Chevron (CVX 0.44%) is making a big splash. The oil giant has agreed to acquire PDC Energy (PDCE) in an all-stock deal valuing the oil and gas producer at $7.6 billion, including the assumption of debt. The company expects the highly complementary transaction will be accretive to all its key financial metrics, including adding $1 billion to its annual free cash flow.
Here's a closer look at the deal and how it will benefit the oil stock, which remains a top holding of Warren Buffett's Berkshire Hathaway (BRK.A -0.28%) (BRK.B -0.68%).
Drilling down into the deal
Chevron is exchanging 0.4638 of its shares for each PDC Energy share, implying a purchase price of $72 per share or $6.3 billion. That's a 14% premium to PDC Energy's average price over the last 10 trading days. It's also assuming PDC Energy's roughly $1.3 billion in debt, pushing the transaction's total enterprise value to $7.6 billion.
The deal is highly strategic for Chevron. In commenting on the agreement, CEO Mike Wirth stated, "PDC's attractive and complementary assets strengthen Chevron's position in key U.S. production basins." PDC Energy has 275,000 net acres adjacent to Chevron's position in the DJ Basin, adding over 1 billion barrels of oil equivalent reserves to the oil company's total. Chevron will also add 25,000 net acres in the Permian Basin, growing the company's position in that high-quality resource basin. Chevron will increase its oil equivalent reserves by 10% for less than $7 per barrel.
Wirth also noted that the deal is "accretive to all important financial measures and enhances Chevron's objective to safely deliver higher returns and lower carbon." The company expects the acquisition to add about $1 billion in annual free cash flow at $70 oil and $3.50 natural gas, which are the current futures prices for those commodities.
Structured to protect shareholders
Given the oil giant's elite balance sheet, Chevron's decision to pay stock to acquire PDC Energy is worth noting. The company could have easily paid cash. Chevron ended the first quarter with nearly $16 billion of cash on its balance sheet, giving it an ultra-low leverage ratio of 4.4%, well below its 20% to 25% target range.
However, Chevron uses its stock to make deals to protect shareholders from commodity price volatility. CEO Mike Wirth noted on the company's first-quarter conference call: "We tend to use equity for M&A because commodity prices are volatile. It creates a more stable deal structure."
The company prefers to use its cash and cash flow to deliver on its four financial priorities:
- Growing the dividend
- Investing in its traditional and lower carbon businesses
- Maintaining a strong balance sheet
- Repurchasing shares
By preserving its cash and balance sheet strength, Chevron could potentially repurchase shares at a lower price in the future if commodity prices decline. The company's low-cost resources and balance sheet flexibility will enable it to repurchase a minimum of $10 billion of shares annually through 2027 at an average oil price of around $60 a barrel (more than $10 below the current price). That's about 3% of its outstanding shares. Meanwhile, if prices are higher, it maintains the upside to repurchasing up to $20 billion of its stock annually, or about 6% of its outstanding shares. In other words, Chevron will easily repurchase enough shares to offset the dilution of this deal within the next year.
Enhancing the buy thesis
Chevron's shareholder-focused approach has made it a top holding of Warren Buffet. Berkshire currently owns 7% of Chevron's outstanding shares, worth over $20 billion. That's 7.1% of Berkshire's stock portfolio, making Chevon the 5th largest holding.
The PDC Energy deal makes Chevron an even better buy. It adds significant low-cost resources and boosts its annual free cash flow by $1 billion starting next year. That will give Chevon more money to allocate on behalf of shareholders, including buying back the shares it will issue to complete the deal. The deal will also further enhance Chevron's ability to sustain and grow its nearly 4%-yielding dividend. That makes it an acquisition that Buffett and those who follow him should love.
