Consider Ensco – Even After 70% Upside

Company is fully funded for the next 24 months and will continue to deleverage

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Jan 16, 2017
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With sentiments improving for the oil and gas industry, few offshore drilling stocks have given stellar returns in the last few months. Ensco (ESV, Financial), which was trading at depressed levels of $6.6 on Sept. 20, 2016, has surged by 70% to current levels of $11.3. Is it still worth considering after the big recent upside?

Oil will continue to trend higher. The past few instances of production cut by OPEC have been followed by a 12- to 24-month rally for oil prices. With steady economic recovery globally and with prospects for further OPEC review in 2017, I am bullish on oil; there are reasons to believe the rally for offshore drilling stocks can be sustained.

However, it is important to discuss the fundamentals that will continue to take the stock higher (beyond just positive sentiments). For Ensco, fundamentals have witnessed improvement recently. Some of the critical factors are:

  1. As of third-quarter 2016, Ensco had cash and equivalents of $1.8 billion along with undrawn credit facility of $2.25 billion. With total liquidity buffer of $4.05 billion, Ensco is well positioned for the medium term.
  2. Ensco has no debt maturity until 2019, and this ensures that the company faces no debt refinancing pressure in challenging market conditions. It is also important to note that the company’s net debt-capital ratio declined to 27% in third-quarter 2016 from 41% in fourth-quarter 2015.
  3. For 2017, Ensco has $450 million in capital expenditure that includes $375 million new rig expenditure and $75 million for rig enhancement and improvement. Further, for 2018, the company’s total capital expenditure is $325 million. The important point to note is that capital expenditure of $775 million for the next 24 months can be funded through $1.8 billion in cash buffer as of third-quarter 2016.
  4. As of third-quarter 2016, Ensco had an order backlog of $3.8 billion, and this ensures smooth debt servicing through relatively steady EBITDA in 2017. I expect order backlog boost in 2017 as market conditions gradually improve. The new rig contracts might come at a lower day rate, but that’s likely to be the industry trend and potential EBITDA margin compression is discounted in the stock.

Besides these fundamental factors, one of the important points of discussion has been the impact of $50 or $60 per barrel oil on the offshore industry outlook. The encouraging news here is that offshore oil drilling has seen significant cost improvements and efficiency since the crisis and beak-even for offshore projects has declined.

Just as an example, Statoil (STO, Financial) expects beak-even of around $25 per barrel for the first phase of Johan Sverdrup. While this does not imply all projects having a similar break-even, I do see cost reductions making offshore projects profitable at $40 to $60 per barrel oil. Therefore, it might be safe to assume that if oil trends above $60 per barrel sometime in 2017, offshore drilling activity is likely to gain traction.

Coming back to Ensco, the company has been relatively aggressive in cold stacking and has made efforts towards selling older rigs. This strategy not only reduces the average age of the fleet, but also provides additional liquidity. In the next 12 to 24 months, I expect Ensco to continue with its asset sale strategy and any additional cash buffer can be used for deleveraging.

There are several positive factors that can trigger upside for Ensco in 2017, but the stock has surged sharply in the last few months and my investment strategy would be to wait for a 10% to 15% correction before buying it. It is also worth noting that broad markets can see some near-term correction, and the stock can decline in line with broad markets. For long-term investors, though, Ensco is appealing and likely to deliver good returns.

Disclosure: No positions in the stocks discussed.

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