Norsk Hydro Scores Coup

Some say the Statoil deal's real value is in Norsk Hydro's aluminum operations.
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The day after

Statoil

(STO)

and

Norsk Hydro

(NHY)

announced plans to merge their oil and gas activities, the deal is being widely viewed as a coup for Norsk Hydro's shareholders.

The deal is expected to unleash the "hidden value" of Norsk Hydro, whose oil and gas assets have been trading at a deep discount because they are bundled up with the value of the company's aluminum operations. Norsk Hydro is currently the world's third-largest producer of aluminum, trailing

Alcoa

(AA) - Get Report

and

Alcan

(AL) - Get Report

.

"The deal will form a pure-play oil and gas company out of Hydro, which right now is an industrial conglomerate," says Arnstein Wigestrand, an analyst for the Scandinavian investment bank SEB Enskilda AS.

Wigestrand also saw the pairing of the two companies' oil and gas operations as a potential cost saver. "Statoil and Norsk Hydro have been competing for the same assets, which has probably ended up with larger prices for some of those assets," he says. "This deal will create a larger and stronger company which will be able to win international assets more successfully."

In Norway Tuesday, DnB NOR Markets downgraded its recommendation on Statoil to hold from buy, while reiterating its buy stance on Norsk Hydro and lifting its price target on the stock by 21% to 215 Norwegian kroner, or about $35.50 for the ADRs.

UBS and Dresdener Kleinwort cut their stances on Norsk Hydro to neutral and sell, respectively, after Monday's big rally but upped their price targets for the company to 200 Norwegian kroner and 170 Norwegian kroner respectively. (In U.S. trading, Norsk Hydro ADRs jumped 19% Monday and closed up another 3% to $30.48 Tuesday. Statoil shares dipped 3.2% Monday but closed up nearly 1% to $26.97 Tuesday.)

"On paper it's a so-called merger among equals, but it's fair to say that Statoil is paying with its own shares" for Norsk Hydro's oil and gas assets, says Morten Normann, a senior research analyst at Kaupthing AS, noting that Statoil's reserves and production facilities double those of Norsk Hydro's.

Norsk Hydro will end up owning 32.7% in the newly combined company, while Statoil will hold a 67.3% stake. For every share in Norsk Hydro, investors are expected to receive 0.8622 shares in the new company, which is not yet named; despite the brand power of the name, the new company will not be called Statoil, according to senior executives at the oil giant.

In Oslo, investors are now beginning to take note of the remainder of Norsk Hydro, which will form a stand-alone company. It is not thought that the new, slimmer Norsk Hydro will be pursuing M&A discussions.

After Monday's rally, Normann sees the real value play right now in Norsk Hydro's aluminum operations, which he says are still trading at a hefty 50% discount to earnings. "If Hydro and Statoil were the only two companies in my universe right now, I'd be long Hydro and short Statoil," he said. "And if I was looking at buying both companies right now, I'd be buying at a ratio of three to one, on Hydro's side."

Other analysts concur.

"Statoil paid too much," says Martin Molsater of the U.S. investment bank First Securities. On the basis of calculations of the value of Norsk Hydro's current oil and gas field assets, Statoil overpaid by 20 Norwegian Kroner per share, according to First Securities.

While bullish on the deal, Molsater points out that if oil prices continue to decline, investors in both companies have more to lose now that the plans have been announced. "What we'll see now with this transaction is that the decline will start from a much a higher level than before the merger plans were announced," he says.

Statoil has been pursuing a merger with Norsk Hydro's oil and gas operations for three years now. The last attempt at talks in late 2004 ended when the Norwegian state -- which owns 71% of the company and 44% of Norsk Hydro -- ended the discussions abruptly.

This time, however, the government is behind the merger plans. The Norwegian state is expected to take a 62.5% stake in the combined company, with a view to increasing that stake to 67% pending parliamentary approval. The newly combined company is expected to be valued at 600 billion Norwegian kroner, or $97.15 billion. Right now, Statoil has a market cap of 363 billion Norwegian kroner, or $58.59 billion, while Norsk Hydro is valued at 228 billion Norwegian kroner, or $36.91 billion.

There are still important aspects of the deal that remain to be ironed out, however. While analysts generally think Norsk Hydro's oil and gas division is a good strategic fit with Statoil's operations, investors are still waiting to see the companies' plans for combining operations and reducing costs.

One of the key factors will be successfully pairing Norsk Hydro's international exposure with Statoil's more regional focus. Right now, Norsk Hydro has more international exposure than Statoil, although the latter has been aggressively buying up positions this year in the Gulf of Mexico.

Statoil says the new company, to be formed officially in the third quarter of 2007, will continue this purchasing spree. "This is a merger driven by the ambition to grow, and this new company will definitely have growth ambitions," says Vice President Ola Morten Aanestad.

Daniel M. Harrison is a Norway-based freelancer. He has no positions in stocks mentioned.