Energy giant Woodside Petroleum Limited (ASX: WPL) has set the sector alight with an audacious $12 billion takeover bid for Oil Search Limited (ASX: OSH) this morning.
Woodside is offering to swap one of its shares for four of Oil Search's shares, which implies an offer price of $7.65 a share if the bidder's closing share price on Monday is used.
I don't think this first all-scrip bid will be enough to win over Oil Search's shareholders and Woodside will probably have to throw in a cash component if it is serious about clinching the deal.
Both stocks are in a trading halt and Woodside's offer price stands at a 13.6% premium to Oil Search's last traded price.
This isn't enough for a few reasons. If the bidder only wants to offer scrip, it will need to hand over a bigger premium as I don't particularly like deals with only equity swaps as history has shown that such mergers do not generate a good enough return – particularly for shareholders in the bidder. I own shares in both companies.
Secondly, 13.6% isn't much of a takeover premium. The average premium is around 20-30% and given the attractiveness of Oil Search's PNG LNG project, any bidder will need to cough up for the asset.
The price of liquefied natural gas (LNG) may be low and set to go lower, but the low cost and large scale nature of PNG LNG puts Oil Search in an enviable position to weather the downturn in energy prices.
Oil Search's balance sheet will soon be flush with cash from the ramp up of the project and I consider the stock to be the most attractive large cap in the sector.
Woodside has a strong balance sheet too with net debt to equity at less than 25% but it doesn't have much in the way of growth options and it was only a matter of time before it would be forced to make an acquisition.
This is the perfect time to be hunting for assets too given that the S&P/ASX 200 Energy (Index: ^AXEJ) (ASX: XEJ) Index has shed more than 40% over the past year and the cost of debt is so low thanks to record low interest rates.
But the fact is, Woodside needs Oil Search more than Oil Search needs Woodside – and for this reason alone Oil Search is worth more than a 13.6% premium, if Oil Search shareholders can even get that.
Woodside shares are likely to fall when trade resumes, while Oil Search will go the other way as the market forms the view that a sweeter offer will have to be tabled.
One also can't rule out another bidder entering the ring, although the Papua New Guinea government will have to give its blessing for any merger since it holds a 10% stake in Oil Search.
The support of the PNG government is one of the conditions Woodside has placed on any potential deal. The takeover is also conditioned on the satisfactory completion of due diligence on Oil Search, a period of exclusivity and the execution of a mutually acceptable confidentiality agreement.
Oil Search shareholders should be hanging on to their stock. This takeover saga has only just begun.
