Ensco (ESV)10 Whereas Walmart is an example of a type of "compounder" we like to buy, Ensco is an example of a "3:1" - a purchase we make when we believe the potential upside is 3x larger than the potential downside. We haveowned Ensco for a number of years, and it has also been discussed in the past, along with our investments in other oil service companies. 11 Ensco is an average business with no long-term competitive advantages. It seems that to effectively compete, a rig company only requires capital and a contract with an Asian shipyard. Such ease of market entry convinces us that a company that builds a rig and then leases it should not expect to earn more than a 10% to 12% long-term return on capital. In a tight market, demand exceeds the number of rigs available, and return on capital rises above the long-term average. At such times, one generally expects to see new orders for rigs. As those rigs come to market a few years down the road, day rates, and thus returns on capital, decline.
Earnings at Ensco and other oil service companies are currently above our expectations for normal returns on capital due to a shortage of available rigs. Capital and time will correct that. Currently, there are lots of rigs under construction. In 2013, 35 new jackup rigs will be built and delivered, an increase of 8% to the current worldwide fleet of 426. Additionally, 21 new floater rigs will be built and delivered, an increase of 7%
to the current worldwide floater fleet of 295. Worldwide oil consumption & production grows at about 1% per year so we believe this level of growth in the offshore rig fleet will ultimately reduce profitability and returns.
We have reduced our position in Ensco and other oil service companies, albeit with the recognition that this period of "excess" earnings can continue for quite some time if the price of oil remains high.
Our goal when investing in commodity businesses is to 'buy assets and sell earnings.'
Capital intensive, cyclical businesses often trade at discounts to the value of the underlying assets when their respective industry is in distress (companies are either losing money or earning less than what 's expected in a more normal environment). When earnings rebound, the market seems to forget that the businesses a recyclical. Investors begin to value them on earnings as if another downturn isn't in the cards. Our average cost in Ensco reflects rigs purchased at a discount to a fully depreciated replacement value. Since then, its stock price has increased, along with day rates (and earnings). The company is now beginning to be considered more on a P/E basis, while at the same time, the value of the underlying rigs has begun to trade through the irreplacement value, reflecting the value of existing contracts and hope for a continued robust demand environment. As our margin of safety 12 has declined, we have reduced our exposure, consistent with our initial thesis and the manner in which we invest in such industries.