hedge fund wisdom sample issue

8/8/2019 Hedge Fund Wisdom Sample Issue

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hedge fund wisdom

Table of Contents

p.02 Baupost Group

Hedge Fund

Portfolio Updates

Q2 201

by market folly

Q2 2010 www.hedgefundwisdom.com 1

Every quarter, hedge funds and institutional managers arerequired to disclose their portfolios to the SEC via 13F filing. Thesefilings only detail long U.S. equity positions, American Depositary Receipts (ADRs), stock options (puts/calls), as well as convertiblenotes. The 13F filing does not disclose positions in other assetclasses (such as commodities, currencies, or debt). It also does notreveal short sales or cash positions.

Hedge Fund Wisdom, a quarterly publication by MarketFolly.com, updates and analyzes the latest portfolios of prominent investment managers. The positions herein represent ahedge fund’s second quarter holdings as of June 30 th, 2010 but keepin mind they are not reflective of a fund’s entire overall portfolio.

Background:

Second Quarter Summary:

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In This Issue:

- Complete updates on 20 prominent hedge fund portfolios- In-depth investment write-ups on 3 stocks hedge funds were

buying in the second quarter- Analysis & commentary on each fund’s portfolio maneuvers

The table below outlines the most frequent buys & sells in thesecond quarter among the 20 prominent hedge funds profiled in thisissue.

p.04 Berkshire Hathaway

p.06 Greenlight Capital

p.08 Lone Pine Capital

p.11 Appaloosa Management

p.14 Pershing Square Capital

p.15 Maverick Capitalp.18 Third Point LLC

p.20 Blue Ridge Capital

p.23 Paulson & Co

p.26 Tiger Management

p.28 Soros Fund Management

p.31 Bridger Management

p.34 Omega Advisors

p.37 Shumway Capital Partners

p.39 Fairholme Capitalp.41 Tiger Global Management

p.43 Passport Capital

p.46 Perry Capital

p.49 Glenview Capital

Hedge Fund Favorites:

In-Depth Equity Analysis

p.52 Ensco plc (ESV)

p.60 Investment Idea #2

p.67 Investment Idea #3

SAMPLE ISSUE

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Investors are always curious as to what

the legendary Seth Klarman has been buyingand selling. Keep in mind though, that equitiescomprise only a small portion of BaupostGroup’s overall assets under management(AUM). As illustrated above, Baupost only hasaround $1.3 billion in long equities andconvertible notes exposure. Compare this with

Baupost Group’s around $22 billion of AUMand you find only a paltry 5.9% of assets areinvested in equities.

Baupost Group typically keeps a lot of cash on hand as it waits for compellingopportunities to deploy into. In May 2010,Klarman revealed that Baupost had $6 billion incash at the time (30% of their assets). He’sconcerned about the run-up equities saw in2009 and said that, “I’m more worried aboutthe world broadly than I’ve ever been in my

whole career.”Currently, Klarman is mainly invested in

distressed assets. In the past, he’s said that heprefers bonds to equities because they are asenior security, offer more safety, and there is acatalyst built-in.

Turning to his most recent equity movements, the most notable change toKlarman’s portfolio was his sale of DirecTV (DTV). This is intriguing because fellow hedge

fund manager Chase Coleman of Tiger GlobaManagement is quite bullish on DTV Apparently Klarman thought it had reached fair value.

Baupost Group also sold completely outof Facet Biotech (FACT) due to its takeover by Abbott Laboratories (ABT). It’s also wortnoting that over the past two quarters, Baupost

has now sold over 23% of its News Corp(NWSA) position, over 39% of its stake inDomtar Corp (UFS), and almost 43% of its Audiovox (VOXX) position. Klarman’s stancon equities is becoming increasingly clear. Heis now targeting private commercial real estateHe has deemed public REITs as too expensivegiven their vicious rally over the past year or so.

Baupost has also put on certain plays tohedge against tail risk events. In particularKlarman is concerned about inflation and has

purchased far out of the money puts on bondsThis play would be profitable for him if interestrates skied north of 10%. Instead of activelyshorting, Baupost prefers to buy insurance onpotential outlier events that will protect themshould the event come to fruition. Thisapproach, coupled with their often-hefty cashposition, defines Baupost’s style of hedging.

For more from the legendary investorcheck out Seth Klarman’s lessons from thefinancial crisis.

