Phillips funds its move to major league

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Issuer: Phillips Petroleum Co
Amount: $2.5 billionType of issue: Global bond Date of issue: May17Bookrunners: JP Morgan, Merrill Lynch
At a time when corporate bond issuers are struggling to win support from fixed-income investors, BBB-rated Phillips Petroleum showed that the global bond markets are still open to finance big acquisitions for companies in the right sectors, as long as they have credible management teams and quality assets.
Phillips achieved hefty over-subscriptions on its

$1.15 billion five-year and $1.35 billion 10-year global bonds. It attracted over $8 billion of demand, despite investors in its outstanding long-dated bonds having recently suffered spread widening following two notch downgrades in its credit ratings from A-/A3 to BBB/Baa2. It increased the total deal size modestly from the initial target of $2 billion.Prompting both the downgrades and the latest global bond oVer was the same event: a transformational acquisition for the 83-year-old company, which operates in four businesses - petroleum exploration and production, gas gathering, chemicals and refining. At the end of April, Phillips received Federal Trade Commission approval for the $7 billion acquisition of Arco's oil assets in Alaska from BP. This is a deal that propels Phillips into the major league in the oil and gas sector. It gives it significant interests in two of the largest oilfields in north America, doubles its reserves from 2.2 billion to 4.4 billion barrels of oil equivalent and promises an immediate jump in its annual oil production of some 70%.Phillips' management has been keen to propel the company into a higher division and compete effectively against the world's leading energy companies. The acquisition of Arco's assets is just the latest and largest in a series of imaginative deals designed to upgrade the company across its four main business divisions.In March, Phillips put its gas production and marketing assets into a new joint venture with Duke Energy, called Duke Energy Field Services, which will be 70%-owned by Duke, 30%-owned by Phillips. It will be a leader in the US market for natural gas liquids. Phillips has also announced a 50:50 joint venture in the chemical business with Chevron, Chevron Phillips Chemical Co, which will be among the top-five global producers in several chemicals. With both joint ventures, Phillips raised the scale of its operations, maintained substantial equity interests in businesses oVering diverse cashflows, and, crucially, raised capital. The deal with Duke threw off $1.2 billion of cash for Phillips and the deal with Chevron another $800 million. Those funds helped part-finance the key acquisition in the company's transformation: Arco's Alaskan assets. "This was a once in a lifetime opportunity," says Phillips treasurer John Carrig of the Arco deal. And the company was prepared to accept the inevitable downgrades that came from funding the remainder of the purchase price with debt. It took out a bridge loan that it later replaced with over $4 billion of commercial paper. Of this $2.5 billion will be refinanced from proceeds of its new five-year and 10-year bonds.The company intends to complete a final joint venture in its refining marketing and transportation businesses, possibly in 2001. That may rise more cash to reduce indebtedness.Meanwhile, Phillips intends to roll over and eventually repay the remainder of its CP outstandings over the next three or four years by drawing on the hefty cashflow that the new assets should produce. Carrig says: "We evaluated the acquisition using a high-teens oil price forecast and then stress-tested the transaction assuming oil prices in the $15 per barrel range. The cash break-even is under $10 per barrel on a WTI-equivalent basis. We expect the deal to accrete to cashflow and proWts per share from 2000. We didn't see a need to issue equity because the cost of the debt relative to the cashXows from the assets looked attractive."If the company deleverages as planned, bondholders should soon enjoy a spread tightening. Bond investors in the US and Europe, suYciently convinced after a six-day roadshow of the likelihood of this return to single-A rating, were happy to buy five-year bonds at 182 basis points over US treasuries and 10-year bonds at 230bp over. When JP Morgan and Merrill began marketing the bonds in early May, Phillips's outstanding bond maturing in 2009 traded at a spread of 230bp bid, 225bp oVered. Early price talk was at 235bp to 230bp. That implied a small new-issue discount. Strong momentum allowed the leads to price at 230bp over, flat to its secondary levels. Spreads on both tranches of the new deals tightened by 8bp in the first week after launch.The popularity of the Phillips bonds stands in contrast with recent corporate bond issues from the likes of UK water utility Kelda Group which have had to promise investors coupon re-sets if ratings are downgraded. Fixed-income investors appear fed up with event risk and are generally credit averse. Mark DeVito, managing director at Merrill Lynch, who covers Phillips, says: "No-one likes to see a downgrade. But investors were convinced that this was a once in a lifetime event for Phillips and they were further convinced of the overall importance for the company to improve its ratings over the medium term." He adds: "This sector has been a safe one for bond investors and given this company's business mix and track record in financing it was an ideal candidate to come to the market." There were a few worries along the way. The deal was sold just two days after the US Federal Reserve raised interest rates by 50bp. Potentially more worrying, WorldCom announced its intention to sell $5 billion of global bonds in maturities of 18 months, three, six and 10 years in the same week as the Phillips deal. But orders remained firm in the Phillips book. Phillips chose to issue five and 10-year global bonds, partly because demand was strong in those maturities, partly as an article of faith with bond investors. "The market isn't really offering call options right now like it used to and we feel that coupons on the longer-dated bonds in the present market are quite high," says Carrig. The company did not want to lock itself into paying high coupons on longer maturities because it fully intends to achieve those upgrades.It didn't go the next logical step of insisting that it should be able to re-set coupons at lower levels if it's bonds are upgraded quickly. "That kind of grid pricing isn't available in the bond market," says Carrig solemnly.

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