A total failure of governance… McDermott and the cost of money at the margin…

If you want to know what the cost of raising funds for a corporation in trouble following a failed acquisition is the recent disclosures from McDermott provide a good guide. Crucial to the continued ability of the firm to stay within its banking covenants and remain a going concern in the Q3 2018 results was the $300m in 12% preference shares sold by McDermott to Goldman Sachs and Company (and affiliated funds). From the sale McDermott received $289m, meaning Goldman banked $11m in fees… to start with… The kicker is that Goldman and its funds (likely credit opportunity funds managed by the bank) also ended up owning warrants to purchase 3.75% of MDR at .01 per share… at the time of pixel those options are worth ~$51.5m (at an MDR share price of c. $7.61).

If you don’t believe MDR is in real financial trouble you need to ask yourself why the best course of action for management was to engage in a financing that cost shareholders ~$62m to “borrow”/ strengthen their balance sheet (sic) to the tune of $300m. The $289m the company got has an interest cost of $36m per year (excluding tax effects) and cost the shareholders 3.75% of their company. No wonder the shares dropped ~40% when the news was announced (already well down on the pre-acquisition price): investors knew they were losing a lot more than 3.75% of the value of the company. Not only that the increased working capital lines ($230m) required that this capital went in. MDR had maxed its borrowing capacity just a few short months after the takeover. In short: it was a financial disaster.

This isn’t a rage against the Great Vampire Squid, because if you need to get your hands on $300m quickly, and you are running out of cash, then for a good reason money tends to be expensive. The real question is how MDR got here, and so quickly, since acquiring CBI?

In my view the short answer is: a total failure of governance from the MDR Board that allowed management to buy a much bigger business they knew literally nothing about. The famed “One McDermott Way” was about installing cheap pipe and jackets in the Middle East and Africa not building on-shore low-margin refining plants. It is about as relevant as an orange juice manufacturer buying Tesla because they are going to apply the lessons learned in de-pipping oranges to extending the battery life of electric-powered vehicles.

The failure of this deal will I believe lead to the end of the MDR offshore contracting business as an independent entity. The reason is nothing more than a failure to ask a basic and honest question about where the skills of the company reside? And for the Board to realise that for MDR management the worst option of being acquired was probably the best option for the shareholders.

This presentation given to shareholders in August indicates that shareholders already had a serious case of post-acquisition regret, and reading between the lines here management are clearly under huge pressure despite the upbeat tone of their communications. The 40% decline their investment post-August is likely to have induced a sense of humour failure amongst even their most loyal of followers. Someone senior is going to have to carry the can soon and that does not make for a harmonious exec. I can’t think of another M&A deal that has locked in  such a loss of value so quickly.

McDermott got into this because in late 2017 their viability as an independent company looked shaky. Management had a very good offshore crises through a mix of skill and luck: their low-cost Middle Eastern model, not applicable when the Norwegians and French were in competition to build a more expensive OSV than the company before them, was more shallow-water focused than Brazil/UDW, and they didn’t have a complex about working old assets to death. McDermott picked up some cheap assets like the 105 when the opportunity presented itself, but management didn’t blow money on value dilutive acquisitions either or go to long on assets or debt. MDR management had steered the company back from the brink to create a genuinely competitive company with an ideal geographic footprint and asset base for the new offshore environment. I was a real admirer of the company.

But then GE started sounding out Subsea 7 (and being turned down), and the MDR footprint would have been perfect for Subsea 7 (BHGE would clearly have made a hash of MDR). There are very few companies the size of MDR that remain independent in an environment where consolidation is the market mantra: they had very little net debt, were big enough to buy and move the needle for a large company in revenue terms, but small enough to acquire in financing to terms. And there is some real intellectual and engineering skills in the core DNA of the McDermott business, no matter how complex the offshore problem, someone in McDermott knows the answer.

At some point in 2017 MDR management and the Giant Vampire Squid decided on a plan to buy CB&I and their shareholders really did think Christmas had come early that December 17th. To avoid being acquired McDermott opted for a type of ‘Pac Man’ defence: it went on to acquire a larger company. You can see the balance sheet of CB&I was substantially larger than MDR:

CBI Balance sheet:

CBI BS .png

MDR Balance Sheet:

MDR BS.png

Crudely MDR had $3.2 bn in assets and almost no debt while CB&I had $6bn in assets but $5.6bn in debt.

The reason MDR could do this was the debt and CB&I losses. CB&I was losing, and had been for a considerable period of time, vast amounts of money in its core business. A pretty crucial question would therefore be “could the One McDermott Way” transform this situation? A secondary question if the answer was yes was how much due diligence should be undertaken to prove this?

This isn’t hindsight talking. Here are the last four years financial performance of CBI:

CBI losses 2014-2017.png

Can any of you, even those without financial training, see something that might worry you about buying this company? (I’ll give you a clue it’s in the last line and it’s a material number). As Bloomberg noted at the time:

MDR Stamp.png

Bridge to Nowhere.png

Boom!