Seth Klarman

Graduated from Harvard BusinessSchool at age 25, went to work for

Baupost & has been there ever since

Author of Margin of Safety

View Seth Klarman’s

Recommended Reading List

Baupost Group

View Baupost Group’s Updated

Portfolio on the Next Page

Key Takeaways

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Baupost Group

1 VIASAT, INC. VSAT 22.96% Added 14.54% $324,701 9,972,375

2 NEWS CORPORATION NWSA 16.11% Cut -17.68% $227,838 19,050,000

3 THERAVANCE, INC. THRX 11.55% Unchanged $163,410 13,000,000

4 BREITBURN ENERGY BBEP 8.75% Cut -2.41% $123,782 8,290,839

5ENZONPHARMACEUTICALS ENZN 7.66% Added 10.57% $108,373 10,175,898

6 CAPITALSOURCE INC CSE 6.82% Unchanged $96,525 20,278,400

7 DOMTAR CORP NEW UFS 6.34% Cut -31.82% $89,699 1,825,000

8THERAVANCE INC NOTE3.000% 1/1 3.05% Unchanged $43,159 51,000,000

9

ADC

TELECOMMUNICATIONS ADCT 2.97% Added 13.25% $41,959 5,662,469

10SOLAR CAPITAL LTD.COMMON STOCK SLRC 2.74% Unchanged $38,731 2,010,973

11CAPITALSOURCE INC NOTE7.250% 7/1 2.69% Cut -17.08% $38,046 40,048,000

12 ALLIANCE ONEINTERNATIONAL INC AOI 2.21% Unchanged $31,328 8,800,000

13ITURAN LOCATION ANDCONTROL LTD. ITRN 1.83% Unchanged $25,954 1,721,066

14LIBERTY MEDIA CORPSTARZ SER A LSTZA 1.55% Unchanged $21,888 422,216

15 SYNERON MEDICAL LTD. ELOS 1.09% Unchanged $15,420 1,500,000

16 MULTIMEDIA GAMES, INC. MGAM 0.83% Unchanged $11,700 2,600,00017 AUDIOVOX CORPORATION VOXX 0.55% Cut -38.11% $7,795 1,060,576

18 ENERGY XXI LIMITED EXXID 0.30% New $4,182 265,000

Next Page: Berkshire Hathaway

Put/

CallTicker

Second Quarter 2010 Portfolio:

Value

x $1000

% of

Portfolio Activity # of Shares

Company NameRank




W hile not a hedge fund, many follow

Berkshire Hathaway due to the prowess of Warren Buffett. After all, he is one of the mostsuccessful investors of all time. Beforeexamining Berkshire Hathaway’s portfolio, takenote that not all portfolio changes are directly attributed to Buffett. While he manages themajority, Lou Simpson also manages theportfolio for Berkshire’s subsidiary, GEICO. Onthe subject, Buffett was recently quoted in theChicago Tribune as saying, “If you see a

purchase on a company in the $300 to $400million range, odds are very good that’s Lou’s.I’m going to want to buy at least $1 billion of whatever it is we buy.”

The most notable adjustment toBerkshire’s portfolio in the second quarter wasthe addition to its Johnson & Johnson (JNJ)position. Berkshire raised its JNJ stake by 73%,adding 17.4 million more shares. Back in 2008,Buffett had actually sold JNJ shares, ensuringthat Berkshire had ‘more than ample cash’ to

invest in various fixed income securities at thetime. Nowadays, he’s putting money right back into shares of JNJ.

Johnson & Johnson recently sold $1.1 billion of debt at the lowest interest rates onrecord for 10-year & 30-year securities. Thisincluded $550 million worth of 2.95% 10-yearnotes. Compare that with the fact that JNJ’sequity has a dividend yield of around 3.6%. Assuch, we can see why Berkshire acquired shares.

The interesting thing here is that you can stilreceive a higher yield on the stock than you would from interest payments on JNJ bond(even if the stock trades somewhat higher).

Bill Miller of Legg Mason argues that“U.S. large capitalization stocks represent aonce in a lifetime opportunity in my opinion to buy the best quality companies in the world a bargain prices. The last time they were thcheap relative to bonds was 1951.” Needless tosay, various large cap equities are cheap, andJNJ certainly is one of them. Berkshire’s othernotable additions were a new stake in Fiserv Inc(FISV), a provider of electronic commerceservices and an addition to its pre-existingBecton Dickinson (BDX) stake. As you’ll seethroughout the issue, hedge funds certainly bought up BDX shares in Q2.

Regarding sales, Buffett’s BerkshireHathaway has reduced its position in Conoco

Phillips (COP) for the seventh consecutivequarter. Buffett has admitted this play was amistake as he purchased it during sky-high oiprices in 2008. Other reductions include KrafFoods Inc (KFT), Procter & Gamble (PG), andM&T Bank Corp (MTB). At quarter endBerkshire’s cash holdings totaled around $28 billion.

