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.

For the tier 2 contractors summer isn’t coming… a long hard grind beckons…

Back in the dark ages of November 2016 a consensus was forming amongst the more optimistic of the subsea and investment community: things had got so bad there must be an upturn in 2017? M2 raised money from Alchemy, the Nor DSV bondholders did a liquidity issue, SolstadFarstad started their merger discussions, York began acquiring a position  in the Bibby bonds, Standard Drilling went back to the market to buy more PSVs (could they be worth less?), and early in 2017 on the same wave Reach also raised money… what could possibly go wrong? A quick rise in the price of oil and the purchase orders would flow robustly again… risk capital would have covered essentially a short-term timing issue and as the summer of 2017 came things would revert, if not back to 2014, at least some degree of normalcy and cash profitability. Everyone would be positioned for the next big upturn… This wasn’t a solvency issue for the companies involved figured the investors, this was merely a liquidity issue that they could profit from by supplying the needed funds…

Things haven’t quite worked out the way they planned. Summer, in terms of high day rates and utilisation didn’t come last year, and it hasn’t come this year with sufficient force to change much this year, but next year the true believers tell you it will be massive. Bigger than ever. You just need enough money to cover another loss-making winter to get there…

No one can know the future, although I think many of the signs were there, and a lack of any due diligence was a common theme of many of the above transactions; but the real question now is when the industry accepts the scale of the change required and the necessary exit of some capital to reflect new demand levels? Or not maybe? There is so much excess liquidity (that’s the technical term for dumb money) floating around, and the capital value of the assets in  subsea is perceived as so high, maybe another cycle of working capital to burn beckons… but certainly not for everyone. And there will be some mean reversion here but it is looking on the downside not the up.

Alchemy Partners appear to have realised this and seem committed to a quick exit from M2, the sale process appears to be highly geared to an asset only deal. Such a transaction would save them from the timing and cost of issuing a full IM, due diligence, and the time spent negotiating an SPA for a loss-making business that a self professed special situations investor cannot bring itself to commit more to. The first question anyone would ask them would be “why is one of the once great names in UK retsructuring unable to make this work?”.  Reputational risk alone for them argues for a quick process here… With XLXs going for $1.5m used Alchemy may feel they get just as much from a clean asset sale as from any possible going concern basis, when matched with the profits made from being in the Volstad Topaz bond they may not come out too badly here.

Reach Subsea have decided the numbers are so bad that their Q1 2018 results won’t appear on the website. (Reach aren’t the only people playing this strategy; for all their entrenched bureaucracy Maersk Supply can’t seem to find their numbers to put up after Q3 last year either). As a general rule in this market if you aren’t putting up numbers it’s because they are even worse than people feared.

For Reach Subsea one is treated to  the newshub with a few bullet points of “financial highlights”. It is hard to comment without seeing the full financial statements but Subsea World News appear to have seen the full numbers and say that turnover was NOK 114m and operating costs were NOK 101m ROV days sold were up 89% and EBITDA was up to NOK 13.2m. However, losses before tax were up 50% on the same period last year. This could just be an accounting convention as part of the change to a new accounting standard for leases, but with M2 unprofitable, along with a host of other ROV companies, the chances of Reach making money with exactly the same business model and service offering have to be regarded as remote.

The spot market nature of the Reach business is highlighted by the fact that their order book is at NOK 147m (mostly for 2018) which is 10%< of the amount of work they are bidding for in the pipeline. Everyone goes on about tendering but it’s a real cash cost and if you aren’t winning 30% of the work you are tendering for then you are tendering too much and just wasting time and resources. Tendering NOK 1.7bn in work implies Reach Subsea should turnover about NOK 600m this year, with their firm pipeline at NOK 147m in Q1 that has seem a long way off.

All these companies are doing is providing capacity at below economic rates of return and burning OpEx in a way thay ensures the industry as a whole cannot make a profit. Eventually investors, not usually management because these are lifestyle businesses, tire of this. ROV rates are such at the moment that even though most are purchased with only a 20% deposit operators are not making enough to cover the deposit on a new one when they wear out. Eventually the small players get ground out because even if they can survive in operational terms hopes of replacing equipment becomes a fantasy. This is how the industry appears to be reducing capital intensity.

