Investors shouldn't be surprised by Phillips Petroleum's (P Quote - Cramer on P - Stock Picks) decision to acquire Tosco (TOS Quote - Cramer on TOS - Stock Picks). And it may only be the beginning of a new round of consolidation among refiners.
Phillips, the nation's 11th-largest integrated oil company (based on market capitalization
), will acquire Tosco, the largest independent refinery in the U.S. for $7 billion in stock. The deal calls for Phillips to issues 0.8 shares for each share of Tosco. Phillips will also acquire $2 billion in Tosco debt.
Phillips said the deal would be immediately accretive to earnings, assuming $250 million in postmerger synergies. To assure accretion, Phillips also announced a $1 billion stock buyback. The companies expect the deal to close by the end of the third quarter.
The combination creates a refining giant, second to only
ExxonMobil (XOM Quote - Cramer on XOM - Stock Picks) in the U.S., with 1.71 million barrels per day of refining capacity, compared to Phillips' 360,000 barrels per day prior to the merger. "We are acquiring the assets and expertise of the country's largest independent refiner and marketer, and combining the complementary skills of the two companies, including Tosco's refining capabilities," Phillips Chairman and Chief Executive Officer Jim Mulva said in a statement announcing the merger.
Tying the Knot
Phillips' refining capacity increased by more than four times via the deal |
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Phillips has long been rumored to be on one side or the other of ongoing consolidation in the integrated oil and refining business.
Talks between Phillips and
Chevron (CHV Quote - Cramer on CHV - Stock Picks) ended when Chevron and
Texaco (TX Quote - Cramer on TX - Stock Picks) decided to tie the knot last fall. Still, many analysts and investors believed Phillips remained in play.
At last week's
Credit Suisse First Boston Energy Summit, refining executives were peppered with questions about the possibility of a merger with Phillips. "We would be interested [in a deal with Phillips]," said William Greehey, chairman, president and chief executive officer of
Valero Energy (VLO Quote - Cramer on VLO - Stock Picks). "We could add significant value to Phillips." However, Greehey noted that conversations between the two companies had not taken place.
However, one fund manager believes the Phillips-Tosco marriage makes sense. "I was a bit surprised given Phillips was talking about a refining and marketing joint venture," said Doug Hohertz of
The Mitchell Group, a Houston energy investment firm and a member of the
TSC Energy Roundtable. "However, if you look far enough out, we are going to be short refining in this country, so it makes sense. And, Phillips said it would still focus on higher-return exploration and production projects. So, in the end, I think it works."
Next?
Phillips' marriage with Tosco brings up the question as to whether additional refining consolidation will follow.
As commodity prices rise and refining margins widen, the cash positions of the refiners and integrated oil companies make acquisitions both possible and attractive. "Given the improved strength of the independent refiners' balance sheets, we would expect further consolidation," said CSFB oil analyst John McNulty in a report prepared for last week's summit.
Indeed, the refiners are talking like they are ready to spend cash to grow through acquisitions. "We do expect to do something with the cash," said Valero's Greehey. "We are looking at several acquisitions right now. I think for the next two years there will be plenty of opportunities to grow through acquisition in the U.S."
Additional combinations in the integrated oil sector are possible as well. "There are a lot of companies that have businesses and assets that would look good in the Conoco family," said Robert McKee, executive vice president of the exploration and production division of
Conoco .
One analyst believes the Phillips news should spark a rally among the independent refiners. "We believe the acquisition of Tosco by an informed corporate buyer validates our view that the refiners should be valued at greater than 10 times forward estimates, not the current average of 8.2 times our 2001 estimates,"
Merrill Lynch analyst Andrew Fairbanks told clients Monday morning.
Undervalued?
Independent refiners could energize your portfolio |
| Company | Recent Price | Market Cap
(in millions) | Estimated EPS | Merrill Lynch Price Target* |
 | | | 2000 | 2001 | |
| Ashland (ASH:NYSE) | $39.92 | $2,59 | $4.35 | $4.75 | $47.50 |
| Sunoco (SUN:NYSE) | 34.47 | 2,75 | 3.70 | 4.60 | 46.00 |
| Tesoro (TSO:NYSE) | 12.30 | 501 | 1.35 | 1.50 | 15.00 |
| Ultramar Diamond Shamrock (UDS:NYSE) | 32.90 | 2,622 | 4.30 | 4.60 | 46.00 |
| Valero Energy (VLO:NYSE) | 37.30 | 2,184 | 4.60 | 4.90 | 44.10 |
Source: Company Reports, Merrill Lynch, CSFB
*Based on 2002 EPS Multiple of 10x EPS, excpet VLO which is 9x |
Fairbanks says the move should increase the visibility of the refiners and push stock prices higher. "We believe the market will begin to recognize that the refiners are unique, valuable enterprises and will begin to price them at higher levels," he says.
Fairbanks upgraded a number of the refining companies, including making
Ultramar Diamond Shamrock (UDS Quote - Cramer on UDS - Stock Picks) his top pick. (In October 1998 Ultramar and Phillips agreed to a joint venture combining some of their North America refining and marketing assets, but terminated the agreement in March 1999.) He rates the company buy. He also increased his ratings on
Sunoco (SUN Quote - Cramer on SUN - Stock Picks) to long-term buy and Valero to accumulate. His firm has not provided banking services to any of the companies mentioned. However, Merrill did advise Tosco in the current transaction.
While Fairbanks believes higher valuations for refiners will result from the Phillips-Tosco merger, he doesn't think it means additional mergers are imminent. "Our investment case is not predicated upon the other refiners being imminently taken over at high valuations," he told clients. "We believe the Tosco transaction will have a positive effect on the only disappointing element of the refining equity story, that is the current valuation being accorded the group."
The Mitchell Group's Hohertz agrees. "I don't think it leads to a wave of consolidation," he said, adding he's not even sure the merger will lead to significantly higher valuations for the group. "The refiners are cheap on an earnings basis, but given where the refining business has been over the last decade or so, I don't think investors will pay a high premium right now."
And, while Hohertz agrees that many of the companies are carrying a fair amount of cash on the balance sheet, he says much of it will be used to retrofit refineries to meet increasingly stringent environmental standards. "The refineries have a tough road ahead of them, especially to meet new fuel specs," he says. "It won't help refining capacity. They will have to spend more money on meeting those specs and less on expanding capacity and acquisitions."
Valero's Greehey agrees. "The new environmental regulations all mean lower supply," he said. "The new regulations will cost our industry $16 billion. That means capital will have to be directed to meet these specs and not for strategic projects."
Still, if Greehey is correct, Monday's deal is only the beginning. Consolidation will become part of refiners' growth plans -- at least at Valero -- in the coming years.
Christopher Edmonds
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