Description

The punchline: The HAL-BHI deal makes a lot of sense, and I suspect that DOJ/EC would have to require HAL to cut bone before the merger collapses. Longer term, the deal allows HAL to meaningfully improve profitability (adj. EBITA margin 15% in 2014e to 20%+ with higher ROIC), and the shares could be worth $80-100 by the end of the decade. I prefer HAL given long-term upside + limited near-term downside if the deal falls through, but would judiciously nibble on BHI given that the current ~20% arb spread on the shares is probably too high.  If needed, please refer to past write-ups on both companies involved here.  

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I believe that an investment in either side of the Halliburton (HAL)-Baker Hughes (BHI) merger is an attractive risk-reward for those with a 3-5 year or longer investment horizon.  This is because a completed merger should allow HAL to materially improve its long-term competitiveness and financial profile v. either entity as a standalone.  Furthermore, the rapid development of technology and understanding around unconventional drilling seems to be pushing the normalized position of these resources lower on the cost curve, which could imply an interesting reversal of fortune in onshore v. offshore assets and which benefits HAL given its strong onshore positioning.

On the merger close itself, my estimate is that BHI’s share price will be +/-20% in a deal/no-deal scenario whereas HAL will be -/+ 0 to 5% on deal/no-deal.  My incremental dollar would probably go into BHI given the risk-reward and a potential >100% IRR on the arb, though it seems like the spread has begun to close a little over the past two days.  I suspect that the market is still not fully appreciating how important this deal is to both companies and how far HAL may be willing to go on divestitures to get it done.  With HAL, there’s less near-term downside, but also less of an immediate positive catalyst to worry about (ie. it may make sense to wait for the deal to close first if you’re planning to pile into HAL).

Background

Schlumberger (SLB), HAL, and BHI make up the Big 3 in the global oilfield services industry, generally providing less-commoditized, technology-intensive services needed to place, construct, and maintain a well.  The Big 3 is a true global oligopoly – no other company comes close in terms of technology, product, or geographic scope, and it is often difficult for upstream customers to avoid using at least one of the three.  Markets such as the US, China, and Russia do have local providers offering land services (and the Chinese are very gradually entering the international market), in which case the Big 3 may only be brought in when a particular technology is needed.

These businesses can be a bit difficult to understand without prior knowledge, but there are a few basic simplifying descriptions that should help paint the picture:

1. The companies are vertically integrated, in that the tools/equipment they use are proprietary, primarily developed and manufactured in-house.

2. The companies all operate on a geographic basis.  There’s value in understanding the local geology and above ground business practices, but the tools used are similar/the same around the world.

3. To serve a region, you need a local physical presence, an investment in tools inventory (PP&E), and a team to operate them.  The Big 3 basically have overlapping footprints, though they don’t offer all services in all regions.

4. Contracts are awarded based on anything from piecemeal bidding (eg. a five-figure invoice for a single service) to fully integrated projects where a service company is effectively cutting out the E&P (frequently touted, but still rarely happens).

While the portfolios of the three are largely similar, there are practical and reputation nuances.  Schlumberger is the bellwether with its roots in the high margin wireline logging business, and is known for its size/scale, international presence, and technological sophistication.  Halliburton’s roots are in cementing, and it is generally viewed as a best-in-class operator in more equipment intensive services including cementing and pressure pumping.  Baker Hughes was historically a tools manufacturer, and is known for its technically strong product portfolio but a lack of scale and operating prowess.

Financial Positioning Pre-Deal

A couple of charts for context:

a) SLB’s margins were historically very similar to HAL/BHI, and it has really only been since the last recession that a ~500bps gap v. HAL appeared.  BHI’s ~300bps gap to HAL has largely been driven by issues in North America after acquiring BJ Services.

b) SLB has historically had more balanced exposure to international markets, whereas HAL and BHI are both concentrated in North America.  The challenge is that SLB has spent years building out its international service infrastructure, and in most markets SLB is the size of HAL + BHI combined.

c) SLB also earns higher margins in each region than HAL and BHI, and its overall margins benefit from its strength in international markets where margins are higher than in North America.  SLB benefits significantly from its operating scale.

