Exxon Mobil (XOM) rarely makes major acquisitions. Today, the oil-giant announced the acquisition of XTO Energy for $31 billion, representing a 25% premium over XTO’s closing price on Friday.
Exxon played the last cycle better than any of the other oil majors. As energy prices rose during the last three years, Exxon patiently committed just 40% of earnings to capital investment while Shell, BP, and Chevron committed between 85% to 100%. Today’s deal is notable because it marks a change in strategy. Exxon’s move is a bet that gas demand is going to outpace oil and coal over the next decade, in part due to tighter emissions standards.
Staying true to their financial conservatism, Exxon is doing an all-stock deal rather than dipping into its healthy cash pile. At the end of the third quarter, XOM had a net cash position (cash less debt) of $2.9 billion. Meanwhile, the company converts roughly 10% of revenue to free cash flow meaning that the company may generate roughly $8 billion in free cash flow in the fourth quarter alone.
Some investors were disappointed Exxon didn’t offer a cash-stock combination, but this concern overlooks the fact that Exxon will assume about $10 billion of XTO’s debt. If you include XTO’s debt obligations in the cost of the acquisition, then Exxon is actually using cash to fund about one-fourth of the XTO purchase.
One could also argue that future share buybacks will reduce the new outstanding shares, effectively “paying” for the acquisition. Exxon has reduced total outstanding shares by 25% since the end of 2004 and has repurchased $17 billion in stock this year alone. I admit this is a bit of a stretch, but it’s worth considering.
Exxon’s acquisition is clearly a wager that depressed gas prices will improve in the coming years, but I wonder if there are any other factors at work.
How much does the Fed’s zero interest rate policy (ZIRP) play into these decisions?
Cash-rich corporations, like individual investors and savers, aren’t earning any return on their cash and equivalents. But until there is concrete evidence that the economic recovery is sustainable, businesses may be hesitant to add to capacity. As a result, mergers and acquisitions present a more attractive use of capital.
Does expected inflation create a greater sense of urgency for firms to put cash to use?
In Exxon’s case, higher inflation means higher natural gas prices and higher revenues. So it’s obvious that expectations for higher inflation would create a greater sense of urgency for an acquisition in this case. Still, it would also be in a non-energy firm’s best interest to purchase assets that can enhance growth if the firm believes that inflation will diminish their purchasing power in the future.
Quick Hits
- Fastest Food Inflation Since ’08 Riots Means Milk Costs 39% More Next Year
- Volcker: We Need to Think More Boldly
Peter J. Lazaroff, Investment Analyst
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