Description: Ensco is the 3rd largest Jack Up drilling contractor in the world, with 42 high specification jack ups in its fleet, as well as four 6th-generation semisubmersible deep water drilling rigs that are currently deployed, and a further four semi subs that are under construction through 2012. Ensco is unique among the contract drillers in that it has demonstrable earnings growth via organic new construction of deep water drilling rigs. We have seen consolidation activities pick up in the sector, with SDRL acquiring SCORE NO, RDC buying Skeie Drilling, and NE acquiring Frontier Drilling, all in multi-billion dollar transactions in the last 2 months. All of these M&A moves have been driven by the need to find external growth.
Thesis: ESV’s ejection from the S&P was the original entry point. Ensco is a classic business in transition, trading at a very cheap valuation, with tremendous downside protection from a rock-solid balance sheet. The Company will end the year with $1.2 bn of cash (or almost $9/share). In my view, ESV is a very attractive R/R. It’s a three year double on very conservative assumptions. The reason this situation is compelling is as follows:
1) Transformation: The Company will be dramatically different in 3 years as it completes the construction on its deepwater semisubmersibles, which will conservatively generate $790 mm of EBITDA by 2013, vs. $146 mm in 2009.
2) Balance sheet: The Company has an existing $500 mm share buyback authorization in place that it will use. The Company demonstrated its discipline when it refused to get in a bidding war with SDRL for SCORE NO. As a former shareholder, I was supportive of the bid. Given the failed bid, the Company will now seek to buy back stock as its next best use of its cash.
3) Winner from Oil Spill: On its core jack up business, Ensco will be one of the key winners as a result of the oil spill. As a result of the regulatory changes impacting the offshore drilling industry, NOCs (National Oil Companies) and IOCs (International Oil Companies) will shy away from contracting with private, inexperienced drilling contractors (which is where the bulk of uncontracted new builds are projected to come in). As safety will be primary amongst the concerns of operators, they are already moving to focus their business with long-tenured and experienced drilling contractors, like ESV.
4) Market Consolidation: The jack up market has consolidated dramatically over the last 10 years. This has resulted in a much more disciplined market than existed 10 years ago, which has meaningfully dampened the downside cyclicality of the industry. There is recurring concern that new builds are going to enter the market and depress margins. The consolidation of the industry combined with the heightened regulatory scrutiny will serve to ensure that the big survive and the weak are forced to sell their assets as they will not be able to win business without a track record.
Contractor Dec-09  Contractor Dec-99
Transocean Ltd. 65  R&B Falcon (now RIG) 42
Noble Drilling 43  ENSCO 36
ENSCO 42  Noble Drilling 32
Hercules Offshore 30  Global Marine (now RIG) 23
Rowan 22  Santa Fe (now RIG) 23
    
Top 5 mkt share 49.3%  Top 5 mkt share 40.6%

Oh, and ESV sports a 3.5% dividend yield and a 6.5% FCF yield on a net cash balance sheet. that is unique and is representative of the deep value of this situation.

• Contract announcements for new build semi subs: The market is concerned with the fact that Ensco has 4 new deepwater rigs coming into the market that have not been contracted. Current leading edge day rates for deep water rigs are trending at $400,000. At these rates, ESV will still generate 20%+ ROICs on the new build assets, which is a function of 1) tight cost discipline in designing and building the rigs, and 2) leveraging its expertise as the best in class operator in the industry in terms of asset efficiency and cost management.
• Announcement of share repurchase: management has been reminded of their words that they know that that their stock is undervalued. Ensco has $500 mm of room left on an existing share repurchase program that was instituted in 2008. From 2006 through 2008, the Company repurchased a cumulative $1.2 bn of stock. ESV’s stock has never been more undervalued.
• Continued improvement in high spec jack up day rates: high spec jack up day rates are stabilizing / trending upwards again. Further positive momentum on jack up rates will be a big boost to sentiment. It’s important to note that jack up rigs are exempt from the recently re-imposed drilling moratorium in the GoM. Further cancellation announcements of new build rigs by speculative builders will also be a further catalyst, as it will alleviate concerns of a potential oversupply of rigs in 2011 and 2012.
• Asymmetry of the investment:
o Conservative assumptions: the Company will reach $1.35 bn of EBITDA without having to assume a rebound to previous peaks in utilization and day rate. In fact, through 2013, I assume that jack up utilization trends lower with flat day rates. I project that utilization in 2013 for the Company’s jack up fleet will be 800 – 1,200 bps lower in 2013 than in 2008.
o Fallout from the oil spill: two big macro impacts from the Macondo oil spill will be higher costs to drill (and therefore higher oil prices) and increased regulation. The net result of those changes is a big benefit to Ensco. As a long established operator (since 1983), ESV has a very strong safety record, leading the overall industry. Secondly, new entrants will not have the same capabilities (financially and operationally) to support the costs associated with higher safety and regulatory scrutiny. Given that a substantial number of new build rigs currently in shipyards are being built by smaller, speculative players, this new operating paradigm may cause further construction cancellations, which would be supportive to existing players like ESV as the supply-demand balance for rigs could potentially tighten. If oil prices also rebound, the global drilling market could have a very tight market for assets, which in a blue sky scenario, could see ESV generate north of $10 / share in Earnings. I am currently forecasting $6 in 2013.
o Balance sheet:
 Status Quo: Under the current conservative projection assumptions driving my base case, the Company will potentially add a cumulative $1.9 bn of cash to its balance sheet through 12/31/13. This is after paying out $1 bn in new build capex, and $200 mm/ year in dividends.
 Deflationary Collapse: In the event that oil prices collapse, the Company will be able to fulfill its new build capex obligations without burning cash. Here is the basic assumption: every rig that is not contracted is cold stacked. Just on the existing contracted backlog, the Company will be able to generate sufficient cash. To use the Shiller P/E once again, under the “cold stack everything” scenario, the Company will have $3.50 of net cash per share at the end of 2012. Average 10 year earnings is $3.20 x 10 = $32.00 + $3.50 of cash = $35.50 / share.