Citi on Woodside – Santos merger, one’s a buy and one’s a sell

Earlier this month, Australia’s two premier energy companies Woodside Energy (ASX: WDS) and Santos (ASX: STO) announced they are in “preliminary discussions” regarding a potential merger. It is a tantalising prospect, which could potentially create an $80 billion energy juggernaut likely ranking in the top 10 globally.

Several brokers have weighed in on the merger, which faces substantial hurdles from the respective boards and shareholders, as well as the ACCC. As I perused the broker research notes for today, a particular note from Citi caught my eye as I feel it went a step further than the usual merger commentary. Citi has reiterated their view that there’s a potential “pairs trade” on Woodside and Santos.

Compare the pair

A pairs trade involves simultaneously buying one stock and selling another. If you already own the stock which is marked for sale, then you’re simply dumping it from your portfolio. But if you don’t own it, (or even if you do) there’s another possibility here, you could choose to short that stock.

Boo! Short selling! Short sellers are evil, nasty villains lurking in dark hedge fund trading rooms, and who are out to destroy the portfolios of honest, average investors, right?

Not in my opinion. Short sellers are simply investors who perceive a mispricing in the market. They sell first, theoretically at a higher price, with a view to buying back in the future at a lower price. I can’t see how this is any different from a value investor buying a stock because they too perceive a mispricing in the market.

The main difference is short sellers sell stock which isn’t theirs. How do they do this? Well, they have to borrow that stock from an investor who intends to hold it for a very long time. The actual owner receives a fee for lending their shares to the short seller, and when the short seller is done, the owner gets their shares back and everything is hunky dory.

The Long term investors who lend stock out to short sellers tend to be your garden variety superannuation funds. Quite possibly the super fund your retirement savings are with right now. So as much as you may curse the short sellers bashing your favourite lithium stock’s price to oblivion, remember – the stock had to come from somewhere!

Anyways, back to the pairs trade. You’re typically trying to implement it on stocks which are quite similar. This will give you some natural protection against a broad market move where both stocks go up or both stocks go down. Under normal circumstances though, you’re trying to exploit a mispricing across the two stocks. One appears expensive and one appears cheap. The goal is to make a profit on the cheap one you buy, as well as make a profit on the expensive one you short.

Citi’s pair prediction

Citi’s pair trade involves buying Santos and selling Woodside Energy. They’ve actually been in the trade since 15 June, so the current research note is more about whether it’s still valid. It is, according to Citi, but the merger has possibly muddied the waters in terms of what the broker calls “idiosyncratic risks”. This requires some “de-grossing” of the position size of the pairs trade.

Whilst Citi suggests a more modest position size for the trade, they still feel it has some way to go. That is, there remains scope for Santos stock to demonstrate “continued relative outperformance” over Woodside stock. The reasons for this view are:

• Santos’s Barossa Project is less risky than Woodside’s Scarborough Project. Both projects are vitally important to the respective medium-to-long term growth profiles of each company. The value of Barossa is under-represented in Santos’s stock price compared to Scarborough in Woodside’s.

• Given Santos is now “in play” as a result of the merger, it could open the door to strategic asset sales which could unlock extra value for shareholders, or more tantalisingly, the prospect of what Citi calls an “interloper” – which could enter the fray and lob a competing bid for the company.

•  If the deal doesn’t go through, Santos may look to implement a further sell down of their PNG LNG stake, possibly around 5%. This would be done to further de-gear the balance sheet.

• Santos has a less onerous capex to return on invested capital (ROIC) profile than Woodside. This just means that Citi believes Santos is going to get far more bang for their invested buck compared to Woodside going forward – order of magnitude “flat” for Woodside versus “>20% top line growth” for Santos.

•  Woodside is more sensitive to the oil price weakness than Santos and will increasingly need to pursue mergers and acquisitions to maintain growth and its dividend yield.

Risk and reward

Citi notes the main risk to the pairs trade, that is the aforementioned “idiosyncratic” risk, is the merger doesn’t proceed. In this scenario Woodside would naturally get a stock price boost (as the acquirer) and Santos a potential de-rating as the acquiree. If Woodside should get cold feet quickly, this would also likely reduce the chance of an interloper snooping into the deal.

It’s a super interesting take on the merger, and one which highlights the complexity in understanding the risks and rewards underlying the valuation of both companies should the merger succeed or fail. Citi’s final take can be inferred from their current rating and price targets for each stock. They rate Woodside as a “Sell” with a $26.50 price target, and Santos as a “Buy” with a $8.25 price target.