Canadian Natural Resources Ltd. will acquire Rio Alto Exploration Ltd. for approximately C$2.4 billion, solidifying its position as Canada's second-largest gas producer and vaulting it to No. 4 among North American independent gas producers. The merger will take place following a spin-off of Rio Alto's international operations to shareholders. The new CNR will have an estimated 1.5 billion cu. ft. (Bcf) per day of production. Its gas exposure will climb to 55% of total production on a BOE basis and the deal will increase the company's estimated 2002 cash flow by about 10%. Canadian analysts give the deal mixed reviews. "I think it's positive," says Victor Vallance, Dundee Securities Corp., Toronto. "It adds incrementally to cash flow per share. It was done at a reasonable price. We're quite bullish on gas, so the acquisition should pay off when gas prices strengthen again." Another analyst suggests Canadian Natural may have overpaid. "Rio Alto had hit a wall, with excessive finding and development costs. It had acknowledged as much by bringing in an independent board and seeking strategic alternatives. There is no, or very little, overlap in the two companies' northwestern Alberta assets, so this is more of a commodity play for Canadian Natural," he says. He also suggests the value ascribed to Rio Alto's overseas operations, which will become a separate publicly traded company prior to the merger, may be excessive, and the market will react accordingly. A third analyst finds the deal fair for Rio Alto shareholders at the outset and more beneficial for Canadian Natural over a longer term. "We had an estimated net asset vale of C$18.35 per Rio Alto share," says David Stenason, Scotia Capital Corp., Montreal. The agreement gives Rio Alto stockholders the option of receiving C$18.10 cash (up to C$850 million) or 0.3468 Canadian Natural common share (up to 12.27 million) for each Rio Alto common share held. Canadian Natural also will assume C$972 million of Rio Alto debt. In addition, Rio Alto shareholders will receive one share of a new publicly traded company, Rio Alto International, for each Rio Alto Exploration share held. The new company will own all of the current Rio Alto assets outside Canada. Its stock will have a C$1.90-per-share book value. Its assets will include operations in Ecuador's Orienté Basin currently producing approximately 7,500 bbl. of oil per day, and Argentina's San Jorge Basin, where its net production is some 1,000 bbl. per day. The new company will be capitalized with approximately 78.265 million shares that will be distributed to current Rio Alto shareholders. Another 8.3 million shares will be issued to Canadian Natural for C$1.90 each, or C$15.8 million, in cash. Canadian Natural's challenge is to turn around Rio Alto's asset base, Stenason says. "But by raising its gas asset base from 47% to 55%, it will get more attention in equity markets beyond Canada, particularly in the U.S.," he says. "Natural gas is the commodity of the future for this industry, and investors like its story." Canadian Natural has an established record of buying troubled companies and turning them around, he adds. "It bought Sceptre Resources Ltd. in 1997 and more recently Ranger Oil Ltd., which was a good explorer but could not translate its discoveries into production growth. That's Canadian Natural's strength-to acquire and exploit." Canadian Natural plans to finance the purchase's cash portion with existing bank facilities and by drawing down a new $500-million bank term facility provided by Scotia Capital. The company anticipates that its debt will increase to approximately two times cash flow as a result of the deal, dropping to 1.3 times cash flow by the end of 2002. Similarly, Canadian Natural expects its ratio of debt to equity to climb to approximately 47% once the deal closes, and to bring that ratio down to 41%, its level earlier this year, by the end of the year. CIBC World Markets is financial advisor and solicitation agent in the deal. Canadian Natural also retained First Energy Capital Corp., Peters & Co. Ltd. and UBS Bunting Warburg Inc. as strategic advisors on implementing the merger. Rio Alto president Richard Cones says the combination of Canadian Natural's strong balance sheet and larger, more balanced asset base with Rio Alto's significant development potential in northwestern Alberta will allow Rio Alto shareholders to realize the development of these properties irrespective of the commodity price cycle. It also will allow Rio Alto shareholders to participate in Canadian Natural's significant near-, mid- and long-term growth potential, he adds. Canadian Natural chairman Allan Markin says, "Rio Alto has done an excellent job of accumulating a large, high-quality undeveloped land base and infrastructure in northwestern Alberta. This asset represents a large, high-quality, operated core area upon which it has an extensive geological database. Its significant development potential can be optimized more efficiently as part of a larger, more balanced company."