Another day, another (albeit much bigger) multinational merger

Monday, 13th April 2015 09:09 - by David Harbage

Following on from the writer’s previous commentary on Optimal Payments (OPAY), this article takes a look at a much bigger piece of corporate action as global oil giant Royal Dutch Shell made a £47 billion offer for the BG Group on Wednesday. Again an agreed (by management of both companies) bid, with consideration being via a mix of cash and new equity, but the magnitude of this deal is dramatically different – for example, requiring regulatory approval in a number of jurisdictions including Australia, Brazil and China. Besides the scale, the most obvious difference surrounds the current respective positions in the business cycle of the energy industry as compared to the high pace apparent in technology (surrounding the electronic wallet & payment industry, in OPAY’s case).      

Consolidation is most prevalent in low growth, mature industries and the catalyst to such M&A (merger and acquisition) activity will often be caused by exceptional adverse factors. The dramatic weakness in the oil price – highlighted by BG chairman Mr Andrew Gould when commenting on the new sources of supply (notably US shale) which had prompted the oil price (which had been over US$100 per barrel for four years until the second half of 2014) to fall to $45 – has dramatically changed the viability, outlook and worth of upstream natural resource businesses.

Royal Dutch Shell (RDS) has long been touted as a natural consolidator or buyer because of its financial muscle (debt is very low, with single digit financial gearing less than half that of its multinational peers’ 20%+ average) and its need to find new exploration assets. Whilst the stock market rumour-mongers can cite a number of perennial take-over targets (for instance, within the FTSE100 index: Smith & Nephew) and likely bidders – often with reasonable industrial logic attached – few materialise in short order. But RDS purchasing the BG Group appears to be an exception, with the gas and (albeit to a much lesser extent) oil exploration arm of the old British Gas business offering the opportunity to add a meaningful (it is significant, relative to the size of RDS) asset to its existing portfolio. Mr Van Beurden, the CEO of RDS admits that BG had been at the top of his company’s ‘shopping list’ for some time, but that the respective valuations had not stacked up attractively enough to deliver financial logic; the 35% fall in BG’s share price (from 1233p in September 2014 to below £8 in January) was twice as precipitous as the reduction in RDS’ equity worth over the same period.

The immediate knee jerk movement in share prices (RDS down from £22 to £20.20, BG up from 910p to 1155p) on the day of the announcement reflected a belief that RDS could be overpaying – offering 383p in cash and 0.4454 RDS ‘B’ share, equating to a premium of 50% to BG’s equity valuation based on pre-announcement prices. But perhaps RDS are not being as generous as first thought, with every £1 fall in RDS’ stock knocking 45p off the proposed BG share price; the current £20.50 valuation of RDS’ ‘B’ shares equates to an offer of £12.96. That the BG stock price currently lags this, by 10%, reflect the uncertainties and risks to completion (due early 2016) on the existing terms.

Beyond regulatory interference (which includes China’s nascent completion rules which seek to influence, if not be applied, even though assets may not be located in the PRC), the prospect of counter corporate activity – as peers seek to reassess their own portfolio of assets or strategic plans, in the light of this major prospective change in the landscape – is a real one. Moreover in this industry, which features high capital expenditure and a low exploration success, the future price of oil is critical in determining cash flow and the financial outcomes. The purchase of assets which are about to come on stream (notably in Brazil, which will take RDS’s proven reserves in the South American continent from 0% to 10% of its total) will provide a significant boost to revenue over the next five years. RDS management anticipate annual cash flow of $55-70 billion (notice the wide range, according to commodity price applied), with capex across the enlarged group of $40 billion by 2020.

Notwithstanding the unpredictability of the oil price, RDS stock’s high dividend (promising an unchanged $1.88 pay-out in 2015 and 2016) means the stock has real attractions – if only as a quasi-bond investment, yielding 5.8% at current valuation. Beyond this, management indicate an intention to utilise the excess free cash flow to repurchase $25 billion of their own stock (effectively that issued to BG holders) from 2017 to 2010 – which will compensate, in part, for the inevitable short term dilution in earnings per share of this major acquisition. In terms of balance sheet strain, dividend cover could fall to 1.2x and gearing rises to circa 20% in 2016, based on RDS’ estimates for the oil price of $67, $75 and $90 in 2016, 2017 and 2018, respectively. Big swing factors for investors to ponder include potential disposal proceeds ($30 billion predicted over 2016-2018) and the level of income generated by BG’s deep water and integrated gas businesses (forecast to be $15-20 billion each).

Bears on the oil price – perhaps as a consequence of taking a pessimistic view on global GDP and demand - may decide to steer clear of natural resources, as a number of high profile equity fund managers have done. However, owning a stake in an essential commodity has appeal, especially if you believe that major sudden falls in price usually revert to a more normalised level as the cycle (prompted by economic demand or other less predictable factor - such as Middle East war or environmental concerns in the West – impacting supply) turns.