The SEC requires the disclosure ofpositions in companies traded on U.S. stockexchanges, as well as American depositary

receipts (ADR’s). As such, some of Berkshire’sother portfolio positions are not disclosedherein. They include the likes of: BYD, POSCOand Tesco. It’s imperative to remember that aSEC 13F disclosure is not indicative of a firm’sentire portfolio by any means.

Warren Buffett

Mentored by Benjamin Graham inthe ways of value investing

Third richest person in the worldaccording to Forbes

View Buffett’s Recommended

Reading List

Berkshire Hathaway

View Berkshire Hathaway’s

Updated Portfolio on the Next Page

Key Takeaways

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1 COCA-COLA CO KO 21.58% Unchanged $10,024,000 200,000,000

2 WELLS FARGO & CO. WFC 17.64% Unchanged $8,194,263 320,088,385

3 AMERICAN EXPRESS CO. AXP 12.96% Unchanged $6,018,944 151,610,7004 PROCTER & GAMBLE PG 10.08% Cut -1.30% $4,682,699 78,071,036

5 KRAFT FOODS, INC. KFT 6.34% Cut -1.42% $2,946,008 105,214,584

6 JOHNSON & JOHNSON JNJ 5.25% Added 72.95% $2,440,334 41,319,563

7 WAL-MART STORES, INC. WMT 4.04% Unchanged $1,876,515 39,037,142

8 WESCO FINANCIAL CORP WSC 3.97% Unchanged $1,843,238 5,703,087

9 U.S. BANCORP USB 3.32% Unchanged $1,543,031 69,039,426

10 CONOCOPHILLIPS COP 3.08% Cut -14.83% $1,428,992 29,109,637

11 WASHINGTON POST CO. WPO 1.53% Unchanged $709,214 1,727,765

12 MOODY CORP. MCO 1.32% Unchanged $613,214 30,783,87613 NIKE, INC NKE 1.11% Unchanged $516,150 7,641,000

14 M &T BANK CORP MTB 0.98% Cut -3.59% $455,657 5,363,821

15 REPUBLIC SERVICES, INC. RSG 0.69% Unchanged $321,908 10,827,700

16 COSTCO COST 0.51% Unchanged $237,598 4,333,363

17 USG CORP USG 0.44% Unchanged $206,232 17,072,192

18 FISERV, INC. FISV 0.43% New $200,904 4,400,000

19 COMCAST CORPORATION CMCSK 0.42% Unchanged $197,160 12,000,000

20 INGERSOLL RAND LTD A IR 0.42% Unchanged $194,386 5,636,600

21 NALCO HOLDING CO NLC 0.40% Added 1.67% $187,209 9,150,000

22 IRON MOUNTAIN INC IRM 0.39% Added 2.63% $179,680 8,000,000

23 NESTLE S.A S/ADR NSRGY 0.35% Unchanged $164,585 3,400,000

24 CARMAX INC. KMX 0.33% Unchanged $153,745 7,725,90025 TORCHMARK CORP. TMK 0.30% Unchanged $139,811 2,823,879

26 LOWE COMPANIES INC LOW 0.29% Unchanged $132,730 6,500,000

27 BECTON DICKINSON BDX 0.28% Added 8.36% $127,794 1,889,889

28 NRG ENERGY INC NRG 0.27% Unchanged $127,260 6,000,000

29 SANOFI-AVENTIS SA SNY 0.26% Added 4.09% $122,154 4,063,675

30 GENERAL ELECTRIC CO GE 0.24% Unchanged $112,157 7,777,900

31 UNITED PARCEL SERVICE UPS 0.18% Unchanged $81,307 1,429,200

32 HOME DEPOT INC HD 0.17% Unchanged $77,414 2,757,898

33 BANK OF AMERICA CORP. BAC 0.15% Unchanged $71,850 5,000,000

34 GLAXOSMITHKLINE PLC GSK 0.11% Unchanged $51,372 1,510,500

35 EXXON MOBIL CORP. XOM 0.05% Unchanged $24,072 421,800

36 GANNETT CO INC GCI 0.05% Unchanged $23,424 1,740,231

37 COMDISCO HLDG CO INC CDCO 0.03% Unchanged $13,799 1,538,377

Berkshire Hathaway Second Quarter 2010 Portfolio:

Next Page: Greenlight Capital


Put/CallTicker

Valuex $1000

% of

Portfolio Activity # of SharesCompany NameRank



Einhorn’s brand new stake in Ensco

(ESV) is the most distinct portfolio change for thesecond quarter. Greenlight’s average purchaseprice of Ensco was $39.41. In particular, thehedge fund likes the company’s $7 per share in

net cash and tangible book value of $37.50. Laterin this issue we’ll take an in-depth look at Ensco to examine the investment thesis and take youinside the head of a hedge fund manager.