I have expressed my scepticism consistently on the ROV industry on many occassions based on one simply premise: Oceaneering. Oceaneering is the market leader, widely regarded as a well run company and has signficant economies of scale and scope, and even they can’t make money off ROVs. Neither could Subsea 7 in  the i-Tech division… so how on earth are all these small companies going to make money? All they can sell on is price, and there is sufficient overcapacity to ensure the E&P companies play all the tier 2 contractors off against each other. To my mind this is one of the drivers of increased tendering that all the tier 2 contractors claim while their numbers become even worse.

Oceaneering is by an order of magnitude the largest ROV company in the world:

Oceaneering market position.png

And yet with all that scale cash flow is getting worse:

Oceaneering FCF.png

That’s not a reflection of Oceaneering management that is a reflection of market conditions. And if the largest company in the industry can’t get any uplift then the small companies, with no pricing power, are also operating at a significant loss without the resources of the larger companies. Talk of other companies doing a buy-and-build strategy in the ROV market is just laughable given the sheer scale of the top 5 companies controlling more than 50% of the market. Someone got there first 10 years ago, and executed well, this isn’t the market for an imitator it is  the market for large industrial players to grind out market share.

What is happening, and will continue to happen, is that those companies with scale and resources will continue to grind out market share and volume by pricing at whatever they can get (in economics terms below marginal cost) and they can keep this game up longer as they have more resources. It is just that simple.

DOF Subsea, DeepOcean, and Reach Subsea, have within days of each other announced they have framework commitments from Equinor. Such “contracts” (in the loosest sense of the word only) guarantee no work just a pricing and standards level from the contractors. The only obvious economic implication from this contracting method is that Equinor believes it doesn’t need to cap it’s costs going forward as overcapacity will keep rates down. Equinor is keeping it’s options open and help keep some small Norwegian contractors alive to prevent SS7 from Technip from strangling them, but it’s generosity appears limited. (It should also be noted Saipem/Aker appear to be making real moves now to bid the Constellation and Maximus in Norway so even tier 1 rates there look set to suffer.)

DeepOcean is the one company that appears to really be on the point of being regarded as a tier 1 contractor in terms of IRM and renewables scale. Acquisitions at the bottom of the market in Africa and the US, a smart charter of the Rieber vessel, and a large European business with a strong renewables business have probably given it enough scale to be regarded as in a different league now from the smaller companies. But it shows the size of commitment a buy-and-build strategy would require and the industry simply doesn’t have enough inherent profitability to make it worthwhile. A point Alchemy have now implicitly acknowledged and their commitment to the socialist idealogy of helping E&P companies lower maintenance costs by supporting them with investors funds seems to have ended. DeepOcean should probably be regarded as the minimum efficient scale a company in this market needs to be to survive, a vast mountain to climb for any investor coming in this late no matter how cheaply they buy some kit.

For all the tier 2 contractors there is no respite. Pricing pressure will remain extreme, they have identical business models and assets, there is no scope for differentiation, and capacity far outstrips any reasonable expectations of demand inceases. Make no mistake Alchemy won’t be the first to throw in the towel and other investors need to think what they know that Alchemy Partners doesn’t? For as long as the industry can find investors willing to believe the downturn is a normal cyclical part of the oil industry, rather than a secular change where the relationship between the oil price and offshore expenditure has fundamentally changed (a regime shift in econometrics) then this seems to be the only likely outcome.

The MDR and CB& I merger and industry consolidation…

Okay so I clearly got this wrong originally… Congratulations McDermott… to the victor goes the spoils.

McDermott is now takeover proof for at least the next 5-7 years and maybe forever if they can pull the turnaround off. They are on a roll as a company where the low cost execution skills they honed in the Middle East seem more applicable than ever.

In my defence I have seen more hostile takeovers when one of the nuns at a convent tried to take an extra biscuit at morning tea having been told no…What were Subsea 7 thinking? McDermott hired Goldman Sachs to make them impregnable to a takeover… I thought Subsea 7 had a better plan than simply a few days before a merger that people had been working on for months, specifically designed to avoid an eventuality such as this,  firing off a letter saying “Hey if you guys feel like losing your jobs and working for us, why don’t you just drop your whole other idea where you run a bigger company with the upside of looking like heroes if your plan works?”. Unsurprisingly it went down like a future Kanye appearence at an NAACP convention.

I’m genuinely surprised. It never occurred to me they would try and gatecrash a party that late without having a better plan.

