“It’s better than sex.” That line was attributed to Ted Turner, reacting to the euphoria surrounding the 1990s merger between so-called old media Time Warner and new media AOL.
Of course, the iconic billionaire had far different things to say about the deal a year or so later, when it became clear almost nothing between the companies meshed. AOL/Time Warner is by no means the worst pairing in history. In fact, the now-legendary dysfunction of that deal doesn’t come close to, for example, the disastrous banking mergers of the past decade.
In stark contrast are the thousands of mergers in the U.S. electric utility industry over the century-plus since Thomas Edison flipped the first switch. In every case and regardless of the challenges, merging companies managed to eventually create a stronger entity. In fact not one union of regulated power utilities has even come apart.
For most industries the success rate lies somewhere in between those extremes. Winning deals have been grounded in economics of scale, allowing the partners to pool expertise, financial strength and asset bases. Losing deals have been all about ego and/or the desire to make a fast buck, and the partners soon come to regret their haste.
Of course shareholders of acquired companies almost always come out ahead, no matter which way things go. That’s because acquirers typically must pay at least some premium to the current market value in order to win their approval for a deal. And prices can get quite steep if the buyer wants them bad enough.
Here in late 2011 few places in the world offer as many attractive targets as Canada. To date the natural resources sector has gotten most of the attention, and with good reason. The combination of new technology coupled with rich reserves and favorable regulation has opened up the country’s oil and gas bounty to development as never before.
Just as in the U.S., companies are tapping previously inaccessible shale reserves of light oil, natural gas and natural gas liquids. Meanwhile, tar sands development is ramping up, spurred by world oil prices that seem increasingly unlikely to fall below USD100 a barrel again.
Canada is also rich in everything from copper to metallurgical coal and iron ore, the two essential elements for making steel. It’s one of the very few sources of rare-earth metals outside of China, which currently accounts for substantially all global output. It contains substantial quantities of uranium stocks, key to fueling the next generation of nuclear power plants being built around the world. And it’s a primary source of forest products and potash as well.
Canada’s resource bounty has particularly attracted the interest of the Chinese, who are as bereft of these riches as Canada is flush. China’s relentless demand for resources in the wake of the 2008-09 credit crunch/market crash was absolutely critical to Canada’s ability to avoid a serious recession in 2009, despite the worst contraction in the U.S. economy since the Great Depression.
To date, Chinese investment in Canada has been mainly passive, that is taking ownership stakes in companies and ventures without taking control. Sovereign wealth fund China Investment Corp’s (CIC) financial support of Penn West Petroleum Ltd’s (NYSE:PWE) oil sands projects is one good example, as is its minority ownership position in Teck Resources Ltd (TCK).
Last month, however, the Middle Kingdom became a bit aggressive. China Petroleum & Chemical Corp Ltd, known more colloquially as Sinopec (NYSE:SNP), launched a CAD2.2 billion bid to buy intermediate oil and gas producer Daylight Energy Ltd (OTC:DAYYF).
Buying Daylight wasn’t important so much for the target’s 35,000 or so barrels of oil equivalent daily production. Rather, its value lies in the 300,000 acres of land Daylight owns in areas with rich proven oil and gas reserves. Daylight’s inventory at last count is 174 million barrels of oil equivalent. That’s valued conservatively between CAD15 and CAD16 per share and rising, as the company added 46 percent to its reserves in 2010 and despite some hiccups this year is on a torrid pace for additions this year as well.
Sinopec timed its offer well. The offer price of CAD10.08 per Daylight share is approximately 70 percent above the stock’s average price for the 20 days prior to the announcement. It was also more than twice Daylight’s price the day of the deal, as the company’s shares had dropped by more than 50 percent in 2011 due to tumbling natural gas prices and pending debt maturities.
In fact, without a deal, it’s likely Daylight would have had to consider a dividend cut to satisfy increasingly restive lenders, setting off a further price plunge. As a result, it was a very motivated seller, with shareholders getting a modest windfall even as Sinopec acquires its rich reserves for only about 60 cents on the dollar.
Political sensitivities are likely to limit further Chinese direct acquisitions. For example, given regulators’ rejection of BHP Billiton Ltd’s (NYSE:BHP) bid for Potash Corp of Saskatchewan (NYSE:POT) last year, we’re unlikely to see Sinopec bid outright for a major Canadian oil company.
But would-be sellers’ need for cash and coupled with voracious global appetites for energy and a still-long list of players is likely to continue spurring deals for Canadian oil and gas producers in coming months.
Despite the fact that Canadian mergers-and-acquisition (M&A) activity is noticeably picking up once again, Sinopec’s moves, for example, are hardly the actions of a management team hungry for near-term success. Rather, they’re part and parcel of China’s long-term strategy to take financial and physical ownership stakes in natural resources globally, with the goal of offsetting huge and growing exposure to increasingly volatile prices of inputs that are vital to the country’s continued economic growth.
Sinopec’s interest in Canadian energy stocks -- including its acquisition of an interest in the Syncrude oil sands partnership -- is very much an indication of how much value there is in the country’s resource base. But neither does it indicate any sort of mania, or the start of a bidding war. Rather, every deal we see going forward is going to have to be based on sound economics, as well as motivated sellers and financially powerful buyers.
The good news is that dovetails exactly with what’s always been my strategy for betting on takeovers. Mainly, I never buy or recommend any company as a takeover target that I wouldn’t want to own if there were never an offer.
Good companies, if they are taken over, will ultimately command good value, and they’ll enrich us while we wait for a deal to emerge. Weak companies are as likely to be taken under -- at a price well below what they’re worth -- and in fact may not survive to see one.
High global oil prices and technological advancement are revving up activity in Canada’s oil sands once again. The key to success isn’t reserves in the ground. Rather, it’s having the financial power to construct what amounts to a massive mining and chemicals plant that are expensive to build as well as operate.
Syncrude, for example, had an average cost of nearly CAD38 per barrel of oil produced. Given the deep pockets of its partners including operator Exxon Mobil (NYSE:XOM), it has few problems meeting that cost, particularly with oil prices again pushing USD100 a barrel. But high costs are indeed an impassible barrier to entry for the myriad companies that have hyped their stocks on the value of their supposed reserves, with no way financially to get it out of the ground.
Consequently, bigger is better when shopping for plays in the tar sands. And there’s no better prospective takeover target than Cenovus Energy (NYSE:CVE), the liquids-focused company spun off last year from Encana (NYSE:ECA).
Although its former parent has struggled to fund its capital spending plans due to sinking natural gas prices, Cenovus has been able to generally strong oil prices to push ahead with development of potentially vast tar sands projects.
Oil sands output rose 14 percent, and the company reported it’s ahead of schedule for a manifold gain in production by the end of the decade. Third-quarter cash flow rose 56 percent, buoyed by an average cost per barrel of oil equivalent of just CAD12.60.
Disclosure: I am long XOM.