ARC Resources: Buying On The Cheap
Summary
- The combination will increase the percentage of liquids produced by ARC Resources.
- Both companies are Montney producers.
- The all-stock deal means that debt will remain low.
- The dividend will likely continue to vary with business conditions.
- Both companies own their midstream operations.
- This idea was discussed in more depth with members of my private investing community, Oil & Gas Value Research. Learn More »
ARC Resources (OTCPK:AETUF) (ARX.TO) and Seven Generations Energy (OTC:SVRGF) (Vll.TO) have announced a business combination that will leave ARC as the surviving entity. Both are considered Montney producers. The majority of the business will be in Alberta with a significant amount in British Columbia. This combination will produce a very significant competitor and it jump starts the ARC Resources transition to more liquids production.
(Canadian Dollars Unless Otherwise Stated)
Source: Business Combination Presentation On Both Company Websites and Filed With SEDAR February 2021.
This all-stock transaction will keep the debt at very conservative levels for the combined company as shown above. There is some hope that economies of scale and continuing technology improvements will provide some immediate benefits to the merger.
The other goal of the combined entity achieving an investment grade rating is very attainable given the low debt shown above.
The dividend is a little more suspect because Canadian companies will not hesitate to cut the dividend if industry conditions head South. Therefore this entity is best reviewed as a variable distribution entity. So the dividend cannot be relied upon as it could be elsewhere. Income investors need to note that the balance sheet will come first.
Source: Business Combination Presentation On Both Company Websites and Filed With SEDAR February 2021.
These two companies, like many in Canada, own their own midstream operations. That can be a very valuable asset in an age where there is considerable opposition to new pipelines in many areas. The area shown on the map is generally supportive of the oil & gas industry. However, there are significant chunks of Canada that oppose oil & gas interests.
For a long time, the goal of the infrastructure was to avoid exposure to AECO pricing of natural gas. That appears to be no longer true at the current time. The coronavirus demand destruction has allowed most production to get to the optimal marketplace because of the lack of industry drilling and completion activity. But that situation should change in the future.
Source: Business Combination Presentation On Both Company Websites and Filed With SEDAR February 2021.
The Seven Generations operations are fairly close to the existing ARC operations. However, this will not be a "bolt-on" acquisition. Instead it is more a diversification move by ARC to increase future strategic flexibility.
ARC Resources like many natural gas producers has been hobbled by the declining price of natural gas. Therefore a move into more oilier production was indicated.
Natural gas producers do not have to go through all the manufacturing processes that oil does when it is refined. Therefore natural gas processing ownership is generally a far cheaper proposition.
The combination of the two companies may mean that there will be a future venture into the refining business. The combined company will be large enough to make that strategic decision a realistic one.
For the time being, the company will be the number 1 condensate producer in Canada. Canada has long imported condensate to mix with thermal and heavy oil so that oil would flow through pipelines. In Canada, condensate often sells at a premium to the price of oil. The combined company could therefore be very profitable.
After The Combination
The combined company will likely spend about a year optimizing operations. Big business combinations like the one proposed often have logistics challenges. There is simply a lot to do because of the size of the companies combining.
Therefore production is unlikely to significantly grow for the first year (post combination). In the past ARC and Seven Generations both had low enough costs to grow under a wide variety of industry conditions. The business combination should increase that wide variety so that growth can occur under even more industry conditions.
Earnings will remain cyclical. But the combined company should have more flexibility to drill in locations that deliver more of whichever products are currently in favor with Mr. Market.
ARC Resources had been shuffling the company portfolio for some time to increase company profitability. This merger is hopefully a giant step in the right direction.
Risks
Any large merger is generally risky. They do not often succeed due to the scale of necessary optimization projects. A large merger can prove far more complicated than management can handle or was bargaining for. Therefore due diligence prior to the merger of large companies has outsized importance.
Any proposed merger can be rejected by the shareholders or fall apart for any number of previously unforeseen reasons. At that point a rejection or cancellation would mean that both companies wasted time and money. Even a cancellation fee does not fix the situation really well.
The combined company may find that the acreage is not all that management believed when it made the acquisition offer.
The workforce needs to be combined. That is often very tricky business. The chances of failure in this area are significant. Sometimes the wrong key officers are let go. That can set back a newly combined company significantly.
Even more significant is the combination of office and accounting systems. This combination is often the part that leads to future failures as it is generally the most challenging.
Summary
Right now this merger looks pretty good. The probabilities of a successful merger that reaps the foreseen benefits is pretty good. The combined company is likely to be a fierce competitor with some very low costs.
More importantly, the company can shift to producing more liquids or more natural gas as market conditions change. Before this merger ARC had a limited ability to produce liquids rich gas (which is not quite the same).
A logical next step may be to acquire some refining capacity to handle the liquids produced. That will lessen the company exposure to the commodity markets. Another possibility would be to build a "cracker" that would serve to produce ethylene for the growing plastics market.
In many ways, the combined company will be "in the catbird seat". As long as management is careful enough to make sure that the business combination is properly completed, then shareholders should have a fairly secure future.
Many natural gas companies are cheap like ARC Resources. So there are a lot of bargains out there. But few offer the low leverage offered here.
Low financial leverage often allows the company several options during an industry downturn. Plus the open credit lines make participating in a cyclical recovery far easier. This combination should result in one of the premier Canadian producers.
The combined company will list on the Toronto stock exchange. It may now be larger enough after the combination to consider listing on the NYSE as well. In any event this company will be a considerably safer investment than many listed issues at the current price.
I analyze oil and gas companies like ARC Resources and related companies in my service, Oil & Gas Value Research, where I look for undervalued names in the oil and gas space. I break down everything you need to know about these companies -- the balance sheet, competitive position and development prospects. This article is an example of what I do. But for Oil & Gas Value Research members, they get it first and they get analysis on some companies that is not published on the free site. Interested? Sign up here for a free two-week trial.
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Occassionally write articles for Rida Morwa''s High Dividend Opportunities https://seekingalpha.com/author/rida-morwa/research
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Analyst’s Disclosure: I am/we are long AETUF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (25)
Consensus earnings estimate for this year is C$.76, a forward P/E of less than 10. Analysts are never wrong, right?
If the merger goes well this stock could gain 50%. If the merger turns out to be a cluster-f, then my stop gets exercised for a loss of about 6%.
With a 3% yield this is a company I want to own. At the right price, of course. The market will tell me what that price is when the short-term bottom is hit. I think that bottom was hit yesterday at C$7.36 but it could re-visit that C$7.16 mark.
The volume you cite if for the US market. Three month average for the TSX is ~3.3 million.
For me, ARC is one of those I may just hang onto because its conservatively managed. So no matter where we are in the business cycle, it is going to be around tomorrow.
But the downcycle this last time was so long and so vicious that I suspect it will take us awhile to get back to normal.
Adding cash flow for the two yields ~C$1.5 billion and free cash flow of ~C$400 million (TTM for both as at Dec 31,20). 400/725 gives free cash flow per share of C$.55, more than enough to cover the current C$.24 annual dividend and provide increased capex or increased shareholder returns. I realize these are just "back of the napkin" calculations but the numbers look promising.
The future of natural gas looks bright and Arc will be there to reap higher returns.
I'd be a buyer of this at current prices in spite of the significant dilution.