Transaction Synergies

For HAL, BHI provides:

1. Scale to optimize international operations;

2. Scale to vastly improve the depth and scope of future R&D programs v. SLB;

3. A few missing pieces within HAL’s product portfolio; and

4. More typical synergies such as procurement that I’ll skip in the discussion.

Altogether, HAL has stated that it expects to achieve $2 billion of cost synergies by year 2 of the transaction from #1 and #2, of which $1 billion is pure fixed costs.  This alone translates to ~4-5% margin expansion, and appears achievable given the size of the respective (esp. BHI’s) operations.  Furthermore, #2 plus #3 plus the act of consolidation vastly improves the competitive position of the RemainCo, which will likely translate into revenue synergy in the long run after some pressure near term.

Local scale

Imagine you are HAL, and you’re trying to offer services in a remote $400mm/yr market in MENA growing 10% annually.  SLB is already on the ground and serving customers with a full suite of services.  You need to set up a requisite facility for storage, equipment servicing, and an office, and then need to decide which services you can be competitive against SLB for and therefore actually earn a return on your $20-50mm upfront investment in equipment inventory.  Whatever crews you bring in will be less utilized than SLB’s, because you need to keep a second crew or piece of equipment around for backup whereas SLB can service 2x the number of jobs with just one more crew than you.  SLB’s larger presence means that they’ve brought in every service in their portfolio that could be used, whereas you decide you can’t offer chemicals or a wireline product because there’s not just enough work to go around to keep your equipment utilized – especially since BHI is entering the market at the same time as you are.  Oh, and because you’re not competitive with SLB on service breadth or cost structure, they look like a much more serious partner for the local oil company than you do.

The above certainly isn’t the exact scenario that plays out in every market, but gives a taste of some issues that HAL and BHI face in international markets.  But if there’s any doubt there’s at least some truth to this, just look at this map from the transaction slide deck.

SLB was early to build out its global infrastructure and develop relationships, while HAL/BHI have been aggressively investing to catch up over the past decade.  By combining with BHI, HAL will be able to consolidate local footprint, improve breadth of services while reducing capital intensity, improving asset utilization, and driving higher margins.

North America is the other major piece of the puzzle, where getting BHI’s margin up to HAL’s level would generate ~$400-700mm of additional pre-tax earnings (depending on which year’s top-line we calculate the savings off of).  The problem here has been BHI’s somewhat disastrous acquisition of BJ Services’ pressure pumping business, which under BHI became meaningfully underutilized.  North America will likely involve BHI’s assets dropped into HAL’s operations and infrastructure.

One reasonable question is ask is whether SLB’s 20% EBITA margin is just a function of superior underlying mix – after all, aren’t they the high-tech wireline provider to the masses?  There’s no way to know for sure, but in the below table, I lay out revenue mix based on older 2014e Spears data, and apply my guesstimate of product line profitability.  The bottom line is that even though SLB does have a huge advantage in reservoir characterization businesses, mix shouldn’t be a problem for a margin convergence thesis among the Big 3 assuming other issues such as scale get resolved.  Interestingly, SLB’s entry into subsea production equipment should actually be margin dilutive on this basis.

Research and development

As the chart below shows, SLB has historically spent about twice as much as HAL or BHI on research and engineering of new services.  This is a huge problem for the latter two, because despite different focus areas, a significant portion of the $600mm in HAL and BHI’s spend is to sustain overlapping product lines.  The union of their $600mm in spend may look more like $900mm to SLB, meaningful that SLB can match the competition and then spend another $300mm to expand its lead in wireline, build unique capabilities in subsea processing, do more research v. development work, etc.  

The R&D opportunity is particularly interesting because HAL will effectively be able to pick and choose the portfolio and development programs that it wishes to keep within BHI.  For example, BHI spent a significant amount of money developing a unique suite of high pressure high temperature tools for McMoran’s high-risk shelf drilling in the deepwater Gulf of Mexico, but that technology is eminently transferrable to other regions and customers over time.  As a merged entity, that technology can be more extensively marketed in future HPHT reservoirs without duplicative investment by HAL.