In the second quarter, Greenlight alsoadded to a bevy of large-cap names includingMicrosoft (MSFT), Becton Dickinson (BDX), andXerox (XRX). While some would argue they area bit late to the party, Einhorn’s hedge fund alsostarted a brand new position in Apple (AAPL) at

an average purchase price of $248.09 per shareThey like the company’s $40 per share in cashand think AAPL has yet to fully penetrate various global markets. Greenlight aincreased their stake in longstanding holdingPfizer (PFE) by 25% as shares continued to slidelower. Lastly, brand new positions in NCR Corp(NCR) and Lockheed Martin (LMT) are duly

noted. Greenlight also sold completely out othree notable past positions: URS Corp (URS) Automatic Data Processing (ADP), and Teradata(TDC). The sale of ADP is intriguing becausefellow hedge fund manager Bill Ackman ofPershing Square Capital Management was buying ADP in Q2 as detailed later in this issue.

Last, but certainly not least, keep in mindthat Greenlight owns two additional longpositions (often mentioned in their investorletters) that do not appear on 13F filingsGreenlight owns Ford Motor Company debt andit was their third largest position at the end oQ2. Additionally, the hedge fund has storedphysical gold for over a year now and itcurrently is their fourth largest holding. AlsoEinhorn has been short Moody’s (MCO) sayingthat, “We believe that an eventual, but likelylegal loss will have a significant impact on MCOshares.”

This illustrates the importance oftracking a hedge fund via their letters and

presentations in addition to SEC filingsMarketFolly.com and the Hedge Fund Wisdomquarterly publication are your sources for

David Einhorn

Has returned 22% annualized

Predicted & profited from the demiseof Lehman Brothers

Author of Fooling Some of thePeople All of the Time

Greenlight Capital

Key Takeaways

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View Greenlight Capital’s

Updated Portfolio on the Next Page


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1 CIT GROUP INC CIT 10.81% Unchanged $358,591 10,590,429

2 PFIZER INC PFE 9.95% Added 27.54% $330,177 23,154,098

3 ENSCO INTERNATIONAL ESV 8.78% New $291,335 7,416,880

4 CARDINAL HEALTH, INC. CAH 6.64% Unchanged $220,162 6,550,500

5 CAREFUSION CORP CFN 5.97% Unchanged $197,916 8,718,724

6 MICROSOFT CORPORATION MSFT 5.31% Added 125.31% $176,267 7,660,442

7 NCR CORP. NCR 4.19% New $139,001 11,468,658

8MARKET VECTOR GOLDMINERS GDX 4.05% Cut -19.27% $134,232 2,583,371

9 BECTON DICKINSON BDX 3.66% Added 170.15% $121,479 1,796,500

10

EINSTEIN NOAH

RESTAURANT GROUP, INC. BAGL 3.49% Unchanged $115,814 10,733,46911 XEROX CORP XRX 3.27% Added 92.86% $108,540 13,500,000

12 EMC CORP. EMC 3.19% Cut -34.96% $105,957 5,790,000

13 TRAVELERS COMPANIES TRV 3.17% Unchanged $105,014 2,132,272

14 ASPEN INSURANCE AHL 3.09% Unchanged $102,423 4,140,000

15 RALCORP HOLDINGS, INC. RAH 2.92% Added 30.80% $96,769 1,765,854

16 HEALTH NET, INC. HNT 2.57% Unchanged $85,353 3,502,337

17 APPLE INC. AAPL 2.37% New $78,602 312,500

18 FOSTER WHEELER FWLT 2.28% Cut -1.05% $75,678 3,593,472

19 EVEREST RE GROUP LTD RE 2.09% Unchanged $69,337 980,445

20 MI DEVELOPMENTS INC MIM 2.09% Unchanged $69,164 5,655,235

21 NVR INC. NVR 1.66% Added 50.76% $55,023 84,000

22 LOCKHEED MARTIN CORP. LMT 1.63% New $54,013 725,00023 HEALTH MANAGEMENT HMA 1.53% Unchanged $50,811 6,539,241

24TRANSATLANTICHOLDINGS TRH 1.38%

Added192.95% $45,663 952,100

25 EMPLOYERS HOLDINGS EIG 1.03% Unchanged $34,248 2,325,000

26 FIFTH STREET FINANCE FSC 0.76% Unchanged $25,198 2,284,492

27 ENERGY PARTNERS LTD. EPL 0.64% Added 75.60% $21,239 1,739,47428 REPUBLIC AIRWAYS RJET 0.63% Cut -0.87% $20,852 3,412,800

