Over the last decade, there has been increasing merger and acquisition (M&A) activities all around the world. There are many reasons why companies would engage in M&A activities; creating synergies being one of the main incentives.
However, not all companies would get a positive result if due diligence and strategic decisions are not planned carefully. In March 2009, Suncor and Petro Canada, two of the most well known oil companies in Canada, proposed to merge together to create the biggest oil company in the country. The deal would produce a new integrated national champion and is said to result in C$1. 3 billion annual savings for the combined company. Suncor would be able to cut costs at its oil sands operations by adding Petro-Canada’s oil sands properties to keep growing notwithstanding the low oil prices.
Despite all the advantages, the companies were faced with antitrust issues as many were concerned that a monopoly would occur in the industry. This paper will evaluate if both firms made the right decision to merge by analyzing their motivations, deal transaction, as well as looking at the pre and post merger performance comparison. Before we get into details of each company’s background and the impact of the transaction, it is important to firstly look at the economic and industry trends that force the two companies to merge. Global Recession
The bursting of the United States housing bubble, which peaked in 2005 – 2006, was the main cause of the 2007 financial crisis. This crisis was infectious as it spread worldwide causing a global recession. The real gross domestic product (GDP) growth rate of the United States for 2009 was forecasted at a rate of 2%. This is relatively low when being compared with the worldwide GDP growth, which was averaging 4. 5% in years prior to the 2007 financial crisis.
The growth of 2% is also considerably low when compared with the real GDP growth rate of 3. 8% and 4. % in 2008 and 2007 respectively in the United States. The fact that the U. S. economy was in a state of recession in 2008 had minimal effects on the worldwide real growth rate. However, the state of the U. S. economy had a substantial impact on countries, mainly Canada and Mexico whose own economies rely heavily on that of United States. The real GDP growth rate for Canada will therefore be negatively impacted and decrease due to the conditions of the U. S. economy. In Europe, countries were also negatively impacted with real GDP growth rates declining.
In the Middle East, however, oil prices remained high, which allowed the GDP growth rates to remain strong in energy-exporting countries at roughly 5%. Emerging markets in Asia, such as India and China, also maintained a higher real GDP growth rate of about 6% – 8% forecasted for 2009 as compared with the United States Industry Trends In 2009, a good number of firms had to put most of their growth projects on hold and shifted their focus on reducing capital spending due to the effects of the recession.
The economic crisis from 2007 to 2010 was actually considered by many economists as the worst since the great depression. During this time, the energy industry did not escape the economic situation since it generally plays a big part in many economies across the world. More specifically, oil prices reflect the word supply and demand for power as well as the state of the global economy. In 2008, the price for crude oil was around US$130 per barrel while the economy was in bad shape, exemplified by the crash of the stock market.
Once 2009 came along the price per barrel fell to about US$30; this drop in price is explained by terrible economic situation and the lack of demand that came with it. Looking at the oil prices from a wider perspective ranging from years 2000 to 2010, prices varied between US$30/barrel and US$70/barrel with a low of US$20/barrel and a high of US$130/barrel in 2008. Due to the economic crisis, there was a general reduction in oil consumption and in some ways was a good thing. Crude oil inventories had a chance to build up and help production since oil prices were predicted to increase once again in 2010.
This boost in inventory also helped the fact that crude oil is a scarce resource being abused daily and will very soon to be extinguished. For this same reason, there is a trend in the industry of finding alternate sources of energy other than oil. Massive dollar amounts are being spent by many firms in research and development in the hopes of finding cheaper, renewable and economically friendly alternatives. Some examples include an increase in wind power, the use of biofuels, which are produced using large amounts of corn, in addition to experimental energy alternatives still in the works uch as hydrogen fuel. Market Background The gasoline market is a very competitive one, and in Canada the price we pay at the pump is subjective by four factors;
- municipal, provincial, and federal taxes,
- the market for crude oil and exploration on an international level,
- the market for refined or finished product as the continental level, as well as
- the retail gasoline markets on a local level.
