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How Hess Corporation Will Look After Post Transformation

 March 05, 2013 02:28 PM

(By Mani) Hess Corporation (NYSE: HES) has outlined strategic initiatives to accelerate its transformation into a pure liquids-focused E&P in a robust response to activist Elliot Associates.

Let's see how Hess will look like post transformation:

Post transactions, Hess should be a more focused E&P company heavily weighted towards crude oil targeting longer-term growth of 5-8 percent per annum, above its prior target of 5 percent plus per annum.

Approximately 78 percent of HES' reserves and 84 percent of its production will come from 5 key areas, including Bakken and deepwater Gulf of Mexico.

[Related -Hess Corp. (HES): A Look At Next Wave Of Restructuring]

Its production mix will be weighted 69 percent towards crude oil, 7 percent natural gas liquids (NGLs), 18 percent international gas, and 6 percent US gas. That compares to its 2012 reported mix of: 70 percent oil, 5 percent NGLs, 20 percent international gas and 5 percent US gas.

However, it still appears as if Hess will emerge post restructuring running an ongoing free cash flow deficit, albeit lower.

"Pro forma upstream capex would be $6.2 billion in 2013, and we assume capex would decline another $500 million with the early 2014 completion build-out of its Bakken midstream infrastructure," UBS analyst William Featherston said in a client note.

Thus, one could infer 2014 capex would be $5.7 billion, above the estimated pro forma cash flow of $4.8 billion. Moreover, the company has a higher dividend obligation, climbing from $135 million per annum to $340 million in 2014.

[Related -Hess Corp: A Key Overhang Removed With Elliot Settlement]

Hess's transformational plan incorporates many of the suggestions proposed by Elliott Associates barring the most dramatic step of breaking the company into two upstream entities.

Elliott Associates, which owns 4 percent of Hess, submitted a detailed proposal in late January to boost the stock price to a theoretical value of $126/share, 82 percent above the current level and more than double the level of last December, when it began establishing a position in the company.

The major difference between Hess transformational plan and Elliott's proposals is Hess plans to keep the upstream business as one unit rather than breaking it as Elliott suggested into a domestic unconventional company and an international company.

Hess' defense makes sense as a split of the upstream business would have negative credit implications, as an independent resource company would have limited debt capacity given the cash flow deficits required in the early development of a large-scale unconventional resource.

"We tend to agree with management's assertion that a breakup into two E&P companies, one domestic and one international, would not be the best way to create shareholder value," Oppenheimer analyst Fadel Gheit said in a note to clients.

Hess also noted that HES would lose significant tax synergies under Elliott's proposal, under which the resource company would be generating significant unused tax deductions while the conventional portfolio would pay cash taxes that would have otherwise been shielded.

The company would accelerate its ongoing transformation into a pure E&P by exiting downstream, including retail, energy marketing and trading.

"We believe a tax-free spinoff would be the most likely vehicle for this separation, although management is currently evaluating all options," Gheit said.

Although an outright sale would generate significant tax liabilities, the company noted that intangible drilling costs (IDCs) associated with its unconventional drilling programs would enable Hess to defer a significant amount of any cash taxes.

"Although not a direct comparison due to the mix of different businesses, the gas station & convenience store group is currently trading around 10x EBITDA, which implies an enterprise value of HES downstream of $3-$3.5 billion," Gheit noted.

Between asset sales, a lower cash flow deficit, and the reduction in working capital tied to the downstream, Hess will be positioned to improve its balance sheet significantly. The company's top priority will be paying down short-term debt, which stood at nearly $800 million at the end of 2012.

Hess will also look to increase its cash position in order to help fund future development spending in case of commodity price volatility. Beyond some balance sheet strengthening, additional sale proceeds will be paid back to shareholders.

Hess will increase its annual dividend by 150 percent, to $1.00/share, starting in the third quarter of 2013. It also announced a share buyback authorization of up to $4 billion, representing about 17 percent of its market capitalization.

The company will add six new independent directors, all former business executives, each with decades of distinguished careers, including three with extensive oil industry experience. The new board should help guide the company with executing its transformation strategy into a pure E&P play.

Hess' transformational plan is expected to be viewed more favorably by shareholders than the suggestions made by Elliott.

"We estimate the plan disclosed today would be accretive to HES 2014 valuation, potentially adding $4-5 per share to its valuation although we suspect some of that was already baked into the stock following the run- up when Elliott filed its position," Featherston said.

Hess is the best performing energy stock year-to-date, outside the refiners, gaining 30 percent, compared with 6 percent plus for both its peers and the S&P 500. It is trading at 3 percent off its 12-month high and 74 percent above the low.



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