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A Closer Look at Ensco’s Q2 Results July 22, 2010

Ensco plc recently announced second quarter 2010 earnings of $126.3 million, or $0.89 per share.  As expected, the results were negatively impacted by lower utilization for the fleet as well as lower average dayrates.  Contract drilling revenues were $406.3 million compared to $449.4 million for the first quarter.  Second quarter 2009 contract drilling revenues were $497.3 million.  The company ended the quarter with $1.2 billion of cash and tangible book value of $5.4 billion, or approximately $38 per share.  The long term debt to capital ratio was 4 percent and total contract backlog was $2.6 billion.

We profiled Ensco in greater detail on June 11 when shares traded at $38.31.  The share price has advanced to $41.20 at the close of trading today.  Recently, we learned that Greenlight Capital acquired a large position in Ensco during the second quarter.  David Einhorn, President of Greenlight Capital, recently explained his rationale for the Ensco position.  In this article, we will take a closer look at Ensco’s results with a particular focus on trends in dayrates as well as the company’s increasing commitment to the deepwater segment.

Quarterly Data by Segment

It is helpful to examine trends in quarterly results by segment over the past ten quarters particularly because Ensco’s sources of revenue have changed dramatically over this period.  The company organizes its business into four segments.  All deepwater activity is grouped into a single operating segment regardless of the location of the rigs.  The company has three jackup segments organized by region:  Asia Pacific, Europe and Asia, and North and South America.

The following exhibit shows quarterly data for each segment for rig utilization, average dayrates, contract drilling revenues, operating income, and total assets. Please click on the image for a larger view of the data.

We can make several observations regarding the data in the exhibit:

  • Overall rig utilization in the second quarter was 74 percent which is far lower than utilization levels in the mid 90 percent level that prevailed during 2008.
  • Average Dayrates have been falling for four consecutive quarters with the deterioration being most apparent in the jackup segments.
  • Deepwater revenues as a percentage of total revenues has increased from 4.3 percent in the first quarter of 2008 to 29.8 percent in the latest quarter.  As a percentage of operating income, deepwater accounted for 44.1 percent of the total in the latest quarter compared to only 4.1 percent in the first quarter of 2008.
  • The company has been making significant investments in the deepwater sector with deepwater segment assets rising from 25.9 percent of total assets in Q1 2008 to 50 percent of total assets in the latest quarter.

The following charts display segment revenues, operating income, and assets by quarter.  As noted previously, the regional segments are all made up of jackup rigs.

Gulf of Mexico Exposure

Several of Ensco’s customers operating in the Gulf of Mexico have submitted force majeure notices related to the federal government’s moratorium on deepwater drilling. According to the company’s latest fleet status report (pdf), such notices have been received for one of the ultra-deepwater semisubmersible rigs (Ensco 8500) as well as four jackup rigs (Ensco 68, Ensco 82, Ensco 86, and Ensco 87).  The company has contested all of the force majeure notices and notes that the jackup rigs are all still operating.  In addition, Ensco 8502 is scheduled to begin work on a contract in August but the customer has questioned whether the moratorium should delay commencement of the contract.

During a conference call to discuss quarterly results, management reiterated the company’s position regarding these contracts and, in response to an analyst’s question, stated that most of the contracts seem secure enough to recognize revenue while the matter is in litigation.  However, there is clearly risk associated with the revenue from these rigs as well as the contracted backlog associated with future work for these rigs in the Gulf of Mexico.  It is especially unclear why the customers operating the jackup rigs would have legal standing to declare force majeure given that the rigs operate in shallow water.

Summary

It is clear that Ensco’s results have deteriorated in recent quarters, but the company remains highly profitable with a very large cash balance and minimal debt.  As we noted previously, David Einhorn’s fund has invested in Ensco shares based on the premise that the current valuation does not assign much, if any, value to the investments the company has made in the deepwater fleet.  This quote from Mr. Einhorn’s latest letter to shareholders (pdf) sums up the bullish thesis very well:

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.

It is also important to note that Ensco’s jackup fleet is made up of more advanced models that should be in high demand once overall industry conditions improve.  All of Ensco’s jackup rigs are of the independent leg design which are more flexible than mat supported jackup rigs.  The company has also invested in high specification jackups, most recently with a purchase of an advanced model from Diamond Offshore.  Higher specification jackups command better dayrates and are less likely to be cold stacked than older and less flexible models.

For more information, please refer to Ensco’s 10-Q report as well as our more complete profile on the company written in mid June.

Disclosure:  No position in Ensco plc.

