Thursday, July 26, 2007

Transocean and ConocoPhillips

We continue to like Transocean (RIG) and ConocoPhillips (COP) based on this weeks news.

Transocean and GlobalSantaFe's Slick Union

Financial engineering has come to offshore drilling.

On Monday, Transocean (nyse: RIG - news - people ) and GlobalSantaFe (nyse: GSF - news - people ) agreed to merge, creating a $53 billion empire. Under the deal, shareholders will not get a premium but they will get a partial stake in the new company and $15 billion in cash.

With global demand for oil and gas surging, the services industry has been under pressure to consolidate. By piggy-backing on one another, larger companies will be able to take advantage of economies of scale and enhance their purchasing power. The Transocean-GlobalSantaFe merger may be the first major domino to fall in a long line of similar aglomertins.

The deal pleased Wall Street, as shares of Transocean jumped 6.3%, or $6.92, to $116.89 in Monday afternoon trading. Similarly, GlobalSantaFe shares climbed 5.2%, or $3.90, to $78.64.

Management may have called the agreement "a merger of equals," but Transocean is clearly leading the way.

First, Transocean dwarfs GlobalSantaFe in sheer size. At $18 billion, GlobalSanteFe's market capitalization is half of Transocean. The combined company will operate under the Transocean name and trade under the "RIG" ticker symbol. More significantly, Transocean's current chief executive officer, Robert Long, will preside over the enlarged company, while GlobalSantaFe's CEO, Jon Marshall will take the chief operating officer title.

The new Transocean will boast 20,000 employees and a global fleet of 146 rigs. "This transaction will enhance our high-end floater fleet, including five newbuild ultra-deepwater units, while growing our position in the worldwide jackup market, especially in the Middle East, West Africa and North Sea," Long said on Monday. "In addition, we will be positioned to better offer the full scope of drilling services to customers in all geographical areas."

Transocean's pseudo-takeover offers shareholders no premium, but the $15 billion payout is a compelling concession. For each Transocean share, shareholders will get $33.03 per share and 0.70 share of the new company's stock. Meanwhile, for each GlobalSanteFe share, shareholders will get $22.46 in cash and a 0.48 share. In total, the companies will shell out $15 billion in cash, funded by a bridge loan from Goldman, Sachs and Lehman Brothers -- in other words, the pay-day will be funded by debt. The combined company will use the first two years of free cash flow to reduce its borrowings.

"The $15 billion cash payment allows us to achieve a more appropriate capital structure and deliver immediate value to our combined shareholders," GlobalSantaFe's Marshall said on Monday.

Financially and strategically, it's a smart move, according to Weedon & Company analyst Matt Conlan

In the case of most offshore driller mergers, there are few operational synergies-- Transocean and GlobalSantaFe predict $100 million to $150 million in annual savings by 2010. However, from a debt capacity stand point, it was advantageous for the companies to merge.

"This is all about capital," Conlan told on Monday. "The enormous debt capacity really drove the deal." The merger allows the companies to buy in 30% of their stock without paying a premium to the current market price. "That greatly enhances your earnings and cash flow per share," he said. Now, "the capital structure will have a 30% debt-to-enterprise value, which is more reasonable," Conlan said. "It's still low-risk." Despite the added debt, the combined company will still have plenty of dry powder to make other acquisitions possible.

Before the deal, Transocean had $3.5 billion in debt, while GlobalSantaFe had $707 million. Combined, the companies have a $33 billion backlog, $16 billion of which is free cash flow. Essentially, "they're give back all of their free cash flow," Caylon Securities analyst, Mark Urness said Monday.

In addition, there are a handful of merger benefits. By joining forces, the former rivals will no longer have to compete against each other for work or spar for future equipment purchases.

Other offshore drilling players will probably follow suit. "I think that the immense debt capacity in the industry is going to continue to put pressure on companies," Conlan said. For years, offshore drilling investors have pressured companies to return value to shareholders, instead of plowing it all back into the business. Like Transocean and GlobalSantaFe, most of the industry is highly underlevered. According to Canlon, the sector has a $100 billion market capitalization and less than $5 billion in net debt. From 2007 to 2009, there will be $40 billion in free cash flow.

With so many players, and so many possible match-ups, its difficult to predict what pairings will occur; however, one likely takeover target is Pride International (nyse: PDE - news - people ). As one of the cheapest companies in the sector, it could attract suitors.

Investors seem to agree: shares of Pride were up 5.1%, or $1.95, to $40.18 on Monday.

ConocoPhillips Net Profit Falls 94 Percent in 2Q, Projects Drop in 3Q Production

HOUSTON (AP) -- ConocoPhillips' decision to snub an invitation from President Hugo Chavez to keep producing crude oil in Venezuela under tougher terms has had two results: much lower net profit in the second quarter and a projected drop in third-quarter production.

On Wednesday, the third-largest U.S. oil company said a $4.5 billion charge in the second quarter to write off its huge assets in Venezuela sliced net income by 94 percent. Without that charge, operating earnings topped Wall Street expectations with the help of higher oil prices and refining margins.

Investors, focusing on operating earnings, drove ConocoPhillips shares up $1.96, or 2.4 percent, to $84.29 Wednesday. The shares have traded in a range of $54.90 to $90.84 in the past year.

Some analysts said the cut in production could make it hard for ConocoPhillips to achieve production-growth targets this year. John Parry, a senior analyst with John S. Herold Inc., said lower output in the July-September period almost certainly will lead to lower third-quarter earnings, perhaps as much as 20 percent versus the most-recent quarter.

"It's still going to be a decent number," Parry said. "It's not going to shake the foundation of the company. But it's going to be a factor."

The April-June results amounted to net income of $301 million, or 18 cents a share, compared with last year's robust second quarter when ConocoPhillips posted a profit of $5.18 billion, or $3.09 a share. ConocoPhillips was the first of the U.S. oil majors to report second-quarter results.

Revenue in the most-recent quarter rose to $47.4 billion from $47.1 billion in the year-ago period.

Excluding the $4.5 billion Venezuelan impairment, ConocoPhillips' adjusted earnings amounted to $4.8 billion, or $2.90 a share -- far exceeding the $2.68 a share forecast of analysts surveyed by Thomson Financial.

ConocoPhillips, along with Exxon Mobil Corp., refused to sign deals last month with Venezuela to keep pumping oil in that country's petroleum-rich Orinoco River basin. The company said last month it likely would incur the $4.5 billion charge in the second quarter.

ConocoPhillips has said its initial investment in Venezuela was $2.6 billion, though analysts say it's worth far more than that.

In a conference call with analysts Wednesday, ConocoPhillips Chairman Jim Mulva said the company is negotiating with Venezuelan authorities on final compensatory terms for its investment. Earlier this month Mulva said such talks could take several more months.

"We're working toward an amicable solution and settlement on compensation," he said. "If we don't, then we resort to international arbitration."

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