Interactive Investor

Stockwatch: scope for shares to double if this merger works

22nd July 2022 11:11

Edmond Jackson from interactive investor

A well-balanced portfolio of assets and ‘a real value opportunity’. Companies analyst Edmond Jackson revisits this tip and likes what he sees.

It is pertinent to re-examine both Tullow Oil (LSE:TLW) and Capricorn Energy (LSE:CNE) in light of an all-share merger declared on 1 June, and Tullow issuing a general update on 13 July. 

Assuming the merger is approved, Tullow would have 53% control and access to Capricorn’s cash balance – which ought to be at least $600 million considering it had $314 million cash at end-2021 plus $1 billion incoming from an arbitration award from the Indian government.  

Capricorn dropped a special dividend in favour of share buybacks and retaining cash for development, so unless there has been particular investment needs, its cash could be nearer $1 billion, or £836 million, which compares with a market value of near £1.1 billion. 

Bear in mind that some $76 million was expected from the sale of two North Sea fields, with further bonus payments possible amid strong production, and around $100 million may be achieved from a Senegal sale. 

While frustrating for Capricorn holders not to see a genuine substantive cash return, it potentially boosts the case for fresh buyers of Tullow.  

It would certainly slash debt, a chief reason why its stock has not responded to higher oil and gas prices. 

The merged group would have resources of one billion barrels of oil equivalent (bboe) – spread across Ghana, Egypt, Gabon and Ivory Coast. Mind that Africa means high political risk and Capricorn has for the last two years struck a $131 million operating loss. Mergers also intrinsically raise risk until integration is proven. 

Parallels with 20 years ago 

Oil and gas prices have overall more than doubled, largely due to Russia becoming an antagonist, and the major “integrated” oil and gas stocks re-rated. Yet indifference has prevailed towards Tullow and Capricorn (where I engaged the latter last 20 May). 

It quite reminds me of the early 1990s when smaller exploration and production stocks were out of favour, then were transformed by rising commodity prices. Premier Oil 10-bagged before it became mired in debt, with even greater gains by Dana Petroleum by the time it was taken over. 

What is different this time is a debt binge linked to central banks’ extensively loose monetary policy. I suspect a key reason for Tullow’s equity dropping from 55p last May to below 40p briefly and currently around 43p, is concern at the effect of belatedly rising interest rates on its circa $2.5 billion total debt. 

Potential firstly as a de-leveraging play 

Even before benefiting from Capricorn’s cash, Tullow says its debt reduction programme budgets for $75 Brent oil versus over $100 a barrel currently. 

The 13 July update is pre-consideration of integrating Capricorn and maintains $200 million free cash flow guidance for the full year 2022. The first half-year saw revenue of around $800 million versus capital expenditure of $155 billion, with $380 million capex likely for the full year. 

Net debt is not mentioned, although at end-2021 Tullow had $469 million cash and, in a latest webcast with analysts, the CEO guides for $1.9 billion net debt by end-2022 versus $2.1 billion at end-2021. 

Last year saw a $312 million net interest charge, up 22% and in context of $515 million reported operating profit.  

Perception of over-indebtedness has therefore weighed on Tullow equity, yet a merger with Capricorn would radically transform this, potentially shifting perception towards a “de-leveraging” play. Assuming, that is, that integration is reasonably free of issues.

CEO says the assets constitute a real value opportunity 

Appointed in April 2020 – fair time for a thorough assessment – Tullow’s CEO emphasises the quality of the company’s resource base, its operating efficiencies and drilling progress.  

Drilling is well ahead of targets: by end-2022, Tullow should have completed at least 10 and possibly 15 new wells. Ghanaian drilling has delivered seven new wells, some 10% below expected cost. 

Given these would come on-stream in 2023, a step-change in production is anticipated. Meanwhile, full-year production guidance is maintained at 59,000 to 65,000 bboe per day.  

Operations in Gabon have also improved while those in Kenya and Guyana are in line with expectations. 

Discussions continue with the Ghanaian government regarding a large gas development where Tullow has interests.  

