The approximately $410-million, all-stock merger of Stone Energy Corp. (NYSE: SGY) and Basin Exploration Inc. (Nasdaq: BSNX) will bring together two Gulf Coast-focused independents with very different growth strategies. Lafayette, Louisiana-based Stone specializes in acquiring and exploiting mature properties. Denver-based Basin explores for new prospects in its undeveloped lease inventory. "You've got one company-Stone-that's very good at acquiring and exploiting properties. And you've got another company that's been very successful building itself by taking a large seismic database, finding prospects, going to lease sales and drilling them," says John Myers, an Austin-based E&P analyst for Dain Rauscher Wessels. "Put those two talents together and you've got a company that can make money two ways." Stone Energy will be the surviving entity, retaining headquarters in Lafayette. Total market capitalization will be approximately $1.5 billion, with $1.4 billion in equity and $100 million in net debt, for total debt-to-capitalization of 23%. Stone's stockholders will own approximately 71% of the new entity. The combination will be accounted for as a pooling of interests and is anticipated to be immediately accretive on a per-share basis to cash flow, earnings and reserves. The transaction should be completed in early 2001. Under the agreement, Basin stockholders will receive 0.3974 share of Stone per Basin share. Based upon Stone's preannouncement-day closing price of $54.16, the offer represents $21.52 for each Basin share, a premium of 10%. In addition to paying approximately $410 million in new equity, Stone will assume approximately $48 million of Basin debt. E&P analysts say the acquisition price is somewhat high but justified. "Stone paid $2.08 per thousand cubic feet of gas equivalent for Basin's year-end 1999 proved reserves and other assets," says C. Van Levy of CIBC World Markets in Houston. "While the acquisition price is well above Stone's 1999 finding cost of $1.36 per Mcfe and the four-year weighted average of $1.24 per Mcfe, it clearly can be justified in the current $4.50- to $5.00-per-Mcf [market] price environment." Bob Morris, who follows independents for Salomon Smith Barney Inc. in New York, echoed that sentiment as he examined the deal on the basis of barrels of oil equivalent (BOE). "Although the $13.25-per-BOE (proven reserves only) implied acquisition price appears 'expensive,' we view the proposed transaction favorably," Morris wrote. "In addition to the proven reserves, Stone will acquire Basin's inventory of more than 50 exploration prospects, which Basin estimates possess a net unrisked reserve potential of roughly 900 billion cubic feet of gas equivalent, or more than four times Basin's year-end 1999 proven reserve base." On a pro forma basis, the merger is expected to increase Stone's proved reserves approximately 54% from 387.4 billion cubic feet of gas equivalent to 596.9 Bcfe as of year-end 1999. The pro forma proved reserves are approximately 65% gas; 87% of reserves in the Gulf Coast and 13% in the Rockies. Also on a pro forma basis, the deal would increase Stone's current daily production 50% from approximately 200 million cubic feet of gas equivalent per day to approximately 300 MMcfe per day. It also would expand Stone's significant drilling prospect inventory approximately 50%, and increase prospective undeveloped acreage from about 74,000 acres to approximately 267,000. Stone and Basin are among the fastest-growing Gulf-focused independents, according to Morris. "Since its initial public offering in 1993, Stone has increased proven reserves at a compounded annual rate of 26%," he says. "Since refocusing its efforts to the shallow-water Gulf of Mexico in 1996, Basin has grown proven reserves at a compounded annual rate of more than 40%." (For more on Basin's Gulf Coast strategy, see "Changing Basins Changes Basin," Oil and Gas Investor, August 1998.) Some of the companies' efforts have been virtually redundant. For example, Myers says, Stone drilled a shallow-water Gulf discovery in Vermilion Block 267 and installed a production platform. In that same block, about 200 feet away, Basin drilled a discovery and installed a platform. "It could have been developed with one platform," Myers says. Stone's upcoming projects include the Narwhal discovery on Eugene Island Block 243, expected to be brought into full production in May. Stone is also developing discoveries at Weeks Island, West Cameron Block 176 and East Cameron Block 64, which are expected to begin production before year-end; and the discovery at Vermilion Block 267. Basin's projects include discoveries at West Delta Block 58, South Marsh Island Block 235, South Timbalier Block 107, and Vermilion Block 329, all of which are expected to begin producing by the first quarter of 2001. The companies plan to implement a hedging program to lock in the cash flow value associated with approximately 25% to 30% of the combined production from total proved reserves during the next two years. Initial economics place the hedges at $3.50 per Mcf of gas and $25 per barrel of oil, executives said in a conference call. Based on the current commodity-price outlook and the security provided by these hedges, the combined company's discretionary cash flow is expected to grow more than 20% in 2001. D. Peter Canty, Stone president and chief operating officer, is to become chief executive officer of Stone in January, with the retirement as CEO of founder James H. Stone, who will continue as chairman. Canty will be CEO of the combined company. Michael Smith, Basin CEO, will join Stone's board of directors. "This integration of core talents will enable us to significantly enhance the value of our combined current and prospective asset base," Canty said. "We believe the combination of our respective strengths will create the premier Gulf of Mexico-focused E&P company." Myers' target price on SGY, assuming the merger is completed, is up, to about $80 per share. Salomon Smith Barney's 12-month target is $73. Stone closed at $51.20 after the announcement; Basin, at $19.8125. Basin was upgraded from Neutral to Strong Buy Aggressive by Dain Rauscher Wessels, and was downgraded from Buy to Accumulate by Frost Securities. The transaction is contingent on shareholders' approval and regulatory clearance. Merrill Lynch & Co. advised and provided a fairness opinion to Stone, while Goldman, Sachs & Co. advised Basin. "I think it makes a tremendous amount of sense," Myers says of the deal. "In the industry itself, bigger companies tend to have a lot of economic advantages over the smaller guys. They tend to trade at better multiples. They've got the bigger opportunity sphere-they can play anywhere in the world."