Buy This Offshore Driller for Major Dividend Upside

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Shares of offshore drilling companies have been under pressure lately, mainly due to weaker oil prices and ordinary guidance provided by National Oilwell. But with the recovering major global economies and the political standoffs in Middle East, crude prices are expected to head north over the longer run.

Naturally, oil exploration activities would follow crude prices, and the leading drilling companies including Seadrill (NYSE: SDRL), Ensco. (NYSE: ESV) and Transocean (NYSE: RIG) stand to benefit here. But for income growth purposes, I believe that Ensco will be a great investment choice due to its stable and sustainable dividends.

Too much leverage?

Let’s begin by comparing the metrics of Transocean, SeaDrill and Ensco.

<table> <thead> <tr><th> <p>Company</p> </th><th> <p>Forward P/E</p> </th><th> <p>PEG</p> </th><th> <p>Debt/Equity</p> </th><th> <p>Yield</p> </th><th> <p>Payout</p> </th></tr> </thead> <tbody> <tr> <td> <p>SeaDrill</p> </td> <td> <p>9.86x</p> </td> <td> <p>0.49x</p> </td> <td> <p>184%</p> </td> <td> <p>9.34%</p> </td> <td> <p>145.27%</p> </td> </tr> <tr> <td> <p>Ensco</p> </td> <td> <p>6.85x</p> </td> <td> <p>0.38x</p> </td> <td> <p>41%</p> </td> <td> <p>3.75%</p> </td> <td> <p>28.93%</p> </td> </tr> <tr> <td> <p>Transocean</p> </td> <td> <p>8.34x</p> </td> <td> <p>0.8x</p> </td> <td> <p>79%</p> </td> <td> <p>-NIL-</p> </td> <td> <p>-NIL-</p> </td> </tr> </tbody> </table>

At the current prices, all three companies appear to be undervalued and it wouldn’t be fair to discriminate stock picks with fractional differences in valuations. However, it is the debt levels that need to be heeded to.

Transocean operates with a somewhat acceptable debt/equity ratio while Ensco operates at a minimal debt/equity level amongst the mentioned peers. But SeaDrill has an extremely high debt metric and pays out more than it earns.

It's understandable that SeaDrill is a fast-growing company and needs to leverage its operations to ensure rapid growth. But debt is accompanied by interest expenses, which eats into the net earnings.

For the recent quarter, SeaDrill reported a net income of $17 million, while its interest expenses stood at $100 million. Furthermore, its annual dividend payout totaled approximately $1.6 billion, while its free cash flow was negative $125 million. If a company has billions in cash reserves, such high payouts get somewhat justified. But SeaDrill has just $518 million in cash and cash equivalents, which puts its dividend payouts in grave danger.

I want returns!

However, Ensco seems to have a better financials. The company pays out a modest 28.9% of its earnings, which aggregates to a payout of around $465 million. But Ensco has cash and cash equivalents of $487.1 million, which is more than enough to cover its annual dividend payouts.

Furthermore, the company isn’t hemorrhaging cash like SeaDrill, as it generated free cash flow of $398 million, with operating cash flows of $2.2 billion, last year.

Shifting focus to Transocean, the company doesn’t pay dividends (yet). Carl Icahn recently wrote a letter to Transocean’s shareholders, urging them to vote for a $4 per share payout. With 359 million outstanding shares, that accounts to an annual payout of approximately $1.5 billion, out of which around $80 million would be bagged by Carl Icahn alone (with his 5.6% stake in Transocean). Although its board has refuted Icahn’s demands, it's obligated to return some value to its shareholders especially after disappointing investors with the overpriced acquisition of Aker Drilling in 2011.

Its trailing 12-month (ttm) operating cash flow stands at $2.7 billion, cash and cash equivalents totaled $5.1 billion while its TTM free cash flow aggregates to around $1.4 billion.

With a 100% FCF coverage and 3x liquidity, I believe that Transocean can comfortably payout dividends of $4 per share. But that’s just speculation and until it board (or shareholders) approves the payout, investors looking for a safe income-growth stock should consider investing in Ensco.

Wrap up

Ensco is the world’s second-largest offshore driller, with the world’s most advanced drilling fleet. The company has been the front runner in offshore drilling, and has a track record of impressive financials. In my opinion, oil E&P activities will follow oil prices and the Street will once again cheer offshore drilling. It’s not a matter of “if” but rather a question of “when.” With that in mind, I believe that Ensco will be a great stock to hold.

Piyush Arora has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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