The Tullow exploration and production (E&P) narrative alone, therefore, looks to have turned a corner – with potential to capitalise on higher energy prices.  

A scalable operating platform for the Capricorn assets 

Capricorn holders are to receive 3.81 new Tullow shares for each Capricorn share held. 

Cost synergies of $50 million a year are proclaimed, albeit requiring some $45 million exceptional costs over two years to fully achieve.  

Quite remarkably, a 1.0x debt-to-equity ratio is targeted by end-2022 “with rapid future de-leveraging anticipated”.  

This would appear to reflect Capricorn’s cash balance, yet only $75 oil is assumed to achieve it. 

It would lead to a “sustainable shareholder returns programme” with a base annual dividend of $60 million. With the enlarged group having over 2.2 billion shares, however, the yield is not initially going to be material.  

If management can deliver – not get embroiled in post-merger internal conflict – there looks a decent chance of a dynamic mid-cap E&P group evolving. 

A macro risk would be a recession impacting energy demand, especially if the US and Europe slow while China simultaneously struggles to contain Covid. 

Another is central banks raising interest rates more aggressively to contain inflation, although they would be unable to without causing a debt bust, so it depends which objective prevails. 

Tullow Oil - financial summary
Year end 31 Dec, reporting in US$

 2015201620172018201920202021
Turnover ($ million)1,6071,3601,8852,0481,7251,396          1,273
Operating margin (%)-68.1-55.51.225.8-80.3-72.940.4
Operating profit ($m)-1094-75522.4528-1,385-1,018515
Net profit ($m)-1035-600-17684.8-1694-1,221-80.7
Reported EPS (cents)-96.7-56.0-13.75.9-121-86.6-5.7
Normalised EPS (cents)-17.08.921.719.2-26.6-26.3-3.1
Op cash flow/share (cents)91.447.995.183.789.849.555.5
Capex/share (cents)16396.323.930.637.130.516.7
Free cash flow/share (cents)-71.2-48.471.253.152.619.038.8
Dividend per share ($)0.00.00.04.80.00.00.0
Covered by earnings (x)   1.2   
Cash ($m)356282284180289805469
Net debt ($m) 3,98247254,868 4,4524,2083,5823,263
Net asset value ($m)3,1552,230 2,7062,893 984-210-466
Net assets/share (cents)295208   19520869.9-14.9-32.5

Source: historic company REFS and company accounts

Legal & General has doubts, but JP Morgan is bullish 

Owning 1.7% of Tullow equity and 3.9% of Capricorn, L&G reportedly has “strong reservations” about the deal and sees “no clear strategic rationale”. 

Yet JP Morgan has seen it as a trigger to resume coverage and targets 82p with an “overweight” stance – arguing the merger would add scale by way of production and reserves and also strengthen the balance sheet. 

A speculative buy case 

Tullow is a mercurial situation albeit with a fair chance the market will at least respect de-leveraging. 

Consensus looks for around $375 million net profit this year, rising to over $420 million in 2023, generating earnings per share (EPS) of around 26p. That is jumbled by the proposed merger but, even if sketchy, a sub-2x price/earnings (PE) ratio with the market price of 43p leaves hefty leeway.  

Capricorn is expected to make around $57 million net profit this year, with EPS over 11p implying a PE nearer 20x at 215p a share – but at least the move into profitability, if achieved, should mitigate risk. 

Strictly, you would wait for more evidence about how this merger consummates. But taking a medium to long-term view could reward averaging into Tullow. 

I upgraded Tullow to a speculative “buy” at 45p last September, and by last March had reached 62p. Despite its drop back, it no longer appears a target for short sellers: within a 2.8% disclosed short position, all three hedge funds are steadily buying back equity. 

Nearly two months ago, I concluded with a “hold” stance on Capricorn given its activities were a moving feast for profit and cash flows. A well-balanced portfolio of assets merited ongoing attention, however. 

For higher-risk tolerant investors, I maintain Tullow merits interest. Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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