Market prices are set by supply and demand; increases in price usually stem from a lack of competition, which will decrease the supply of the good all the while its demand curve remaining intact. Price fluctuation can also be derived from foreign exchange, especially the U. S. Dollar/Canadian dollar as a barrel of oil is always priced in U. S. dollars internationally. Petro Canada Background Petro-Canada prides itself as Canada’s gas station. Petro-Canada competes in the oil industry, both producing and selling gasoline to the millions of Canadian citizens; with its head quarter is located in Calgary, Alberta.
They currently operate more than two hundred Petro-Pass facilities, more than two hundred bulk plants as well as a grand total of twenty eight terminal locations. Petro Canada has operations in Algeria, the Netherlands, Tunisia, the United Kingdom, Syria, Italy, Libya, Trinidad and Tobago, Venezuela, Morocco and Norway. Petro-Canada is committed to customer service and satisfaction, reliable year-round service, a dedicated local support staff as well as offering environmentally responsible products.
The introduction of the Preferred Price gas savings program has helped the company to not only increase its customer base, but also retain loyal customers by implementing a switching cost which will hopefully deter consumers to vary brands when it comes to the purchase of gasoline in Canada. The Preferred Price card allows customers instant cents-per-liter savings for every fuel purchase, making the card more than a simple prepaid fuel card; according to North Star research , the most popular purchase motivator when it comes to gasoline is savings.
In 2008, Petro Canada had a debt-to-equity of 23. %, up by 100 basis points compared to last year which is a rather healthy number as a whole; they remained well below their long-term range they had set form themselves which was a range between 25% and 35%. Also their debt-to-cash flow from operating activities was 0. 7 times, a slight dip from 1. 0 times the preceding year. This result was also under their range which was set at no more than 2. 0 times which shows that Petro-Canada has maintained a very balanced level of any debt they have taken on when compared to either its cash flows from operating activities (short-term) as well as equity (long-term).
Petro Canada Motivation Since Petro-Canada was a former Crown corporation under the Public Participation Act, which does not allow shareholders to own more than 20 percent of the firm’s shares outstanding, this merger would make the company more valuable from the investor’s point of view. Historically, stock performance indicated that the company had been suffering from the decline in stock prices from $60. 00/share on May 22, 2008 to its trading price of $29. 35/share on March 20, 2009 according to Bloomberg data.
The fact that Petro Canada comes to the merger with Suncor would boost its share price since Petro-Canada benefits from Suncor’s strong financial performance. In terms of management and organizational improvement, the merger between Petro Canada and Suncor would be a good resource funding the firm’s development projects in Edmonton, Fort Hill mine, up grader and Montreal cocker. These projects’ completions will bring significant earnings to the operation. Also, Petro Canada and Suncor share the same business vision which would enhance the performance and bring the Canadian energy industry to the next stage supporting the economy.
Suncor Background Suncor is successful today because they are the only company who, back in 1967, believed that Canada’s oil sands could be developed commercially in which they pride themselves on. Suncor is Canada’s premier integrated energy company, which is the fifth largest in North America, and has a presence globally as one of the largest independent energy firms. Its products include oil sands, which they extract bitumen from and transform it into refinery feedstock and most importantly diesel fuel.
Suncor also produces natural gas, which they use as hedging against internal consumption. In addition, they are currently investing in a number of international and offshore projects; like the Libya Exploration and Production Sharing Agreements, which is supposed to double daily production, the Syria Ebla Gas Development, which would produce 80 million cubic feet per day of natural gas, and the White Rose Extensions, North Amethyst and West White Rose Satellite Extensions, which are expected to add reserves of approximately 50 million barrels.
When it comes to refining, Suncor’s operations allow its resources in Canada to flow into the North American energy market; Suncor’s refineries operate out of numerous locations including Edmonton, Alberta, Montreal-Quebec, Commerce City, Colorado, and Sarnia, Ontario. Also, it is important to mention that Suncor is a pioneer when it comes to responsible development. They operate the largest ethanol facility in Canada, which is integrated with fuel to reduce the impact on the environment. Suncor also owns four wind farms, which helps reduce carbon dioxide emissions by about 284, 000 tones every year.
