A wave of mergers and acquisitions is almost inevitable in the energy sector, making attractive takeover candidates among stocks to buy now.
Strategic buyers looking to maximize near-term growth opportunities, as well as private equity firms looking to capitalize on the industry's long-term potential, are making lists of possible takeover targets.
Individual investors should do the same.
Why Energy M&A is on the Way
Back in the 1980s, energy investor and then corporate raider T. Boone Pickens said that it was cheaper to drill for oil on the floor of the NYSE than in the field.
That seems to be the case once again today.
These production costs are getting more expensive, tearing away at profits for some of the energy sector's smaller companies.
Many of the companies in the energy industry sell at very low multiples of earnings and cash flow and would be attractive takeover targets for larger competitors.
Some, particularly in companies associated with natural gas and coal, sell at significant discounts to the value of the assets. Among the services companies, it is cheaper to buy the company than to build a fleet of drilling rigs or service boats right now.
Therefore, the best way for energy-related companies to grow revenue and earnings is going to be to buy competitors.
Energy companies aren't the only ones who have noticed the low valuations in energy stocks. Private equity firms have become aware of the pricing dislocation and long-term potential of oil, gas and coal stocks, and are loading up.
At the end of March, private equity giant Kohlberg Kravis and Roberts (KKR) announced that it was forming a new energy-related partnership and hoped to raise $1.5 billion. The fund will concentrate on oil drilling partnerships as well as minerals and royalties. It may also provide mezzanine financing to other oil and gas companies.
This is not the firm's first foray into the energy sector as the firm's energy and infrastructure division currently manages more than $4 billion in assets.
And it's not the only firm looking at energy as a source of buyout profits...
In September, The Blackstone Group L.P. (NYSE: BX) closed its first-ever energy specific fund with a $2.5 billion fund closing. Houston-based White Deer Management just completed a $1.28 billion energy related PE fund. ArcLight Capital just closed a new midstream-oriented partnership and has over $10 billion in energy-oriented funds. Apollo Global Management just closed a $1.3 billion energy fund earlier this year.
How to Find the Right Energy Stocks to Buy
Before investors start shopping for the next takeover target, they need to learn to think like these private equity investors.
For example, cash flow and asset value are far more important to PE firms when hunting for the right stocks to buy than traditional measures like accounting earnings, P/E ratios and dividend yields.
These funds also look for relatively unlevered balance sheets so they can use additional debt to maximize returns.
Investors need to study recent deals and financings to gain insight into the multiples of cash flow and earnings before interest, taxes, depreciation, and amortization (EBITDA) that strategic and buyers of energy companies pay attention to.
Taking these metrics into account, an example of an attractively priced energy services company is Tesco Corp. (Nasdaq: TESO).
The company trades right around its book value and has an enterprise to EBITDA ratio of less than 5, well below many of its competitors. The company has no debt so the balance sheet could be levered to pay for the takeover.
Another example of such a takeover candidate is Energy XXI (Nasdaq: EXXI) a Bermuda-based exploration and production company.
Exploration and production companies are often valued on proven reserves. This is simply the amount of oil and gas reasonably believed to be in the ground on properties owned or controlled by the company but not yet brought to the surface.
The value of the reserves is thought by many to be worth far more than the current price of the stock. EXXI is currently trading around $26, but has more than 100 million barrels of proven reserves in Texas and Louisiana.
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Tim Melvin is a Contributing Writer at Money Morning.