The offshore drilling market has struggled in 2014, and Ensco (VAL), among others, has taken a beating as a result. Oil and gas explorers have pulled back on capital spending due to falling returns on wells, and few companies have the appetite to commit hundreds of millions, or even billions, of dollars to contract anything but the best projects with the newest rigs.
So is it time to cut bait from offshore drillers or double down? Below I'll outline three reasons I think Ensco's stock could rise.
Upgrading the drilling fleet
It has been fully apparent this year that newer drilling rigs with greater capabilities and safety features are going to win a majority of the drilling contracts going forward. The top end of the market is enjoying dayrates of $600,000 or more, while older rigs are struggling just to find employment.
Seadrill's newly completed West Jupiter rig. Source: Seadrill.
That's been evident for Ensco, which has an average rig age of nine years even after cold-stacking five rigs in the second quarter of 2014. But management has made a major effort to improve its fleet capabilities; with seven rigs under construction and 14 sold since the beginning of 2010, the rejuvenation process is moving along.
In the meantime, the jackup fleet is holding its own as the floater fleet is upgraded. Operational utilization for Ensco jackups in 2013 was 98%, and that moved up slightly to 99% in the first half of 2014. As the fleet becomes younger and improves capabilities, I think there's both earnings and margin upside for Ensco.
Highest margin in the industry
Ensco might not have the newest fleet in the drilling industry, but it has some of of the lowest leverage ratios and highest utilization rates, resulting in an industry-leading 29% net income margin. The company's high utilization in jackups and floaters (94% in first-half 2014) has resulted in a strong operating margin, and Ensco's $4.7 billion in debt means it faces lower interest expense than most competitors.
Those margins should continue to be strong because of three ultra-deepwater rigs set for delivery in 2015. DS-8 has been contracted with Total from third-quarter 2015 to third-quarter 2020 at an average rate of around $650,000 per day, and DS-9 is contracted from third-quarter 2015 to third-quarter 2018 for over $550,000 per day.
Over the long term, these new ultra-deepwater rigs will provide consistent cash flow for further expanding the fleet, paying dividends, or reducing debt. With $4.7 billion in long-term debt against $11 billion of contracted revenue backlog, Ensco is well positioned for the future.
Solid dividend and payout ratio
Any investor looking at offshore drilling stocks today should look for a strong dividend, but also at that dividend's risk profile. Ensco pays a solid 5.9% dividend yield, and it is less risky than more highly leveraged competitors like Seadrill (SDRL), which has an 11.1% dividend yield.
Based on 2014 earnings estimates, Ensco is paying out just 51% in earnings through its dividend, while Seadrill is paying out 132%. Diamond Offshore and Transocean also have higher payout ratios of 113% and 66%, respectively.
This is key given the lower amount of leverage Ensco employs versus its competitors, such as Seadrill. It can take more downside in revenue if the industry struggles and still pay its bills.
If the drilling industry improves and Ensco maintains its profits it could raise its dividend significantly, providing great upside for income investors.
Foolish takeaway
There's no guarantee a stock will rise or fall, but if you own stocks that are positioned well to grow in the future you're already a step ahead of the market. Ensco is making the adjustments necessary to stay competitive in the offshore drilling market, and I think it provides both great upside and low risk compared to many peers.
