CA - ONEOK And Magellan: Big Takeover News

2023-05-15 11:32:34 ET

Summary

• ONEOK, Inc. and Magellan Midstream Partners, L.P. agreed on an acquisition.
• ONEOK will pay a takeover premium of a little more than 20%.
• This deal will be accretive on a per-share basis.
• There could be major tax implications for Magellan Midstream Partners, L.P. holders, potentially offsetting the nice takeover premium.

Article Thesis

Energy midstream companies ONEOK, Inc. ( OKE ) and Magellan Midstream Partners, L.P. ( MMP ) agreed on a takeover. This deal results in a nice one-time gain for MMP holders. It will be accretive for OKE in the coming years, and also has implications for other energy midstream companies with inexpensive valuations.

What Happened?

On Monday morning, energy storage and transportation players ONEOK and Magellan Midstream announced that the former would acquire the latter in a cash-and-stock deal that values Magellan Midstream at almost $19 billion, including the debt that OKE will assume.

This is one of the largest deals in the energy midstream space in recent memory. Since ONEOK will pay a takeover premium of a little more than 20%, Magellan Midstream's share price jumped upwards immediately following the takeover news. On the other hand, ONEOK saw its share price decline on Monday morning, as shareholders seemingly didn't like the deal, despite the fact that it will be accretive in the coming years. The issuance of new shares of OKE and related fears about dilution potentially explain some of the selling pressure.

What You Need To Know About The Deal

The proposed takeover price of $67.50 results in a premium of around 22% for shareholders of Magellan Midstream Partners. That's not a gigantic premium, but still a very solid takeover premium, especially when we consider that overall financial market conditions are rather tight, which has resulted in acquirers being less generous when it comes to offering hefty takeover premiums in the recent past.

The deal will neither be all-cash, which would require a hefty debt increase at ONEOK, nor is it all-stock, which would cause substantial dilution. Instead, the two companies agreed on a part-cash, part-stock deal that avoids either of the two extremes. Magellan Midstream's owners will receive $25 per share in cash, which should be sufficient to pay all related capital gains taxes even in the most extreme cases, while Magellan Midstream's owners will also receive 0.667 shares of ONEOK per share of MMP they own at the time of closing. Overall, this roughly pencils out to a two-thirds equity, one-third cash deal.

We don't know yet when the deal will close, but the two companies are targeting a closing date in the third quarter. Depending on how reviews by regulators go, it might take longer, however.

While there is always some risk that a deal gets blocked by regulators, I do believe that this is a rather small risk in this case. Neither Magellan Midstream Partners nor ONEOK is among the largest energy midstream companies, thus it is not reasonable to assume that the combined company would be in a market-dominating position. Larger energy midstream companies such as Enbridge Inc. ( ENB ) or Energy Transfer LP ( ET ) have engaged in M&A as well, and they have not run into major problems with regulators. ONEOK, a smaller acquirer, should thus not run into trouble, either, I believe. Due to the different focus areas of the two companies -- OKE is focused on natural gas and natural gas liquids, while Magellan Midstream is focused on oil and refined products -- there is not too much overlap, which should reduce regulatory risks further.

Importantly, this will be a taxable event for holders of Magellan Midstream Partners. While the implications of that differ a lot depending on one's purchase price, cumulative distributions received so far, marginal tax rate, and so on, it is highly likely that at least some holders of Magellan Midstream Partners will have to pay considerable taxes once this deal closes, or prior to that if they decide to bag the takeover premium now before waiting for the deal to close. ONEOK will have a step-up in tax basis following the closing of this deal, which should be beneficial for its corporate tax rate in the future. From a tax perspective, this deal could thus be (indirectly) advantageous for shareholders of OKE.

Does This Deal Create Value?

Mergers and acquisitions always make the acquirer larger, but that does not automatically create value, as serial acquirers such as AT&T Inc. ( T ) have proven in the past. Empire building can even destroy shareholder value when it goes hand in hand with too much debt and/or too many new shares being issued.

Takeovers should thus be evaluated on a per-share basis -- does the deal grow profits per share, cash flow per share, and so on once factoring in the impact of dilution and/or higher interest expenses? When that is the case, i.e. when metrics such as earnings and cash flow are growing on a per-share basis following the acquisition, then it can be assumed that the value of each share should rise as well, which makes the deal accretive for shareholders -- the good kind of M&A.

In this case, this should hold true, at least if what the management teams of the two companies are forecasting comes to fruition. ONEOK's management stated the following [emphasis by author]:

Expect to achieve immediate financial benefits, including cost, operational and tax synergies, supporting meaningful expected accretion: The transaction is expected to be earnings per share (EPS) accretive beginning in 2024 with EPS accretion of 3% to 7% per year from 2025 through 2027, and free cash flow per share accretion averaging more than 20% from 2024 through 2027 .Base forecasted synergies are expected to total at least $200 million annually.

From a tax perspective, ONEOK expects to benefit from the step-up in Magellan’s tax basis from the transaction, thus deferring the expected impact of the new corporate alternative minimum tax from 2024 to 2027. The benefit from the basis step-up has an estimated total value of approximately $3.0 billion , which has an estimated net present value of approximately $1.5 billion.

While investors can't be certain that these goals or guidance numbers will be achieved, it makes for a reasonable base case, I believe. Since Magellan Midstream was trading at a very low valuation of just 10x EBITDA (relative to its enterprise value, i.e. including MMP's net debt), it is not hard for this deal to be accretive for OKE shareholders -- when the acquired company or asset is cheap enough, even sizeable takeover premiums make sense. While interest rates have gone up over the last year, OKE can still access debt markets without major problems, and getting rates that are low enough to make a 10x EBITDA multiple work out is not a hard task. OKE has secured a little more than $5 billion in bridge financing already, thereby reducing execution risks.

Earnings per share accretion is nice, but I believe that free cash flow per share accretion matters more. First, infrastructure companies with high depreciation charges are mostly valued based on the cash flows they generate instead of the earnings they generate. Second, free cash flow is the relevant metric when it comes to ONEOK's ability to pay down the takeover-related debt over time, and free cash flow per share is also the relevant metric for ONEOK's dividend and shareholder return potential in the long run. With free cash flow per share rising by an estimated 20% due to this deal, debt reduction should be meaningful in the coming years, and OKE's dividend has gotten safer -- I do not believe that investors need to worry about suffering from a dividend cut due to the takeover.

There will be some synergies, but since the pipes in the ground will remain in place, synergies won't be overly high. Still, in management, administration, and so on there will be some potential for savings over time.

Final Thoughts

ONEOK trades at 9x EBITDA today, which is a rather inexpensive valuation in absolute terms. However, some midstream peers trade at even lower valuations -- ET's EBITDA multiple is 7, for example. OKE's dividend yield of 6% is nice, but not the highest in the industry by far. I thus do not see ONEOK as a leading value in the energy midstream space.

That being said, the takeover of Magellan Midstream looks attractive. The deal will diversify ONEOK's income and cash flows, it will make OKE more resilient due to a large portion of fee-based contracts at MMP, and it will likely be accretive on a cash flow and profit per share basis, while also coming with tax advantages for OKE on a corporate basis. It's thus somewhat surprising that OKE's shareholders seem to not like the deal for now, based on the pre-market share price reaction.

This deal has made ONEOK, Inc. more attractive, but the company still isn't quite as compelling as some of the other energy midstream companies investors can purchase today, both from a value and from a dividend perspective. I thus rate ONEOK a hold despite the fact that I like the deal.

The deal for MMP could indicate that other midstream players are attractive takeover targets as well, which could result in some upwards price moves across the industry in the foreseeable future.

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