What lies ahead in OFS sector?

Trend One: Larger, well-capitalized OFS companies have quickly gone on the offensive. During cyclical downturns, OFS operators typically begin a detailed internal analysis to identify technology, product, service line, geographic, and other gaps in their market product or service offerings. Next, they promptly begin to research and identify strategic acquisitions that best address their needs. Early in this cyclical downturn, our clients and many other OFS operators began to receive inbound inquiries from these companies.

The potential acquirer most often has a clear, thoughtful, and articulate rationale for the strategic fit of the acquisition within the acquirer's current operations. These calls are being executed by senior corporate development executives who are prepared to address a potential seller's skepticism of the buyer meeting their valuation expectations given market conditions, including providing valuation parameters (with appropriate due diligence caveats) based upon 2014 financial performance. Strategic acquisitions by large, well-capitalized OFS operators are beginning to unfold and we will follow the progress of these programs closely in the second half of 2015.

Trend Two: Early M&A focused squarely on diversification. This is commonplace for many industries during a cyclical downturn, and the OFS industry is no exception. It has directly focused on diversification broadly as a technique to help endure the current industry environment.

• Geographic diversification is being reevaluated by operators. North American onshore OFS companies are analyzing their key customer activity by basin to determine potential acquisition targets in strategic geographies. Offshore OFS companies appear to be focused on acquisitions that include operations in the Middle East and Asia, where activity levels seem to be less affected by current commodity prices.
• Product and service diversification is also a current M&A strategy. OFS operators are seeking to provide a more diversified portfolio of product and/or service offerings to their existing customers through their M&A activities and joint ventures. Many companies are assessing diversification outside of their current OFS market activities. Certain OFS equipment manufacturing and fabrication business are targeting acquisitions that would provide them access to the general industrial and downstream petrochemical industries. Market diversification often seeks to apply the company's core competencies, such as metallurgy and engineering, in industries that may be countercyclical to their OFS business activities.

Diversification related M&A activity is widely expected to accelerate as the year progresses.

Trend Three: Interest in stock-oriented merger transactions. Although the past few years have been dominated by cash-oriented M&A transactions, numerous small- to mid-size OFS companies have very recently indicated their interest in stock oriented merger transactions. Survival has been the most common rationalization for this material change in thinking about M&A, as financial effects of the industry downturn are now being fully experienced by OFS operators. Additionally, the largest OFS companies typically increase market share during cyclical downturns. The larger OFS operators have the ability to bundle services and reduce prices to levels where smaller operators may not be profitable.

Stock mergers are no less complicated than cash M&A transactions, but, if key issues of control and relative value are overcome, the underlying belief is that both entities will reap the benefits of the combination when market conditions recover. Stock transactions also preserve the acquirer's liquidity, a key consideration given the uncertainty surrounding the expected length of the current downturn. Synergies, economies of scale, and additional competitive advantages better position the new entity to survive, and potentially thrive, through the market down cycle. While many companies are primed to begin merger discussions, the duration of the current industry down cycle may dictate how serious these discussions become.

Trend Four: Though historically not a common phenomenon, earnouts are becoming much more prevalent as part of an M&A transaction. The past several years have been a sellers' market for OFS business owners, and accordingly the majority of OFS M&A closings have been all-cash transactions. If an earnout was part of the transaction compensation, it was usually a small percentage of the total proceeds and the earnout period was most often 12 months. However, in today's OFS M&A market, this is no longer the case. The most pronounced trend in the current M&A market is the attempted utilization of larger earnouts (as a percentage of total potential proceeds) and longer earnout periods. In a market environment where current year performance will certainly be below prior year performance:

• Buyers are unwilling to base value on prior year (2014) performance;
• Buyers are concerned about the timing of a cyclical rebound;
• Sellers are not motivated to exit their business during the downturn; and
• Sellers are concerned about selling and missing out on value associated with a quick market rebound.

The method buyers are utilizing to bridge the gap is an earnout that has the potential to bring total consideration closer to a reasonable market valuation based upon 2014 financial performance and which is structured over a period of up to three years (potentially allowing the sellers the benefit of a market rebound). Following the November 2014 OPEC meeting and the resulting rapid deterioration in crude prices, a number of buyers and sellers were required to introduce and agree upon earnout structures that would alleviate market concerns in order to close. Larger and longer earnouts are expected to be a key component of OFS M&A transactions for the near term.

Trend Five (emerging): Distressed and consolidation focused M&A. Although it is too early in this cycle to remark upon the distressed and consolidation focused M&A activities, as not enough of these types of transactions have been completed to date, there appears to be an abundance of distressed and value focused buyers that are targeting the upstream oilfield services industry. Deal flow for these buyers has been slow, but is expected to accelerate as 2015 progresses.

IN CONCLUSION

Upstream OFS service companies are operating in an environment where their customers are slashing all forms of spending and are closely analyzing procurement practices. In addition to dramatically reduced order volumes, these same customers are renegotiating contracts and demanding immediate and material price concessions. But, in the face of these challenges, M&A related discussions continue. Sellers remain cautious, looking for signs that the market has bottomed and better times are ahead. Buyers are seeking motivated sellers and are employing creative means to keep potential M&A discussions moving forward.

The OFS M&A market will continue to evolve as 2015 unfolds, and our experience from prior cycles tells us this market is resilient and inventive. M&A activity is expected to accelerate as OFS operators have an opportunity to more fully appreciate the challenges of the current industry environment.

ABOUT THE AUTHOR

Jim Rebello is a managing director of Duff & Phelps Securities LLC and is head of the firm's energy M&A practice. He has more than 20 years of principal investing and investment banking origination, execution, and management experience. Prior to joining Duff and Phelps, Rebello was a managing director and member of the executive management committee of Growth Capital Partners LP, a merchant and investment banking firm in Houston. He also was a principal of both SMI I and SMI II, GCP's mezzanine investments funds. Before that, he was a corporate financial analyst with Energy Ventures Inc., and he was earlier employed by Prudential Capital's Southwestern Energy Group as a credit analyst. Rebello graduated summa cum laude from Northeastern University, receiving a BS degree in business administration with concentrations in marketing and management. He is a FINRA Series 7, 79, and 63 registered representative.