Suncor`s financial statements from 2008 show that their debt-to-equity ratio was up to 35. 2% compared to 24. 3% in 2007. Their recorded net earnings in 2008 were $2. 1 billion, which is $800 million lower than the net earnings from 2007. Suncor`s stock price was down in both the Toronto stock exchange and the New York stock exchange in 2008 compared to the prior year with prices of $23. 72 and $19. 50 compared to $53. 96 and $54. 37. In addition, production also went down 271 000 barrels in 2007 to 264 000 barrels in 2008.
The motivation for Suncor to merge with Petro Canada is comprised of numerous business and financial benefits. As mentioned earlier, the merger propelled Suncor to the fifth largest energy company in North America and boosted its production to 19 billion barrels. Petro Canada also brings its experienced management team to the table who add complementary cultures, leading environmental and social responsibility practices. In terms of the economy of scope and scale, the merger with Petro Canada brings Suncor to a higher quality asset portfolio which contributes oil sands growth opportunities.
Its production capacity increases to 433,000 barrels per day with a reduction cost of $300 million per year and a cut of $1. 3 billion annual operating costs via capital spending and job reductions. Also, Suncor can expand its resource base of 7. 5 billion oil equivalent (boe) barrels of developed and undeveloped which brings Suncor to own a resource of 19 billion. The firm can lower its production costs in producing crude oil and natural gas from the North Sea, North Africa and Latin America. Strategy and Setting Analysis Suncor Energy has always strived to be Canada’s premier integrated energy company.
Prior to the merger with Petro-Canada, Suncor primarily focused on oil production and refinery in areas such as oil sands development and upgrading as well as conventional and offshore oil and gas production. The merger with Petro-Canada has allowed the merged energy company to have an increased hold on the product marketing and resale aspect of the oil and gas market. The merger has created the largest independent energy company in Canada, offering all of the services and production elements that a premier energy company should. Suncor, like most companies, has a goal and inherent strategy of achieving continued growth.
The company believes that the key to continued growth lies in a more diverse and financially flexible company with a strong focus on further investment in oil sands extraction and production. Through the merger with Petro-Canada, the merged company is now a larger, stronger and more financially flexible corporation with the ability to make adequate investment in oil sands operations. The synergies offered by the merger by means of both scale and scope has trimmed over one thousand employees from the company and resulted in operating savings of $400 million.
Other than M&A activity, Suncor has completed many significant investments before merging with Petro Canada such as health care at Mc Murray, boreal wetland conservation, charitable and non profit group, ethanol plant expansion, build stronger community through the united way, etc. In January 30, 2008, Suncor announced that it has received final approval of $20. 6 billion to invest in crude oil production which is located in McMurray. It was expecting to increase crude oil production capacity to 550,000 bpd in 2012.
This project includes constructing four additional stages of in-situ bitumen production, a new up grader to convert that bitumen into higher-value crude oil, and various infrastructure and utilities. The development results in updating new technologies which can help Suncor to expand or growth in return and reduce environmental footprint. According to George, president of Suncor, “Suncor’s in-site operations disturb only about 15% of land, as compared to oil sands mining and more than 90% of the water needed for the process is recycled”.
Amounting to $20. 6 billion in investment, Suncor has already invested approximately $2. 5 billion on detailed engineering, site work and fabrication of major vessels. After the announcement of the crude oil investment, the stock return on the market has increased from $44. 74 to $46. 21 according to Yahoo Finance data, which shows that the investment has positive impact on the market. Terms of the Transaction On March 23rd, 2009, Suncor Energy Inc. announced its intent to acquire competing rival Petro-Canada.
The merger of these two oil companies created Canada’s largest energy company as well as the fifth largest energy company in North America with a total market capitalization of $46. 7 billion as of April 27, 2009. This new entity is currently conducting business under the name of Suncor Energy Inc. and is listed on NYSE under the symbol SU. The need for cost savings due to the harsh industrial and economic conditions the two companies were facing was the driving factor behind this merger. The merger allowed a reduction of $1. 3 billion in annual costs.
