Why BG shares could jump by 25%

Last week was an exciting one for oil & gas watchers. The oil price has stabilised - if perhaps only temporarily - a major find was confirmed at Gatwick Airport, and Shell launched a bid for long-time takeover candidate BG Group. BG's share price rose sharply on the news, but still trades at a substantial discount to fair value implied by the Shell offer. What's more, the share element of the recommended takeover could mean tasty profits for BG shareholders between now and when the deal finally completes.

Shell will pay 383p in cash and 0.4454 Shell B shares for every BG share held. Shell currently trades at 2,058p, valuing the equity portion of the proposed deal at 917p a share. Add the cash and it's almost 1,300p.

But Shell's shares have tumbled by 7% since the offer was made public and now trade near October 2011 lows. Based on the price just prior to the announcement, they were at 2,208p, which would value each BG share at 1,367p.

BG has now become a play on the Shell share price, and both BG shareholders and potential investors in BG need to understand prospects for the oil major. And here, opinions differ. On Monday, RBC Capital said it thinks they're worth 2,125p, Investec Securities said 1,900p, and Deutsche Bank 2,425p. On that basis, BG could be worth anything between 1,229p and 1,463p.

However, even Investec reckons the 10% discount to the implied offer "looks anomalous". As this is an upstream deal, regulatory approval should not require the detailed market share investigations that typify downstream deals, it says. The deal could also close sooner than early 2016.

The market seems to be more worried about shareholders not voting the deal through (75% approval required), particularly if the oil price remains low. However, we regard BG as a sizeable add-on for Shell rather than make-or-break. Economically, the deal washes its face at an oil price of $70+/bl so we believe it is unlikely to be rejected by shareholders. However, this does suggest that Shell (and BG) are likely to become higher beta stocks with regard to the oil price evolution in 2015.

Deutsche Bank, meanwhile, sees a clear opportunity here. Taking into account all forecast dividends paid by both Shell and BG between now and completion, the broker gets a fair value for BG of 1,260p, an 8% premium to last Thursday's closing price of 1,160p.

"The attraction of this spread depends on perspective; with a haircut for time-value, risk of deal failure, risk of a counterbid, risk of declines in price of RDSB and FX all relevant considerations," says Deutsche, which currently rates Shell a 'hold'. However:

Turning to BG, on the presumption of deal completion the stock has become a less levered play on the Shell share price (383p of value being fixed in cash), albeit with additional upside potential if (a) the discount to theoretical "fair" value narrows, or (b) a counterbid emerges. This perception of additional upside potential leads us to conclude that, given current pricing, BG would be the more attractive way to gain exposure to the prospective combination.

As we've noted before, Shell is one of the oil industry's most reliable dividend payers. It hasn't cut the payout since World War II and total dividends have shown compound growth of 5% since 1989. Following a period of underperformance since July last year, the shares offer a prospective yield of 6.2%, too.

The deal certainly makes sense, with BG's interest in Brazil's Santos Basin strengthening Shell's position in deepwater, and the company's LNG interests in Australia extend its dominant market position.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.