Investing in oil drillers is an uncertain proposition right now. Even though demand for energy across the world remains robust, particularly in the emerging markets, there is a near-term rough patch currently hitting the industry. That's because the major oil companies are cutting capital expenditures right now, in light of disappointing returns on new projects. Instead of investing in new rigs, most of the integrated super-majors are choosing to return excess cash to shareholders.
That has resulted in a supply glut, and a slowdown for many oil drillers such as Ensco PLC (NYSE:VAL). Not surprisingly, the stock has followed suit. Shares of Ensco have declined 11% just since the start of the year.
However, it's worth noting that Ensco's underlying fundamentals haven't deteriorated nearly as much as the bearish sentiment would suggest. Nevertheless, here's why Ensco shares are down this year.
Industry softness fuels stock decline
Ensco, like many others in the oil drilling industry, is seeing weak demand for some of its rigs. This is causing higher idle times and lower utilization, which is weighing on profitability. For example, last quarter Ensco incurred a huge charge against earnings per share because of this. Specifically, Ensco took a $1.5 billion non-cash impairment charge for eight of its floaters, four of which will now be held for sale.
Ensco's desire to unload its older, underperforming rigs is a continuation of the fleet upgrading strategy that the company has embarked on over the past year. Earlier this year, Ensco offloaded three jack-up rigs that were built in the 1980's. Ensco collected a total of $97 million in proceeds, which will help supplement future investment in its fleet. These moves make sense, since it's wise for oil drillers to sell old rigs while they can still generate a profit.
While the fleet upgrading comes at a cost to earnings now, it's necessary for future growth. The strength of Ensco's fleet is what's keeping the company afloat during the rough patch. Last quarter, revenue and earnings from continuing operations both grew 6%. Going forward, management expects 2% revenue growth on a quarter-over-quarter basis.
Strong financial position
Until the market improves, Ensco management is confident in the company's financial standing. At the end of last quarter, Ensco held an $11 billion revenue backlog excluding bonus opportunities. Its balance sheet is strong too, with a long-term debt to equity ratio of 40%.
And, investors are treated to a 6% dividend yield that is well-supported with cash flow. Ensco paid $351 million in dividends over the first half of the year, and generated $357 million in free cash flow. This represents a free cash flow payout ratio of about 98%, or essentially all of the company's free cash flow. While this is still tight and doesn't provide much breathing room, Ensco still brought in more cash flow than it distributed to investors so far this year. Plus, management reiterated its commitment to the $3 per share annualized dividend after providing earnings last quarter.
If this is indeed near the low point of the lull in offshore drilling activity, it's a good sign that Ensco has still put up solid results. Future growth is likely going to be a result of positive developments in new areas. For example, last quarter Ensco signed a 5-year contract with Total for the ENSCO DS-8, which the company states will add $1.2 billion to its backlog.
The Foolish bottom line
Ensco, like other oil drillers, is seeing some softness in utilization and day-rates, as a result of weakening industry dynamics. Members of Big Oil are cutting back on new orders for rigs, based on poor returns from recent new projects. This has caused Ensco's share price to suffer since the start of the year. Nevertheless, it's worth remembering that oil prices are near $95 per barrel, and are still supportive of drilling activity.
Before the industry fundamentals recover, investors are still receiving a 6% dividend, which provides solid consolation until the oil drilling sector gets back to growth.