By Stewart Glickman We at Standard & Poor's Equity Research Services think the shares of contract-drilling outfit Ensco International (ESV
; recent price, $29.50) are attractively valued, based on our expectations for increased oil- and gas-drilling activity in the Gulf of Mexico, where nearly half of its fleet is active. The stock carries our highest investment recommendation of 5 STARS, or buy.
Although we see risks in our forecasts, including the timing and the magnitude of any substantial recovery in the Gulf's drilling activity as well as the sustainability of the current high oil and natural gas prices, we believe that the risk/reward ratio is very favorable and expect the shares to significantly outperform the market.
OFFSHORE DRILLING PICKUP. Ensco's fleet is almost entirely made up of so-called jackup rigs, most of them capable of drilling in water depths of more than 300 feet. In addition, it has one of the fleets more technologically advanced premium jackup rigs in the industry, with an average age of about 18 years. These units command higher dayrates (the daily equipment and operating fees Ensco charges to oil and gas producers), typically because they can handle greater water depths and are better able to operate in harsh environments.
We believe Ensco's rig quality and its leverage toward premium jackup rigs put it in an advantageous position to demand higher dayrates once the drilling-rig market tightens, which we expect to start occurring in the second half of 2004.
With natural gas prices remaining at historically high levels and inventories tight, we expect offshore drilling activity in the Gulf to pick up after protracted softness. Natural gas prices, which have averaged above the $4 per Mmbtu (million British thermal units) mark since November, 2002, have remained above the $5 mark since January, 2004, and hit $6.68 per Mmbtu in June, 2004. While we don't anticipate prices to remain at this level, we do project them to stay well above $4 throughout 2004 and 2005.
IMPROVING RATES. Over the last 12 months, the number of rigs in the U.S. land-drilling market, which is typically the first market to benefit from higher spending by oil and gas producers, increased by about 13%. Yet in the offshore market, the rig count has actually declined 9% over that same span. We think conditions are ripe for an improvement in offshore drilling activity.
Currently, overall industry utilization in the Gulf ranges from 72% to 73%, about unchanged from a year ago. Meanwhile, dayrates for 250-foot jackup rigs are in the mid-$30,000 range. However, Ensco's available fleet in that region is largely spoken for, as its utilization in the Gulf was at 87% and 86%, respectively, in the first two quarters of 2004.
S&P sees utilization rates in the Gulf climbing as more rigs leave the region, and our expectations are that once the overall utilization rates reach the low- to mid-80% level, dayrates should start to improve significantly. For Ensco's Gulf jackup fleet, we estimate utilization to average 89% in 2004, while we expect dayrates to average around $39,000, up about 50% over 2003.
CHALLENGING DEMAND. In addition, most of Ensco's international fleet is currently at reasonably high utilization rates. In the North Sea, which is starting to see stirrings of improvement, five of Ensco's seven jackups are under contract. In West Africa, the company has one jackup, currently operated by Shell. The Asia Pacific region remains the strongest market for Ensco, where 13 rigs are currently active. Two rigs under construction are intended for operation in the region, and another being mobilized to this region will undergo shipyard work in Singapore.
In the Caribbean, one jackup is operating at high dayrates, and the Middle East also appears to be a very promising environment -- Ensco is sending two rigs to this region. Only its fleet of six barge rigs in South America is poorly utilized, in our view.
Ensco has been very active in upgrading and enhancing its fleet to meet the demand for more challenging drilling projects. Two rigs currently under construction, the ENSCO 106 and ENSCO 107, are premium jackups capable of drilling in demanding environments. The ENSCO 106 is expected to be delivered to the Asia Pacific region in late 2004, with the ENSCO 107 to follow in late 2005.
MODEST PREMIUM EXPECTED. The August, 2002, acquisition of Chiles Offshore added three jackup rigs capable of drilling up to 30,000 feet down in more than 350 feet of water in a severe environment and two high-specification jackup rigs capable of drilling up to 30,000 feet in 360 feet of water. In addition, Ensco continues to upgrade its rigs.
Based on our view of Ensco's technologically advanced fleet compared to its industry peers, we believe the shares deserve to be valued at a modest premium to the group. Indeed, over the last several years, the stock has traded at enterprise value (market capitalization plus net debt) to forward EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples of about 10% higher than its peers. Yet the shares were recently trading at 10.2 times our projected 2005 EBITDA estimate, in line with peers. In addition, on a price-earnings basis, Ensco was recently trading at 21 times our 2005 earnings-per-share estimate of $1.41, below the peer-group average of 26 times.
Our 12-month target price of $37 is based on our expectations of Ensco achieving an enterprise value of about 12.5 times our 2005 EBITDA estimate, which represents a 10% premium to our peer-group average estimate of 11.4 times.
NO PENSION HIT. We believe Ensco has high earnings quality. Based on our proprietary Standard & Poor's Core Earnings methodology, we see 2005 S&P Core EPS of $1.33, 5.7% lower than our operating EPS estimate of $1.41. The S&P Core EPS estimate assumes stock-option expenses, under accounting regulation SFAS 123, of 8 cents per share but no pension adjustment, since Ensco has no defined-benefit plan.
We believe that the key risks to our investment recommendation and target price are a significant decline in oil and gas prices, any reduction in capital spending by oil and gas exploration and production companies, the possibility that our expectations for higher demand and lower supply of offshore rigs in the Gulf of Mexico may not materialize, and a general weakening of economic conditions that could adversely affect capital investments and demand for oil and natural gas. Analyst Glickman follows shares of oil and gas drilling companies for Standard & Poor's Equity Research Services