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Shell paid too much to buy BG Group


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On April 8, Royal Dutch Shell (RDS.A) (RDS.B) (RDSA) (RDSB) announced its intention to acquire BG Group (BRGYY) (BG.) in a $70 billion cash-and-stock deal that values BG’s equity at GBX 1,350 per share, or 11% above our GBX 1,200 fair value estimate for BG at the time the deal was announced.

The deal will be roughly 70% stock and 30% cash, and it’s expected to close in early 2016. Our BG thesis has been that near-term execution problems and political issues in Brazil and Egypt were creating an attractive entry point for long-term investors.

And to be sure, a company of Shell’s size and financial health is in a great position to take a long-term view. But the 50% premium Shell is offering over BG’s April 7 closing price is a rich offer. We’ve increased our BG fair value estimate and lowered Shell’s to reflect the offer price.

BG Group is a major player in natural gas and liquefied natural gas production, areas that Shell has been focusing its capital spending. BG Group’s assets complement Shell’s by providing access to Brazil’s attractive deep-water plays and the North American shales, among other resources.

Shell intends to significantly restructure the combined company by selling $30 billion of assets during 2016-18 and cutting capital spending compared with what each company was planning to spend on its own. Approximately $1 billion in operating synergies are also expected to be realized by combining the companies. Provided that oil prices recover and reach at least $70 per barrel in coming years, management believes it will be in a position to repurchase $25 billion of shares during 2017-20. Combined with the company’s pro forma $14 billion annual dividend, this is a significant return of capital to shareholders.

After our in-depth review of Shell’s acquisition of BG Group, we reduced our fair value estimate by roughly 3% based on our belief that the firm overpaid for this purchase; its no-moat rating is unchanged. We raised our fair value estimate for BG to GBX 1,280 per share from GBX 1,200, and its narrow moat is intact.

Key Questions From Investors About This Megadeal

Was this a fair price given that BG was a stock we believed was very undervalued? 

Even when considering that Shell is having to pay a takeover premium, this looks like a pricey acquisition. BG indeed looked very attractive to us and was one of our favored upstream stocks, especially for names with meaningful oil exposure. However, this deal was 11% above our GBX 1,200 fair value estimate, and 52% above where BG’s shares were trading. The premium Shell is paying, in our view, at best makes this deal a fair one unless long-term oil prices trend well above our $75 Brent midcycle forecast.

Can Shell make good on its promise to pay a $15 billion all-cash dividend and repurchase $25 billion of stock from 2017 to 2020?

We’re skeptical. Dividends and buybacks on this scale require $30 billion of asset sales to be executed as planned, successful realization of synergies, and a meaningful recovery in oil prices. These factors that Shell can control are a tall order given its operational record. Investors should keep in mind that Shell has made many bold promises in recent years that wound up being missed by a wide margin (for example, its previous target to grow production to 4 MMboe/d by 2017; the company wound up being unable to grow production at all).

Should Shell have considered buying a different company in order to address its weaknesses, such as a weak shale portfolio, or was bolstering its strengths in deep-water and LNG the right move from a strategic standpoint?

This is being asked a lot in the wake of the deal given Shell’s weak shale portfolio and the notion that higher-quality assets could be potentially for sale either now or in the coming quarters. We can see both sides to this argument, but most important to us is the price paid for a given set of assets. If you can purchase high-quality Brazilian oil reserves at a steep discount to fairly valued U.S. tight oil, we’d take the former. This of course didn’t happen given the 50%-plus takeout premium Shell is paying.

Does this deal signal that an M&A wave is about to start in the oil and gas sector?

Not necessarily. RDS was down 6% on April 8, which is hardly an endorsement that major M&A activity is what investors want. Of course, part of the swoon in Shell’s shares was due to it overpaying for BG. However, the idea that we’ve entered a period similar to the late 1990s, where the majors need to become larger companies in order to survive, is simply not the case today. We expect more M&A activity from here to be sure, but this also could well be the biggest deal during this downturn by a large margin.

What are the risks that the deal will not go through as planned?

