The oil industry has an abysmal track record of creating value for investors, especially when it comes to merger-and-acquisition (M&A) transactions. Recent deals have caused financial ruin because most companies were too bullish on their oil price assumptions, which came back to bite them when crude crashed earlier this year.
However, even though the industry's prior attempts at consolidation failed, it still must go down that path, given the need to cut costs to better combat persistently low oil prices. It might finally have found the right strategy blueprint in Devon Energy's (DVN +0.99%) merger of equals with WPX Energy (WPX +0.00%).
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Joining forces without breaking the bank
One of the biggest issues with oil mergers in recent years is that buyers paid huge premiums for their targets, funded in part by a significant amount of debt. The poster child for this destructive strategy is Occidental Petroleum (OXY +0.07%), which wrestled Anadarko Petroleum away from Chevron (CVX 0.51%) by swooping in with a bid $5 billion above the oil giant's offer. Worse yet, Occidental used debt to fund most of the $57 billion deal. It had hoped to sell $10 billion to $15 billion of assets to help pay down the debt, but that strategy blew up when oil prices tanked earlier this year. As a result, Occidental is struggling to get its balance sheet back on solid ground.
Instead of paying a hefty premium to acquire WPX Energy, like most of the sector's recent botched deals, Devon and WPX are combining via a merger of equals. The all-stock transaction's exchange rate implies a low-single-digit premium to WPX's closing price on Friday, so it will be highly accretive to the combined company's financial metrics on a per-share basis. The companies see it improving their combined operating cash flow by 5% to 10%, doubling free cash flow, and reducing the oil price level needed to maintain a steady production rate to just $33 a barrel.
Furthermore, the all-stock deal will preserve their financial strength since Devon and WPX boast leverage ratios well below the industry average. The combined company will also have more than $1.7 billion in cash and minimum near-term debt maturities, with the next meaningful one not due until 2023. Though it plans to use a large portion of that cash to pay off $1.5 billion in debt in the near-term to strengthen its financial position.
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A new way to reward shareholders
Another aspect of this transaction that stands out is Devon's new dividend strategy. The company plans to implement a variable dividend. This new program will feature a base dividend of $0.11 per share -- Devon's current rate -- and a variable distribution paid quarterly as long as it meets certain criteria.
The base dividend would consume about 10% of the company's operating cash flow. Meanwhile, the variable distribution would be up to 50% of its excess free cash flow, which is operating cash flow minus capital expenditures and the base dividend. Devon would make that additional quarterly payment as long as it had a cash balance of more than $500 million, a strong balance sheet backed by leverage at its target level, and a constructive commodity price outlook. It expects to start paying this variable dividend as soon as it closes the WPX deal.
This industry-first variable dividend stands out as it would immediately reward investors during periods of higher oil prices as they'd receive a large portion of the excess cash via a variable payment. In a sense, the variable payout will replace share repurchases, which, like M&A, has destroyed more value across the industry than it has created. However, Devon will consider opportunistic share repurchases with the other 50% of its excess cash that it doesn't return to investors via the variable dividend as well as high-return growth projects. Though by immediately paying a large portion of its free cash flow to investors each quarter, Devon will avoid the temptation of using those funds to accelerate its production growth rate, which has also proven to be a disastrous strategy for the sector. Instead, it will reward investors during good times, while ensuring it has a large enough safety net to endure another downturn.
A potentially winning idea
Devon Energy and WPX Energy have laid out a very compelling blueprint for consolidation in the oil patch. The transaction will combine two equally strong companies and enhance their financial profile. On top of that, they're rolling out a unique variable dividend strategy to immediately send a high percentage of excess cash back to investors instead of allocating it toward items like buybacks and accelerated growth that haven't worked for the sector in the past. This mold-breaking merger might therefore set a new trend of designing deals aimed at enriching shareholders instead of empire-building.
