SapuraKencana Petroleum (SKPETRO) announced that it has entered into a non-binding memorandum of understanding (MOU) with Seadrill Ltd. (Seadrill) for the proposed combination and integration of the tender rig businesses of both SKPETRO and Seadrill.

Enlarged entity to command 59% share of the global rig business. The tie-up will see SKPETRO taking control of an enlarged rig business comprising 16 tender rigs in operation and five more units currently under construction (the group will own 21 rigs in total upon completion of the transaction). In addition, SKPETRO will also be given the right to manage three tender rigs which are not part of the proposed transaction. We are positive on the deal for SKPETRO in the long run as not only will it inherit an existing orderbook of USD1.6bn, the acquisition will also allow the group to capitalize on Seadrill's expertise and contribute to its deepwater customer base across East Asia.

Is the EV of USD2.9bn pricey? The acquisition values Seadrill's rig business at 16-20x forward earnings which we consider fair given that SKPETRO stands to benefit substantially from Seadrill's vast assets and potential in Brazil. The enterprise value includes: i) USD363m in remaining capex, ii) a USD800m debt in the tender rig business, iii) USD350m via the issuance of new shares, iv) USD187m via a seller's note, and v) USD1.2bn via internally generated funds or equity.

Debt/EBITDA will surge to 5.2x in FY14. Management expects the group's debt/EBITDA ratio to increase to 5.2x in FY14 upon completion of the acquisition but has also guided that this would decline significantly in the following years with improved earnings contribution from Seadrill's assets. Based on our estimates, SKPETRO may need to raise USD800m-USD900m in debt and USD300m-USD400m in equity for the remaining USD1.2bn to be raised.

Net gearing to rise above 1.0x. Upon completion of the acquisition, SKPETRO's net gearing will rise above 1.0x in FY14 as a result of the RM5bn (USD1.7bn) increase in debt. The group's net gearing as at 31 July stood at 0.6x based on a net debt of RM3.9bn and shareholders' funds of RM6.1bn. However, the recurring cash flow from the asset will help to mitigate the increase in net gearing in the next few years.

Minimal accounting goodwill expected. Management expects to see minimal accounting goodwill arising from this transaction as it expects the business value to exceed the accounting goodwill. As at 31 July, SKPETRO had an accounting goodwill of RM4.9bn, with an NTA/share of RM1.87.

Acquisition may be earnings accretive. We believe the acquisition will be earnings accretive for SKPETRO. Assuming that the group raises equity at a theoretical price of RM2.71 per share, it would need to issue 400m new shares to pay off the USD350m portion and another 450 shares to raise an additional USD400m to cover the remaining USD1.2bn required. This would bump up EPS by 22.7% in FY14, as shown in Figure 4.

MOU includes JV with Seadrill's 40%-owned Archer Ltd. The MOU includes a provision for SKPETRO to enter into a JV with Archer Ltd to introduce the latter's wireline services in the Far East markets. Archer is a global oilfield service specialist in drilling services and well services with more than 40 years' experience. As such, the tie-up may enhance SKPETRO's service offerings in this region.

Maintain BUY. Management expects the transaction to be completed by end-Jan 2013 upon signing the agreement within 11 weeks. We are positive on the deal but are not making any changes to our earnings estimates for now until the deal's final structure is disclosed. Our FV remains unchanged at RM3.00, pegged to the existing 20x FY14 EPS. SKPETRO remains as one of our top picks in the oil and gas (O&G) sector. The stock's rerating catalysts are: i) new contracts secured in Brazil and domestically, and ii) potential earnings accretion from the acquisition of Seadrill's rig business.

Source: OSK