The offshore drilling industry seems to have only negative news to offer, the most recent being the downgrades of several offshore drilling stocks by Moody’s. Among the downgrades, the steepest was for Ensco (ESV, Financial), which was downgraded by five notches to B1 from Baa2.
In the last year, Ensco has slumped by 64%. The stock did not witness further downside on downgrade as it was largely discounted in the stock. The key point is the company’s credit perspective as offshore drillers have significant leverage. Over the next 24 months, the key factor for offshore drillers will not be growth but survival in challenging times.
Coming to the backlog analysis, when Ensco’s order backlog for 2016 was last reported, the company’s backlog was $2.7 billion, and this is likely to translate into fiscal year 2016 EBITDA of $1 billion to $1.2 billion. Further, the operating cash flow is likely to be in the range of $700 million to $800 million. Even if operating cash flow of $700 million is considered, the company’s 2016 and 2017 consolidated capital expenditure of $900 million will be largely covered through the cash flows.
Ensco has $1.3 billion in cash and short-term investment as of fiscal year 2015 and an undrawn revolving credit facility of $2.25 billion that is maturing in 2019. Ensco might have been downgraded by five notches, but the company’s liquidity position remains strong enough to navigate the crisis.
The downgrade comes primarily from two factors.
First, Ensco has witnessed few recent rig cancellations, and that can potentially make the order backlog slimmer beyond 2016. If the offshore market remains depressed in 2017 as well, Ensco is likely to face new challenges.
Second, there are rigs that will be going off-contract in 2016 and 2017. They are likely to be cold stacked. Further, if rigs are contracted when offshore market conditions improve gradually in 2017, the EBITDA margin will be significantly lower than the peak EBITDA margin cycle in 2014 and 2015.
Therefore, even if Ensco has the same level of debt, the company’s debt to EBITDA (leverage) and EBITDA to interest expense (coverage) will worsen in the coming 12 to 24 months.
Ensco has an attractive debt maturity profile, and that is a positive factor in the midst of negatives. The company has no debt outstanding through 2018, and this ensures no immediate debt refinancing concerns. For companies that have to refinance debt in the current market scenario, the cost of debt is likely to be significantly higher.
Another factor that will continue to provide some liquidity support for Ensco is the scrapping of rigs or divestitures. Since September 2014, Ensco has sold seven rigs, and further rig sales can be expected in the foreseeable future to reduce leverage.
Ensco has difficult times ahead, and the company has been taking steps to cold stack rigs, bring down G&A cost and reduce leverage. While the company’s order backlog for 2016 ensures that debt servicing metrics remain smooth, the concerns beyond 2016 will be discounted in the stock – in particular if there is increasing possibility of offshore market conditions remaining challenging well beyond 2016.
From an investment perspective, investors should remain cautious on Ensco. If they want exposure to the offshore drilling sector, Noble Corporation (NE, Financial) and Rowan Companies (RDC, Financial) might be relatively attractive, but they should refrain from big exposure to any offshore drilling stock (short term or long term).