29 BIOFUEL ENERGY CORP. BIOF 0.30% Unchanged $10,031 7,542,104

30 FLAGSTAR BANCORP, INC. FBC 0.16% Cut -95.00% $5,182 1,649,998

31FURIEXPHARMACEUTICALS INC FURX 0.15% New $4,978 490,000

32 SYMMETRICOM, INC. SYMM 0.12% New $4,069 799,562

33 ORITANI FINANCIAL CORP. ORIT 0.06% New $2,000 200,000

34 M.D.C. HOLDINGS, INC. MDC 0.06% Unchanged $1,895 70,324

Greenlight Capital

Put/Call

Ticker

Second Quarter 2010 Portfolio:

Valuex $1000

% of Portfolio

Activity # of SharesCompany NameRank




+

Ensco plc (ESV)

Hedge Fund Favorites:

Equity Analysis

ENSCO PLC(ESV)

($mm)

Share Price (ADR) $41.51Net cash per share $6.7952-week High $52.3252-week Low $33.33

Sales - LTM $1,812EBITDA $990EPS $4.73Return on Equity 11.3%

Market Cap $5,934Cash $1,237Debt $266Enterprise Value $4,963

Hedge Fund Activity

David Einhorn’s Greenlight Capital established a new position in ESV during Q2, takingadvantage of the market’s panic surrounding the BP oil spill and six-month deepwater drillingmoratorium in the Gulf of Mexico. Commenting on his purchase in Greenlight’s Q2 letter, Einhorn writes, “The shallow water drilling business, which is unaffected by the drilling moratorium, generates$4.00 per share in unlevered mid-cycle earnings and $8.00 per share in peak earnings. At thPartnerships’ average cost of $39.41 per share, we appear to be getting the shallow water fleet at a low value and the deepwater fleet (in which ESV has thus far invested over $15 per share to build andshould add $2.00 and $4.00 to mid-cycle and peak EPS respectively) for free.” Other notable hedgefunds buying ESV in the second quarter include John Griffin’s Blue Ridge Capital and Carl Icahn.

Stocks like ESV traded down 30% during the quarter, and ESV was trading below its book

value. Given that ESV’s book value may be understated, Einhorn took advantage of the margin osafety created by the market sell-off. ESV’s stock price has largely recovered since then. Neverthelesseven though the margin of safety is no longer there, ESV still looks cheap at 1.1x tangible book valueand can be viewed as a low-risk way to play an economic recovery, since downside is protected by thecompany’s book value. On the upside, it should capture the entire move in oil prices in the case of recovery. In addition, a stock like ESV can play the role of a US inflation hedge in a portfolio, and it ia dividend-paying stock with a 3.4% yield (something many investors focus on these days: “gettingpaid to wait”).

Company Background






Ensco plc (ESV)Hedge Fund Favorites:

Equity Analysis

Company Background

Business Model

profits of $0.8 billion. ESV’s business model hahigh operating leverage, so changes in the top

line dropped directly to the bottom lineRevenues declined 20% but operating incomedropped more than 30% because of theoperating leverage and increasing depreciationas new– and more expensive – oilrigs comeonline. Interestingly, the top-line culprit wascapacity utilization and not the average effectiveday-rate across the fleet. Even though day-rates were lower in the Asia Pacific, Europe and Africaregions by 5-10%, they were higher in the Americas and for deepwater drilling by 20-25%Nevertheless, capacity utilization dropped from96% in 2008 to 72% in 2009.

The offshore drilling services industry ishighly competitive as contracts are awarded based on a bidding process. One way focompanies to differentiate themselves is to ownhigher quality and more sophisticate rigs thatcan go to deeper drilling levels or be bettermaintained and afford higher capacityutilization. ESV is trying to offset the pressurein its core operation of jack-up rigs by investingin more sophisticated deep-sea drilling, where

the rates have not collapsed.

Ensco International PLC (ESV) is a globaloffshore drilling company. It rents its rigs and

rig crews on a ‘day-rate’ basis to oil and gascompanies such as Conoco Philips, who bear theeconomic risks of the success of the wells. ESV was founded in 1975 in the US but in December2009 the company was re-domesticated to theUK – primarily in order to take advantage of amore advantageous tax structure. Currently it isheadquartered in London, UK, and 86% of revenues come from non-US operations.

