Idea of the Week: SM Energy pending acquisition to boost cash flow. Current bonds yielding 6%

• SM Energy is an independent E&P company with a current production of 55.5MMBoe a year.

• Planned acquisitions of Uinta Basin assets has the potential to contribute significantly to future earnings with an expected increase of 16 MMBoe a year and  around 35% increase in EBITDA.

• Credit profile remains healthy, though post-acquisitions Net Debt to EBITDA expected to increase to 1.7x. However, expected increase in cash flow from the acquisition will support debt repayments with a normalization of net debt to EBITDA to 1x – 1.5x depending on oil prices.

• Investors can consider SM 6.500% 15Jul2028 Corp (USD) with a current YTM of 6%.

SM Energy is an independent oil and gas Exploration and Production (E&P) company with wells located in the Midland Basins and South Texas. The company is a listed company on the New York Stock Exchange, with a current market cap of USD 4.6 billion. As of FY23, the company has a total net acreage of 301 thousand with total proved reserves of 605 MMBoe (Million Barrels of Oil Equivalent). Production in FY23 was 55.5 MMBoe, or 152MBoe/d (Thousand Barrels of oil equivalent per day) with a mix of 48%, 40% and 12% of oil, natural gas and natural gas liquid respectively.

USD 2.1 billion acquisitions in the pipeline

SM Energy had announced 2 major acquisitions this year, with one being the acquisition of Uinta Basin oil and gas assets owned by XCL for USD 2.04 billion and another acquisition from Altamont comprising of assets adjacent to the Uinta Basin for USD 70 million. The acquisitions are expected to close by October 2024, and will be fully paid in cash for which SM Energy has arranged financing for. The financing includes USD 1.5 billion in Senior Notes and a commitment from a syndicate of banks of up to USD 1.2 billion in bridge term loans.

The deal is expected to expand the group’s top tier portfolio, adding an approximately 63,000 net acres or a 20% increase in net acreage from FY23. Production is expected to increase by 44MBoe/d, with a proforma 2025E net production of 195MBoe/d. The group oil production commodity mix is expected to also increase to 52% in 2025, thanks to the favorable oil mix of 88% oil in the Uinta Basin.

Decent financial performance from high oil prices

Higher oil prices in the last 3 years have been positive for SM Energy’s profitability and free cash flow.  In 1H24, free cash flow came in lower due to increased capital expenditures incurred for new wells drilled. We expect free cash flow for 1H24 to continue to remain positive, though lower than previous years with an expected increase of capex of USD 100- 120 million from the pending Uinta Basins acquisitions.

We are cognisant of SM’s Energy earnings volatility, especially with their current 3Q-4Q hedging of around 30% of their net oil productions, leaving 70% of their expected productions to market prices.  Nevertheless, we expect oil prices to be supported at current levels as OPEC+ has recently announced that they will delay production increases until December.

We further expect earnings to improve after the acquisition given the group guidance that the deal is expected to increase production by 43 Mboed at 88% crude oil and be immediately accretive to key financial metrics. If the acquisition goes through in October, we expect an increase of USD 240 million and USD 120 million in revenue and operating income. This is assuming oil prices and gas prices remains at an average of USD 70 and USD 2. Nevertheless, even if the deal is delayed, we expect 2H24 operating profit to be decent given the current oil prices are supportive towards earnings.

Table 1: Projected earnings

Credit Highlights

Table 2: Selected credit indicators

The credit profile of SM Energy is decent with credit indicators indicating a healthy balance sheet, contributed by recent performance. Net debt as of 1H24 was at USD 1.1 billion, though is expected to increase to USD 2.9 billion once the acquisition goes through. So far, the company has managed to obtain financing of USD 2.7 billion for the USD2.1 billion acquisition along with the early retirement of their 2025 senior notes of USD 350 million. The balance of which will be used to fund existing capex requirements and also the integration of the new acquisitions.

On that note, we expect the Group net debt to EBITDA to increase to around 1.7 times after the acquisition. Nevertheless, the Group has committed to reducing their post-acquisition leverage levels to about 1 times Net debt to EBITDA by 2025, from the projected increase in cash flow from the acquisitions. However, this is based on their assumption of NYMEX WTI Oil at USD 78/bbl and NYMEX Henry Hub Gas prices of USD 3.25/MMBtu. With assumptions of lower oil prices at USD 60 and USD 2 gas prices, they expect to remain in the 1.5 times area.

Though we expect the company to have higher leverage going forward, we believe the new acquisition will contribute significantly to cash flow. Another point to note is that, if the acquisition does not occur by 1 July 2025, the USD 1.5 billion notes embedded with a “special redemption feature” will have to be redeemed at par. Therefore, the risk associated for the company if the deal falls through will be the accrued interest of the Senior notes amounting to around USD 90 million

Recommendation

Currently, SM Energy bonds are rated BB- and are considered high yield bonds. We opine that their credit remains healthy and current oil prices are supportive of their profitability. While the 2026 bonds seem more attractive, the bond can currently be called at par, which we expect the Group to do after the acquisition to reduce leverage levels. As such, investors can consider the 2028 bonds with a YTM of 6%, however, do note that the bond can also be called at par in 2026, giving investors a yield to worst of 5.5%.

Related Risk

SM Energy operates in a highly competitive environment with revenue generated from sales of oil and gas, both of which are volatile. Significant decline in prices may affect earnings and cash flow generation.

While the guidance on the acquisition is mostly positive, execution risk remains the primary risk as it works towards integrating the Uinta Basin after the deal. Their ability of the asset to deliver on the expected oil production is key to reduce leverage levels, especially after taking on up to USD2.7 billion in debt to fund the acquisition.

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