Kerr-McGee, Part 2 (Drip Port) February 12, 1999

<THE DRIP PORTFOLIO>
Kerr-McGee, Part 2
It's time to vote. Plus, Touchstone Friday.

by Jeff Fischer (TMFJeff@aol.com)

ALEXANDRIA, VA (Feb. 12, 1999) -- Continuing from Thursday's column, today we either put Kerr-McGee (NYSE: KMG) to rest, or we crown it a Round One winner. Following a description of the company on Thursday, it's now time to consider the fiscal side of ol' Kerr-McGee.

Valuation: Kerr-McGee's stock drilled another new low to end the week. At $30 per share, its market capitalization is $1.45 billion. This is the value granted the company despite the fact that Kerr-McGee has a book value of $35 per share, and owns more than $3 billion in assets. The assets are not producing meaningful returns now. When oil prices rise, the assets will be worth more to investors because they'll create more value. Simple.

Next... in the red corner, wearing the red boxers... is Oryx Energy!

Kerr-McGee should acquire Oryx Energy (NYSE: ORX) by the end of this quarter, following a shareholder vote on February 26th. At $10 per share, Oryx has a market value of $1.18 billion. (Its book value is only $1.34 per share.) So, the combined companies have a market value of over $2.6 billion with annual sales topping $2.3 billion. Oryx has a heavy 8.8 debt-to-equity ratio, however, which ruins Kerr's low debt-to-equity ratio of 0.54. Why is Kerr acquiring Oryx, a $1.1 billion company, at a price of over $3 billion? Because one must include the heavy debt in the acquisition price. When you include debt to determine the new company's enterprise value, we have a total price tag close to $5 billion for the combined firm.

The earning estimates for these companies are literally guesses. They depend almost entirely on oil prices, because oil drowns out (in size) the importance of the company's chemical and natural gas businesses.

Kerr-McGee is hoped to rebound and earn $1.76 per share this year and $2.48 per share in 2000. Oryx is expected to lose money again in 1999, to the tune of a $0.28 per share loss, but then turn a small profit of $0.19 per share in 2000. Combined, the companies should be able to work more efficiently by the end of 1999, creating some savings. Until that time, count on these estimates as a good case scenario for both companies.

The stock of Kerr-McGee trades at a significant discount to larger oil companies. Exxon (NYSE: XON) trades at 25 times estimated 1999 earnings, and 22 times the year 2000 estimate, while Mobil (NYSE: MOB) is at 27 times this year's estimate. Independently, Kerr-McGee trades at 17 and 12 times the next two year's estimates. Err, guesstimates.

Profitability: Kerr-McGee's net profit margin (net income divided by revenues) was 4.4% in 1998, down significantly from 11% in the prior two years. Low oil prices are much to blame, and the company is also paying to restructure itself and sell non-core businesses. Oryx, on the other hand, achieved 14% net profit margins in the boom years before 1998, when it actually lost money. Both of these profit margins (11% and 14%) are the highest that we've seen in our oil and gas study, and yet both of these stocks have been net-flat over the past decade and longer.

Why?

For more context, which is definitely needed, we'll look at each company's return on capital employed (ROCE). We define ROCE as "operating earnings divided by the sum of total debt plus shareholders' equity." For a comparison to strong market-beating stocks, Mobil estimated that its ROCE was 10.1% last year, down from 14% a year earlier, and Brian estimates that Exxon's 1998 ROCE was 11% in 1998, down from 15.6% in 1997. ROCE for both companies rose steadily this decade until the sharp decline in oil prices.

So, what are the ROCE figures for Kerr-McGee and Oryx? Well, you tell us. Fools voted that we analyze this industry, and we've since been doing this study together in spirit (as always, and on the message board). The math for ROCE is easy and is explained above. Please post the ROCE that you find for Kerr-McGee and for Oryx in the Drip Companies message board, and then we'll discuss it on Tuesday (the stock market is closed Monday).

Part of the reason for doing this is to show how people determine different ROCEs for the same company, and to discuss that. The other part is: ROCE is important to understand before you invest in any oil company. The high net margins at these companies would make one think that the stocks would perform well. Why haven't they?

Leverage: As we covered, Oryx has a leery-making debt-to-equity ratio of 8.8, with $1.2 billion in long-term debt and recent shareholder equity of $157 million. This will significantly impact Kerr's low debt-to-equity ratio of 0.54.

Use of Cash Flow: Kerr pays a very hefty dividend yield of 5.75%. Oryx doesn't pay a dividend at all. The new combined company? Not sure yet. We are sure how they'll utilize capital expenditures this year, however.

Combined, the companies recently announced plans to spend $545 million in capital expenditures for 1999, which is down 45% from combined expenditures last year. $430 million will be spent on exploration and production (the company will produce 190,000 barrels of oil daily, and 580 million cubic feet of natural gas), while $130 million will be spent on its chemical business.

Beyond that, Kerr-McGee recently announced that it rescinds its 1998, $300 million stock repurchase program due to the acquisition. Whether or not management begins another repurchase plan soon is anyone's guess. With share prices at levels seen ten years ago, one wouldn't be surprised if management moves to buy shares; however, there is Oryx's debt to consider and the dividend to be paid. Incidentally, nothing has been said about lowering or halting the dividend. The notion of decreasing the dividend isn't too outlandish given the industry's condition, yet, such a move would probably harm the company more than it'd help: the news would lower the share price immediately.

The Snapshots for Kerr-McGee and Oryx: Study Kerr-McGee's snapshot and the snapshot for Oryx at your leisure.

Conclusion: That's up to you. Do Kerr-McGee and Oryx make it to Round Two? Why or why not? Is the high dividend and low price-to-book value at Kerr calling your name? Are you able to look past 10 years of underperformance? Will the Kerr-Oryx DRP be friendly (right now Kerr requires $750 to start, which we could do if we sold a certain lagging position and saved up for a few months). Finally, what are these companies' ROCE figures, anyway? Post your analysis and your decision on the Drip Companies message board.

We'll be here to report the results on Tuesday and move onto our next contender, too.

Touchstone Friday. Our last $100 was sent to Mellon Bank (NYSE: MEL) on January 22. We haven't heard back yet, which isn't surprising. Our investment for this month will be sent, most likely, to Mellon again. We'll announce with certainty next week. We also have an extra $40 to send because, as shown in the numbers below, we sent $40 to Intel (Nasdaq: INTC) several months ago, but the transfer agent apparently never received it. The check has never been cashed.

So, this month we'll send $140. If we're sending any to Mellon, we must send at least $100 (that's the minimum), and that's probably what we'll do. Mellon is still by far our smallest active position. The extra $40 will go to Intel or J&J, most likely. (Or maybe to Mellon, too.) Again, this'll be decided early next week. As always, no rush -- plus, what you do should be your own decision, entirely.

As for columns: this past week George talked P/E ratios on Monday. Are they important? See George's column and then discuss it with other Fools. On Tuesday, Brian tackled the new BP Amoco (NYSE: BPA). The company scored well enough to advance to Round Two. On Wednesday, Brian (the ever-efficient) covered the $280 billion behemoth, Exxon Mobil. It also moved to Round Two. Nobody was surprised. On Thursday, I (the non-efficient) didn't even finish little $1.2 billion Kerr-McGee. We introduced Kerr and Oryx. Now the ball is in your court: dump it, or keep it for round two?

Have a Foolish long weekend. You have three days to think about it and then share your analysis on Kerr-McGee! Fool on!

[To discuss these columns, please visit the Drip Companies message board on the Web.]

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