Long-term revenue benefits

A combined entity will also likely drive revenue synergies and improve HAL’s long-term competitive positioning.  In addition to local scale and R&D arguments, BHI fills out HAL’s product portfolio by giving it strong specialty chemicals and artificial lift assets, meaning these businesses are put in a better position to win revenue on HAL-dominated projects.  Furthermore, there is a gradual industry trend driven by SLB to offer services on an integrated basis, with service companies (namely, SLB) gradually taking on more of the risk and pushing traditional oil companies out of the equation.  A merged entity should result in a compression of the integration advantage that SLB currently holds, and could potentially accelerate the adoption of integrated services given a second credible/comparable provider.

(Dear DOJ, hopefully you are either not reading this or don’t care about the superfluous opinion of an anonymous and highly biased party on the internet.  Thanks.)

The second and more obvious part of the revenue synergy here is the removal of a key bidder in integrated, international, and technology-intensive services.  Weatherford is a fourth player in some categories, but its overlap with the Big 3 is actually not that high.  In many important markets and products, the transaction looks like it takes a three bidder market down to two, but it really changes the bidding dynamics from {#1 v. #2.5 v. #3}, where HAL and BHI bid vigorously against each other while SLB’s position was relatively secure, to {#1 v. #1.5}.  This is potentially better for HAL and potentially better for the customer, but neutral to slightly negative for SLB.  Anti-trust divestitures would surely reduce the scale of the pro forma entity in critical geographies and product lines, but there is no practical way to get around the fact that the companies picking up HAL/BHI assets will not really be able to compete in the same way that SLB and HAL can.

Tax opportunity

HAL pays a high-20s tax rate while BHI pays in the low-30s.  While there are probably tax structure improvements that BHI could make under the HAL umbrella, a big chunk of the delta will naturally be closed once BHI’s loss-making international operations get rolled into HAL and start to generate profits (loss-making foreign operations reduce income but don’t generate tax refunds, therefore inflating tax rate).

Deal Dynamics

On my numbers, the market is pricing in a 50% chance of the deal closing v. 40% a few days ago, down meaningfully from a peak several months ago of more like 70%+.  It appears as if most of this jitter is coming from new divestiture proposals that have been disclosed, as well as news flow around reviews and approval timing from around the world (it seems like regulators are hesitant to make quick decisions, and for good reason).  However, I believe that the industrial logic of this transaction is strong enough that it overwhelms anti-trust divestitures in all but the most draconian scenarios.  If anything, HAL is the “safer” way to make this bet without exposure to downside in case the deal falls through.

Anti-trust is indeed by far the biggest risk here as HAL has already raised the $8.5bn of cash it needs to close, and the deal is a no-brainer for BHI shareholders and should be passed (albeit with some resistance ) by HAL.  The question is then how far the DOJ and EC will go in divestitures demand, and whether HAL would be willing to accept them to get the merger done.  From HAL’s perspective, this is a game-changing transaction that fills out its missing product lines and changes its competitive position in the industry.  Even if we attribute the entire stated $2 billion cost synergy opportunity to the take-out premium BHI gets, HAL still stands to benefit on the basis of competitive position, pricing perspective, and the avoidance of a $3.5 billion termination fee by closing.  Unless DOJ says HAL needs to divest the majority of BHI and HAL’s competitors refuse to bid acceptable prices, it seems like the deal should close.

HAL’s approach to the transaction appears to be well-planned and resourced, with a dedicated integration team headed by CFO Mark McCollum (who handed off CFO duties because the integration is more important) and strong legal representation that was involved in all of the past decade’s major oilfield services deals including BHI/BJ (in which BHI had to divest two stimulation vessels, and a sand control and frac fluid business in the Gulf), and SLB/Smith (no divestitures).  HAL has already announced and is in the process of auctioning off assets that generated $5.2 billion of revenue in 2013, and the current timeline calls for a response from the DOJ and EC mid-December, though it seems reasonable to expect some slip in this timeline to Q1 2016.  While it’s possible that the bids are too low, the opportunity to pick up service assets could be too tempting to pass up for smaller competitors and equipment manufacturers who want more recurring revenue streams.

