Why I Remain Bearish on Ensco

Slimming order backlog is a concern and impacts credit metrics

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Oct 24, 2017
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I have covered several stocks in the exploration and drilling sector recently, and my focus has been on the credit metrics. In particular, companies in the offshore drilling sector need to pursue survival strategies as challenging times are likely to continue for the next 12 to 24 months.

In this article, I will discuss another battered offshore driller from a credit perspective to conclude if the stock is appealing at current levels. Ensco (ESV, Financial) has declined by 52% year to date, and that makes the stock worth discussing. A deep correction seems like a buying opportunity if credit metrics are strong.

I must mention that I wrote on Ensco on June 2 when the company announced the acquisition of Atwood Oceanics. In that article, my position was to remain on the sidelines and as I elaborate on key points in this article, my view largely remains the same.

Concerns related to oil price

It is important to note here that oil has remained in the range of $45 to $55 per barrel. While I am bullish on oil trending higher in the long term, the current prices are not attractive from an offshore drilling perspective.

Onshore assets have been delivering attractive IRR even at $50 to $55 per barrel oil, but there are few offshore assets that can deliver decent IRR at $50 per barrel oil.

Even if oil moves higher in the next 12 to 24 months and trades in the range of $60 to $65 per barrel, I don’t see any meaningful improvement in day rates for offshore drillers. Rig utilization can potentially improve.

Offshore drillers will see challenging times and compressed EBITDA margin at least for another 12 to 24 months. Therefore, the order backlog and cash buffer needs to support credit metrics in this time duration.

The positives

Before talking about the company-specific concerns, I want to highlight some positives. From a financial perspective, the following points are worth noting:

  1. As of the second quarter, Ensco had cash and short-term investments of $1.85 billion. This provides ample liquidity buffer.
  2. As of the second quarter, Ensco had undrawn credit facility of $2.25 billion. This takes the total liquidity buffer to $4.1 billion.
  3. As of the second quarter, the company had only $1.0 billion in debt maturity through 2023. If industry conditions improve in the next 12 to 24 months, debt refinancing or debt repayment through internal accruals is unlikely to be a concern.

Besides the financial factors, I must mention that the acquisition of Atwood Oceanics has strengthened the company’s fleet in terms of high-specification assets.

Key concerns

As of December 2016, Ensco had total order backlog of $3.6 billion, and this declined to $3.3 billion as of June 30.

The company’s order backlog of $3.7 billion (after considering the Atwood acquisition) is a major concern for the next 12 to 24 months.

The reasons are as follows:

For fiscal 2017, the company’s order backlog is $1.6 billion. But the backlog sharply declines to $1.0 billion in fiscal 2018 and $580 million in fiscal 2019. If industry recovery is slow, leverage is likely to increase and EBITDA interest coverage will also decline.

Just to put things into perspective, Ensco is likely to report annualized EBITDA of $600 million for fiscal 2017 and considering annualized interest expense of $220 million, the EBITDA interest coverage comes to 2.7.

With order backlog of just $1.0 billion for fiscal 2018, the annualized EBITDA is likely to be in the range of $300 million to $350 million based on first-half 2017 EBITDA margin. Considering interest expense of $220 million, the EBITDA interest coverage is likely to decline to 1.6. Even if the EBITDA is higher at $450 million (new order intakes and Atwood acquisition impact), the EBITDA interest coverage is likely to remain at 2.0.

Therefore, a slim backlog in fiscal 2018 and thereafter is a concern for Ensco; with industry recovery likely to be slow, the credit metrics can potentially worsen in the coming quarters.

Another important point to note is that the current backlog has contracts that have a relatively higher day rate. As new contracts flow, there will be EBITDA margin compression and even with higher rig utilization, the company’s cash flow might remain depressed.

Conclusion

Ensco has seen sharp correction in fiscal 2017, and there are fundamental reasons that support the downside. Even after the big correction, investors can remain on the sidelines.

The company’s credit metrics remain a concern for the next 12 to 24 months even as Ensco might be positioned to survive the crisis. Avoiding exposure to Ensco also makes sense when there are other offshore drillers who have better credit metrics with Diamond Offshore (DO, Financial) being one of the examples.

Disclosure: No positions in the stocks discussed.