Background
Ensco is an internationally diversified offshore driller with a jackup fleet of 39 rigs and 4 completed ultra- deepwater semisubmersible rigs with 4 additional semis under construction. Ensco has an outstanding track record for upgrading and managing its fleet while maximizing return on investment by acquiring/constructing assets at a low cost of capital. For example, Ensco chose to become a player in the deepwater market by constructing high quality rigs using a uniform design and without the "bells and whistles" that drive up production costs. As a result Ensco's deepwater rigs were constructed at a cost of $440m per rig vs. the industry average of $571m. Ensco also has one of the world's more modern jackup fleets and is highly regarded in the industry for quality and safety.
The disaster in the Gulf, first the oil spill and then the drilling moratorium has caused Ensco to lose 26% of its stock price from the 52 week high they reached in April, after reporting stellar financial results and a strong dividend, though as of now, Ensco has not had force majeure declared on a single contract nor has it taken a hit to its P&L. In fact, Ensco's latest rig status (June 15th) reveals that Ensco's jackups have achieved contract extensions in the GOM. Ensco has 4 deepwater rigs in the GOM that can potentially be affected by the moratorium. 32% of Ensco's 2011 revenue is exposed to GOM deepwater and 41% of EBITDA. The mitigating factor is that all of these rigs are pretty much brand new, which gives Ensco more leverage if it's customers attempt to declare force majeure since the termination fee is likely very high. The latest status for each rig is summarized below.
- Ensco 8500: Anadarko declared force majeure on all GOM deepwater rigs except for Ensco's, which it is keeping for workovers and completions
- Ensco 8501: Noble Energy will use the rig for 6 months of completion work, after which it will pass the rig over to Nexen (Nexen and Noble Energy share the rig)
- Ensco 8502: Scheduled to be delivered to Nexen in August. Nexen is currently trying to defer delivery and is in negotiations with Ensco. We believe the recent compromise between Noble Corp and Noble Energy provides a reference point. Noble's rig will receive a standby rate that is slightly above break even for the next 6 months. Afterwards the 2 parties will pursue a new contract equal to the term of the previous at a dayrate of $397,000, roughly equal to current market rates. Though the original rate was $600,000 (signed at market peak), this is not a bad deal and is a much better alternative to losing the contract and shopping the rig around elsewhere
- Ensco 8503: Cobalt intends to take delivery of the rig in 2011 as planned once the drilling moratorium expires
Valuation
To arrive at a valuation range we considered 2 scenarios. The first assumes that the moratorium lasts 6 months as originally planned and the second assumes that the moratorium drags on and on for 18 months
In the 6 month case there is a possibility that Ensco can get through this without taking a hit and will earn over $1,050 in EBITDA and about $5.00 in EPS, which means you can own the company now for 6.3x earnings (ex $7.00 of net cash per share) and 4.2x EBITDA. At a more normalized mid cycle EBITDA multiple of 6.0x-7.0x the price target in this scenario is $52.00-$59.50 (36%-56% upside). Recent pressure on the Obama administration over the economic impact to the Gulf from the moratorium and the recent ruling which overturned the moratorium (government is appealing) are encouraging signs
In the downside case, companies all declare force majeure on the contracts. Though there will likely be a substantial termination fee for such an occurrence let's put that aside for the moment. Since Ensco will have to shop these rigs around elsewhere in the world in markets flooded by rigs from the GOM, I assume that day rates fall to $300,000 and utilization drops to 70% on these rigs. Let's further assume that the Ensco 7500 and Ensco 8504, which are not in the Gulf, will have to find work at depressed rates of $250,000 and $300,000. In this case, Ensco can still earn almost $3.00 in EPS and $725m in EBITDA. At an EBITDA multiple of 6.0x that gets us close to Ensco's current stock price (2% downside). Thus, the market is pricing in an absolute worst case scenario.
The opportunity becomes even more attractive when considering the following:
- Ensco has one of the most conservative balance sheets in the industry with $7.00 of net cash per share, a history of returning cash to shareholders and a dividend yield of 3.5%
- Ensco has a replacement value of about $83.00 a share and NAV value of $47.00
- During the oil spill turmoil, Ensco attempted to acquire Scorpion's jackup fleet for a total consideration of $1.2 billion. Investors were not happy to see Ensco spend so much of its cash at once and sent the stock down several dollars. Not wanting to overpay for the assets when Seadrill put in a competing bid, Ensco dropped the bid. Due to the turmoil over moratorium the stock never got the chance to recover
- The normalized EBITDA and EPS levels for 2011 do not even reflect the contribution from 3 deepwater rigs that will be delivered in 2011 and 2012
- A stronger than expected recovery in the jackup market could result in jackup dayrate and utilization increases.
Risks
- Moratorium lasts longer than 6 months and general headline risk over the spill and moratorium headline risk over the next several weeks
- Nexen is able to defer delivery of the Ensco 8502 at terms that are unfavorable to Ensco. We believe it is in Nexen's interest to maintain a good relationship with Ensco
- Though shallow water drilling will be allowed in the GOM the permitting process has been temporarily put on hold pending new safety procedures. If this takes longer than a few more weeks or if jackup drilling in the GOM becomes less attractive, Ensco's jackup GOM exposure (8% of 2011 revenue) could take a hit
- The global recovery in the jackup market stalls and pushes down utilization rates and dayrates
- Rates on deepwater rigs fall globally forcing the Ensco 7500 (contracted through 3Q10) and the uncontracted newbuild rigs under construction to find work at depressed dayrates