BG closed on April 7 at 7% below Shell’s offering price, indicating that the market believes there is at least some chance the deal may not be consummated. That said, we’re not aware of any reason that this acquisition would not go through. We are risking the value of this deal for both companies by 5%, which we believe is sufficiently conservative.

Shell’s Fair Value Estimate Drops Following Rich Bid for BG

We’ve lowered our Shell Class A fair value estimate to $58 per ADR from $60, and our Class B fair value estimate to $61 per ADR from $63. Our valuation is based on our midcycle price estimates for oil and natural gas, which we forecast to be $75/bbl for Brent, $69/bbl for WTI, and $4/mcf for U.S. natural gas (Henry Hub). Beyond our midcycle oil and gas estimates, our financial forecasts use near-term energy prices based on Nymex future contracts for the next 36 months. For Brent oil pricing we currently use $58 per barrel in 2015, $65 in 2016, and $69 in 2017. WTI oil pricing is forecast to average $50 in 2015, $58 in 2016, and $62 in 2017. We forecast Henry Hub natural gas (U.S.) to be $2.78 per mcf in 2015, $3.18 in 2016, and $3.38 in 2017.

Shell’s two share classes possess the same rights, except Class A shares are domiciled in the Netherlands, whereas Class B Shares are traded in London. What this ultimately means is that Class A shareholders must pay a dividend withholding tax, and this can be claimed only on U.S. taxable income reported to the Internal Revenue Service. In other words, tax leakage is possible (in tax-sheltered accounts). U.S. investors don’t have to pay withholding taxes on U.K. dividend income, which makes Shell’s Class B shares a simpler proposition from a tax perspective. This has led to Class B shares trading at a premium (recently 3%-7%) to Class A. Accordingly, we apply a 5% discount to our valuation of A shares.

Low Oil Prices Keep Shell Without a Moat

Given our view that long-term oil prices will be well below $100 going forward because of the emergence of low-cost U.S. tight oil, we don’t believe Shell’s assets are cost-advantaged enough to provide it with a lasting competitive advantage that will allow it to generate excess returns on capital. Despite plans to lower capital spending, cut costs, and delay high-cost projects, we believe Shell will continue to generate weak returns on capital for the foreseeable future. The core issue here is that Shell is simply too high up the global cost curve and lacks meaningful exposure to high-quality U.S. oil and gas shale resources. Additionally, its downstream footprint is geographically disadvantaged and is underexposed to cost-advantaged markets such as the U.S. Gulf Coast and midcontinent. This segment is thus also a drag on returns. Adding it up, we don’t believe that Shell still possesses an economic moat.

New CEO Shows Promise for a Better-Run Shell

Shell faces what amounts to an almost existential crisis: Even when oil prices were $100, its portfolio was strewn with problems. Huge bets on shale that destroyed capital, cost overruns on key projects (the Motiva refinery, for example), and a chronically poor-performing downstream all combined to leave the company with very weak returns on capital. Even though significant restructuring actions have begun under new CEO Ben van Beurden, the recent collapse in oil prices adds considerable pressure that we think the company will struggle mightily to overcome. After all, Shell’s issues of poor execution and capital efficiency predate even ex-CEO Peter Voser, who was responsible for a lot of the recent poor strategic choices.

Thus far, van Beurden has done all he can, and oil companies surely will be able to cut costs significantly from here to better align themselves with the new oil price environment. But investors should not expect miracles; Shell isn’t Exxon (XOM) or Chevron (CVX), and never will be. Improvements are expected, but the firm is far more likely to remain a laggard than become a leader among the oil majors for the rest of this decade.

Shell has made some big mistakes in recent years: aggressive betting on shale gas and exploration while lacking the requisite knowledge to effectively evaluate acreage it was purchasing, cost overruns at multiple megaprojects, and failure to aggressively restructure its downstream segment. To be fair, errors such as these haven’t been uncommon in the large-cap oil space during the past half-decade, but for Shell they seem far more common. New CEO Ben van Beurden seems to be running the firm much better than his predecessor Peter Voser did. While miracles shouldn’t be expected, we think it’s very likely that Shell will be better-run going forward compared with the past few years.

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