Reducing inefficiencies during M&A

This change signifies that OFS companies became more strategic in the way they approached mergers and acquisitions by focusing more on adding significant value while taking advantage of market downturns.

IMPORTANCE OF SYNERGIES DURING M&A

M&A synergies can be broken down into three types: revenue, financial, and cost synergies. Revenue synergies focus on increasing top-line revenue by taking advantage of cross-selling, access to new markets, and reducing competition through consolidation. Financial synergies seek to improve the acquiring company's financial position by reducing their cost of capital and/or increasing free cash flow.

On the other hand, cost synergies aim to increase bottom-line net income by reducing costs stemming from administrative, production and logistical redundancies, leveraging economies of scale, and headcount reduction. Companies in the oil and gas industry often focus on attaining revenue and financial synergies naturally inherent in a deal, and reduce headcount at an attempt to realize any cost efficiencies. The strong emphasis on increasing revenue can completely discount any efficiencies developed by the acquired company that could be rolled into the combined firm to reduce overhead and improve operations.

Mergers and acquisitions rely strongly on proper integration to capitalize on identified cost synergies and realize the full value of the transaction. However, when the acquiring company focuses its attention solely on initial headcount reduction and integrating the purchased company into the preexisting operating model as quickly as possible, the post-transaction integration proves to be superficial. Oftentimes, when widespread integration is attempted, momentum quickly declines as integration teams are delegated to subordinates or disbanded long before the acquisition's full potential is realized.

In either case, the result is that the acquired company is integrated with little development of cost synergies and minimal improvements to streamline operations. Over the recent boom years, this has been especially true in oilfield services as firms have been almost wholly focused on gaining market share and meeting increasing order demand.

Synergies can significantly affect three major aspects of performance: growth, returns, and margins. As previously discussed, there is a tendency for OFS companies to focus heavily on revenue synergies, which directly influence growth and returns, and place cost synergies second. Examining the performance of the five OFS companies who announced acquisitions with the greatest overall total in the past five years can help paint a high-level picture of companies' intentions during the acquisition.

Although the OFS companies grew their average revenues 75% more than Standard & Poor's (S&P) companies since 2008, Figure 2 shows that they still failed to outperform the market in terms of share price increases. During this time, companies in the S&P 500 were able to increase their operating margin by 21%, while the OFS companies reduced theirs by 23%. If these companies had been able to maintain their 2009 level of operational efficiencies, they would have saved an average of $4.2 billion per year going forward.

IMPLEMENTING OER TO MONITOR EFFICIENCY LEVELS

A large portion of a company's stock price is associated with the ability to generate and increase earnings, which is measured through various ratios and metrics such as gross margin, EBITDA/EBIT margin, and net income margin. Equally important for companies and investors is monitoring the efficiency levels of companies through their management of various costs utilizing Operational Efficiency Ratios (OER).

This metric divides a company's expenses by its total revenue, and answers the question: How much does each dollar of revenue cost? The OER metric is useful for monitoring financial performance at both a high level, as well as an individual P&L level. Utilizing OERs, a deep dive into a company's financials can help companies assess their own performance levels, the performance levels of an acquired company, and finally of the merged company.

PERFORMANCE IMPROVEMENT INITIATIVES

These metrics can serve as performance baselines and identify key impact areas requiring improvement. Performance improvement initiatives can significantly drive down high-cost inefficiencies, such as IT and operations support, and lead to improved cost savings in M&A deals. However, failure to implement performance improvement initiatives can lead to increased inefficiencies over the long-run, thereby negating any identified cost savings and synergies.

Baker Hughes' purchase of BJ Services Company shows a quantifiable example of low cost synergies. In August 2009, Baker Hughes announced its intention to acquire BJ Services, a large provider of pressure-pumping-services, for $5.76 billion. At the time of announcement, Baker Hughes had an OER of 0.92, while BJ Services had an OER of 0.93, and reviewing the company OERs for the previous five years provides additional insight. BJ Services' OER had worsened by more than 21% from its best performance, and inefficiencies were realized earlier and broader than was the case at Baker Hughes. Baker Hughes may well have looked at BJ Services and discovered a trend from 2006 onward that showed performance issues and therefore opportunity.

