With energy giant Woodside Petroleum Limited (ASX: WPL) making an audacious $12 billion takeover bid for Oil Search Limited (ASX: OSH) earlier this week, there has been renewed speculation of Santos Ltd (ASX: STO) becoming a takeover target. With investors considering the merits of Santos as a takeover play, here are four good reasons why it is hard to justify.
Balance sheet
Santos' balance sheet is in a poor state. Its FY2015 half-year presentation delivered last month showed its net debt as at 30 June was $8.8 billion. The majority of this debt is denominated in USD, meaning it is impacted by the AUD/USD exchange rate. Since June, the AUD/USD exchange rate has depreciated a further 7 cents. By Santos' own calculations, this increases its net debt by approximately $700 million, which puts the current net debt figure closer to $9.5 billion. With a market capitalisation hovering around the $4.5 billion mark, and even accounting for proposed asset sales, it will be hard to avoid a capital raising.
Commodity prices
Santos is operationally leveraged to the oil and gas price. To combat the 47% reduction over the past 12 months in the average realised oil price, it has reduced capital expenditure by more than 50%, and unit production costs by 11%. But it hasn't been enough. To remain free cash flow positive, it needs to sell oil at US$45 to US$50 per barrel at an AUD/USD exchange rate of between 70 cents and 75 cents. At present, neither metric is in its favour.
Australian dollar vs U.S. dollar
Which brings us to the AUD/USD dilemma. Within the next 6 to 12 months, many financial commentators are predicting the Aussie dollar will drop to the mid-to-low $0.60s. At 65 cents, net debt would reach a staggering $10 billion. An upshot would be an increase in the value of its U.S. assets, as well as operating cash flow, but that is little compensation against such a large debt.
Share price
Santos is down 45% year to date, and almost 70% in 12 months. But this doesn't mean the company is "a bargain". A takeover target needs to be attractive in more areas than just price. The fundamentals in Santos don't stack up at present, and it is difficult to pinpoint a company that could make a deal work.
Foolish takeaway
Santos is facing strong head winds with high debt levels, low oil and gas prices and a depreciating Australian dollar. Investors would be foolish to ignore the high risks of investing in Santos in the vain hope of a takeover offer emerging.
