Fourth Bid Lucky For Santos?

A considerably higher bid has emerged for Santos ((STO)), after several in recent weeks, as Harbour Energy returns with an offer that the Santos board finds encouraging, allowing due diligence to proceed.

Santos disclosed that, during late March, Harbour Energy made offers of $6.25/share and $6.37/share before finally launching a $6.50/share indicative bid. This is considerably higher than the offer Harbour Energy made back in August 2017 at $4.55/share.

The $6.50 bid is a 28% premium to the stock’s last close and a 30% premium to the one-month volume-weighted average price (VWAP). The US dollar-denominated consideration is US$4.98 a share, comprising a cash component of US$4.70/share and a special fully franked dividend of US$0.28/share.

Harbour Energy’s plan to invest heavily in Santos is likely to result in a materially higher valuation than Morgans currently estimates. The broker calculates Harbour Energy is offering 17x 2017 free cash flow and 20x 2P reserves, a steep premium to valuation, but maintains a Reduce rating with an unchanged valuation-derived target of $4.31.

Morgans has always struggled with its valuation of Santos, given the company’s opposing priorities of de-leveraging its balance sheet and increasing investment in its diversified operations.

UBS envisages risks around due diligence and remains cautious about the prospect of a firm bid emerging. Due diligence items are likely to revolve around abandonment liabilities as well as the company’s participation in the Darwin LNG backfill and PNG LNG expansion. The main variables to the broker’s valuation are the oil price and discount rate.

To justify $6.50/share UBS would need to de-risk all growth projects and assume an oil price of US$75/bbl. The broker acknowledges the risk of underperformance in the near term has been lowered by the increased probability of a formal takeover offer and the recent rally in oil prices.

Citi suspects Santos is unlikely to start talking about growth in order to get a higher bid, as the offer is now at a point where the company is willing to engage. Therefore, if the bid fails, the market is unlikely to pay more for growth than previously indicated. Citi believes investor investment horizons will dictate whether they consider the bid to be a fair price, or too low relative to the potential upside.

Gas Demand

The offer only makes economic sense to the buyer if the value of gas reserves and resources in production or in the ground are re-priced substantially higher, Shaw and Partners asserts. The broker suggests the street view of the stock’s value is well below the proposed offer, which captures an option on higher gas prices, or higher gas production from projects that are not yet sanctioned.

The broker notes industry activity supports the rising value in Australian gas, noting Woodside ((WPL)) has bought more gas and smaller domestic companies are increasing activities to find, appraise or develop gas. AEM reports also document a drop in supply from fields offshore in Victoria.

Meanwhile, the broker points to unsatisfied demand for gas in China that is driving Chinese companies on a global spending spree. Hence, the solution to Australia’s gas supply gap is the development of new fields and investment in new infrastructure, although all remaining resources the broker identifies are owned by small companies which lack the capability to meet the shortfall.

Credit Suisse firmly believes that Harbour Energy intends to push more gas through the latent capacity at GLNG. Yet, the broker is overwhelmed by the US$7.75bn debt package Harbour Energy has announced, particularly when coupled with US$2.5bn of Santos corporate debt, which it assumes is retained.

Credit Suisse is also interested in how much the company’s tax revenue would reduce, given the interest costs on this pile of debt, and asks how can commitments on capital expenditure be assured if the oil price declines again.

FIRB Hurdle

The conditions on the offer remain the largest hurdle. Foreign Investment Review Board (FIRB) approval may be difficult to obtain given the national significance of GLNG and the Cooper Basin. As Santos is no longer a material east coast gas supplier, UBS expects the FIRB to look at Harbour Energy’s plans for the Cooper Basin and WA gas.

Morgans suggests the FIRB could be enticed by the commitment by Harbour Energy to invest heavily in the assets, that could take some pressure of the east coast gas supply balance and partly lower GLNG’s reliance on third-party gas. However in a global climate where energy security ranks amongst the highest concerns, the broker suspects this is where the official focus will be.

If Harbour is successful, it would remove the only Australian participant in the GLNG joint venture, while also handing over the controlling interest in the Cooper Basin gas venture to a US fund. This is a critical hurdle to overcome, brokers suggest, for the offer to proceed to a formal bid.

Offer Conditions

The offer is conditional on a minimum 15% of existing Santos shares rolling over into unlisted shares in a special-purpose company that will remain invested in Santos. Morgans is uncertain regarding just how Harbour Energy can achieve a minimum 15% of existing stock staying invested in an unlisted entity.

Conditions also includes binding debt financing commitments, completion of confirmatory due diligence and regulatory approvals, as well as a unanimous recommendation of the bid from the Santos board.

FNArena’s database has one Buy rating (Credit Suisse), three Hold and one Sell (Morgans). The consensus target is $5.45, signalling -7.2% downside to the last share price. Targets range from $4.31 (Morgans) to $6.35 (Credit Suisse).