On Tuesday, oil and natural gas driller Ensco plc ESV revealed its plan to acquire smaller rival Atwood Oceanics Inc. ATW in an all-stock deal worth $839 million, whetting investors' appetite for consolidation in the struggling sector.
An Unprecedented Period of Hardship for the Industry
With crude prices oscillating between $45 and $50 a barrel – down 55% from mid-2014 levels – the top energy companies have cut spending (particularly on the costly drilling projects) on the back of lower profit margins. This, in turn, has meant less work for the beleaguered drillers as offshore exploration for new oil and gas projects has almost come to a standstill.
Secondly, with large, multinational energy firms looking to reign in their skyrocketing capital expenses, the offshore drilling space is witnessing intense competition, as multiple firms chase a single contract. This excess capacity, in turn, has led to significantly lower utilization/dayrates.
More Tough Times Ahead
Despite early signs of recovery in North America, the current oilfield environment remains one of the most difficult. With new competitors entering the market and drilling contractors too rattled to make new investment decisions, oilfield machineries and equipment suppliers have seen their pricing fall drastically.
While firms catering to North American land drillers have been the worst affected, lack of new deepwater drilling orders are starting to haunt the subsea part of the industry. This comes after commodity price rout has already made a number of deepwater drilling projects uneconomical.
As such, with several quarters of reduced activity and diminishing contract backlog, most of the players are facing continued pressure on revenues, earnings and cash flows. With no signs of immediate improvement in market sentiment, 2017 is likely to rank as the third consecutive year of declining oilfield services spending. Even if commodity prices improve, the structural oversupply and pricing pressure will weigh on the sector components’ operating margins.
Amid this grim backdrop, Ensco's announced buyout of Atwood Oceanics is widely seen as one of the biggest game changers for the oversupplied energy drilling industry. Experts believe that consolidation would lead to a less fragmented sector offering better funding deals and lower cash burn rate. Importantly, focus would now be on sustainable, long-term business models as compared to the existing trend of too many players going after too little work.
The Ensco/Atwood Transaction
Agreement Terms: As per the deal, Atwood shareholders would receive 1.60 shares of Ensco common stock for each share they hold. At Atwood’s Friday’s closing stock price of $8.08, the deal values the company’s shares at 33% premium. The deal has been unanimously okayed by both companies’ boards but is subject to shareholder and regulatory approvals.
Ensco and Atwood – each carrying a Zacks Rank #3 (Hold) – expect to close the transaction sometime in the third quarter of 2017. The current stockholders of Ensco will own approximately 69% of the combined company, with Atwood shareholders owning the rest. Following the announcement, Atwood stock surged 24%, while shares of London-based Ensco fell about 5%. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Win-Win for Both Companies: Apart from getting the 33% premium on their stock holdings, Atwood holders get continued cyclical exposure by owning shares of Ensco. On the other hand, for Ensco shareholders, Atwood’s floating rigs and ultra-deepwater drillships nicely fits into Ensco's portfolio of assets.
The transaction will meaningfully diversify Ensco's offerings of products and services. The combined group will have a market capitalization of about $7 billion, supplying offshore drilling rigs across varying water depths spread over six continents to the world's largest energy groups. Ensco, one of the strongest players in the oil drilling sector, will get access to Atwood's six ultra-deepwater floaters, including four drillship and five high-specification jackups.
Because of the complementary nature of both the company’s products, post-acquisition, Ensco will provide a complete array of offshore drilling equipment used in the production of oil and gas. Because of the addition of new growing market segments to the combined company’s operations, we see significant operating synergy from this deal.
In addition, management expects this acquisition to strengthen Ensco's earnings and cash flow per share through cost synergies of approximately $45 million next year and $60 million in 2019. The combined company will have a broader customer base, greater exposure to the deepwater drilling business, and a wider array of products.
Is This the Start of Industry Consolidation?
With significant amount of idle assets and a number of financially troubled offshore rig operators in the industry, consolidation was waiting to happen for a while. In these trying circumstances, merger and acquisition deals will help service providers to cut their average costs and benefit from mutual fleet exchange.
A prolonged period of low oil prices has eventually led to ‘survival of the fittest.’ As is evident from the Ensco-Atwood deal, larger companies – especially those with cash to spend – are set to take advantage of this opportunity and buy quality assets at cheap valuations.
We have identified well-capitalized established players such as Transocean Ltd. RIG, Noble Corp. plc NE and Diamond Offshore Drilling Inc. DO as potential buyers. On the other hand, vulnerable companies like Pacific Drilling S.A. PACD, Ocean Rig UDW Inc. ORIG and SeaDrill Ltd. SDRL – the ones with increasing levels of debt and distresses assets – might be counted as possible targets.
With oil still below the psychological $50-a-barrel threshold, energy investors should brace themselves for more M&A activities to unfold in the offshore drilling space.
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