- Higher M&A activity is expected as companies take advantage of lower funding costs and boost growth through acquisitions.
- Santos and AWE have been added to the portfolio.
- NRW Holdings and Tiger have been cut.
There are two schools of thought on mergers and acquisitions (M&A) activity in 2015. The first is that company boards are unlikely to approve widespread M&A activity because global demand remains sluggish and economic, political and regulatory risks are rising. The smarter play may well be returning capital to shareholders to boost yield as interest rates fall.
The second view is for sharply higher M&A activity as companies take advantage of lower funding costs and boost growth through acquisitions. And after heavy falls in the Australian dollar spur interest from offshore predators that want to build a bigger foothold in this market.
Lower rates to boost activity
I favour the second view. I understand boards’ nervousness with M&A: business confidence is low and “‘animal spirits” to fuel a takeover boom are missing. But low interest rates are conducive to higher M&A activity, valuations in commodity-related sectors have tumbled, and ongoing gains for Australian shares will driver valuations higher.
Speculation was rife this month that Seven Group Holdings would launch a takeover play for Beach Energy after quickly building a 13.8% stake in the oil and gas company. A Beach takeover could be too big for Seven to swallow, but watch other suitors for Beach emerge.
Greater consolidation among small and mid-tier energy producers is a good bet given the magnitude of share-price falls during the oil-price collapse. Contrarians who can hold mid-tier oil stocks for a few years, and withstand further short-term price volatility, will profit.
The additions
Two energy stocks are added to the list of takeover targets this month: sector giant Santos and mid-tier oil producer and explorer AWE. Both satisfy this column’s key rule: choose undervalued companies that are attractive investments, with or without a takeover. Treat any takeover approach as the cream rather than the cake.
Newspapers have speculated on a Santos takeover for the past few months. One paper reported that Santos was “vulnerable” to a predator when it traded near $12. It is now around $8.11, having fallen from a 52-week high of $15.32 amid the carnage in energy prices.
Santos (STO)
[1]Source: Yahoo!7 Finance, 5 January 2015
Santos must be on the radar of larger global energy groups. The bulk of the capital investment in the massive Gladstone Liquefied Natural Gas (GLNG) venture, of which Santos has a 30% stake, is done. With first cargo from GLNG expected later this year, Santos has greater appeal.
Huge recent M&A deals in oil and gas, notably BG Group’s $6 billion divestment of its Queensland gas pipeline to APA group in late 2014, and Apache’s US$2.75 billion sale of its Liquefied Natural Gas interests to Woodside Petroleum, show the potential for corporate activity in energy.
The timing looks right. The falling oil price, wreaking havoc on the energy sector, will sow the seeds for constrained oil supply in coming years and an eventual price recovery. And the lower exchange rate will make Australian assets more attractive to offshore predators, particularly in sectors such as minerals and energy where commodities are priced in US dollars and the target company’s revenue stream is not contingent on the Australian dollar.
FN Arena has an $11 share-price target for Santos and a sentiment indicator (where 1 is the highest and -1 the lowest) of 0.7.
Investors see value emerging. Santos has rallied from a 52-week low of $6.96 after its fourth-quarter activities report in January broadly met market expectations. The stock has plenty of risk given lingering uncertainty about the oil price and the potential for further credit-rating downgrades that would affect its cost of capital.
But a forecast Price Earnings (PE) ratio of 15.1 times for FY14, and implied yield of 4.6%, fully franked, puts Santos firmly in value territory – and on the radar of predators that might snap it up before the Gladstone project ramps up this year.
AWE on the radar
Like Santos, AWE is also attracting more buy recommendations from stockbroking analysts. AWE has upstream oil and gas production and exploration projects in Australia, New Zealand, the United States and Indonesia. It is among the more established, better-run mid-tier energy stocks on ASX.
AWE (AWE)
[2]Source: Yahoo!7 Finance, 5 January 2015
Small energy stocks are ripe for consolidation. They are responding to lower oil prices by cutting capital expenditure and operating costs wherever possible. The priority is preserving balance sheets and cash flow to survive further oil-price falls.
Macquarie says valuation support is emerging among mid-tier energy stocks, “assuming oil prices recover from current levels”. Preferred stocks are AWE, Sino Gas & Energy, Senex Energy, and Karoon Gas. Its 12-month price target for AWE is $2. The company trades at $1.39
FN Arena has a target price of $1.61 and a sentiment indicator of 0.5>
AWE looks a lower-risk play than other mid-tier energy producers and explorers. With a reasonably open share register, it could attract interest from a larger energy company that believes the time is right to pounce on an undervalued, quality mid-tier player.
Portfolio update
The takeover portfolio has underperformed since its last publication in mid-November [3]after some good results — a median loss of 4% compared with a 3.4% gain in the S&P/ASX 200 index over that period.
The portfolio was hampered by exposure to two resource-related stocks: NRW Holdings (down 58%) and Tiger Resources (down 65%). A 27% fall in Nearmap after stellar gains last year also hurt.
The stand-out performer was medical-device maker Reva Medical, which has been in the portfolio since it started early last year. It rallied 70% from mid-November. OnTheHouse also ticked higher with a 13% gain after losses last year.
To recap, the portfolio includes NIB Holdings, iiNet, Reckon, Automotive Holdings Group, Monash IVF Group, Vision Eye Institute, Australian Agricultural Company, Reva Medical, Ten Network Holdings, NRW Holdings, Tiger Resources, Nearmap, iSelect, OnTheHouse Holdings, OxForex Group and Ensogo (formally iBuy Group).
We’ll lick our wounds and cut NRW and Tiger from the portfolio, replacing them with AWE and Santos, and stick with the rest. This portfolio mostly includes small- or mid-cap stocks, so suits experienced investors comfortable with potential higher volatility.
• Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Feb 3, 2015. Portfolio update based on comparison with Feb 3 and November 11 prices.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.