(09/19/14) Offshore Drilling: An “Unloved” Sector

Given our long-term affection for energy, we are drawn to the unloved and under-appreciated offshore drilling area of the energy sector as the stocks have been cast aside by short-sighted investors, explains John Buckingham, editor of The Prudent Speculator.

We understand that there are near-term operational headwinds but we are very much willing to remain patient, especially when we are rewarded with generous dividend yields or the expectation of a hefty payout.

After all, we believe many of these stocks are priced for imperfection, with management teams needing simply to deliver on already depressed expectations to see a handsome share price recovery.

Looking at our three recommendations in the space, Diamond Offshore (DO), Ensco PLC (ESV), and Paragon Offshore (PGN), we think it a fine time to address the concerns present in the offshore drilling industry.

We think that there is a unique opportunity for investors without a position or for those with only a very small position to add to their exposure.

To be sure, we respect that all three stocks are facing pressure related to new jackup and floater drilling rig supply coming to market over the next few years, while the recent weakness in energy prices adds to worries that day rates might see more sizable declines.

Ensco remains perhaps our favorite driller as it trades at about eight times its projected earnings over the next 12 months.

ESV has one of the youngest drillship fleets amongst its peers and has done a solid job over the last eight years transforming itself from a domestically focused jackup company to a pure-play global offshore drilling company with one the most capable ultra-deepwater rig fleets.

While investors have been selling shares off as they expect day rates to materially drop, we think pricing for ESV will remain solid. Additionally, we don’t mind collecting a dividend yield north of 6% while we patiently wait for the cycle to turn in Ensco’s favor.

While Ensco’s fleet is much more modern than that of Diamond Offshore or Paragon Offshore, we believe the outsized selloffs in both names since July has more than priced in the operating challenges that the industry and companies with mature fleets face.

Time will tell how severe the trough in the drilling cycle will be, but we believe the current stock prices for PGN and DO discount a far worse scenario than is likely to play out, while neither company has significant debt maturing until 2019.

Trading for less than four times trailing and forward earnings estimates, with significant free cash flow generation supporting a prospective dividend (likely to be announced in Q4) of upwards of $1.00 per share that has been discussed in prior regulatory filings, we think an investment in Paragon to be a risk worth taking, even if the yield does not turn out to be in the double-digits.

And speaking of yield, Diamond has long rewarded investors with a hefty regular and special quarterly payout that has totaled $3.50 per annum. No guarantee that the 8.4% yield will be maintained throughout the downturn in the drilling cycle, but consensus earnings per share estimates for DO are still in the $3.00 range for this year, as well as 2015 and 2016.