After the acquisition was finalized and BJ Services was operating as a part of Baker Hughes, the OER numbers tell a different tale. As depicted in Figure 3, Baker Hughes' OER began to vary greatly year-to-year, and improved to 0.89 in 2010, again to 0.85 in 2011, then worsened to 0.89 in 2012, 0.91 in 2013, and finally to 0.88 in 2014.

This initial drop in OER can be partially attributed to an increase in revenue ($4 billion) and a massive reduction in head count (5,100 employees). It is important to note that these numbers are significantly higher than the Top 10 (according to market cap) total OER averages, also depicted in Figure 3.

In 2014, Baker Hughes' OER of 0.88 was almost 3% higher than the top 10 OFS companies' (according to market cap) average of 0.85. If Baker Hughes had operational efficiency levels of the top 10 average, they could have seen an operating income gain of $585 million.

STEPS TO ENSURE SYNERGIES ACROSS OPERATIONS

So what can be done to ensure cost synergies are realized across operations during OFS M&A deals?

First, form integration teams and empower them to make and implement strategic changes. These teams should be comprised of key influencers in both the acquiring company and the acquired, and should be stood up with a long-term focus (2+ years).

Second, develop and record the strategic objectives for the deal as well as the operational requirements for the combined company going forward. Strategic objectives will serve as the integration's overall goals and drive all subsequent processes.

Third, take a detailed, top-down look at both companies' financials by utilizing OER metrics to identify high-impact areas and establish financial baselines to measure improvements.

Fourth, a bottom-up process assessment should be implemented with particular attention paid to high-impact areas, as well as those necessary to achieve stated goals (known as key processes). The high-level steps include:

• Map key processes for each company, compare, and classify them
• Redundant - identify as areas of possible improvement
• Non-redundant - separate according to alignment with objectives/goals
• Clear alignment - leave as is and monitor
• Unclear alignment - identify as area of improvement
• Map support processes (redundant) and perform gap analysis to ensure key processes are all provided for
• Identify current process owners within each firm
• Create metrics for all processes to monitor performance
• Assign process owners going forward and hold them accountable for integration and performance going forward
• Prioritize identified areas of improvement and high impact areas
• Perform business process audits, based on priority, to consolidate and streamline operations
• Monitor performance against metrics by tying them to process owners' key performance indicators (KPIs)

Lastly, continue to monitor performance at P&L level through use of developed process metrics, KPIs, and financial analysis utilizing OER analysis. Beyond basic monitoring, continuous process improvement checks should be established and performed by objective parties to continue cost efficiency improvements, and increase margins well into the future.

HOW CAN THESE STEPS HELP WITH LAYOFFS?

Oil price fluctuations put increased pressure on net income through a reduction of revenue and increases the need for OFS companies to cut costs to maintain profitability margins. Many times, this pressure leads companies to engage in M&A deals to supplement revenue without adding significant costs. While these types of deals present an opportunity to implement sustainable cost-cutting measures through performance improvement, most OFS companies chose to undertake significant layoffs instead. The negative results from company-wide layoffs are numerous: negative public perception, damage to employee morale, and ultimately exposure to the same mistakes companies made following the drop of 2008.

Implementing the integration process discussed above creates sustainable cost-cutting measures that allow the company to operate effectively and generate a positive image both internally and externally. Internally, morale is helped with perceived job security and externally, the inevitable negative press associated with layoffs is avoided. Companies often see positive impacts to financial coverage from analysts looking favorably at increased efficiency.

Finally, it makes the company stronger, and much better prepared for a rebound in oil prices and the related demand. M&A deals during market downturns present the perfect opportunity to increase focus on creating efficient combined organizations, instead of aggressively adjusting headcount and/or relying on broad-stroke integrations in an attempt to keep up with the market.

ABOUT THE AUTHOR

Thomas Royce is a management consultant with experience across the public and private sectors. He is currently focused on improving the operational efficiencies for organizations within the oil and gas industry. He has extensive experience in the areas of strategic direction, organizational efficiency improvement, financial analysis, and change management; and is skilled in governance enhancement, project management, and business process improvement. His current certifications include: Project Management Professional (PMP), Prosci Change Management Practitioner, and Lean Six Sigma Yellow Belt. Contact North Highland for additional information.