Shell And BG Group: Strong Strategic Fit, But Additional Financial Risks Ahead

Article by Pim Keulen published 12 April 2015 by Seeking Alpha 

Shell And BG Group: Strong Strategic Fit, But Additional Financial Risks Ahead

Source: total.com

Summary

• Shell announced the acquisition of BG Group for the amount of $69 billion.
• From a strategic point of view, the deal seems to make perfect sense.
• From a financial point of view, the deal has a long-term horizon with accompanying risks.
• It will come down to management’s capabilities to deliver the outlined financial metrics in order to make this deal work for shareholders.

Last week, Royal Dutch Shell (RDS.A, RDS.B) announced the acquisition BG Group (OTCPK:BRGXF) for a total sum of $69 billion. Despite heavy M&A activity, this deal is the largest M&A deal announced this year. Both analysts and contributors on Seeking Alpha have discussed the metrics of Shell’s acquisition. However, the reactions are somewhat mixed. As I cover Shell on a regular basis, I would like to share my point of view regarding the BG Group acquisition.

Strategic point of view

In my first article about Shell, I discussed the importance of LNG and efficient LNG production technology for the company. Over the past few years, Shell has been focusing more and more on natural gas, rather than oil production. With the acquisition of BG Group, Shell acquires one of the leading natural gas players with major projects all around the world. In its press release, Shell names BG’s deepwater and integrated gas projects as one of the main strategic drivers behind the deal.

In my opinion, Shell is making just the right move to focus more on natural gas instead of oil production. According to Total (NYSE:TOT), the world’s energy supply will be significantly different in 2035 compared to 2010 (see graph below). The portion of natural gas in the total world energy supply will grow to 25% in 2035, up from 22% in 2010. On the other hand, oil will decrease to 28% in 2035 from 32% in 2010.

An important factor to watch is the current natural gas price. This topic is already covered by Seeking Alpha contributor Zoltan Ban in this article. Some of BG Group’s projects are more complicated than others and require capital expensive production facilities. Considering the current low energy prices, Shell may end up losing on complicated projects instead of generating the expected positive free cash flows.

Along with the announcement of the acquisition, Shell announced another round of divestments for the total amount of $30 billion. I expect Shell to sell most of BG Group’s low yielding assets, as the company has done successfully over the past year. For Shell, this strategy worked out great on the bottom line, and it would not be surprising if the company takes this same approach towards BG Group’s assets in order to improve the overall return on Shell’s investment.

Overall, I am confident that the acquisition fits perfectly in Shell’s long-term strategy to focus more on natural gas instead of oil.

Financial point of view

Apart from the good strategic fit, Shell needs to pay a total amount of $69 billion for the acquisition of BG Group. This price reflects a 50% premium on top of BG Group’s share price. Shell will pay around $19 billion in cash and $50 billion in stock. After the transaction, BG Group’s shareholders will own 19% of the combination (source: SeekingAlpha.com).

At first sight, the acquisition price seems a bit too high, especially since the deal will not contribute to net income per share in the first two years to come (source: shell.com). Shell expects to realize $2.5 billion in cost savings each year. However, the deal will only start having a positive effect on net earnings per share in 2017. Although many shareholders of Shell have a long-term perspective, a two-year time frame for this deal to work out for Shell’s shareholders is quite a long time.

Further, I question the financial structuring of the deal. Shell will pay just $19 billion in cash and $50 billion in stock. Then over the period 2017-2020, Shell will repurchase its own stock for the total amount of $25 billion. In fact, Shell finances this part of the acquisition price with future cash flows. Although this may sound logical, future cash flows need to be realized first. Given the fact that Shell needs quite a long time to make this deal work out financially, the amount of future cash flows remain uncertain. As a result, Shell risks a significant decrease of its return on equity.

In my opinion, Shell should have considered paying a much larger part in cash. First of all, the interest rates are historically low. Now is the perfect time to issue long-term debt with an attractive interest rate. Second, Shell risks paying much more per share in the period 2017-2020 than the company’s current share price. As a result, the net total number of shares outstanding (issued stock in 2015 minus repurchased stock in the period 2017-2020) will be much higher than expected by the end of 2020.

Overall, I do have some doubts regarding the financial aspects of the deal. Given the long-term time frame for this deal to work out for Shell’s shareholders, the uncertainties and risks rise as well.

Conclusion

Looking from a strategic point of view, Shell’s acquisition of BG Group makes perfect sense. However, looking from a financial point of view, the deal has several risks and uncertainties for Shell’s shareholders. Basically, it is up to Shell’s management to deliver the promised performance in order to make this deal work for its shareholders, e.g. the $30 billion asset sale, the realization of $2.5 billion in cost savings each year, free cash flow between $40 billion and $50 billion in 2020, continuing dividend growth, and total share repurchases of $25 billion before the end of 2020.

Despite my thoughts with respect to the financials, I believe this deal will work out for Shell and its shareholders. I am very confident that Shell’s management will deliver because it has a very strong track record over the past years (e.g. see this previous article). Further, Shell’s shareholders in general have a long-term investment horizon. So, they will not back down from a two-year time frame to get this deal to make sense from a financial point.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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