“Chicago Bridge and Iron is not based in Chicago, doesn’t make bridges, and uses no iron”.
We argue that mergers and merger waves can occur when managers prefer that their firms remain independent rather than be acquired. We assume that managers can reduce their chance of being acquired by acquiring another firm and hence increasing the size of their own firm. We show that if managers value private benefits of control sufficiently, they may engage in unprofitable defensive acquisitions.
If you want to have a look at what signals the insiders in offshore SURF are sending, and that major shareholders are supporting, look no further than McDermott (“MDR”) acquiring Chicago Bridge and Iron (“CBI”). MDR, which had $435m cash on hand at Q3, generated $155m EBITDA in the quarter, and is widely regarded as a very well run company, brought a declining onshore construction and fabrication house (with a small technology arm). No wonder the shares dropped 9% in aftermarket trading while CBI rose.
What it means is that a well informed group of rational senior executives in the offshore industry, in a company with ample liquidity and investment capability, decided the best option for growth and shareholder returns were for them to diversify onshore in the US. I don’t think that rings of confidence for an offshore recovery. At the moment anyone with enough financial capacity to charter ships (at below economic cost) and hire engineers can win market share. It is obvious what that will do to financial returns and why therefore companies are looking at different sources of growth and not recycling cash flow generated from the industry back into it. Over the long term this is part of the story of how the offshore industry will lose the capital it needs to in order restore the market to equilibrium.
This is a defensive merger. MDR was simply too small not to be acquired as part of a major acquisition had it remained independent (part of the reason the shares have dropped is the loss of the “acquisition premium” in their value), but it also needed to pay in shares only to keep its operating flexibility in this market. MDR was just big enough to raise the needle signficantly for someone else, but not large enough to buy an industry leader or number two. MDR had the choice of going on a shopping spree of SURF companies, maybe Aker Solutions or someone, and then trying to compete with Susbea 7 or FTI, and slowly over time getting materially bigger, risk being acquired as the industry consolidates, or buying something big and leveraging up so as to make it to big and risky to be acquired. The short-term risk was someone like GEBH, having failed to acquire an installation capability with SS7, deciding MDR was large enough to swallow. I’d love to know if the Board instructed one of the banks to sound out other bidders instead of this? I suspect instead that Goldman Sachs, lead adviser to MDR, was brought in with a specific mandate to keep MDR independent and CBI was the company they settled on.
Clearly, and having sounded out the shareholders as well, MDR management have decided that the least risky option, or at least the deal that could be done, was onshore US, a business about which MDR management have limited exposure. Whether consciously or not, the fact is MDR management couldn’t find enough value, on a risk weighted basis, to carry on investing in offshore.
MDR management decided to diversify, a so called “vertical merger“. Financial markets generally dislike verticals, which have a limited range of situations when they are likely to be profitable, preferring to believe shareholders are better at diversifying individually than company management. However, financial economists have spent a huge amount of time studying M&A, and from what I can ascertain all they really agree on is that returns are hugely dispersed around the mean i.e. sometimes it works and sometimes it doesn’t:
[o]n balance, one should conclude that M&A does pay. But the broad dispersion of findings around a zero return to buyers suggests that executives should approach this activity with caution.
I get why it was done I think: scale. Cynical theories abound in economic research:
What, then, is the motive for the widespread and persisting phenomenon of conglomerate mergers? In this study, a “managerial” motive for conglomerate merger is advanced and tested. Specifically, managers, as opposed to investors, are hypothesized to engage in conglomerate mergers to decrease their largely undiversifiable “employment risk” (i.e., risk oflosing job, professional reputation, etc.). Such risk-reduction activities are considered here as managerial perquisites in the context of the agency cost model. [Emphasis added]
In this case the argument is really that increased scale will help the offshore business as a standalone unit with lower unit costs being spread over a large company. If management can make it work, and they prove to have swooped on CBI in a moment of weakness, then everyone will be happy. That isn’t really my point with this: it is my agreement that offshore contracting/SURF still has excess capital at an industry level and I agree with MDR management that in the current environment deploying more, even at current price levels, looks hard to justify.
So rather than hold out for an acquisition premium, or try and build up slowly, MDR management have made the company virtually impregnable to being acquired, for a few years anyway, and if they can turnaround CBI as they have done with MDR the risk will be worth it. But I also think it sends a signal that management have far more confidence in the lighter CAPEX onshore market than they do about the offshore market, and even though they had the opportunity to buy a string of assets and companies at rock bottom prices MDR management (with the support of the Board and shareholders) decided it was less risky to buy an onshore construction business. That is consistent with the investment profile of many E&P companies who are cutting offshore investment in favour of onshore.
I think that this M&A decision tells you a lot about what those actually making the investment decisions in profitable offshore companies think about the market direction and the risk weighted returns available from it, for the forseeable future. MDR are backing themselves to apply the lessons learned in the downturn to another business rather than applying it to more businesses in the sector.