Stock to Watch: Dana Petroleum (Ed Jackson)

What should you make of the cash takeover approach for Dana Petroleum (DNX) by the Korean National Oil Corporation (KNOC)?


Trading remains energetic, with the Mid 250 shares just above 1,400p after press reports have mooted a take-out price of 1,800p to 2,000p, up from 1,100-1,200p a share before the approach was confirmed.

It affirms the case I made for value last February at 1,045p a share, when Schroder Investment Management raised its stake from 10.2% to 11.1% and has since increased to 13%.
It appears KNOC is serious, otherwise Dana would not risk distraction or opening its books.

The main risk is whether KNOC's sense of value meets sufficiently with the Dana board's opinion, especially now it completes the £270 million acquisition of Petro Canada Netherlands. This is Dana's fourth and most significant international acquisition in the last three years and it is interesting how KNOC's approach has followed quite swiftly after it was announced on 14 June. Perhaps it shows respect for Dana's ability to grow reserves by acquisition despite a mixed drilling record over the last year.

Broker estimates of fair value vary, mainly due to differences in the way exploration prospects are 'risked' i.e. priced on a probability factor for what extent of anticipated success. Despite a couple of sceptics in the market, even before the Petro Canada deal was announced Goldman Sachs entertained in May a share price target over £20 - Dana as its 'conviction buy' in the sector - because the market is respecting nothing for promising exploration in 2011.

Another factor is whether rivals step in now Dana is 'in play', and create pricing competition.

I am quite cautious about this because the company's assets are well diversified, often derived from buying what majors are divesting. This strategy has served private shareholders well over the long run; I have certainly felt comfortable with a substantial holding in Dana despite its share price volatility. Yet it begs the question how many bigger companies will want to prioritise Dana, to buy and integrate into their operations. I will believe in the auction speculators are rubbing their hands for, when I see it.

Not to dispel some genuinely strong factors in support of a deal.

The timing is astute given a recent drop in oil prices and - for a foreign buyer - while sterling is weak until the UK reduces its public deficit. KNOC has US$6.5 billion firepower to double its reserves and it is overdue meeting an objective to complete a deal in the first half of 2010. Dana has various African interests in particular, besides the North Sea, which might appeal to KNOC's long-term strategic interests - hence justifying a fairly full price being paid, with a possible sweetener from 2011 exploration success. The adviser to KNOC is Merrill Lynch who has previously raised capital for Dana, publishing detailed investment research with a positive view on long-term value. All this should help smooth negotiations
A key current factor is drilling the Anne Marie prospect off the Faroe Islands, potentially a high-impact well that could offer further regional scope. A result looks likely in August and given the significance it looks unlikely a deal will be concluded before then.

Hopefully this will be decisive than the kind of 'discovery' Dana has quite become typified for: hydrocarbon shows that will be assessed for further exploration, but nothing that currently looks commercial. If management prefers not to sell then this might be their best smokescreen defence. Since it has been reported the Koreans want to retain Dana management it seems unlikely they would go hostile as did Centrica when bidding for Venture Production last year.
Might the shares slump back to about 1,100p if this approach falls away?

Possibly so, if markets continue to fear a double-dip recession and gamblers hoping for a quick profit are forced to close out. So at about 1,400p a share, the risk/reward profile might be up to 20% down and roughly 25-30% up if a deal was cut in the region of 1,800p. Since management may feel it is justified looking for more, introducing a risk KNOC might walk away, overall risk/reward seems quite balanced. Hence I am inclined to wait and see if the share price drops when speculators' patience wears thin in the weeks ahead. Eyes should also be trained on the outcome at Anne Marie.
Part of the difficulty for shareholders trying to assess what value the Dana management has created over recent years of rising oil prices, is annual reports trumpeting impressive growth statistics - devoid of analysis of all the money spent over the years, achieving the current reserves and production/earnings profile. Exploration and development is a capital intensive business and Dana's £235 million budget for 2010 is set to rise given a strengthening in the US dollar, the industry currency. When shareholders are not being paid dividends and there are inevitable disappointments in this industry, you begin to wonder about the return on invested capital when the growth story is a moving feast with new flavours of 'jam tomorrow'.
Since this is not (yet) a contested takeover, there is no additional information or reserves upgrades being put into the public domain - like you see when oil company shareholders are courted as part of a defence. You have the 2009 annual report, an 18 May Interim Management Statement and some highly varied broker opinion as to fair value. So it is up to the parties involved, whether they can strike a deal, as investors we can but watch and react.