For the offshore drilling industry, challenges are far from over, and there are more stocks worth avoiding than buying in the industry.
However, along with challenges, there are opportunities, and several offshore drillers have provided robust returns in the medium term after being beaten down to deep-value levels. This article will focus on Ensco (ESV, Financial) with the stock having declined by 41% year to date, focusing on the backlog and the company’s credit health to determine whether Ensco is worth considering after the big correction.
The first point that is worth noting from an industry perspective is as follows: Even at $40 to $50 per barrel oil, it is likely that the offshore industry recovery will be slow and challenging conditions will continue not only in 2016 but potentially through 2017.
The reason for mentioning this point is to suggest that Ensco or any other offshore driller will have to face another four to six difficult quarters and the key analysis would be to check if the company’s credit health can remain stable during this period.
I would first focus on a few credit positives followed by challenges and then provide my broad conclusion considering the factors. I see the following credit positives for Ensco for the medium term:
- First, Ensco has no debt maturity until 2019, and this eases the refinancing pressure in challenging market conditions. While debt servicing is the critical aspect to be considered, the company’s front-end loaded backlog will ensure smooth debt servicing at least for the next 12 to 18 months.
- Second, Ensco has $1.3 billion in cash and short-term investments coupled with $2.25 billion in available revolving credit facility. With the company expecting capital expenditure of $240 million for the remainder of fiscal year 2016 and capital expenditure of $450 million for fiscal year 2017, the company is fully funded for medium-term investments. Ensco has capital expenditure of $325 million for fiscal year 2018, and the current cash position is sufficient to fund investments through 2018.
- Third, Ensco recently used cash in hand to repurchase $861 million in aggregate principal amount of senior notes for a 28% discount. This has reduced annual cash interest expense by $45 million and is likely to provide a positive boost to the credit metrics (in particular, EBITDA interest coverage).
However, even with these positives, the stock has corrected meaningfully year to date, and it would be important to consider key concerns that can potentially continue to impact the stock negatively:
- First, if the company’s fleet status is analyzed, there are several rigs that are going off-contract in fiscal years 2016 and 2017. With industry conditions likely to remain challenging, recontracting of these rigs will be difficult, and that will impact the EBITDA and cash flow outlook.
- Second, even if rigs are contracted in the next 12 to 18 months, the day rates will be significantly lower than day rates the previous contracts commanded. This will translate into EBITDA margin compression along with operating cash flow compression. This is an important point to mention as EBITDA downside will impact key credit metrics and covenant headroom.
- Third, Ensco has two long-term contracts with Petrobras (PZE, Financial), and there can be potential risk of these contracts being terminated. While the probability might not be high, markets are likely to have discounted that risk.
With these positive and negative factors in consideration, investors can still wait in the sidelines before any exposure to Ensco. The best time to buy the stock would be when there is more clarity on the likely EBITDA margin compression going forward and its impact on the company’s credit health coupled with cash flow potential.
If investors want to consider some exposure to the offshore drilling industry, there are better options in the market.
Just as an example, Diamond Offshore (DO, Financial) has a stronger balance sheet health and is better positioned to navigate an extended crisis in the offshore drilling industry.
Disclosure: No positions in the stocks discussed.
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