The problem with buying a larger company as a defence is its asymmetric returns: it is a leveraged bet on management and financial skill and if it goes wrong the value in the acquiring company is wiped out. And that unfortunately is what has happened here.

In case you were wondering the merger between MDR and CB&I consumed ~$300m in fees, slightly more in cash than McDermott later managed to raise from Goldman (and paid in cash of course), a symmetry in irony I am sure the bankers enjoyed.

McDermott CBI fees.png

And yet for the $300m in fees the due diligence didn’t uncover the cost overruns in the projects, and despite having three of the most illustrious banks on Wall Street: Goldman, Sachs, & Co, (lead adviser), Moelis & Co (advising on the financing only), Greenhill & Co (advising the Board of MDR) no one managed to ask: really, can we do this? And if they did, get the right answer!

But after the fees comes the interest bill… in cash and kind now… the hangover so to speak, and this one is mind-numbingly painful:

MDR Capital Structure

MDR Cap Structure.png

MDR are paying an interest bill (per annum) of: ~$90m for the Senior Loan, ~$138m for the notes, $36m for the preference shares (not included here), and the Amazon lease payments which must be ~$30m for a $345m vessel: ~$294m in total per year (say one Amazon per year at current build costs?). MDR only made an operating profit of $324m in 2017.  In addition, the three CB&I projects they have taken a hit on will consume $425m in cash in 2019! So by the end of 2019 MDR will have spent ~$1bn in cash on deal fees, interest, and project costs. As someone nearly said “a billion here, and a billion there, and pretty soon you’re talking real money“.

All this talk of “synergies” is hokum. Everyone involved in projects knows that the pipeline fabricator in Dubai isn’t getting cheaper steel because MDR are losing money building an LNG train in Freeport. But the interest and fees are real cash. Maybe they will sell the non-core businesses and bring the debt pile down but it brings execution risk and no certainty the debt reduction will be proportionate. These asset sales have the feeling of looking for change down the back of the sofa as they were never announced as part of the original deal and the tanks business is a complex carve out that will involve vast consultants fees and by MDR’s own admission take at least nine month… on the other hand interest, like rust, never sleeps…

The fact is the reason the on-shore business of CB&I is structurally unprofitable is because despite the contract size and complexity there are a large number of equally competent (more so actually) companies who bid all the margin away. That’s no different to subsea but MDR had a genuine competitive advantage in that business and CB&I didn’t in on-shore (as their financials showed).

In really simple terms now McDermott must make a smaller offshore business, in very competitive market that consumes vast amounts of capital to grow; pay for a larger unprofitable onshore operation where management lack skills and knowledge. The odds of success must be seen as low? The square root of zero I would suggest. McDermott will be starved of CapEx as the CFO uses any cash he can to pay for the interest and charter commitments while trying to compete against onshore behemoths much larger in scale. Maintaining market share in offshore will be impressive, forget about growing it. And all this to feed a beast in a low margin onshore business that competes against giants like Fluor.

If the Board of McDermott took shareholder value seriously they would try to get Subsea 7 management back to the table and sell them the offshore business for a price close to what Subsea 7 were offering last year. The world has changed but the price for a trophy asset might still be good. What happens to the rump CB&I would be sold at auction, for probably not much, but such is reality. Such a scenario would yield more than letting this state of affairs continue.

It’s grim up North… And the labour theory of value…

It’s Grim Up North.  The Justified Ancients of Mu Mu

Ricardo, Marx, and Mill believed that prices were determined by how much people had, in the past, invested. And that blinded them to any understanding of the workings of the market.

Friedrich Hayek

[I am not really a Hayek fan (in case anyone is interested). But he was a very smart guy who understood social and economic change processes better than most. Beyond that you get diminishing returns. As an aside I have been too busy to blog much lately, which is a shame as some really interesting things have been happening, but it doesn’t seem to have affected my visitor numbers much, which just goes to show maybe my silence is more valuable.]

The Oil and Gas UK 2018 Economic Report is out. For the North Sea supply chain there is no good news. There is clearly a limited offshore industry recovery underway as we head towards the end of summer. However, the market is plagued by overcapacity, and while service firms without offshore assets are starting to see some positive gains, if you are long on floating assets chances are you still have a  problem, it is only the severity that varies.

The UKCS is what a declining basin looks like: fewer wells of all types being drilled and dramatically lower capital expenditure. There is no silver lining here: an asset base built to deliver 2013/14 activity levels simply has too many assets for the vastly reduced flow of funds going through the supply chain. The report makes clear that the base of installed infrastructure will decline and there will be a relentless focus on cost optimisation to achieve this.

UK Capital Investment 2018.png

The volume of work may be increasing marginally but the overall value may even down on 2017 at the lower end of the 2018 forecast (purple box). Clearly £10bn being removed from the oil and gas supply chain, c. 60% down on 2014, is a structural change.

And the OpEx numbers unsurprisingly show a similar trend:

UKCS OpEx 2018.png

Party like it’s 2012 says Oil and Gas UK. Unfortunately a lot more boats and rigs were built since then.

