billion

The combined impact of the Frontier acquisition and the agreement with Shell increases Noble’s backlog to $12.9 billion from $6.9 billion previously.  The exhibit below from Noble’s investor presentation illustrates the timing of the backlog.  While much of the incremental backlog is scheduled for the second half of the decade, the increase is still substantial.

Based on the two deals, Noble will have the second largest contracted backlog in the industry behind Transocean.

Balance Sheet Strength Offers Opportunity

Many value investors are inclined to favor companies with minimal leverage since this reduces downside risks substantially in times of unexpected adversity.  Often, this means that a company will use far less leverage than one might consider “optimal” under favorable conditions.  A conservative capital structure can penalize results when all is well with the world, but also reduces the risk of disaster when times get tough.  A side benefit of a conservative capital structure is that a company can opportunistically use the balance sheet when very favorable conditions arise.

Based on an investor presentation given by Noble’s management, the company has been looking at Frontier as well as other opportunities for quite some time but decided to act now due to the distress caused by the impact of the Deepwater Horizon disaster on the industry as a whole.  Having very little debt and significant cash on hand allowed management to benefit from disruption in the industry rather than be a victim of it.

Many companies today are hoarding cash and this can destroy shareholder value if management does not have a proven track record of intelligent capital allocation.  Therefore, it is important to look at balance sheet strength and cash balances in light of what management has done in the past.  In the case of Noble, the track record of free cash deployment inspired some confidence that capital allocation would be intelligent going forward.

Resources:

For more information on Noble Corporation as well as further details regarding the Frontier and Shell transactions, please refer to the following links:

The Rational Walk’s Noble Corporation Profile (as of June 2, 2010)
Noble Corporation Press Release
Investor Presentation Slides (pdf)
Investor Presentation Webcast Replay (available through July 27, 2010)

Disclosure:  Long Noble Corporation.

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Ensco International Profile and Analysis June 11, 2010

Ensco 102

This is the fourth in a series of articles covering “unpopular” larger companies.  Benjamin Graham believed that such companies may present opportunities for enterprising investors.  We discussed the Graham approach in more detail in a recent article.

It is impossible to escape the daily barrage of terrible news from the Gulf of Mexico.  BP is obviously the target of unceasing criticism, much of it well deserved, and the company’s share price has reflected a great deal of uncertainty regarding ultimate liability and the safety of the dividend.  However, investors are also abandoning nearly any company involved in the oil sector regardless of exposure to the spill or to the drilling moratorium in the Gulf of Mexico.  As we pointed out in previous articles on Noble Corporation and National Oilwell Varco, investor panic often creates interesting opportunities for long term investors.

Ensco 102 in The North Sea

Ensco International plc is an offshore contract drilling company that provides services to oil majors and independent oil exploration firms.  The company has historically focused on jackup rigs designed for relatively shallow water but has devoted the majority of capital expenditures in recent years to build up a fleet of semisubmersible rigs capable of deepwater operations.  Ensco has a fleet of 45 mobile offshore drilling units comprised of four semisubmersibles, 40 jackups, and one barge rig.  In addition, the company has one new semisubmersible unit ready for deployment in August and three semisubmersible units scheduled for delivery in 2011 and 2012.

Overview of Business

One of the common filters that many value investors use involves looking for companies trading at or below tangible book value.  In recent days, Ensco traded below tangible book value and the recent rally has increased the market capitalization to slightly above tangible book.  Of course, this statistic is merely “interesting” until we delve deeper into the quality of the assets on the balance sheet as well as the durability of the business.  The exhibit below displays a snapshot of Ensco as of June 11, 2010:

Ensco is geographically diversified with significant revenues originating from its Europe, Africa, and Asia Pacific reporting segments. The chart below shows Ensco’s 2009 revenues broken down by business segment.  Ensco segregates worldwide deepwater operations into a separate segment and has regional segments for shallow water operations using the company’s large jackup fleet.  We can see that shallow water operations comprised 87 percent of revenues in 2009.  Furthermore, shallow water activities outside the Americas accounted for 66 percent of revenues.   Clearly Ensco is not principally a deepwater player in the Gulf of Mexico.

The following exhibit shows some key data from the past five years.  Note that the company does not employ much leverage and has enjoyed healthy margins over this timeframe due to the overall strength in oil prices which has led to healthy rig demand and high dayrates.  However, the company’s return on equity has decreased somewhat due to significant cash balances earning low returns (cash balance was over $1.2 billion as of March 31, 2010).  Additionally, high levels of capital expenditures on semisubmersible deepwater rigs over the past three years have only started to generate meaningful revenue recently as newbuild rigs enter service.

Cash Generation Machine

High oil prices and healthy demand for the company’s services have resulted in Ensco resembling a cash generation machine in recent years.  Much of the cash flow has been devoted to the company’s expansion program which has focused on building up the fleet of semisubmersible rigs capable of operations in very deep waters.  In addition to investing in capex, Ensco has returned cash to shareholders in the form of dividends and share repurchases.  The company recently increased the regular quarterly cash dividend to $0.35/share from $0.025/share.

The exhibit below shows the cash generation capability of Ensco over the past five years along with the use of the cash.  The company expenses regular maintenance on existing rigs.  We have classified a portion of the capital expenditure program as “maintenance capex” to reflect minor upgrades of existing rigs that could arguably not increase rig capabilities.  The vast majority of capex has been identified as rig enhancements or newbuild rigs.

As noted previously, Ensco’s cash balance has increased dramatically and stands at over $1.2 billion as of March 31, 2010.  Since the recently enhanced dividend will consume approximately $200 million per year, management seems to be aware of the negative aspect of continuing to pile up excess cash on the balance sheet.

