Oil drillers such as Transocean (NYSE:RIG) and Diamond Offshore (NYSE:DO) have been walloped in recent months under a cascade of negative sentiment. It seems that everyone from the sell-side analyst community to the financial media have nothing but terrible things to say about the outlook for offshore oil drilling. Supposedly, demand for oil rigs is drying up, particularly in the emerging markets, which means a supply glut will soon result in lower utilization and increased idle times throughout the industry.
It's true that conditions aren't perfect right now for oil drillers. Both Transocean and Diamond Offshore are seeing bumps in the road that make their near-term outlooks less than stellar. But for the most part, oil drillers have fantastic long-term fundamentals and should reward their shareholders for many years. One, Ensco PLC (NYSE:ESV), remains my top pick in the oil drilling space.
Why Ensco is a diamond in the rough
The market is clearly worried that lower demand for energy and oil rigs, along with increased costs associated with upgrading older fleets, will have a significantly negative impact on future earnings across the oil drilling space. To be sure, some drillers are actually suffering from this.
For example, Diamond Offshore's operating profit declined by nearly 17% in 2013, driven primarily by higher drilling expenses. Going forward, investors are right to be skeptical about Diamond Offshore's 2014. That's because it plans to double its capital expenditures this year to upgrade its fleet.
Similarly, Transocean whiffed in its own most recent quarter. Transocean's operating cash flow declined last year, due in large part to an extremely poor fourth quarter. Transocean realized worsening utilization and fleet efficiency in the final three months of the year. Utilization stood at 75%, down eight percentage points from the third quarter. In addition, fleet efficiency dropped on a quarter-over-quarter basis as well, to 91%. The reason for this is that Transocean was forced to endure prolonged downtime on certain ultra-deepwater rigs.
Meanwhile, Ensco thrived last year, achieving record revenue and earnings of $4.9 billion and $1.4 billion, respectively. The company saw success in several key markets including South Korea, where Ensco accepted delivery of the ENSCO DS-7, a new ultra-deepwater drillship that started operation ahead of schedule. And, in Singapore, Ensco delivered the first two of its ENSCO 120 jackups that are specifically suited for harsh environments.
Ensco's outlook not as bad as feared
While Transocean and Diamond Offshore are grappling with increasing idle times and significantly higher expenses, Ensco should sail through its near-term difficulties with ease. To be fair, Ensco expects current-quarter revenue to fall by 5% versus the fourth quarter of 2013. But that signifies an entirely manageable near-term bump in the road rather than a concerning long-term deterioration. And, the company still expects full-year 2014 revenue to grow 5%-6%.
Ensco's high-grading strategy of upgrading its fleet is little cause for concern because of shrewd management practices. Ensco invested $1.8 billion in its fleet last year, but also doubled its dividend. That implies the company has more than enough cash flow and an impressive $11 billion backlog, most of which is front-end loaded, to simultaneously invest in its fleet and reward shareholders. Plus, Ensco has sold older rigs at a profit recently, and reinvested the proceeds in its fleet. All these actions will blunt the impact of the company's high-grading strategy.
Ensco PLC: The goldilocks oil driller
In my opinion, Ensco provides investors with the best mix of growth and income within the oil drilling space. It offers a competitive 6% dividend yield and a modest level of capital expenditure requirements. While its competitors such as Transocean and Diamond Offshore grapple with deteriorating core metrics and increasing expenses, Ensco is still seeing strong demand for its rigs and is high-grading its fleet in a manageable way.
Ensco will only see a small dip in revenue in the current quarter, but thanks to its front-end loaded contract backlog and fluid fleet upgrading strategy, its long-term fundamentals remain extremely promising.