Concho Resources - Strategic, Yet Rich, RSP Deal
- Concho is willing to pay a big premium to acquire RSP.
- The adjacent properties make that deal worthwhile from a strategic point of view, yet the premium seems rich as Concho actually sold some of these assets a few years ago.
- I understand the caution from an investor point of view, as I never was a big fan of the standalone valuation to start with.
Concho Resources (NYSE:CXO) announced a major deal with the acquisition of RSP Permian (RSPP) in a rather large $9.5 billion deal, welcomed by investors of the latter, but not necessarily by shareholders of Concho. This is despite the promise of $2 billion worth of synergies.
The tie-up makes perfect sense from a strategic point of view and does not add much to pro-forma leverage (given that this is an all-stock deal), yet the exchange ratio seems a bit rich in terms of the value attached to RSP. While the deal is large and seems a bit rich in relation to Concho's own valuation, I was never a big fan of the standalone value to begin with. Even based on annualized Q4 adjusted earnings, Concho trades at 40x earnings, while cash flows are lagging as a result of large net capital investments needed to sustain the growth story.
Concho has reached an all-stock deal to acquire RSP Permian by offering 0.32 of its own shares in exchange for each share outstanding of RSP. The $9.5 billion deal is comprised of an $8.0 billion stock component, valued at a 29% premium and includes $1.5 billion in net debt of RSP as well. To illustrate how large the deal is for Concho, investors in RSP will combined own 25.5% of the shares of Concho.
Let's focus on the operations. With the deal, Concho will add 92,000 net acres in the Permian, located in close proximity or adjacent to the properties of Concho itself. The acreage contains 5,000 gross drilling locations that currently produce 56,000 barrels of oil equivalent per day and contain 2.2 billion barrels of oil equivalent in terms of its reserves. Concho will grow production from 211,000 to 267,000 barrels of oil equivalent per day following the deal, see Permian acreage jump from 550,000 to 642,000 net acres, see an increase from 21,000 to 26,000 drilling locations and see resource potential jump to 12.2 billion barrels of oil equivalent.
It seems as if investors in RSP will obtain a rather large stake in Concho given its operational contribution. RSP contributes 21% of pro-forma production, 14% of combined net acreage, 19% of gross locations, and 18% in terms of net resources. To put these numbers into perspective, Concho operates with a net debt load of $2.8 billion ahead of the deal, which values the overall business at $25 billion. The $9.5 billion deal for RSP, therefore, gives the company a +27% stake in the combined value of nearly $35 billion of the combination. It contributes $2.0 billion worth of synergies to RSP, which is the same as reducing the deal to $7.5 billion and the share of RSP to the overall value drops to 22%. This is much more reasonable, yet is still a bit on the high side given the contribution of RSP.
The rationale behind the deal is that of creating a premier asset in the Permian as a pure play. Given the adjacent locations of the acreage, real operational synergies could be achieved - as well as the avoidance of duplicate corporate functions, of course. No dollar amount of synergies is being communicated, other than that the present value of these synergies is seen at $2.0 billion. Synergies are seen by sharing knowledge and infrastructure as well as through a reduction of corporate overhead and greater purchase power, as both companies are active in close proximity to each other.
Concho claims that it becomes the leader in the Permian following this deal, surpassing previous leader Pioneer and widening its lead compared to Apache (APA) and EOG (EOG), among others.
Market Takes It as a Negative
I understand why investors of Concho are cautious about the deal with RSP, as the latter is valued at 27% of the pro-forma enterprise valuation, while its operational contribution comes in much closer to 15-20% based on some operational achievements. Following the announcement of the deal, Concho's shares plunged from $157 to $143 per share, before recovering to $150 currently. The 150 million outstanding shares will see quite a bit of dilution. The $8.0 billion equity component implies that some 50 million shares will be issued, for a pro-forma share count of roughly 200 million shares.
This means that the $14 plunge in the shares corresponds to a $2.8 billion reduction in the value of the shares on the back of the deal, being quite significant on the back of a $9.5 billion deal. That seems to suggest that investors in Concho are more comfortable to value RSP at $6.7 billion, instead of $9.5 billion, despite the promise of the synergies. Part of the reason why investors are skeptical is that Concho itself sold acreage to a company that ended up in the hands of RSP, as it's now buying back the same assets at much higher valuations.
While this is a very sizable deal, as roughly a fourth of Concho's shares will be held by investors in RSP Permian, the reality is that I have found Concho an expensive play altogether for a long time. The company reported operating earnings of $1.07 billion in 2017, aided by gains on asset sales worth $678 million, for adjusted operating earnings of $396 million or $522 million if we add back derivative losses. After applying a near $150 million in interest expenses and applying normal tax rates, it is evident that the business would be posting GAAP earnings of $250-300 million in such a case, close to $2 per share at the higher end of the range.
Based on the Q4 numbers, adjusted earnings trend at a rate in excess of $900 million. Accounting for $150 million in interest and a 25% tax rate, that works out to $3.75 per share in earnings power - translating exactly into a 40x earnings multiple. Part of the problem for the industry at large is that huge impairment charges following the 2014 collapse in oil prices mean that GAAP accounting is distorted for oil companies at this point in time. Depreciation charges amounted to $1.15 billion last year, while "organic" capital expenditures amount to a little over $1.6 billion, as the resulting $450 million cash flow gap was larger than adjusted earnings. The good news is that these negative cash flows are not going to waste as they actually result in solid production growth, yet result in negative free cash flows to investors as well.
In the case of Concho, these impairment charges appear to be somewhat limited. The company's GAAP accounting methodology is not as distorted compared to other players, which see huge net capital investments needed just to keep production flat after depreciation charges have been minimized following huge impairment charges taken in the past.
Paying a 40x pro-forma earnings multiple for a growing business seems a bit rich, certainly in a capital-intensive industry that goes hand in hand with limited cash flows or perhaps negative free cash flows, especially after the company makes a relatively expensive deal as well. Consequently, I continue to have a very hard time justifying today's valuation in absence of expectations of vastly higher oil prices in the coming years.
While the company obviously represents quality within its peer group given its low break-even costs, low leverage, and value creation over time, the high valuation might be very hard to justify in a world in which oil demand could come down over time, as long-term environmental trends regarding the usage of oil might curb consumption quite drastically. Hence, I would be very hesitant to apply terminal discounted cash flow assumptions.
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