Tidewater and Gulfmark… big but not big enough…

The Tidewater-Gulfmark combination is a classic M&A play in a market awash with overcapacity: two companies merge and cut costs, integrate, get the savings, and everyone goes home for tea and biscuits. In a market that has declined so substantially the deal clearly makes financial sense: if you can run the same number of boats with 1/2 the management team you should take the money and run. But how much money are they (the shareholders) actually really taking here?

The Tidewater-Gulfmark acquisition is predicated on two types of synergies:

  1. Cost savings of around ~$30m per annum from 2020 onwards. That is based on the combined spending of both companies and they seem fairly certain on it. But the combined company will have  245 vessels, so that is about $336 per boat per day (based on a 365 year). In other words it isn’t going to fundamentally alter the economics of the (combined) company or their ability to take market share on cost. Bear in mind that Tidewater alone spends $245m per annum on direct vessel operating costs.
  2. Revenue synergies. Always beware of this number as it is nebulous to calculate and even harder to achieve in practice. These are meant to be achieved when a combined entity can sell more but that isn’t the case here. What little logic you can deduce from management is transparently thin, this is far more a market recovery play based on higher utilisation and day rates. This makes logical sense as well: all that has happened here is one management team are being removed and the number of boats increased. Nothing has changed the ability of the combined entity to sell more days something this confusing slide seems designed to obsfucate.

Offshore leverage.png

The higher day rates strike me as extremely optimistic given Siem Offshore recently announced that North Sea rates has been capped by vessel reactivations. But Tidewater are full of optimism:

In a market recovery, utilization should improve to approximately 85% for active vessels, including 82 Tier 1 vessels and 91 non-Tier 1 vessels.

With an increase in offshore drilling activity, the combined company should also be able to quickly reactivate 20 currently-idle Tier 1 vessels.

The combination of higher active vessel utilization and additional active vessels could yield in excess of $100 million in additional annual vessel operating margin.

With potentially higher average day rates in a recovering market, the impact on vessel operating margin could also be significant.

To give you a sense of the sensitivity of operating margins to higher industry-wide average day rates, if we were to assume overall active utilization of 85% and 20 incremental working vessels over and above the two companies’ respective active fleets during the 12 months ended March 31, 2018, and also assume no OpEx inflation, each $1,000 day of rate increase on the Tier 1 vessels could result in an annual incremental vessel operating margin of approximately$45 million.

I think someone then had too much coffee:

This analysis also assumes $500 day increase in average day rate for the active non-Tier 1 vessels.

If we were to assume somewhat stronger market conditions, a $5,000 a day increase in average day rates on the Tier 1 vessels (and a $2,500 per day increase in average day rates on the non-Tier 1 vessels), would put the combined company on a path towards more than $450 million of annual vessel operating margin, or about 50% of the company’s combined vessel operating margin at the last industry peak in 2014.

Yes, and we would also need to assume then that the shale revolution hadn’t happened, the Chinese shipyards hadn’t overbuilt with “at least a hundred” vessels waiting to be delivered (something acknowledged on the call), and that vast quantities of drill rigs weren’t idle.

To put those utilisation figures in context here is Tidewater’s utilisation from their latest quarterly filing:

Tidewater Utilization 2018.png

Yes, it’s a Q1 number but 85% utilisation is 311 days per annum, a boom number if ever there was one for supply vessels, and it is a massive increase year-on-year that would basically entail the vessels working fulltime from 1 February to 30 November. There is no indication in the backlog of any buildup of this size. Management are asking you to believe a realistic scenario is that not only do they add more vessels to their fleet from layup but they do it on the back of large percentage increase in day rates. There is no indication in the rig market that the kind of order backlog required for this sort of demand side boost is coming to fruition.

Management also highlight how tough the market is in Asia. These are global assets (within reason) and regional increase in day rates will be met with increased supply. As a follow up on my note on vessel operators now being traders. I noticed that Kim Heng, ostensibly a shipyard (of ther Swiber AHTS fame), had purchased another two cheap AHTS coterminously selling one to Vietnam and getting a charter for another in Malaysia (at rock bottom rates one can assume).

A lot of offshore supply equilibrium models show increasing day rates and utilisation levels and use scrapping as the balancing factor. They need to because the only variables you can use are day rates, utilisation, and fleet size, and the easiest way to boost the first two is to lower the third. But as the Kim Heng deal makes clear scrapping is coming extremely reluctantly, and in a large number of markets (especially Asia and Africa) well connected local players with low quality tonnage can consistently take work. I doubt Kim Heng purchased the vessels becaise they expected to scrap them at 20 years of age. They will run them until they literally rust away or fall apart and need a day rate substantially below the prices paid per vessel implied by this deal ($12-13m  per vessel). For as long as these “long tail” companies remain realistic competition then the upside in this industry is capped at the current prices implied in “distressed” sales. [I am going to write a whole post when I get the time on “The Scrapping Myth”].

Tidewater management acknowledge what I think will be the most powerful determinant of profitability in offshore supply going forward: the industry structure. After the merger there will still be 400 companies worldwide with 5 vessels on average and Tidewater will control only 10% of the market:

Vessel count.png

There is substantial evidence that you need more than 20% market share to exert pricing power and you need a far smaller competitor set than 400. None of these companies will be strong enough in any region to have any pricing power and all will have enough local and regional competition to ensure that there is limited upside. There is substantial redundant capacity via companies that have enough capital to reinstate it as rates pick up. Maybe this is only a first step but it would take years of mega M&A given the long tail of the industry to create even a few companies with pricing power and the asset base is so homogenised that you only need a couple of credible competitors with sufficient supply to ensure profitability is at cash breakeven levels. The fact that the operating costs, including dry docking, are so far below new build costs will I think encourage marginal tonnage to hang around for a long time and there are no signs E&P companies are forcing scrapping. Indonesia, India, and Malaysia have all been markets dominated by aging tonnage financed all with equity, and Standard Drilling is leading the charge to bring this model to the North Sea. But it kills resale values and inhibits bank lending to all but the largest companies because of the volatility in asset prices.

Industry debt levels.png

Unless The Demand Fairy appears every European supply company is going to struggle to compete with those with equity finance. From NAO to the right (bottom graph) all these companies look like financial zombies.

Over time the long tail of the offshore supply industry is going to struggle with getting access to capital which I think will be a far stronger driver of supply reduction than M&A. One area where I totally agree with Tidewater management is the ability of larger companies to have superior access to finaning. Larger companies will pull away from the smaller as they also will have access to credit and the ability to handle the cost of idle days (a key factor in OSV profitability). If you only own 5-20 boats then you will simply become unbankable because the residual value of your assets will wipe out your book equity (if it hasn’t already) and each idle day is simply too expensive relative to the upside of a working day for banks to lend money on. Even then companies really need to aim at a much higher number, but there will always be the odd Kim Heng waiting to capture any excess margin. Private equity companies will eventually leave the industry as they realise that these depreciating assets do not offer the IRR return required to keep investing and disress investors realised that current prices aren’t “distress” prices at all but “market” prices given current and likely demand levels.

It is easy to sit on the sidelines and throw stones. Management in the industry, particularly for a company the size of Tidewater, have to act within the constraints of what they are given in terms of an external environment and cannot simply decide to exit. In an option set with few good choices this is in all likelihood the best. Ultimately supply needs to reduce to ensure the supply demand balance is reallocated in the vessel operators favour, or at least falls into balance, and this looks to be some way off. Management and investors in more marginal companies can decide to exit and without The Demand Fairy appearing more will have too.

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