Encana’s Newfield Sweeteners Draw a Sour Response: Liam Denning

When you’re selling a deal, it helps to throw in a gift or two.

That’s Encana Corp.’s approach in pitching Thursday’s surprise $7.7 billion acquisition of Newfield Exploration Co. to investors. This is one tough crowd, though: Encana’s stock dropped by almost 18 percent in early trading. In theory, the synergies it touted were worth an additional $1.1 billion to its market cap. Instead, $1.7 billion was wiped off.

Encana no doubt anticipated a certain degree of skepticism about the all-stock transaction. It could hardly do otherwise having seen the treatment meted out recently to other acquirers such as Chesapeake Energy Corp. In general, scarred E&P investors yearn for the relative boredom of solid operations and steady free cash flow (preferably funding payouts). Hence, Encana twinned its announcement with a decent set of quarterly results and a promised dividend increase and big bump-up in share buybacks.

In the friendlier times of a few years ago, these likely would have done the job. Encana’s synergies are predicated on cutting overhead and applying its advanced fracking methods to Newfield’s positions in Oklahoma. And Newfield’s general and administrative costs certainly do suggest there’s some fat to trim:

Assuming synergies come in on target and on time, Encana should make good on its promised payouts in 2019. Using consensus forecasts for Ebitdax  as a proxy for cash flow, the pro forma figure of $5.2 billion should cover $3.5 billion of capital expenditure, about $140 million of (increased) dividends and most of the $1.5 billion of stock buybacks. The implied 11 percent payout yield can hardly be sniffed at.

And yet, of course, investors positively snorted at it; the yield promptly rose to 13 percent.

There’s something inherently jarring about boosting your share count by more than half while simultaneously offering to buy some of it back. The bigger difficulty Encana has here is that it seemed to be doing fine as it was. Free cash flow, solidly negative for several years, was almost break-even in the 12 months through September, and was expected to rise to $1.2 billion in 2020 on a stand-alone basis, according to forecasts compiled by Bloomberg. And yes, entering Oklahoma adds another leg to Encana’s diversified strategy across different tight-oil basins, but proving the value of this is something that can only be achieved over time and comes with risk attached.

Clearly, the promised dividend and buyback are meant to be down payments on the synergies and other benefits eventually coming through. At one point on Thursday morning’s analyst call, CEO Doug Suttles was asked if he was surprised by the slump in Encana’s stock. He responded that he hadn’t even looked at it (ahem) and that shareholders would realize the value of the deal “over time.” The flip-side is that, until that day comes, Encana just bought itself a big overhang.