As expected, Santos (STO, Buy) put forward a revised offer for Oil Search, representing an 8% increase on its initial proposal two weeks earlier. Oil Search indicated that in the absence of a superior offer, the board intended to unanimously recommend in favour of the merger.
Under the proposed terms, Oil Search shareholders will receive 0.6275 Santos shares for every Oil Search share. Santos shareholders will own 61.5% of the combined entity, with Oil Search shareholders owning the remaining 38.5%. The offer is still subject to due diligence, as well as Oil Search shareholder approval, Papua New Guinea (PNG) court approval and regulatory clearances.
We see substantial merit in combining the two entities. The proposed merger would create the largest exploration and production company in Australia with a combined market capitalisation of US$22bn. Further, the combined company would have more than US$5bn in liquidity, providing balance sheet strength to fund growth.
At this stage, however, we have taken a conservative view of potential cost benefits of the deal given Oil Search does not operate the PNG LNG asset and its Alaska project is at an early stage. Therefore, we see most benefits coming from head office rationalisation, which we forecast at US$60m annually.
Our estimated net present value (NPV) ratios amount to a ‘fair value’ of 0.69 Santos shares for every Oil Search share. Given Oil Search’s cash flow and value are longer-dated, however, we expect some EPS dilution in the early years and so we would not expect Santos to pay to that price.
Overall, we see the 0.6275x being offered as a fair ratio, considering the risk and likely impact on EPS. With projected gearing of less than 25%, and an estimated net debt to operating earnings multiple of less than 2x, we see opportunities for Santos to conduct capital management to reduce EPS dilution. Assuming US$60m in annual synergies, we view the proposed merger as 5% NPV-accretive for Santos.
We maintain our Buy recommendation on Oil Search with a $5.50 target price.
RESEARCH EDITOR
Walter is the Editor of Ord Minnett's retail investor publications, such as the Opening Bell, Ords Weekly and the Ords Monthly, along with various investment guides and investor information published by Ord Minnett.
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Oil Search, OSH
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