Dan Ward & Sten L. Gustafson UBS Investment Bank Houston
With the current upcycle in the energy industry extending into its third year, energy companies—oilfield service companies, in particular—have been generating record amounts of excess cash. Sten Gustafson and Dan Ward of UBS examine the implications of this combustible hoard of dry powder.
For corporate mergers and acquisitions to occur, there necessarily must be a certain planetary alignment, including, among many other things, a quantitative and qualitative congruence of expectations (both buyers’ and sellers’), sufficiently compelling financial accretion (i.e., value creation), attractive “optics” of buyers being viewed as not buying too late or sellers selling too early, and the delicate “social issues” of management control following the transaction.
The lack of any one of these many components can disrupt this planetary alignment. Hence, this is the reason most consolidation tends to occur in fits and starts, mostly only during certain periods of a conducive environment. Historically, this often occurs after a relatively sustained upturn, when sellers feel their shareholders have already seen considerable appreciation, and buyers still manifest a bullish outlook.
Prior to the accounting changes in mid–2001 that eliminated pooling of interests accounting treatment, companies would leap through considerable hoops to maintain the highly favorable pooling treatment, which would enable the acquirer to simply combine the two companies’ balance sheets, avoiding both the write–up of assets (and the resulting increased depreciation) as well as the creation of considerable goodwill.
Applying the purchase accounting treatment rules of today, on the other hand, to most of the large–scale oilfield service transactions of the late 1990s would have had attributed anywhere from 50% to almost 70% of the acquisition value to goodwill, and the resulting asset write–ups would have led to meaningful earnings dilution. Thus, the rationale for such contortions to comply with pooling treatment was readily apparent.
Interestingly, many industry analysts hypothesized that, once pooling was eliminated, investors would start to utilize a “cash earnings” metric (adding back the incremental depreciation to the earnings), much like European companies and analysts had been doing for years, which would essentially bridge the two accounting treatments. However, more than five years later, this has never really materialized.
One of the most important hoops for maintaining pooling treatment demanded that the transaction be almost entirely an all–stock deal. Thus, although it generated favorable accounting treatment, companies had to utilize the most expensive capital they had (their own stock) to effect the transaction. Without the less expensive leverage available to drive accretion, there necessarily had to be enough of a valuation multiple differential (and/or meaningful combination synergies) to enable the acquirer to pay a change of control premium.
This is one of the most challenging aspects of an all–stock transaction—without an ability to truly pay a change of control premium, the aforementioned “social issues” are difficult to resolve. While many CEOs may believe in consolidation, the practical reality is that few boards are willing to turn over control without a meaningful premium.
Once pooling was eliminated, utilizing cash as a meaningful component of the acquisition consideration could then be introduced to fuel accretion while also enabling the payment of the necessary change of control premium. But if pooling were eliminated more than five years ago, why are conditions meaningfully different now versus just a few years ago? The key difference—and the catalyst for further consolidation in the oilfield services industry (and the broader energy industry as well)—is the cash that is piling up quickly on the balance sheets across the industry.
With the current upcycle in the energy industry extending into its third year, energy companies—oilfield service companies, in particular—have been generating record amounts of excess cash. The torrent of cash from sustained high levels of activity and pricing have driven the cash levels up and the debt levels down to the point where many companies are at, or are rapidly approaching, negative net debt levels.
With all macro indicators seeming to point to a sustained upcycle, the “problem” of excess cash is more than likely to continue unabated, as cash flow from operations will continue to far exceed even increased capital expenditure levels.
Nearly a year ago, the oilfield service sector suffered a crisis of confidence among investors who did not fully buy into the continued rapid increase of earnings projections among oilfield service companies. The coalescence of this skepticism and bullish earning estimates drove forward valuation multiples down to historically low levels. These low valuations, combined with rising cash levels and robust projections (even if conservatively assuming little to no growth), put many private equity firms and hedge funds onto the scent of many oilfield service companies.
Armed with billions in funds to be deployed, private equity firms circled many companies hard, and as a number of recent proxy statements have attested, a number of these buyouts nearly reached the altar. Driven by the same fundamentals, investors, including a number of hedge funds, began to demand the large–scale return of capital from such companies, through any number of means, although share repurchases (either through a defined program and/or via a “happy meal” component of a convertible security issuance) have tended to be the most prevalent.
Photo courtesy of Atlas Copco
The low valuation levels of their own stocks made such a repurchase a compelling investment for these companies, resulting in a decapitalization of an over–equitized balance sheet, an improvement in returns from a lowered weighted average cost of capital, as well as immediate accretion to all per–share metrics.
With a leery eye on the sharply cyclical past, nearly all such companies have made relatively moderate repurchases—while certainly larger than historical repurchases, they have remained below 10% of the total shares outstanding, and in some cases only keeping pace with option exercises.
Now that share prices have regained momentum, reaching all–time highs, and valuation multiples trending back towards historical averages (though still below average), the argument for immediate, continued large–scale repurchases has been blunted a bit. Moreover, there is necessarily a certain limit on how much these companies can ultimately repurchase on an extended basis without impacting trading liquidity, or making themselves a smaller target for another acquirer, especially in light of the strong consensus for continued excess cash flow for the next few years.