ESV has grown through acquisitions to afleet of 39 jack-up rigs, which are suited fordrilling in relatively shallow waters (~400 ft water depth, ~25,000 ft drilling depth), butmore recently it has been diversifying intodeepwater drilling with its 4 semi-submersiblerigs, which can go to 8,000 ft of water or deeper(~35,000 drilling depth), and has 4 more of these rigs on order with delivery dates betweenlate 2010 and 2012. Jack-up rigs are floating barges fitted with 3 or 4 ‘legs’ that can be raisedor lowered to adjust the barge’s height. Once therig is towed to location, the legs are ‘jackeddown’ to the seafloor. Semi-submersible rigs are

partially submerged and held in place by hugeanchors. They are much more stable andpractical than jack-up rigs when the seafloor ismuch deeper.

Revenues peaked in 2008 at $2.4 billion with profits of $1.2 billion, but in 2009 they dropped below 2007 levels to $1.9 billion and





Equity Analysis

Business Model

First Look & Investment Thesis

Shallow-water and deepwater drilling areeffectively two different markets and havedifferent dynamics as evidenced by the differenreaction in day rates. Shallow-water drillingutilizes less sophisticated rigs, which require asmaller capital investment and lead-timeTherefore, when oil prices are high, it is easier toincrease the supply of jack-up rigs instead of thesemi-submersible ones, which can only beconstructed at specialized shipyards and require

a larger capital investment and lead time. As aresult, the jack-up rig market can becharacterized by more pronounced cyclicality.

In contrast, there are fewer newdeepwater rigs coming online and projectsinvolving these rigs are much more expensive, sodeepwater operators tend to take a much longerterm view. As a result, deepwater rigs are lesoften in an oversupply dynamic and their dayrates are more stable. There is actually a naturatrend upwards in deepwater rigs’ day-rates as

the easy-to-reach wells dry up and we need tomove to deeper waters to satisfy oil demand.

Reportedly, there are 58 jack-up and 37semi-submersible rigs currently underconstruction, more than half of which (fromeach category) are deliverable in 2010. One keydifference is that most jack-up rigs are not pre-contracted, whereas many semi-submersiblesare. Therefore, the inflow of jack-up rigs putundue pressure on the jack-up rig market, as thenew fleet will have to get absorbed.

Recently, the day rates of jack-up rigshave collapsed, whereas the day rates for semi-submersible rigs have only marginally declinedfrom their peak levels. It is expected thademand for ultra-deepwater rigs will remainstable, whereas shallow-water drilling may be inchronic oversupply, because new oil weldiscoveries occur in increasing depths.

The business model of oil and gas drillingservice providers is to contract their rigs andoperating crews on a day-rate for periods of timeextending from a few months to a couple of years forward. These companies strive tocontract a day rate that more than covers thecosts of maintaining their rigs and crews (themarginal costs). When there is an oversupply of rigs, capacity utilization (the number of days inthe year that a crew and rig are contracted for)

drops across the industry, and service providers bid down prices as long as they can cover theirmarginal costs.

Since the cost of operating a rig isrelatively fixed (maintenance and salaries do notchange with oil prices, generally), drillingservice providers’ business model has highoperating leverage. Therefore, changes in thetop line affect the bottom line much more thancompanies in other industries.

One of the key drivers of drilling service

providers’ margins is the level of and projectedoil and natural gas prices, which are determined by the growth of the economy and the oil-production plans primarily of the OPECcountries. When the price structure in the oilindustry is strong, drilling service providers canask for higher day rates and longer contracts.However, when oil prices are low, day-ratesdecline as they are a cost component for oil andnatural gas companies (Conoco Philips, BP,etc.). Also, when uncertainty increases in the

market, contract terms are shortened andservice providers’ backlogs stall, creatingunpredictability in their business model sincetheir profitability is critically dependent oncapacity utilization rates. Therefore, thestrategic goal of drilling service providers is totake advantage of good times to lock in theirfleet at high-spread day-rates and for longperiods of time with high-quality oil and gascompanies.







Equity Analysis

At First Glance

Ensco is exposed to drilling in the Gulf of Mexico, where 3 out of its 4 deepwater rigs are and where the new additions to the fleet will be primarily deployed. Therefore, there is heighteneuncertainty around the company’s future prospects. In addition, ESV’s stock price has all but fullyrecovered since the 30% decline in its stock price subsequent to the April 20th incident. Finally, thcompany has concentration risk because 39 of its 44 rigs are jack-up rigs, which are experiencingsignificant capacity utilization declines; a trend that is likely to continue. Overall, even though thecompany may be cheap at 1.1x tangible book value, there is no real catalyst, so the stock is a pure oiprice play.

