Stokes & Co strike oil

One of Australia’s smartest investors is acting quickly as the oil price drops: Kerry Stokes is moving to control Beach Energy.

Summary: Seven Group, under executive chairman Kerry Stokes and chief executive Don Voelte, is already sitting on a handsome profit after acquiring a 13.8% stake in Beach Energy last week. Stokes now has the option for a quick exit, pocketing $30 million in cash, or to snatch control of Beach – a possibility with substantial strategic merit.

Key take-out: A quick exit seems unlikely because the raid on Beach has the hallmarks of a classic Stokes deal where he has dealt himself into a game, and is now in a position to control events.

Key beneficiaries: General investors. Category: Shares.

Seven Group is sitting on a $30 million paper profit from last week’s raid on Beach Energy, but the acquisition of the 13.8% stake in the oil and gas producer by a company better known for its media and industrial equipment assets is about a lot more than short-term reward.

What Seven could be trying to achieve through deals such as investing around $175 million in Beach shares is a rebalanced portfolio, which is currently overloaded with interests that are weighted towards Australian dollar income and US dollar costs.

Most of Seven’s industrial equipment, sold under the WesTrac banner, is sourced from US-based Caterpillar. Many of its television programs are acquired in the US, and the bulk of the paper used in its newspapers and magazines is priced in US dollars.

Currency values are moving against that structure just as demand for Caterpillar equipment in the mining and oil industries drops during the resources slump, with the added problem of highly-competitive Japanese and Chinese equipment landing in Australia.

The problem can be seen in Seven’s profits, which dropped by 40% last financial year, and a sharply lower share price which has fallen by around 40% over the past 12 months.

Creating an oil and gas division, first through the $200 million acquisition of Nexus Energy and now through the investment in Beach, shows that Seven could be building a new division which will enjoy US dollar income and largely Australian dollar costs.

It is a high-risk strategy that reflects the heavy influence on the current direction of Seven by its managing director, and former Woodside Petroleum chief executive, Don Voelte.

Taking risks through dramatic expansion moves is second-nature to Voelte, who famously forced Woodside to develop the Pluto liquefied natural gas project as a single train (gas processing system) before Woodside owned sufficient gas for a second train that would have significantly lowered average production costs.

Voelte was criticised at the time, but proved correct when oil and gas prices soared and Woodside became one of the Australian stock market’s favourite cash generators – and dividend payers.

The Pluto play is looking less attractive now thanks to falling oil and gas prices and the failure of Woodside to find sufficient gas for that much-needed second train, a missing link which will hurt profits in future years and could force the acquisition of third-party gas.

An equally bold strategy appears to be unfolding in Seven under Voelte’s guidance, and with the obvious backing of the man who dominates the company’s share register with his 70% interest in the stock, Kerry Stokes.

The Stokes stake in Seven, which has grown by more than 2% from 67.8% over the past six months by his not participating in a round of share buy-back programs, is a big issue for outsiders to digest as they consider the outlook for the stock, and for its latest target, Beach.

At nearly 70% ownership (the precise figure is 69.97%) Seven is very much a family business with a stock-exchange listing, one reason why it is poorly-researched by leading investment banks and those which do generally have a neutral to negative view.

Beach is different. It is a widely held stock which has always lacked a single dominant shareholder but has been led for more than 20 years by a skilled geophysicist, Reg Nelson.

Though it is successful at what it does, most of Beach’s assets fall into a second-class category, meaning it has never been a target for oil and gas major. The same low-quality issue can be found in Nexus.

The lack of a dominant shareholder is a clue as to why Seven has launched its raid on Beach, and why it might move for control, particularly if the recent recovery in the oil price revives interest in oil and gas as an investment class.

Even without the raid Beach’s shares would be rising, just as Woodside’s have with yesterday’s $1 (2.6%) increase all about higher oil and gas prices.

One of the major appeals of Beach is its position to supply energy to gas-short Australian east coast markets, especially at a time when large amounts of gas are being re-directed to feed Queensland’s new LNG export industry.

There is also the potential for Beach’s Cooper Basin assets in central Australia to become the centre of unconventional (shale) gas development though the jury is out on whether the Cooper will easily (and cost effectively) release its unconventional gas.

The lack of a major shareholder in Beach has opened the door for Seven to soak up the interests of institutional investors, many of which have developed a gloomy view of the oil and gas outlook.

Management change at the top of Beach is another factor; Nelson’s successor, Robert Cole, is a former Woodside executive who once worked closely with Voelte.

In theory, the stars are aligned for Seven to snatch control of Beach, either with a full takeover bid, or through the steady acquisition of control as stock becomes available, possibly through events such as when a $200 million convertible bond can be put back to Beach on April 3.

Bondholders are currently well out of the money even after the rise in Beach’s share price since Seven’s hand was revealed, with the lift from around 95 cents to recent trades at $1.22 still 66 cents short of the $1.88 strike price.

What the financial and capital structure details reveal is that Beach is effectively in play, with Seven holding the whip hand in the early stages of what could be a long-run game that is similar to how Stokes gained control of Seven, and other targets, including WA Newspapers.

While he could well succeed with acquiring control of Beach there are four interesting questions to consider. They are:

  • The future price of oil and gas and whether Seven has picked the start of a sustainable recovery, or whether oil will remain depressed until the global flood of supply abates.
  • Whether Seven has the firepower to bid for all of Beach given that the two companies are roughly the same size in market capitalisation ($1.6 billion for Seven, $1.58 billion for Beach) – a size difference which becomes less important in a creeping acquisition.
  • The time it might take for creeping takeover of Beach, with time a factor given that Stokes turns 75 later this year.
  • The importance to Seven of US dollar income to offset its extensive US dollar costs.

It is possible that Seven will be tempted to cash out now, pocketing a handy $30 million profit for one week’s work, a move which would upset the takeover theories.

However, a quick exit seems unlikely because the raid on Beach has the hallmarks of a classic Stokes deal where he has dealt himself into a game, and is now in a position to control events.

But, whether he has the patience to play the long game this time is unclear, as is the future price of oil, doubts about the quality of assets going into Seven’s new energy business, and the question of whether Seven, with its falling profits and currency problems, can afford to play in the oil patch.