DEVON ENERGY'S deal last week to buy Ocean Energy didn't sit well with some Ocean investors. At a time when energy prices are soaring, Ocean's holders are slated to receive only a small premium for their shares. Monday Devon Energy agreed to purchase Ocean, for just under $20 a share in stock, a 4% premium to Ocean's closing price the previous Friday. Devon is paying $3.5 billion, or $5.3 billion including the assumption of Ocean debt.
Late Friday, Ocean was trading at 20.08, up 81 cents on the week, and roughly at parity with the value of the deal, in which 0.414 of a Devon share will be exchanged for each Ocean share. Devon was changing hands at 48.46, up 23 cents. The merger, which is expected to close in May, will create the largest U.S.-based independent oil and gas producer, with a market value of $11 billion and a total enterprise value (debt and equity) of $20 billion.
"The deal is disappointing," says Alan Fournier, a principal at Pennant Capital, a Chatham, N.J., investment fund that holds Ocean stock. "Ocean should have auctioned the company."
Fournier says Ocean has great assets, including an interest in a valuable oil field off the coast of West Africa and productive fields in the Gulf of Mexico, that make it worth at least $25 a share. Ocean traded at 21 as recently as December, when energy prices were lower.
Fournier thinks Ocean accepted the deal partly because its management, led by CEO Jim Hackett, is due to get senior positions at Devon. "It's pretty clear their intention was preserving their jobs," he says.
Hackett is slated to get the No. 2 spot, as Devon's chief operating officer, and there has been speculation that Ocean's CFO, William Transier, will become CFO at Devon. This would mark a rare instance in which the CFO of an acquired company gets the job. No decision has been made on the CFO job, according to an Ocean spokeswoman. Devon's chief executive, Larry Nichols, will retain his position after the merger.
In an interview Thursday, Hackett defended the deal, saying that while the transaction might not sit well with "investors wanting a quick return on their money," it will benefit long-term holders because of the strategic benefits of combining the two companies. "This generates the maximum value for shareholders over the long run," he said.
Hackett said employee concerns about job security played a role in the decision to merge with Devon rather than put the company up for auction. He said other potential buyers are free to approach Ocean with a higher cash offer, and that Ocean will consider any such offer. But Hackett doubts a better bid will emerge. "We don't think there's a superior alternative out there," he said.
Some have suggested that ExxonMobil, the dominant partner in Ocean's West African oil venture, could buy Ocean and claim full control of the field, whose reserves now are estimated at a billion barrels. "Our sense is that they [Exxon] aren't interested," Hackett says. Exxon has been reluctant to buy independent North American oil and gas companies in recent years. Its rival, Royal Dutch Petroleum, has bought E&P companies, but the view on the Street is that it probably isn't interested in Ocean because it doesn't want to be a junior partner to Exxon in the West African field.
Fournier thinks Ocean holders ought to keep their stock, based on a possible higher bid. With Ocean trading just about at deal value, investors are paying nothing for this effective call option. Any buyer seeking to top Devon would have to pay a $139 million break-up fee -- less than $1 per share.
Jeffrey Mobley, an oil analyst at Raymond James, says the deal "probably will go though" despite objections from some Ocean shareholders. Prior to the announcement he had a "strong buy" rating on Ocean, with a $29 price target. Mobley and others think the company can generate 10% annual growth in oil and gas production, starting in 2003.
Devon's production is expected to grow just 2% this year. "Ocean shareholders may not be receiving as good a deal as Devon shareholders, given the increased financial leverage and lower growth profile of the combined entity," Mobley said in a client note.
Ross Margolies, manager of Salomon Brothers Capital fund, an Ocean investor, says Ocean holders "have a gripe but not a horrible one." He figures Ocean could be worth $25 a share within a year because of the appreciation potential of Devon. Barron's profiled Devon favorably last summer, when its stock was at 40 ("Here's the Drill," Aug. 12, 2002), because of its acquisition savvy.
Table: Drilling Down
"This is a great deal for Devon," Margolies says. Not only does it raise Devon's production prospects but it reduces the company's debt leverage from 61% of total capital to about 52%. Devon's $7 billion of debt is a legacy of its many acquisitions in recent years.
Ocean looks attractive relative to its peer group based on some financial measures, and pricey based on others. At 20 a share, Devon would be paying just over 10 times projected 2003 profits of $1.85 a share, and a modest 4.5 times cash flow, based on Ocean's enterprise value divided by its projected earnings before interest, taxes, depreciation and amortization. These levels are slightly below the valuations of Ocean's peers.
Ocean is pricier, based on enterprise value to proven reserves, another key industry measure. Its reserves are valued at about $1.45 per thousand cubic feet, based on gas metrics, or about $9 a barrel in crude-oil terms. Ocean has significant potential, but unproven, reserves in West Africa and the Gulf of Mexico.
Devon trades for 10 times projected 2003 profits of $4.86 a share and for about 4.9 times cash flow.
Although the E&P stocks have moved up in recent weeks, they're no higher than in December. Yet gas has risen to $6 per million BTUs from $4, and oil has surged to $37 a barrel from $30. Investors apparently are concerned that oil and gas prices will plunge after a war with Iraq. But Margolies thinks high prices for energy, especially gas, are likely to hold, and his funds have increased their exposure to energy significantly since year-end.
If no other company comes forward with a bid for Ocean, that will be negative for the sector. In the meantime, Ocean investors have a right to wonder whether management was looking out for itself or for shareholders.
-- Andrew Bary
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