Digging Deeper

ESV will be doubling its deepwater fleet by 2012, which will disproportionately impact itsgrowth and more than offset pressure in jack-up pricing and utilization. Even though there are nostrong catalysts to unlock value and the stock will be volatile with oil prices, the book value provides amargin of safety. The majority of their jack-up rigs were constructed in the 1980s (and re-built in th1990s / early 2000s) and have largely been depreciated on the company’s books, though they stilhave considerable intrinsic value. This can be considered to be a ‘hidden asset’ on the company’ books, as evidenced by the recent gain booked on the sale of 3 of its jack-up rigs (originally built in1981-83). Therefore, the strength of ESV’s book value means that there is limited downside

rendering the stock an asymmetric bet on an economic recovery.

Thesis Monitoring & Contrarian View

Oil services companies very rarely trade at a discount to book value, so at 1.1x the downside islimited. On the other hand, they track closely gains in oil prices, so you can capture the entire upsideESV has good management, decent-quality rigs, good visibility on revenues because it discloses itscontracts per rig, and generates solid cashflow. As such, the company is good and cheap, though ilacks any real catalyst now that shares have traded up since the oil spill.

In addition, ESV is transitioning from a jackup driller to deepwater drilling, where day rateshave not collapsed and are much higher. Therefore, the company will more than offset pressures in itcore operations and can improve profitability. Book value will continue to grow and cashflow wilremain very strong, so buying at 1.1x book is a low-risk way of playing a recovery.

Investment Thesis





Equity Analysis

Contrarian View

Thesis Monitoring

Upside / Downside

The long lead time for the construction of oil rigs meansthat there will be an oversupply in both jackups and deepwaterdrills for some time, putting pressure on day rates. Thereforeprofitability will keep going down. In an environment whereindustrials and other cyclicals are growing earnings throughcost-cutting, oil drill service providers will have decliningearnings. This industry will lose if oil prices drop but also ithey remain flat, because of the supply of rigs coming online inthe near future that will lower day rates. Therefore, you may b

better off playing an economic recovery through other cyclicalthat are not facing a potentially prolonged oversupply issue.

The keys to the investment thesis are the strength of ESV’s book value and the ‘hedge’ againstdeclining capacity utilization and day rates in the jack-up fleet that will be provided by the additionadeepwater rigs that will be joining ESV’s fleet between late 2010 and 2012. Therefore, the thesi would be invalidated by either of the following:

• Asset sales that result in losses, which would indicate that there is no ‘hidden asset’ in ESV’s book

and that the book value’s worth is questionable.

• Extensions in the Gulf of Mexico drilling moratorium, which would negatively affect the value o

ESV’s deepwater rigs (although the new-builds will be easier to relocate).

Trends that would negatively impact ESV’s intrinsic value:

• Rapid day-rate declines in jack-up rigs

• Declines in deepwater-rig day-rates

• Further declines in fleet capacity utilization





Equity Analysis

DownsideUpside

Valuation & Catalysts

ESV’s tangible book value (TBV) of $38provides 8% downside protection. Its TBVreflects the depreciated value of rigs that wereconstructed ~20 years ago (and re-built later)so oil and natural gas prices would have to staymuch lower for an extended period of time for adiscount to NAV to be warranted. Partiaevidence is provided by the sale of 3 rigs in

March and April 2010, which were sold for pretax gains of $52mm compared to book value o$90mm.

An additional consideration is thcompany’s backlog of $3.0bn, which can beconverted into cashflow at a 55% efficiency(using the EBITDA margin as a cashflowproxy); so, the company has contracted futurecashflow of $1.65bn, which covers 30% of EV.

ESV has traded historically at ~2.0x its book value, which is currently $40.35 pershare, implying a potential upside to $80(100% upside). This upside will be realized inthe case of an economic recovery. ESV shouldcapture most – if not more – of the move in oilprices, given the high operating leverage of its business model.

Another source of upside is theimpending additions of new deepwater oil rigsto its fleet. The four new deepwater rigs shouldmore than offset any pressure in the jack-upmarket. A single deepwater rig at a $400K day-rate and 90% capacity utilization would add$130mm in revenues and approx. $70mm inEBITDA at 55% EBITDA margin (thecompany’s aggregate margin), which wouldtranslate to additional value of $2.75 per shareat the current EV/EBITDA multiple of 5.5x. By the end of 2012, 4 deepwater rigs will have been added to ESV’s fleet, adding $11 in value.