These cost savings are said to come from liquidating overlapping operations, improved logistics, streamlining business practices and job reductions. The combined company will be benefiting from a strong financial position and greater financial flexibility with a pro forma debt-to-capitalization of about 30% along with a debt-to-CFO ratio of roughly 1. 3 times. The merger between these two companies was worth about C$18. 43 billion and consisted of a stock transaction. In this arrangement, Petro-Canada shareholders received 1. 28 common shares of the new company Suncor Energy for every common share of Petro-Canada owned.
Suncor shareholders received one common share of the new company for every common share of Suncor owned. This resulted in 40% ownership by former Petro-Canada shareholders and the remaining 60% ownership was attributed to Suncor shareholders. Thus, Petro-Canada was acquired at a 28% premium when compared to the closing price of Petro-Canada’s stock of 29. 67 Canadian dollars on Friday March 20th, 2009. Suncor Energy stock dropped C$0. 16 to $30. 74 compared to the previous closing price prior to merger announcements of $30. 90.
On the other hand, Petro-Canada’s stock increased by C$6. 5 to $35. 70 after the merger announcement was made public. In a letter to the shareholders of Petro-Canada and Suncor Energy, it was announced that the newly merged entity will comprise of eight former board members of Suncor Energy and four former board member of Petro-Canada. It was also stated that 66. 66% of Suncor Energy and Petro-Canada’s shareholders votes must approve the merger for it to occur. Petro Canada shareholders were the first to approve the deal at more than 96% in favor, which later was followed with 98% vote of Suncor shareholders supporting the merger.
Furthermore, the exchange of shares for the newly created entity will generally be tax-deferred for the shareholders of both companies. As of April 27, 2009, there were 484,894,005 shares of Petro-Canada and 936,789,920 shares of Suncor Energy outstanding. Following the completed merger it is expected that, based upon the number of shares previously outstanding by the two companies on April 27, 2009, that there would be 1,557,453,616 shares outstanding and no Senior Preferred Shares of Junior Preferred Shares outstanding.
Lastly, if the occurrence of any damaging event, as outlined in the information and proxy package, the company held responsible for any damages will be obliged to pay $300 million within two business days to the other party. Also, if a breach of representation, covenants, or warranties occurs, as outlined in the arrangement agreement, the party in fault will pay a fee of $20 million the terminating party. The merger of Suncor Energy and Petro Canada was effective as of August 1, 2009, after the approval of the Competition Bureau was received in July of 2009.
The approval is reflected in a consent agreement with the Competition Bureau that the companies have agreed to take steps to maintain retail and wholesale competition in Ontario, including divesting 104 retail locations, and entering into certain supply and throughput arrangements in Ontario for a period of 10 years.
In order to valuate Petro-Canada, we have decided to use the discounted cash flow method in order to price their stocks and find the end result of how much Suncor should pay for this merger. By using Bloomberg, we have established an adjusted company beta of 1. 54 for Petro-Canada. In order to calculate the average market return we used the S;P500 as our standard and used historical data dating back to 1970; this covers forty years of data which allows us to avoid any years where there were significant fluctuations in regards to market returns (i. e. 2008 market crash). With the aid of Yahoo!
Finance, we used the closing price for the S;P500 and calculated market returns year over year. According to our calculations, the average market return over the past forty years is 8. 19%. Our risk free rate was provided via Bloomberg as we used Canadian T-bills as our benchmark over the past twenty years, which gave us a historical return of 6. 23%; this gives us a market premium return of 1. 96%. According to our findings, Petro-Canada’s cost of equity is 9. 25%; Re: Rf + ? (Rm – Rf), Re: 6. 23% + 1. 52 (8. 19% – 6. 23%) = 9. 25%. According to their 2008 financial statements, we found an equity weighting of 76. %, which means the remaining 23. 5% of the weight is allocated to debt.