Returns

My rough numbers (summarized below) assume:

1. HAL+BHI returns to 2013/14 revenue levels by 2020;

2. Divestitures add up to HAL’s stated maximum $7.5bn of 2013 revenue ($5.3bn in 2016) and is sold for 1.1x sales which is below the 1.7x where HAL and BHI trades (BHI incl. M&A premium);

3. Operating margins expand to 20% by 2020;

4. Free cash flow generation settles at around 80% of net income and is used to pay down debt;

5. No interim dividends, but HAL does a levered recap to return to 1x ND/EBIT at the start of 2020.

At 16x earnings of $4.92 + $10.79/share levered recap, I get an $89 target price at 2020 or an 18% 5-year return CAGR.  The table below shows sensitivity of returns under this framework to 2020 margins – we don’t need to make heroic synergy assumptions to get a reasonable return with HAL, and with BHI, there’s an opportunity to make a short-term arb spread on top of this.

A reasonable knock against these numbers would be the top-line rebound assumption, which is predicated on a return to a higher crude price environment.  While the last year has clearly reminded us of how price inelastic crude can be and that perhaps $100/bbl was too high to be sustainable anyway, I think most would probably also agree that at $45/bbl, we may have gone too far the other way.  I’m comfortable with a “recovery by 2020” assumption given that there should be a ~10% cumulative increase in crude demand 2013-2020, and there will continue to be a shift towards activity in “harder” rocks over time.  I don’t foresee a pure free market mechanism pushing prices back to $100/bbl by then, but $60-70/bbl would be reasonable and would allow service companies such as the Big 3 to continue to do their work profitably.

Risks

1. Deal doesn’t close.  Buying HAL instead of BHI would be the easy response to this since I think HAL stock goes up a little bit if the deal fails to close (ie. I think the market still thinks that the $3.5bn termination fee is slightly better than paying BHI shareholders a large premium).  I think the imperative within both companies to close is actually strong and points to an eventual close.

2. Integration challenges.  BHI is a tools business and culture clashes and other operating challenges ruined its BJ deal.  I think there will generally be less risk around internal processes, etc. with HAL (the services/execution company) acquiring BHI, and HAL has also been extremely methodical about working through the integration barriers and processes that BHI ever did with BJ.  Here is an interesting interview of Mark McCollum in which he talks about the process (via HAL IR site): http://deloitte.wsj.com/cfo/2015/11/12/cfo-as-chief-integration-officer-mark-mccollum-of-halliburton/

3. Competition.  Competitive response from SLB stronger than expected, ie. SLB attempts to take share at the expense of margin.  This is possible, as SLB is undergoing a continued internal restructuring, and it may see HAL as a long-term threat if they don’t go on the offensive (unclear if SLB really sees anyone as a threat).  HAL was previously the 2nd lowest cost provider in many services with BHI providing a price umbrella of sorts (but expressed as cost).  There is also on-going commoditization in the service and equipment industry where the Big 3 continue to innovative at the top, but services at the bottom can be provided by smaller companies or by foreign competitors, such as Chinese oilfield service providers.  Finally, SLB is clearly positioning itself well in deepwater with WesternGeco, Framo, and now Cameron, and this HAL+BHI combination could look more like a sustaining event in deepwater five years down the line than a real improvement in competitive position.  However, I suspect that with crude at sub-$80 levels, onshore unconventional drilling will actually be the greater area of focus going forward, and that is exactly where HAL+BHI will be the strongest.  

4. Crude price.  Even if crude doesn’t recover, I suspect that some amount of margin expansion is still achievable, though perhaps the revenue recovery comes a lot slower than desired.  

Catalyst

Transaction close, synergy realization, crude price recovery.