Einhorn Comments on Ensco Position in Q2 Letter July 20, 2010

Last week, we reported that David Einhorn’s Greenlight Capital took a large position in Ensco plc during the second quarter.  Ensco was profiled in an article on The Rational Walk in early June and the company is scheduled to report second quarter earnings on Thursday, July 22.  Here is what Mr. Einhorn had to say about the Ensco purchase in his letter to shareholders (pdf) dated July 16:

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.

As we noted in the Ensco profile last month, sometimes the market can overreact to developments that are broadly impact an industry but have relatively less impact on specific companies within the sector.  The offshore contract drillers, as a group, are still recording attractive profits despite significant headwinds caused by the uncertain regulatory climate as well as oil prices that are far lower than at the 2008 peak and have negatively impacted contracted dayrates.  In the long run, the price of oil in a world of increasingly scarce traditional oil deposits will have far more of an impact on companies like Ensco compared to the transitory effect of regulatory changes in response to Deepwater Horizon.

Disclosure:  No position in Ensco.

Einhorn’s Greenlight Capital Takes Large Position in Ensco July 12, 2010

David Einhorn

In a sign that value oriented hedge fund managers are continuing to wade into the depressed offshore drilling sector, David Einhorn’s Greenlight Capital has reported a 5.2 percent stake in Ensco plc as of June 30, 2010.  Mr. Einhorn controls 7.4 million shares with a market value of slightly over $300 million at today’s closing price.  This represents a substantial commitment for Mr. Einhorn’s funds which were valued at $2.93 billion as of March 31. It appears that his purchases were definitely made in the second quarter, and most likely were made after the Deepwater Horizon disaster.

We have profiled two companies in the offshore drilling sector over the past six weeks:  Ensco and Noble Corporation.  Click on the links below to read the analysis and follow up articles.  Both companies remain good selections today for investors who seek exposure to the offshore drilling sector and are willing to look beyond the temporary difficulties associated with the Gulf of Mexico oil spill and the Federal Government’s regulatory response.

Ensco Articles

Noble Articles

Regulatory Situation

Disclosure:  Long Noble.  No Position in Ensco.

Ensco Provides Rig Status Update June 15, 2010

ENSCO

Last Friday, we presented a profile and analysis of Ensco plc.  At that time, the latest fleet status report was dated May 14, 2010 and was nearly a month old.  The company provided an updated fleet status report (pdf) today and the details for the Gulf of Mexico fleet are mostly unchanged.

The two semisubmersible rigs currently in operation are still listed in the fleet status report with the same contract expiration.  Three of the jackup rigs have contract extensions and there were minor dayrate changes for Ensco 82 and Ensco 87.  An updated exhibit summarizing the Gulf of Mexico fleet is displayed below.

The company also provided the following statement regarding the Gulf of Mexico fleet:

ENSCO 8500 Series® ultra-deepwater rigs currently contracted for work in the U.S. Gulf of Mexico are subject to the moratorium which applies to certain deepwater drilling and related activities in the U.S. Gulf of Mexico. Jackup rigs in the U.S. Gulf of Mexico are not currently covered by the moratorium. Current or future Notice to Lessees (NTL) or other directives may impact our customers’ ability to obtain permits and commence or continue deep or shallow water operations in the U.S. Gulf of Mexico. At present, we are unable to determine the extent, if any, that these factors will impact the contracts, operations and/or revenues of the Company’s rigs currently contracted for work in the U.S. Gulf of Mexico. The Company is in discussions with customers to identify mutually agreeable contingency plans in light of recent developments in the U.S. Gulf of Mexico, which could have a material adverse effect upon our results of operations.

This information is consistent with our observations in the earlier article.  At this point, Ensco remains exposed to the possibility that Ensco 8500 and 8501 contracts will be modified or terminated.  In addition, if the moratorium is not lifted by August, it is possible that the Ensco 8502 contract will be impacted as well.  In a speech tonight, President Obama did not back down regarding the six month moratorium but stated that the commission investigating the disaster should complete its work “as soon as possible”.

While the loss of the contracted dayrates for the three deepwater rigs would have a negative short term impact on Ensco, as we pointed out in the previous article, the company can eventually redeploy these rigs elsewhere in the world.  Although securing new contracts and mobilizing the rigs for use elsewhere in the world would take time and result in costs that may not necessarily be recovered, the rigs are well suited for work elsewhere.  Furthermore, due to Ensco’s geographic diversification and overall level of financial resources, a short term financial hit can be easily absorbed.

Disclosure:  No position in Ensco.

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.