The effective tax rate used by Petro-Canada is 46%. Calculating the company’s cost of debt via their 2008 financial statements, we found that Petro-Canada has issued a total of nine different bonds each with their own coupon rates as well as maturity dates. By using the face value of each bond, coupled with its current market value, time to maturity, as well as coupon rates allowed us to figure out each bond’s yield to maturity.
Taking into consideration the weights of each bond, our calculated cost of debt for Petro-Canada turns out to be 7. 4%. Now that all inputs have been calculated, we can apply the weighted average cost of capital (WACC) for Petro-Canada, which according to our findings is equal to 7. 99%; WACC: Wd * Rd * (1-Tc) + We * Re, [7. 24% * 0. 235 * (1-0. 46)] + [9. 2545% * 0. 765] = 7. 99%. Next, both short-term as well as long-term growth rates are needed in order to apply the discounted cash-flow model to Petro-Canada. By using their total sales dating back from 2003, our calculated short-term growth rate was inaccurate due to high volatility in sales year over year.
Therefore, in order to calculate short-term growth rates we have used the company’s average return on equity against its average retention ratio over the past six years. On average, return on equity was calculated at 21. 83% while the average retention ration was 90. 55%; this leads to a short-term growth rate of 19. 77% which we will be using to project the next five years for our DCF model. Long-term growth rate was calculated by using the past twenty years of Canada’s gross domestic product growth rate; this calculation gave us an average long-term growth rate of 0. 4%.
We opted to use the past twenty years of data instead of a ten year term, which netted us a growth rate of 0. 42%, simply due to the fact that all our calculations thus far have been based on a scale of twenty years minimum. Based on our DCF calculations, we have found that the present value of total equity for Petro-Canada to be roughly $26B. With a total number of shares outstanding of close to 485M, this results in a price of $53. 73 per share of Petro-Canada. At the time of the merger, Petro-Canada was trading at $29. 5, meaning it was undervalued by 55% according to our findings.
If we compare this to what Suncor paid as a per-share basis, they also paid less than our per-share calculation; although Suncor paid a “premium” to merge with Petro-Canada, they paid at a discount of roughly 40%. Sensitivity Analysis In order to properly evaluate the use of the short-term and long-term growth rates in our calculations, we have applied a sensitivity analysis to both rates as to determine the effects of a change in the growth rate on the final valuation provided by the discounted cash flow model.
The analysis demonstrated that it is the long-term growth rate that effects the valuation so drastically due to the steep increase in the termination value. On the other hand, the short-term growth rate has a far less drastic effect on the valuation of the company. Long-Term (Perpetual) For the long-term growth rate, we decided to use a rate of 0. 58%. By default, it is common to use zero as a long-term growth rate since it is impossible to determine long-term growth in any industry due to the multitude of factors that affect such growth.
For our case we used a small long-term growth rate since the oil industry is bound to grow at least at some rate. Moreover, the effect on the valuation in the 0% to 1% range is minimal enough that the end result does not change our conclusion.
The year following the acquisition, the production in barrels per day produced jumped up from 264 700 barrels in 2008 to 456 000 barrels in 2009. Although production has moved up because of a major increase in assets, Suncor still started off the year facing one of the most challenging global economic downturns of the past century. Suncor’s net earnings in 2009 were $1. 146 billion, compared with $2. 137 billion in 2008.
The decrease in net earnings is explained by the commodity prices which were weaker in 2009. As for revenues, they were $25. 480 billion in 2009 compared to $28. 37 billion in 2008. The decrease is explained once again by the lower benchmark prices in 2009. The royalties increased $1. 199 billion in 2009 from $890 million in 2008. This increase is explained by in the increased production resulting from the merger with Petro-Canada. Energy trading revenues also decreased due to decreased commodity prices down to $7. 577 billion in 2009 from $11. 320 in 2008. The decreases in net earnings, revenues and royalties mainly due to the decrease in commodity prices were offset by the upstream production and sales volumes caused by the merger.