The failed Subsea 7 acquisition highlights a big problem in the offshore industry: excess capacity where everybody wants to be the consolidator (naturally) and not the acquired entity. In all markets now there are at least five companies who can deliver any project and in some cases more, and as the larger assets are all global in nature the bigger projects will attract 3-5 serious bids. That is too many for bidding not to be excessively competitive to the point that anything other than breakeven economic profits can be achieved. 30-40% market share is normally considered to be of sufficient scale to have some pricing power yet even at the high-end the industry remains extremely fragmented. The Heerema exit from pipe-lay was the start of the marginal players exiting the market to reduce capacity, but more exits are required with asset utilisation in the 50-60% range.

Consolidation is the answer everyone agrees to excess capacity, but getting there is clearly going to be a very complicated journey. Without it all the scale companies are building on their onshore operations will end up cross-subsidising the offshore installation assets.

 

McDermott and Subsea 7…

Okay so I was too hasty in this post on Monday… When you’re wrong, you’re wrong…

MDR’s rejection of Subsea 7, and some good Q1 numbers,  seems to have sent the stock price down below the Subsea 7 offer and another ~35m shares traded yesterday (25/04). MDR only has 286m shares on offer and over 140m have changed hands in 3 days (up from a daily (30 day average) on Monday of 10m).

You need to be a holder of record on April 4 to vote in the CB&I merger, so anyone buying now I don’t think can vote? Being the US they can definitely sue for review but that looks harder for an offer subject to due diligence. And they can definitely press management to enter discussions, but the share price drop seems to reflect that maybe this is a train that cannot be stopped no matter how good the underlying logic of the counter bid?

Subsea 7 surely know what they are doing here? I have to think deep down they are backing shareholders to vote against the combination next week and enter talks with them. Subsea 7 must surely have sounded out the larger shareholders (Norges Bank and the Government Pension Fund of Norway being two of the top 20)? Subsea 7 are a deal machine and have enough experience to know all these things and my working assumption is that they simply didn’t just float this proposal out there hoping MDR would change their mind as late as 2 weeks before the final vote. The McDermott CB&I deal was so obviously an acquisition to stay independent and they must have picked up on this? This bid from Subsea 7 is must be part of a plan where they must be confident they have the numbers, or a good chance of getting them, or would not waste their time… ?

There is a certain logic in leaving it late to launch a bid as MDR management clearly didn’t want one and Subsea 7 could have faced months of useless negotiations or it was spend driving the price up of a trophy asset and other companies coming in… I spoke to a Saipem shareholder today who told me they have been sounded out about backing a bid should it turn into a sale process…

Was I suffering from a confirmation bias due to my dislike of vertical mergers?

But maybe Occam’s Razor applies here and I am over thinking this…? Maybe this was just a last minute attempt to be invited to a party where the invitation never arrived? In which case disregard my post of yesterday as well. This bid from Subsea 7 appears destined to be the start of a move of tactical genius or a total damp squib…

Blackrock as the 12% shareholder is worth watching here… they have a history of selling shares in offshore contractors at the perfect time (and being cleared of any wrong doing for the sake of good order).

This will be fascinating to watch for a few days to see how this pans out.

Vikings at the Gate…

F Ross Johnson: Well, that LBO stuff is way over my head. I just can’t follow it, Henry.

Henry Kravis: You don’t have to. Bankers and lawyers work it all out.

F Ross Johnson: All I want from bankers is a new calendar every year and all I care about lawyers is they’re back in their coffins before the sun comes up

Barbarians at the Gate

 

“Through all the machismo, through all the greed, through all the discussion of shareholder values, it all came down to this: John Gutfreund and Tom Strauss were prepared to scrap the largest takeover of all time because their firm’s name would go on the right side, not the left side, of a tombstone advertisement buried among the stock tables at the back of The Wall Street Journal and The New York Times.”
Bryan Burrough, Barbarians at the Gate: The Fall of RJR Nabisco

For Chicago Bridge and Iron I am reminded of Danny DeVito (Other People’s Money):

Because have a look at the McDermott share price:

MDR 230418.png

McDermott shares closed on Friday night at 6.05 and then Subsea 7 announced their bid and they have closed tonight at the price Subsea are bidding at… which means “the market” thinks it is going to happen, and maybe at a higher price. Only the details and human factors need to be filled in now.

