In the aftermath of the news that European integrated energy giant Royal Dutch Shell (NYSE:RDS-A)(NYSE:RDS-B) will buy BG Group in a nearly $70 billion deal, speculation quickly turned to who's next. Deal speculation is ripe in the energy sector now that the price of crude oil has fallen by nearly half since the highs reached last year.
One of the most frequently mentioned takeover targets is BP (NYSE:BP). Ever since the 2010 oil spill in the Gulf of Mexico, BP has sold off billions of assets to cover the financial penalties. This has left BP a smaller, slimmed-down company, and quite vulnerable to a takeover attempt.
While BP still has some prized assets, and a takeover from a bigger integrated major such as ExxonMobil Corporation makes some sense, it's not likely to happen. Investors buying BP now should do so because of the company's high cash flow and industry-leading dividend, not because of the flimsy takeover rumors.
Better reasons to buy BP
To be sure, BP has a number of things going for it from an investment perspective. The company offers a nearly 6% dividend yield, which places it at the top of the integrated majors. This in itself is a compelling reason to buy the stock. Indeed, BP has taken great strides in restoring its dividend since the Gulf spill, after suspending its dividend in the immediate aftermath of the spill, and then restoring the payout at half its previous rate.
BP's dividend is still well below its pre-spill level, but the company has raised its dividend modestly in the years since the spill. Between 2012 and 2015, BP has grown its dividend by 42%. BP has been raising its dividend by about 9% per year in this time. If BP can keep this dividend growth rate going, it won't be too long before the dividend is fully restored to its former greatness. The prospect of a 6% dividend yield along with 9% dividend growth makes BP a very attractive dividend stock for income investors.
It's reasonable to think BP can keep growing its dividend. Even though oil prices are down significantly in the past year, BP still generates more than enough cash flow to support its generous payout. That's because of BP's integrated model, which provides balance even when oil prices crash. A sudden, sharp decline in oil prices like the one we've seen over the past year can actually benefit refiners, because volatile fluctuations in commodity prices create wider refining spreads. This causes downstream margins to expand, thereby improving refining profitability.
To demonstrate, consider that BP's downstream segment produced $1.2 billion in profit before interest and tax last quarter, a huge increase from just $70 million in profit in the same quarter in 2013. This helped offset a 41% decline in upstream exploration and production profits. Overall, BP generated $32.8 billion in operating cash flow last year, up 55% from $21.1 billion in 2013.
ExxonMobil may not have the appetite
While BP's fundamentals have recovered since the Gulf spill, the civil trial is still ongoing. This is the trial that will determine whether BP was grossly negligent in its actions, and will also clarify the amount of oil that spilled into the Gulf. If the ruling goes against BP on both fronts, the company could face as much as $13.7 billion in additional penalties. This alone is probably enough to keep ExxonMobil on the sidelines -- at least until the fines are behind BP once and for all.
Moreover, ExxonMobil may not have the appetite for another major deal, because its last one didn't exactly go well. ExxonMobil is the most frequently mentioned possible suitor for BP -- it's the biggest energy company in the world, and it's one of only a few companies with the financial resources to allow such a huge acquisition. But as investors may remember, ExxonMobil spent $41 billion to buy out natural gas giant XTO Energy, just before natural gas prices plunged. ExxonMobil CEO Rex Tillerson later admitted the timing was poor. This may give him additional reservations about making another massive deal.
Buy BP, but not because of M&A rumors
The bottom line is that it makes some sense for ExxonMobil to buy BP, based mostly on the premise that ExxonMobil is one of the only companies that could afford to. However, BP's legacy issues from the 2010 Gulf spill haven't been resolved yet. That, and the fact that ExxonMobil already made a massive buyout that now looks bad in hindsight, probably mean BP will remain an independent company.
Still, BP remains a good stock to buy for a number of reasons. The stock pays a sky-high dividend, and the company is generating strong free cash flow. Those are much better reasons to buy the stock than the flimsy BP takeover speculation that arises every few months.