Not only did barrels per day rise but other income was also achieved by the settlement of a bitumen processing contract held by Petro-Canada of $438 million. When it comes to the cost to purchase crude oil, it decreased down to $7. 383 billion in 2009 compared to $7. 582 billion in 2008. This drop is mainly explained by the lower benchmark crude oil prices. Other expenses such as operating, selling and general expenses, transportation costs, and depreciation and amortization all increased in 2009 mainly because of the increase in production and assets the merger produced.
Finally, for cash flow operations the numbers are $2. 799 billion in 2009 compared to $4. 057 billion in 2008. Once again we see a decreasing figure due once again to lower benchmark commodity prices. On August 1, 2009, Suncor Energy Inc. completed its merger with Petro-Canada. As such, the results for the second quarter ended June 30, 2010 reflect the results of the post-merger Suncor and the comparative figures for the second quarter ended June 30, 2009 reflect solely the results of legacy Suncor prior to the merger.
As we can see from table above, Suncor earnings, CF, total production and return on share holder’s equity has increased significantly from the second quarter in 2009 to the second quarter in 2010. Net earnings are approximately 10. times higher, while operating earnings is approximately 20. 5x higher and CF is also 6x higher compared to last year performance. The increase in earnings and cash flow from operations was mainly due to an increase in production volumes, which has doubled as a result of the merger. The increase in earnings can furthermore be explained because of the higher benchmark prices in the second quarter of 2010, compared to the second quarter of 2009. This makes the return on shareholder equity to almost triple the amount of what investors used to earn last year.
Thus, we can conclude that the merger has been a success for Suncor since it improves the company’s performance and profitability. Holding Period Return: Even though the financial data that we collected shows that the merger brings positive result for Suncor, we still want to see how well the company is doing compared to the rest of the industry. Therefore, we calculated the holding periods returns from March 20, 2009, which was the Friday before the announcement was made on the following Monday, until November 5, 2010.
The S;P 500 index was used as a market indicator, while the Dow Jones US Oil ; Gas index was used as an industry indicator. The holding period returns were 59. 503%, 42. 771%, and 39. 349% for the market, Suncor, and the industry respectively. While Suncor underperformed when being compared with the market return by 16. 732%, it still however, outperformed the industry return by 3. 422% which is significant enough.
Therefore, the industry as a whole has lagged behind the market, however, Suncor returns are still above industry average. From our discounted cash flow valuation we concluded that Suncor acquired Petro-Canada for far less than the actual value of the company. Although Suncor paid a premium for Petro-Canada in relation to the market price of the company’s shares, our analysis confirms that the price paid was still a deal for Suncor in its merger activities.
Through the sensitivity analysis we determined that changes in long-term and short-term growth rates can have drastic effects on the valuation of the firm, but nevertheless conclude that the price paid for Petro-Canada was worthwhile. There are many factors which contribute to the benefit of the merger, but the post merger performance confirms that the merger has been successful. As presented in the post-merger performance section, the merged company is performing better than the industry average in terms of holding period return.
Although the company is not performing better than the market as a whole, the greater return than that of the industry is a great indicator. Reasons that the company is not performing as well as the general market can be attributed to the economic downturn, unforeseen problems in the oil sands operations and the time, effort and money needed to consolidate the two companies in recent periods. As an end note, the operating synergies offered to the merged companies and the scale and scope obtained by the merger will allow the merged company to compete on a global level.
Now the largest oil refining and marketing corporation in Canada, Suncor has the ability to become a market leader. Although the merger has resulted in some short-term job losses and the like, the long-term growth opportunities for Suncor as a market leader will eventually replace such losses exponentially.
Bibliography
- http://www. suncor. ca/en/investor/3348. aspx (Suncor ; Petro-Canada past financials)
- http://suncor. ca/en/investor/3342. aspx (Suncor 2009 financials)
- http://suncor. ca/default. aspx
- http://petro-canada. ca/default. aspx
- http://omrpublic. iea. org/pricessearch. asp
- http://www. tititudorancea. com/z/world_crude_oil_prices_graphs_history. htm
