Offshore Drilling: After 3 Major Dividend Cuts Is This High-Yield Driller Next?

By Markets Fool.com

The offshore drilling industry has been hammered over the past 12 months, first by an oversupply of new rigs, followed by a severe collapse in the price of oil that dragged rig dayrates down with it. The stocks of major offshore drillers includingSeadrill , Transocean , Diamond Offshore , and Ensco have all plunged as a result, a fact made only more painful by recent dividend cuts or suspensions.

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Seadrill, Transocean, and Diamond Offshore respectively recently announced a complete dividend suspension, an80%cut, and an 86% reduction.

With the entire offshore industry suffering so mightily, how likely is Ensco to follow suit by slashing its $3 per share annual payout, and how badly would this harm long-term investors?

How Ensco's dividend compares against its rivals' former payouts

Company Forward Yield Former Dividend Payout Ratio (% of operating cash flow) % of contracts expiring by end of 2016 (or new rigs yet without contract) Debt/Capital Ratio
Seadrill 0% 110% 80% 66%
Transocean 3.3% 45% 87% 39%
Diamond Offshore 1.4% 54% 77% 35%
Ensco 9.8% 32% 70% 27%

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Source: Yahoo! Finance, Morningstar.com, Company Fleet Status Reports

As this table shows, Ensco's dividend sustainability has a few things working in its favor. The company's debt load, as measured by its debt-to-capital ratio, is the lowest of all the major drillers. Its fleet availability post-2016 -- when most analysts believe the offshore drilling industry will turn the corner -- is also lower than its major competitors. It addition, the dividend represents only 32% of Ensco's operating cash flow, indicating the company might be able to sustain the payout for a while longer even if the offshore drilling market doesn't improve.

A dividend cut would be a good thing for long-term investors
So if Ensco's dividend is so much more sustainable than its peers, why would it consider cutting it? The answer lies in the uncertainty of oil prices and the offshore drilling market. No one can accurately predict how long oil prices might remain low, which means that Ensco's management may decide that the prudent course is to save cash immediately to strengthen the company's balance sheet and increase flexibility going forward. There are two ways that preserving cash now might produce long-term gains that out-weigh the short-term pain of a dividend cut..

First, its important to realize that Ensco's lower debt levels and lower operating cash flow payout ratio mean any dividend cut might be smaller than that of its peers. For example, cutting the payout in half would save the company $351 million per year in dividend costs, yet still yield nearly 5%. Alternatively, the company could suspend the dividend and use half of the savings -- which would total $702 million per year -- to buy back shares that are trading at substantially undervalued levels. At today's valuation such a buyback would represent a 4.9% reduction in share count. This could greatly aid earnings increases, share price appreciation, and even long-term dividend growth when oil prices finally recover to more sustainable levels.

Second, savings from a dividend reduction could be used to further bolster the company's balance sheet. While Ensco's debt levels are already highly manageable, further debt reduction could enable the company to tap the debt markets later to strengthen its position within the industry.

For example, it might acquire one of its rivals, such as it did in 2011 when it bought Pride International for $7.3 billion. That deal made Ensco into the world's second-largest offshore driller, and another deal could allow the company to leapfrog industry juggernaut Transocean. In the process it could squeeze out synergistic cost savings to deliver higher profitability in the future -- potentially improving future dividend growth prospects.

The takeaway: Ensco's dividend is likely to be cut due, but it's still a good investment
While Ensco certainly might prove the exception to the recent dividend suspensions and cuts in the industry, I believe management will choose the more conservative course and cut the dividend sometime in 2015. Should that occur, I would advise investors to take a long-term view and look at the potential benefits the extra cash could provide, such as strengthening the company's balance sheet and maybe even its industry position. A stronger, financially healthier, and possibly larger Ensco would likely make a better long-term income investment than one that clings stubbornly to a dividend that may prove unsustainable should oil prices remain low for several years.

The article Offshore Drilling: After 3 Major Dividend Cuts Is This High-Yield Driller Next? originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned however SeaDrill is a holding in several portfolios in The Grand Adventure dividend project which he leads. The Motley Fool recommends Seadrill. 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.