Offshore Driller's Valuation After the Dividend Cut
In this article let's take a look at Ensco PLC (ESV), the international offshore oil and gas contract drilling company, which is the world's second-largest offshore drilling rig fleet amongst competitive rigs, with an ultra-deepwater fleet that is the newest in the industry.
We all know that a dividend cut, even a little one, is not welcome in the market. So let�s take a look at the new intrinsic value generated. For investors looking at a buy recommendation, we have seen in a previous article that Duke Energy (DUK) has an upside potential.
The company
The firm has focused on operating safely and going beyond customer expectations, with primary focus on jackup and ultra-deepwater semisubmersible rig operations.
The company has a presence in the most strategic offshore basins across six continents, but new multi-year projects in West Africa, Brazil, Southeast Asia and the Mediterranean are gaining importance. Ensco's main industry peers are Noble Corporation (NE) and Seadrill (SDRL). Both peers are making investments to improve their fleets.
Dividend cut
Ensco has a strong balance sheet, good level of cash that allows it to reward current shareholders through higher dividends. During the third quarter, the company cut its quarterly dividend to $0.15 per share from $0.75, following a similar decision made by Transocean (RIG).
According to company�s report, dividends have been paid since 1997 and with a current dividend yield of almost 3.5%, and we believe Ensco remains well positioned to comfortably increase its dividend in the future. We must say that the company�s dividend yield of 8% was among the top 5% of the S&P 500 companies.
DDM valuation
The company currently has a dividend yield of 2.3% and is close to 5-year high. The Yahoo! (YHOO) Finance consensus price target is $133.47, so now let�s try to estimate the fair value of the firm, for that purpose I will use the Dividend Discount Model (DDM). In stock valuation models, DDM defines cash flow as the dividends to be received by the shareholders. The model requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model or the H-Model (which is a special case of a two-stage model).
Once selected the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.
Let�s estimate the inputs for modeling:
First, we need to calculate the different discount rates, i.e. the cost of equity (from CAPM). The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stock j = risk-free rate + beta of j x equity risk premium
Risk-Free Rate: Rate of return on LT Government Debt: RF = 3.03%[1]. I think this is a very low rate. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So, I believe it is more appropriate to use this rate.
Gordon Growth Model Equity Risk Premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) - (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[2]
Beta: From Yahoo! Finance we obtain a ? = 1.02
The result given by the CAPM is a cost of equity of: rESV = RF + ?ESV [GGM ERP] = 4.9% + 1.04 [11.43%] = 14.27%
Dividend growth rate (g)
The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm�s debt-to-equity ratio is unchanged and it doesn�t issue new equity.
g = b x ROE
b = retention rate
ROE = (Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
The "PRAT" Model:
g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)
Collecting the financial information for the last 3 years, each ratio was calculated, and then to have a better approximation I proceeded to find the 3-year average:
Retention rate | 0,84 |
Profit margin | -0,07 |
Asset turnover | 0,23 |
Financial leverage | 1,58 |
Now, is easy to find the g = Retention rate � Profit margin � Asset turnover � Financial leverage = -2.1%
Because for most companies, the GGM is unrealistic, let�s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. In other words, a smoother transition to the mature phase growth rate that is more realistic.
Dividend growth rate (g) implied by Gordon growth model (long-run rate)
With the GGM formula and simple math:
g = (P0.r - D0)/(P0+D0)
= ($17.37 � 16.65% - $0.6) � ($17.37 + $0. 6) = 11.57%.
The growth rates are:
Year | Value | g(t) |
1 | g(1) | -2,12% |
2 | g(2) | 1,57% |
3 | g(3) | 5,27% |
4 | g(4) | 8,97% |
5 | g(5) | 12,67% |
G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).
Now that we have all the inputs, let�s discount the cash flows to find the intrinsic value:
Year | Value | Cash Flow | Present value |
0 | Div 0 | 0,60 | |
1 | Div 1 | 0,59 | 0,504 |
2 | Div 2 | 0,60 | 0,439 |
3 | Div 3 | 0,63 | 0,397 |
4 | Div 4 | 0,68 | 0,371 |
5 | Div 5 | 0,77 | 0,358 |
5 | Terminal Value | 22,32 | 10,374 |
Intrinsic value | 12,44 | ||
Current share price | 17,37 | ||
Upside Potential | -28% |
Final comment
Intrinsic value is below the trading price by 28%, so according to the model and assumptions, the stock is overvalued and subject to a potential "sell" recommendation. However, we must keep in mind that the model is a valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.
Earlier this month, shares were down by 5% after the company confirmed that ConocoPhillips (COP) terminated its order for the company's Ensco DS-9 deepwater drillship. The day rate was about $550,000 a day, $16.5 million a month, $198 million per year.
The past quarter, Arnold Van Den Berg (Trades, Portfolio) has divested in the stock to 619,536 shares, a decrease of 4.88%.
Disclosure: As of this writing, Omar Venerio did not hold a position in any of the aforementioned stocks
[1] This value was obtained from the U.S. Department of the Treasury
[2] These values were obtained from Bloomberg�s CRP function.
This article first appeared on GuruFocus.