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Equity Analysis

Catalysts

Market Valuation

Financials & Comparables

ESV’s stock trades at a historically low valuation of 6x maintenance FCF (operatingcashflow less maintenance capital expenditures)and 1.1x tangible book value. The reason for thislow valuation is the increasing supply of rigs andexpected further declines in day rates.

High oil prices in 2006-2008 drove rigutilizations in the high 90% range, raising day

rates and making it a service providers' market. As a result, a lot of the service providers putorders for new oil rigs, since the spread betweencost and potential profitability had widenedconsiderably. However, now that oil rigutilizations have dropped in the 80% range andday rates have fallen by ~30% in many cases,profitability potential is not nearly the same. Still,the rigs have a long lead-time and a large numberare already scheduled for delivery in the coming 1-2 years. These deliveries will put further pressureon utilization and day rates, thus further erodingservice providers' profit margins. In addition, themore profitable semisubmersible oil rigs that will

be coming online for Ensco are contracted fothe Gulf of Mexico, where there may be delays oeven contract terminations depending on theregulatory impact of the BP oil spill.

Nevertheless, Ensco has the strongest balance sheet in the industry with less than 5%debt to equity and sufficient cash to survivethrough a prolonged slow economic recovery

The oil rig services industry resembles theeconomics and dynamics of the shippingindustry. Diana Shipping (DSX) is a closeexample, with a 12% ROE (11% for ESV) and nonet debt on its balance sheet ($1.0bn net cash forESV), trading at 1.0x BV. ESV is a better deal i you believe that the over-supply in oil rigs imuch less out of balance compared to shipping.

Contract backlog has suffered a 25%decline over the past year due to lack ofcontracting activity for deepwater drilling and very soft conditions for jack-up rigs.

Following the April 20, 2010 explosion of the Deepwater Horizon – a Transocean drilling rig

licensed to BP that was operating off the coast of Louisiana – President Obama ordered a six-monthmoratorium on deepwater drilling on May 27, affecting drilling in waters deeper than 500 ftResolution of the uncertainty surrounding Gulf of Mexico oil drilling could possibly be one catalyst foESV and related stocks, the group of which has lost 10-20% of their value.




Equity Analysis

Financial Snapshot

Comparables

EV / SalesP / E (ex. net

cash)

Company Ticker PriceMktCap

Enterprise Value

(EV)Debt/Equity

EBITDA margin

EV /LTM

EBITDA 2010 2011 2010 2011 ROE

Ensco ESV $41.51 $5,934 $4,963 4.6% 54.6% 5.0x 2.9x 2.6x 9.5x 8.1x 11.3%DiamondOffshore DO $59.03 $8,207 $8,750 41.2% 59.5% 4.2x 2.6x 2.5x 8.2x 8.3x 32.1%PrideInternational PDE $23.04 $4,047 $4,883 27.3% 29.6% 11.6x 3.3x 2.5x 14.1x 7.9x 4.3%RowanCompanies RDC $25.21 $2,885 $3,196 26.2% 33.7% 5.5x 1.8x 1.7x 10.1x 12.2x 10.1%

Vantage

Drilling VTG $1.29 $305 $477 34.8% 30.5% 10.1x 2.1x 1.2x 64.5x 7.2x 2.0%HerculesOffshore HERO $2.29 $263 $986 89.3% 16.1% 9.1x 1.5x 1.4x -3.8x -3.8x 10.8%

Competitor Average 43.8% 33.9% 8.1x 2.3x 1.9x 18.6x 6.3x 7.5%

CompetitorCompetitorMedian 34.8% 30.5% 9.1x 2.1x 1.7x 10.1x 7.9x 4.3%

Share Price (ESV) $41.51

Net cash per share $6.79

52wk High $52.32

52wk Low $33.33

Sales - LTM $1,812

EBITDA $990

EPS $4.73

ROE 11.3%

Market Cap $5,934

Cash $1,237

Debt $266

Enterprise Value $4,963

Shares (mm) 143.0

% Owned by Insiders 10%

Avg Daily Volume 3.6mm

Shares Short 8.2mm

Assets $6,921

Debt $266

Equity $5,768

Debt / Equity 4.6%

EV / Sales 2.7x

EV / EBITDA 5.0x

P/E (ex. net cash) 7.3x

NetDebt/EBITDA N/A

Dividend $1.40

Yield Yield (ex. netcash) 4.0%

DPS / EPS '10 33%

Gross Margin 63%EBITDA Margin 55%Net Income

Margin 37%

Consensus Analyst Estimates

Sales 2010 $1,690

2011 $1,930

EPS 2010 $3.64

2011 $4.29

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