Over 70m MDR shares changed hands today when the daily average is 10.8m. The share price up 15% in a day. MDR only has 286m shares on issue so well over 25% of the company changed hands today. You can be sure that the institutions buying these shares didn’t buy them as a long term investment strategy to back a company that run boats-and-barges to buy a bridge-building company (not that CB&I really builds bridges I just liked the alliteration). These shareholders are hedge funds, many of whom run merger arbitrage funds, and they want their $7 in cash, and hopefully more if Saipem can man up and launch a counter bid,

The only people selling shares didn’t believe in the merger and are getting out without taking the deal execution risk, and the people holding on want Subsea 7 shares as well as cash so they can keep some of the upside. This is a very hard dynamic for MDR management and advisers to reverse.

Right now some of the best minds at Goldman Sachs, McDermott’s lead financial adviser, are trying to work out how to fend off the Norwegians… and it is not easy because tomorrow the largest of these new investors (and some of the old) will start calling the Chairman, and probably Phillppe Barrill (a Director from SBM and seen as independent), and demand McDermott start talks immediately with Subsea 7 and ditch CB&I. Some of these funds are relatively aggressive. I have no idea about the legal situation here, and tonight some very expensive lawyers will do an all-nighter documenting it, but the fact remains the size of the shareholding change means Subsea 7 is already in the lead in this race.

The MDR/CBI merger always had a weak strategic logic and rationale. Whereas the Subsea 7 one is excellent from both a cost saving and growth perspective. Drop the pipelay spread on the Amazon for example, and assume higher utilisation on the new Subsea 7 newbuild, and you have saved $75m in CapEx and maybe $10m in cost/revenue synergies alone. Subsea 7 can afford to pay more here and Goldman will come under pressure from some shareholders to get them a higher price, which will split them from the management team who hired them. Expect the Board to have to hire another financial adviser tomorrow (a CYA move) who will be paid a success fee on a transaction occurring not just the CB&I one. Think of the cost savings from one organisational structure? Combine the Middle East and Africa powerhouse of MDR with the Subsea 7 SURF and deepwater business? This will be the deal of the downturn and I struggle to see how such an irrefutable commercial logic can be ignored. Hardly an original thought as the MDR share price shows.

Or MDR shareholders could take a chance management can turnaround CB&I? For the fund managers whose Christmas bonus depends on a valuation in 8 months time they will take the $7 a share today rather than risk a declining price in a few months.

Expect some real fireworks this week if MDR push on without opening talks with Subsea 7.

CB&I can look to Gregory Peck:

I’d love to know if this was the plan all along? Years ago P&O Cruises wanted to merge its cruise business with Carnival but wasn’t sure how to get them to pay the price they wanted? So P&O opened merger talks with Royal Carribean, and agreed a $63m break fee, then Carnival came running and Royal Carribean were ditched (the break fee was worthwhile in the greater deal economics). And it was always the plan from the bankers that this would happen.

I don’t think this is the case here. I am not close to it but I get the feeling that MDR really want to be independent and the CB&I deal was about ensuring that not getting the best price for shareholders. But they have achieved the same thing regardless.

Game on… Subsea 7 seeks to gatecrash the McDermott and CB&I merger…

Subsea 7 is seeking to gatecrash the McDermott and CB&I takeover

I said at the time this was a purely defensive merger for MDR, who just didn’t want to get swallowed by GE. So this is effectively a hostile bid by Subsea 7 who must know MDR management well enough to know that they want to be in control not an acquired entity. The publicity around this means they have effectively gone directly to the MDR shareholders having been given the cold shoulder by the MDR Board.

A Subsea 7/MDR industrial combination makes a lot more financial and strategic sense than putting MDR management in charge of a turnaround job in a sector they have no experience in (despite their obvious competence in offshore). Subsea 7 are also unlikely to have done this without engaging an investment bank to sound out some of the key US shareholders and see how receptive they are to this.

Outside of the Middle East this takeover will be paid for with synergies that will see Susbea 7 takeover everything and massive cuts in staff numbers to McDermott. McDermott have won market share lately though because their DNA is to be more cost focused than some other companies, they have a vast technical and operational heritage, Subsea 7 will need to ensure they don’t try and make the company more like them in the Middle East for this to work. But I believe they are backing themselves for a full hostile takeover here and on a purely economic basis they should prevail.

McDermott buys Chicago Bridge and Iron…

“Chicago Bridge and Iron is not based in Chicago, doesn’t make bridges, and uses no iron”.

Anonymous

 

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.

Gorton, Kahl, and Rosen, 2005

 

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.