Devon-PennzEnergy merger seen as favorable

The U.S. financial community has taken a generally positive view of the proposed merger of Oklahoma City's Devon Energy Corp. and Houston's PennzEnergy Co.

The two companies announced a definitive merger agreement May 20 (OGJ, May 24, 1999, Newsletter). The deal would create a top-10 U.S. independent oil and gas producer.

Following news of the merger, several credit-reporting agencies either upgraded both firms' credit ratings or put them on watch with positive implications.

Only one ratings firm sees the deal as possibly detrimental to Devon. Standard & Poor's put Devon on watch with negative implications, although it sees the deal as potentially beneficial to PennzEnergy.

The merger

The Devon-PennzEnergy merger agreement would create an upstream independent with a reported total enterprise value of about $4.7 billion.

The new Devon Energy will be headquartered in Oklahoma City. PennzEnergy Chairman James L. Pate will be chairman, and Devon Pres. and CEO J. Larry Nichols will be president, CEO, and a director.

Highlights of combined operations, as of yearend 1998, include:

Total proved reserves of 660 million boe, composed of 52% natural gas and 48% liquids.
U.S. proved reserves of 423 million boe.
Canadian proved reserves of 144 million boe.
North American reserves consisting of about 60% natural gas.
Non-North American reserves of 93 million boe, primarily in Azerbaijan.
Net production of 230,000 boed, comprising about 60% gas.

The firms also have a large inventory of exploration prospects and together hold 15 million net undeveloped acres.

The companies hope to save $50-60 million/year as a result of the merger, which will be accounted for as a purchase. They will incur a one-time, non-cash charge of $350-500 million, after-tax. The exact amount of this charge will depend on oil and gas prices, say the companies.

Under the share-exchange deal, 0.4475 share of the new Devon Energy would be exchanged for each PennzEnergy share. The new firm would be owned 69% by former Devon shareholders and 31% by former PennzEnergy shareholders.

This is a revealing ownership split, given the somewhat even division of the firms' exploration and production assets.

PennzEnergy owns about 55% of their combined reserves and about 57% of combined average daily production (see table [157,103 bytes]).

However, PennzEnergy's 1998 results were considerably worse than Devon's. PennzEnergy lost $261.3 million last year on revenues of $837.4 million, while Devon lost $60.3 million on revenues of $387.5 million.

Reactions

Financial analysts have taken a mostly positive view of the announcement.

Moody's Investors Service placed PennzEnergy's Ba2 senior unsecured rating under review for possible upgrade following the merger announcement.

"PennzEnergy has suffered from recent negative operating and financial trends, including declining production, above-average unit operating costs, and internal cash flow that fell well short of capital spending needs for full replacement of reserves at the company's historic finding and development costs," said Moody's.

"Moody's ratings review will focus on the strategic benefits of the combination, including: the overlay of operations and opportunities to achieve cost reductions without impairing future performance, the company's financial and operating strategies, growth initiatives for incremental production, and the levels of capital spending needed to develop the combined reserve base."

Credit Suisse First Boston (CSFB) raised its rating on Devon's stock to "strong buy" from "buy." The underlying valuation of Devon creates limited downside in the worst-case scenario, says CSFB.

Banc of America Securities and Goldman Sachs both raised their Devon ratings, Banc of America Securities to "buy" and Goldman Sachs to "trading buy." And Duff & Phelps Credit Rating Co. placed PennzEnergy on rating watch with positive implications.

A negative for Devon

Standard & Poor's put both companies' ratings on watch, with positive implications for PennzEnergy and negative ones for Devon.

"Despite the potential to create significant long-term value," said S&P, "the transaction will result in a more leveraged company from the perspective of Devon's creditors. Creditors of PennzEnergy, however, will benefit from a much stronger obligor if the merger closes.

"Net long-term debt is expected to rise to $1.3 billion or about 50% of total capitalizationellipse.Nevertheless, Devon will have a very strong capital structure, relative to the universe of exploration and production companies, even before it completes its plan to reduce debt by approximately $500 million via asset sales and the issuance of new equity."

Depending on the rate and extent of debt reduction, says S&P, the new Devon's ratings could be either affirmed or lowered.