Markets & Finance

ENSCO: A Gas Driller That's Cooking


By John Kartsonas We at Standard & Poor's expect domestic oil and gas contract-drilling outfits to enjoy a good second half in 2003, especially in light of lofty prices for natural gas. And we believe ENSCO International (ESV), with one the largest fleets of premium drilling rigs in the Gulf of Mexico, is particularly well-positioned to benefit from the improving conditions.

We view the shares as attractively valued, based on our expectations for increased drilling activity in the Gulf, where more than half of ENSCO's fleet is active. In addition, we believe that once investors' confidence in the sustainability of high natural gas prices increases, the shares should trade at a premium to the ENSCO's industry peers. It carries our highest investment recommendation of 5 STARS, or strong buy.

ENSCO's fleet consists almost entirely of so-called jackup rigs, most of them premium rigs capable of drilling in depths of more than 300 feet of water. In addition, ENSCO's fleet of rigs is one of the industry's youngest, with an average age of 18 years. The quality of its fleet -- and the high percentage of premium rigs -- we believe, puts ENSCO in a position to demand higher dayrates (an industry term for the daily rate charged for rig operation) once the market tightens, which we expect to start happening in the third quarter.

LAND BEFORE SEA. With natural gas prices remaining at historically high levels, and with gas inventories about 20% below their five-year average, we expect offshore drilling activity to accelerate. Historically, it takes about six to eight months for higher natural gas prices to translate into higher rig utilization rates, and later, to higher dayrates.

Natural gas prices averaged above the $4 per million BTU mark last November for the first time since the spring of 2001. Since then, U.S. land rig counts have increased more than 30%, as land drilling is the first market to benefit from the energy producers that contract for drilling rigs.

However, U.S. offshore drilling has yet to show signs of improvement. Utilization of available operating rigs in the Gulf of Mexico stands in the low-70% range, while dayrates for 250-foot jackup rigs are in the mid-$25,000 range. But ENSCO is bucking the trend: Its available fleet in that region is currently fully utilized, with only two rigs in the shipyard undergoing enhancement work.

EXTENDED CONTRACTS. We look for the Gulf utilization rate to continue increasing, and our expectations are that once it reaches the low- to mid-80% range, dayrates should start to improve significantly. For ENSCO's Gulf of Mexico jackup fleet, we estimate utilization to average 85% in 2003, while we expect dayrates to average slightly above $31,000, about 18% higher than last year.

ENSCO's international fleet is also enjoying good utilization rates, compared to the rest of the industry. In the North Sea, one of the weakest markets, all seven of its jackups are currently under contract. In West Africa, ENSCO has one jackup working for Shell. Asia Pacific remains ENSCO's strongest market, where only one of its nine rigs remains idle. In addition, when a rig now a Singapore shipyard is finished being upgraded, all planned enhancements for the Asia Pacific fleet will have been completed.

Internationally, ENSCO maintains good coverage in terms of the duration of its drilling contracts, with many extending into 2004. In the North Sea, we expect dayrates to soften in the second half, as many jackup rigs come off contract in that region. In the Asia Pacific market, we expect both utilization and dayrates to remain firm, while the three jackup rigs drilling in the Middle East region shouldn't see much improvement in dayrates.

QUALITY EARNINGS. ENSCO has been very active in upgrading and enhancing its fleet to meet the demand for more challenging drilling projects. The recent acquisition of Chiles Offshore added three jackup rigs capable of drilling down to 30,000 feet in more than 350 feet of water in severe environments and other highly specialized rigs. ENSCO also

acquired a 25% ownership interest in a newly built jackup rig, with the option of acquiring the remaining 75% within two years.

S&P believes ENSCO has high earnings quality. Based on our proprietary Standard & Poor's Core Earnings methodology, we see 2003 Core EPS of 82 cents, a 6.1% divergence from our Operating EPS estimate. The S&P Core EPS estimate assumes stock-option expenses, under accounting regulation SFAS 123, of 5 cents per share but no pension adjustment since ENSCO has no defined-benefit plan.

PREMIUM RIGS, PREMIUM PRICE. The shares were recently selling at 22 times our 2004 EPS estimate, which is about in line with the peer-group average. In addition, their enterprise value was 10.5 times our 2004 EBITDA (earnings before interest, taxes, depreciation, and amortization) estimate, and 20.5 times cash flow per share, both slightly higher than the respective peer group average of 10 times and 20 times.

We believe ENSCO's premium rig fleet deserves a premium valuation, which has been historically the case. In the last five years the shares have traded at enterprise value (the total of the market value of its equity, plus total debt and minority interest, less cash) to forward EBITDA multiples of about 10% higher than its peers. Our target price of $35 is based on our expectations of ENSCO achieving an enterprise value of about 13 times our 2004 EBITDA estimate, which represents a slight premium to our peer group average estimate of 12 times.

Looking at ENSCO's fleet, the shares are currently valued at about 130% our estimated net asset value and at an 11% discount to our replacement value calculation. Our net asset value calculation is based on our assumption that the current cycle's peak dayrates will average about 85% to 90% of the previous dayrate peak. Then, subtracting cash costs, depreciation, and taxes, we estimate peak earnings. And using a discount rate of 12%, we calculate the current market value estimate for each rig.

FAVORABLE OUTLOOK. Our target price assumes that the shares will trade at approximately 160% of our estimated net asset value. Historically in previous upcycles, drilling stocks have traded at net asset value multiples in excess of 100% and as high as 200%.

Although we see risks in our forecasts, including the timing and magnitude of any significant recovery in the Gulf of Mexico drilling activity as well as the sustainability of the current high oil and natural gas prices, we believe that the risk-reward ratio is favorable, and we see ENSCO's shares significantly outperforming the market. Analyst Kartsonas follows oil & Gas drilling stocks for Standard & Poor's


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