Yet the cash continues to build—so what to do? The oilfield service industry has been adding new capacity across all asset classes, but as noted earlier, such expenditures have been—and will continue to be—outpaced considerably by cash flow from operations. In a largely commodity business, adding additional capacity will ultimately bring supply/demand dynamics to the point where pricing and utilization are negatively impacted.
Thus, at this stage in the cycle, with additional capacity already arriving at the wellsite or on the near horizon, many companies have begun to look upon their growing cash hoard not as excess capital to be returned to “long term” shareholders who often flit in and out of their stock, nor as funds for future capacity additions, but rather as a powerful cache of record dry powder to effect consolidation in an industry which recently has seen a number of increasingly larger new entrants and overall new capacity.
Utilizing cash in this current environment to effect further consolidation has a number of advantages, both financial and strategic, and thus will likely serve as a catalyst for further M&A activity:
- Generates greater earnings accretion, even at higher acquisition premiums, by using the cheapest cost of capital and minimizing the issuance of additional shares
- Normalizes the balance sheet by deploying excess cash and re–introducing moderate levels of leverage (which can be rapidly paid down with the strong projected cash flows—thus essentially bringing forward future cash flows to pay for current cash flows)
- Rationalizes growing asset bases through consolidation, rather than adding to the overall market capacity
- Creates greater opportunity for cross–border transactions, as flowback issues are diminished/removed
Moreover, it now will have greater long–term positive impact on a company when compared to using cash to repurchase shares. Although a company repurchasing its own shares at or slightly above market value would generate somewhat higher immediate earnings accretion while also being an investment in a known quantity with no integration risk, ultimately this is more financial engineering than strategic positioning. No improvement in market position has been achieved, no upgrade of an asset base has occurred, and no increasingly valuable human capital been added. The company’s financial capital base has merely been shrunk.
These advantages have already begun to be seized and realized, as evidenced by a number of recent oilfield service transactions where cash has been deployed in a variety of ways. The many variants available for cash components also provide the additional flexibility that can serve as a further catalyst for consolidation.
A few months ago, Hercules Offshore utilized cash for roughly 35% of the transaction value of TODCO, enabling it to acquire a company essentially twice its size at an acquisition premium, while still generating meaningful earnings and cash flow accretion, and normalizing its pro forma leverage (while still being in a position to pay it down entirely in just a couple of years). The recent Transocean/GlobalSantaFe and TGS–NOPEC/Wavefield transactions have also utilized cash in slightly different ways to end up with the same benefits.
In the Transocean/GlobalSantaFe transaction, a new company will be created that will issue both stock and cash to both sets of shareholders, effectively enabling both sets of shareholders to fix a portion of the value of the deal while performing a leveraged recapitalization of the pro forma company to partially monetize the billions of dollars of its contract backlog and rationalize its balance sheet.
Through a different mechanism, the TGS–NOPEC/Wavefield transaction is targeting a similar result, by having a stock–for–stock transaction followed by an immediate repurchase of shares, of up to 10% of the company. Again, many structures can be employed through the use of cash, providing a greater number of avenues to reaching agreement on a deal.
No upside is without its downside, unfortunately, and although the use of cash has considerable benefits, it is not without its considerations. In a stock–for–stock transaction, boards and management teams do not necessarily have to make a call on where they are in the cycle. If it turns out that the high point of the cycle was yesterday, or whether it is 200% up from here, the shares issued were likely to have essentially been equally overvalued or undervalued as the target’s shares. Hindsight is thus not as much of as issue.
By using a cash component and thus fixing a portion of the value paid, both the boards of the buyer and the seller are then charged with the responsibility of making a statement as to where they believe they are in the cycle—the strength of which statement depends on the percentage of cash used. Indeed, the greater the cash component, the greater faith the buyer is placing in a continued upcycle. This is undoubtedly a weighty issue laid at the feet of a board.
While this challenge will certainly give some boards pause, we believe the advantages will outweigh these concerns in most cases, and these growing cash balances will spur further consolidation in the near–term. A growing hoard of dry powder of this magnitude is too combustible to stay unlit for long.
About the authors
Sten L. Gustafson [[email protected]] is a managing director in the Global Energy Group at UBS Investment Bank, where he has global responsibility for the oilfield services sector. Joining UBS in 2004 from Morgan Stanley, he has covered the oilfield service sector for nearly 13 years, and has been involved in many of the largest oilfield service transactions around in the world, including advising Hercules Offshore in its recent acquisition of TODCO. Gustafson earned a law degree from the University of Houston and a BA in English from Rice University.
Dan Ward [[email protected]] is a managing director responsible for the global energy mergers and acquisitions practice of UBS Investment Bank, and also advised Hercules Offshore in its recent acquisition of TODCO. Prior to joining UBS in 2005, Dan covered the energy industry for 10 years in M&A and corporate finance capacities for Deutsche Bank, Morgan Stanley, and Salomon Brothers. Dan earned an MBA from Columbia Business School and a BS in economics from Villanova University.
