Consolidation Through Mergers A Viable Option To Preserve Equity

By David Yager, National Leader Oilfield Services, MNP LLP

No sector of the economy should be considering the urge to merge more than Canada’s beleaguered oilfield services (OFS) business. The signals are powerful. Overcapacity in virtually every product and service line. Prices down to slimmest of margins. Bankers are unhappy and getting twitchy. Shareholders are morose. OFS operators have to do something because doing nothing is no longer an option.

The short and medium-term outlook is not promising. Oil prices are going down, not up. Additional uncertainly looms in Alberta until the royalty issue is clarified. New oilsands projects are dead. LNG is paralyzed by price, cost and global market turmoil. E&P companies looking to drill are demanding the lowest prices possible. Bankers who have been patient for months cannot kick the forbearance letter can down the road forever.

Because of a collapse in business along with oil prices, oilfield service managers have been cutting costs since late last year. Workers have been laid off by the tens of thousands. Capital spending and maintenance programs have been slashed or postponed. Pay cuts are common. Dividends reduced or eliminated. Principal payments postponed where possible.

The last major expense not yet addressed in any meaningful way is a measurable reduction in administrative (non-revenue generating) costs per dollar of revenue. This is the CEO, COO, CFO, VP marketing, HR manager, safety officer and corporate head office, plus reduced expenses for field service locations and product and service delivery.

How do you do that?

Selling out is ideal because operating the company is no fun whatsoever. The problem in cyclical OFS is valuations are at multi-year lows. Owners will want to sell from last year’s numbers and buyers will be focused on 2016. Businesses sell at a multiple of cashflow and there’s very little free cash flowing.

Consolidation by merging with one or more competitors is a way to preserve equity in a business and sell at a future date when valuations are higher. Exchange control of the current organization for a meaningful but smaller equity interest in a bigger and more efficient entity with a greater chance of success. Reduce administrative costs in a meaningful was as a percentage of revenue and create a survival strategy an unhappy and skeptical banker might believe.

It’s happening. The granddaddy of all mergers is the US$35 billion combination of Halliburton Co. and Baker Hughes Inc. There will be massive fixed cost reductions when this deal closes. The second-largest OFS company in the world is getting into fighting trim to profitably service its clients even if oil stays below US$60 forever.

Canadian public drillers CanElson Drilling Inc. and Trinidad Drilling Ltd. agreed to tie the knot in June for the same reason. One public company, not two, and a commensurate reduction in administrative costs. When the two companies consolidate fixed support costs the annual savings will be in the millions.

Plus clients want to do more business with fewer vendors. Oil companies lost a lot of the upside of $100 oil to high costs and low productivity. It costs more to deal with hundreds of suppliers generating thousands of transactions. Fewer quotes, reviews, POs, field tickets, invoices, processing and payment saves money. 

Why aren’t more OFS operators combining? The biggest issues are valuations and egos.

On the valuation side it is easier being public. The market determines value every day. Private companies are different. The smaller the company the lower the multiple. Many owners are not sophisticated in such matters so their default value is invariably high. Many companies don’t have quality financial statements or reports for quick and accurate assessment.

Valuations are at a turning point. Whatever a business was worth last year, there is a growing realization that in 2016 it is only going to be a fraction of that amount. But if you merge with a direct competitor the valuation methodology will be simpler because you’re both in the same business, own the same assets and operate in the same market.

As for ego, this manifests itself in “corner office syndrome,” the corporate finance term for a consistent obstacle to consolidation. The CEO/owner cannot conceive how the business could possibly go forward without him or her at the helm. It’s all about control, even if it isn’t really there because of the balance sheet or business environment. Therefore, even when a merger makes sense for owners, investors, lenders, customers and even most employees, egos too often get in the way. Many merger discussions never get past the first meeting.

If conversations haven’t started already, OFS owners and managers should be thinking hard about becoming part of bigger entities with a better chance of surviving in a shrinking and intensely competitive business environment. If you can survive and succeed on your own, that’s great. If you can’t, be realistic and protect as much capital as you can.

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