Segment Details

As the chart above demonstrates, Ensco is well diversified geographically and current revenues are dominated by shallow water operations outside North and South America.  However, management is clearly committed to expanding deepwater operations significantly.  The vast majority of capex over the past three years has been dedicated to the deepwater segment.  The exhibit below shows selected segment data for the past three years.

The importance of deepwater has increased even further in the first quarter of 2010.  Deepwater operations accounted for 29 percent of revenue and 39.8 percent of operating income for the first quarter — a dramatic increase over full year 2009 statistics.  In other words, the large level of capex allocated to the deepwater segment over the past three years is now starting to generate significant revenues and profitability as more semisubmersible units become productive.

U.S. Gulf of Mexico Exposure

Ensco has ten rigs located in the Gulf of Mexico.  Seven jackup rigs are operating in shallow water areas at dayrates ranging from approximately $50,000 to $100,000.  Two semisubmersible rigs are operating in deepwater areas at estimated dayrates of $295,000 and $365,000.  One newbuild semisubmersible rig is contracted to begin operations in August at a dayrate of approximately $480,000.

The exhibit below lists each of Ensco’s rigs located in the Gulf of Mexico based on the company’s May 14 rig status report.  Ensco Investor Relations has indicated that the next fleet status report will be posted on June 15.  The company did not respond to a request for an interim update prior to the June 15 report.

Last week, we pointed out that there was much confusion regarding the Federal Government’s moratorium policy related to shallow water exploration.  As of today, it is still not entirely clear whether the government intends to stand in the way of shallow water operations, although indications are that such exploration will probably continue to be permitted.  Deepwater exploration is obviously another matter.  President Obama continues to insist on the six month moratorium on deepwater exploration but the significant impact on the Gulf Coast economy has caused prominent politicians such as Louisiana Governor Bobby Jindal to argue for lifting the moratorium.

Under a worst case scenario for deepwater, the “force majeure” clauses in Ensco’s contracts may be activated and the company may lose the anticipated revenues from Ensco 8500, 8501, and 8502.  However, the company’s extensive global operations make it highly probable that these rigs will be redeployed elsewhere within a reasonable timeframe.  In a recent conference call, Ensco Chairman and CEO Dan Rabun stated that the Ensco 8500 series is “perfect for Brazil, Gulf of Mexico, and West Africa and Asia”.  Furthermore, since most contracts call for Ensco’s customers to pay “mobilization” costs for rigs, it is possible that the rigs could be redeployed elsewhere without Ensco paying for substantial transportation costs.

How Good is Tangible Book?

Earlier, we stated that one must examine what is in tangible book value before an investor gets too excited about a company that is trading at or below tangible book.  The quality of assets is obviously critical if tangible book is to be considered a margin of safety for the investor.

The critical component of Ensco’s tangible book value is the property and equipment account which is stated at $4.5 billion as of March 31, 2010.  Since a great majority of the company’s tangible book value resides in illiquid offshore drilling rigs, can we feel somewhat confident that the assets are worth what they are stated on the balance sheet?

While it is very difficult to make a definitive assessment, three recent asset sales provide a clue that management is conservative regarding the valuation of rigs.  The company sold Ensco 57 on April 23.  Ensco 57 sold for $47 million while the rig had a net book value of $30 million.  On March 19, the company announced the sale of Ensco 50 and Ensco 51.  These rigs were sold for $95 million and had a net book value of $63 million.  The cumulative gain on sale for the three rigs came to approximately $49 million.  While the sale of three older jackup rigs may not be reflective of overall valuation of the fleet, a positive surprise upon the disposition of assets is a good sign that management might be conservative.

Summary

Ensco plc is a well diversified, high quality company that appears to have been unfairly punished in recent weeks based on “guilt by association”.  When a high profile incident has a major impact on an industry, market participants often sell any company in the industry first and ask questions later.  With a market capitalization only slightly above tangible book value, diversified international operations, and what appears to be manageable exposure to the deepwater Gulf of Mexico, investors should have some downside protection.

The company is not without risk, but the relevant risk is related to the potential for depressed energy prices that reduce demand for the company’s rigs rather than any specific regulatory action related to the Gulf of Mexico.  In the event of a “double dip” recession that reduces worldwide demand for oil, Ensco’s profitability and cash flow would decline along with every other contract drilling company.  However, the long run demand for fossil fuels in the developing world makes the case for a long run decline in oil prices highly doubtful.  Alternative energy sources are decades away from threatening to seriously displace oil and gas as fuels.

In contrast to Noble Corporation which we profiled last week, Ensco has not suffered the same magnitude of decline since late April and the company is more expensive in terms of cash flow or earnings multiples.  The likely reason is that Noble is much more exposed to the Gulf of Mexico deepwater than Ensco, although even Noble is well diversified from a geographical standpoint.  In the event of a favorable outcome for deepwater regulation in the Gulf of Mexico, Noble is likely to have a more rapid recovery.  If the deepwater moratorium continues for a longer period or becomes permanent, Ensco may be the better choice.  Both companies seem to offer a favorable risk/reward profile at current quotations.

Resources:

Ensco plc 2009 10-K
Ensco plc Q1 2010 10-Q
Ensco Q1 2010 Conference Call Transcript (pdf)
Ensco Fleet Status Report as of May 14, 2010 (pdf)
MMS Deepwater Production Summary as of June 7, 2010 (pdf)
Ensco Investor Presentation on June 10, 2010 (pdf)

Disclosure:  No Position in Ensco plc but considering long position.  Long Noble Corporation.

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