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Overlooked Risks of Chevron's Hess Deal

Big news broke earlier this week as Chevron Corp. (NYSE:CVX) agreed to an acquisition with Hess Corp. (NYSE:HES) that it thought to be valued at $53 billion in an all-stock package.

Hess is an American oil and gas company that sits in the exploration and production part of the value chain, meaning Chevron's decision to acquire it phases in horizontal integration.

Although the Hess acquisition brings about plenty of benefits for Chevron, the energy giant's shareholders may suffer from temporary drawdowns.

What the Hess deal brings to the table

Let's start with a few positives by looking at the benefits of the Hess deal.

According to Chevron's official statement, Hess will onboard $1 billion in cost-saving synergies and increase Chevron's free cash flow. Hess' exposure to the Stabroek block in Guyana and Bakken adds stealth to the company's Permian and DJ Basin endeavors. Moreover, integration into Chevron's mid-to-downstream facilities might provide Hess' existing assets with the necessary latitude to achieve greater profit margins.

Further, Hess CEO John Hess is anticipated to join Chevron's board. Adding Hess and his employees to Chevron's labor force allows for the sharing of human capital across the company, concurrently leading to more efficient managerial decisions.

Ultimately, the Hess takeover strengthens Chevron's market position, while synergies add residual value prospects for shareholders.

Things to watch out for

Although Hess could enhance Chevron's business model, it must be considered that capital market-based influencing variables may detract from the stock in the short term.

One such factor is merger arbitrage. Principally, merger arbitrage is a trading theory that says investors tend to sell an acquirer's stock during an acquisition while buying the target company's stock due to the takeover premiums embedded in acquisitions. In essence, the methodology states that although acquisitions may add long-term stock value, they generally diminish short-term value.

Chevron stock's week-on-week slump indicates investors are pricing a merger arbitrage scenario, which can be substantiated by the fact the acquisition will close at a 10% premium. Moreover, the forecasted synergies from the acquisition are yet to be unlocked, meaning the takeover premium is isolated for now.

Even though merger arbitrage is merely a theoretical concept, it often holds true. Therefore, it presents a noteworthy risk to Chevron's shareholders.

An additional risk to Chevron's shareholders is the possibility of an antitrust lawsuit.

Chevron mentioned that it is not worried about legal issues, stating, "There's no refining. There's no marketing. The oil markets are big. We have a 2% market share in the global oil markets. Our portfolios have really very little overlap at all, so we don't really believe there are any competition issues here."

In a nutshell, Chevron thinks the market size of upstream oil and gas dictates that larger acquisitions will be easier to complete than in industries with dominant market participants. However, an issue remains that stock market participants will speculate on possible lawsuits and regulatory obstacles, concurrently adding instability to the stock.

Wall Street investors' take on Chevron's stock

The Chevron-Hess acquisition is recent news. Nevertheless, rumors have been up in the air for quite some time. As such, observing prepositioning from Wall Street's finest investors provides plenty of insight into the impact the acquisition may have on Chevron's stock.

According to GuruFocus' aggregation of 13F filings, the consensus among fund managers is neutral, with various big names buying and selling the stock over the past few quarters. Although merely an indicator, the guru trades tool provides valuable insight and, for now, it suggests there is no clear-cut consensus on Chevron's stock for the time being.

Overlooked Risks of Chevron's Hess Deal
Overlooked Risks of Chevron's Hess Deal

Valuation and dividends

Chevron's acquisition might influence the objectivity of its current valuation metrics due to the factors I mentioned earlier. Nevertheless, the discount cash flow model provides an objective outlook.

The DCF model shows that Chevron's stock is undervalued by nearly 70%. Sure, factors such as the Hess acquisition, interest rate uncertainty and volatile commodity prices should be considered. However, 70% is a hefty valuation gap, supporting a bullish case for the stock.

Overlooked Risks of Chevron's Hess Deal
Overlooked Risks of Chevron's Hess Deal

Further, Chevron's dividend profile deserves attention as it is arguably best in class. In fact, temporary merger arbitrage risk can be phased out by the company's forward dividend yield of 3.91%.

Overlooked Risks of Chevron's Hess Deal
Overlooked Risks of Chevron's Hess Deal

Final word

Chevron seems undervalued if looked at in isolation. The company is set to benefit from synergies from the Hess acquisition, which might unlock the absolute value communicated by the discounted cash flow valuation model.

Nonetheless, investors would be wise to consider the short-term impacts of the Hess acquisition as features such as merger arbitrage and fears of antitrust lawsuits are not out of the question.

In a nutshell, Chevron seems like a solid long-term investment at its current price, but the Hess deal has exacerbated its short-term risk premiums.

This article first appeared on GuruFocus.