1 + 1 = 0
By Robert J. Uek, CFA
Co-Portfolio Manager, Essex Environmental Opportunities Fund
When a merger or acquisition is proposed, the M&A bankers often seem to justify the combination using a fantastical mathematical model something like: “1 + 1 = 3”. In other words, the resulting entity instantly should be worth more than simply the summation of the valuations of the standalone companies. Sounds nice, but as veteran investors know, mathematical impossibilities don’t really happen and the outcome is usually not so happy.
So, today’s announced acquisition of Concho Resources by ConocoPhillips has us proposing our own magical M&A banker math: 1 + 1 = 0. Of course, we are being facetious in that the merger is probably not a zero. But we fail to see compelling merits to the proposed deal between two fossil fuel exploration and production companies.
It would be an understatement to say that the fossil fuel industry is struggling: bankruptcies are soaring, earnings in the energy sector are nearly non-existent, and stock performance has been woeful. The Energy sector is now less than 2% of the value of the S&P 500 Index and stalwart Exxon Mobil has gone from the most valuable company in the world a few years ago to being kicked out of the Dow Jones Industrial Average. We could be on the cusp of a great contrarian trade…but we could have said that a year ago or two years ago or three years ago or at just about any other point in the past decade. There may be an opportunity for a short-term trade in the traditional energy patch, but by almost any measure, the long-term outlook for both companies involved in this transaction is bleak. In order to thrive in the future, the traditional energy industry will need to overcome rising public opposition to fossil fuels, increasingly stringent emissions standards, government bans on internal combustion engines, higher financing and insurance costs for exploration activities, and, most importantly, the ever-decreasing technology costs of renewable energy. Seems like a tough task.
To us, this deal feels like a combination of two buggy-whip manufacturers shortly after the launch of the Ford Model T, with fossil fuel companies playing the role of the buggy whip manufacturers and electric vehicles being the modern-day version of the Model T. Backward-looking companies generally don’t survive disruptive technological shifts. No doubt, the consolidation of two struggling companies is an opportunity to reduce duplicative costs and rationalize supply, but for an industry whose best days are in the rear-view mirror it seems like a poor allocation of capital for the acquiring company. Maybe the newly merged company will be able to better withstand the industry headwinds for a while longer, but the eventual outcome will still be the same as that of most companies facing disruptive technological threats: zero. The problems facing ConocoPhillips aren’t solved by this acquisition; they are pushed into the future. Wouldn’t the shareholders of the buggy whip manufacturers have been better suited if management had the vision or fortitude to invest in a business that would benefit from the next century of growth in the emerging auto industry? Why are ConocoPhillips shareholders ok with this acquisition? And at a cost of $10 billion, the Concho acquisition is not a small commitment. That’s $10 billion that could be allocated to acquisitions or research in areas such as solar energy, wind energy, hydrogen, fuel cells, lithium and other battery materials, battery technology, or any other big opportunities with brighter futures than fossil fuels.
This commentary is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. The opinions and analyses expressed in this commentary are based on Essex Investment Management LLC’s (“Essex”) research and professional experience and are expressed as of the date of its release. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is intended to speak to any future periods. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties.
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Top ten Fund holdings as of 9/30/2020: Sunnova Energy International (5.85% of portfolio), Keyence Corp (5.26%), Generac Holdings, Inc. (4.27%), Hannon Armstrong Sustainable Infrastructure Capital Inc. (4.25%), Vivint Solar Inc. (3.95%), Orsted A/S (3.92%), Itron Inc. (3.04%), PSI Software AG (2.98%), Infineon Technologies AG (2.98%), and Cognex Corp. (2.94%). Current and future portfolio holdings are subject to risk.