Unit Operating Costs 2018.png

An unsurprisingly the pressure on per barrel costs seems to have reached the limits of downward pressure.

This should make supply chain managers seriously consider what their investment plans are for assets specific to the region and the likelihood of assets having to work internationally to be economic. It should also make people reassess what stuff is actually worth in a market that has reduced in size by that quantum and from which there is no realistic path to 2014 activity levels.

Technip paid $105m for the Vard 801, about $55m/45% discount to the build cost. Such a deal seems realistic to me. Some of the deals I have seen in offshore remind me of The Labour Theory of Value: if you dig a massive hole that costs a lot it must therefore be worth a lot. In reality with so much less cash floating around for assets that will service the UKCS an asset is worth the cash it can generate over its life, and the fact that it is substantially less than its replacement cost is just another clear example of how the industry will reduce its invested capital  as production levels in the basin decline. Like airlines offshore assets have a high marginal cost to operate and disposable inventory which is why you can lose so much money on them.

Boskalis appears to have paid an average of c. $60m for the two Nor vessels which equates to a similar discount on an age weighted basis. Quite where this leaves Bibby needing to replace the 20 year old Polaris and 14 year old Sapphire is anyone’s guess. But it is not a comfortable position to be in as the clear number four by size (in terms of resource access) to have competitors funding their newest assets on this basis. Yes, the shareholders may have paid an equivalent discount given the company value they brought in at, but if you want to sell the business eventually then you need a realistic economic plan that the asset base can self-fund itself, and at these sort of prices that is a long way off. Without an increase in the volume and value of construction work 4 DSV companies looks to be too many and this will be true for multiple asset classes.

As a mild comparison I came across this article on $Bloomberg regarding Permian basin mid-stream investment:

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies..

That is just one part of the value chain. I get you it’s not a great comparison, but the idea is simply the ability to raise capital and deploy it in oil production, and it is clear that for Permian projects that is relatively easy at the moment. The sheer scale of the opportunities in the US at the moment is ensuring it gets attention and resources that belie a strictly “rational” basis of evaluation.

IMG_0957.JPG

That is what a growth basin looks like. The narrative is all positive. Once short-term infrastructure challenges are resolved that stock of drilled but uncompleted will be turned into production wells.

Oil and Gas UK go to great pains to explain the economic potential of the UKCS. But finance isn’t strictly rational and I still feel they need to be realistic about the cycle time tradeoff offshore entails. Shale, as we have seen, has an enormously flexible cost base relative to offshore and that has value.

The comments I make below are part of a bigger piece that I keep wanting to write but a) don’t have the time; and, b) probably doesn’t work for a blog format. But I think the impact of the private equity companies taking over North Sea assets needs to be realistically assessed.

Don’t get me wrong here I am a massive supporter of them. In terms of the volume of cash, and the ability to buy and invest at the bottom of the cycle, the North Sea would clearly have been worse off without private equity. But the results are in and there has not been a development boom… there has been a focus on the best economic assets that may make the fields last longer, but that is a different test. There may clearly have been an investment boom relative to what there would have been without private equity money, but again that is a slightly different point.

Private equity firms have a much higher cost of capital than traditional E&P companies and at the margin that will limit the number of projects they fund. The focus on lowering costs and returning cash as quickly as possible, often to compensate for how hard it will be for the owners to exit such sizeable positions, also adds to the change in the investment and spend dynamic (on the downside obviously). I am genuinely interested to see how these large multi-billion dollar investments are exited given how much trouble the super-majors are having at getting out.

Private equity may well be the future of the North Sea but that has huge implications for the supply chain. It is also worthwhile pointing out that while the smaller companies maybe able to sweat old assets they have a limit for larger projects. Quad 204 is a classic project where it is hard to see even one of the largest PE backed companies having the technical skills and risk appetite to take on such a vast project.

The majority of the larger deals also involved significant vendor financing from the sellers. Shell had to lend Chrysaor $400m of the $3bn initial consideration. This happened not through generosity, or a desire to maintain economic exposure to the assets, but because debt finance from the capital markets or banks was simply unavailable even to such large and sophisticated buyers. Siccar Point went to the Norwegian high-yield market in January borrowing $100m at 9% for five years. The fact is finance is scarce, and when available expensive, and this is impacting the ability of E&P projects to get financed. Enquest has had to do a deeply discounted rights issue, and borrow off BP, to complete Sullam Voe.

The E&P majors are helping to finance their own exit because it is the only way they can get out. The turnaround from that to an investment boom that could raise asset values in the supply chain is a long one.

In order to make money in this environment the E&P companies, particularly those backed by private equity, are focusing on driving down costs and limiting Capex with a ruthless efficiency and commitment few in the supply chain believed possible long-term. Where offshore assets are concerned the oversupply situation only assists with this. I met one of the private equity investors last week and I can assure you there is no pressure to replace old assets, safety first definitely, economics and finance second just as definitely.

The reality for the supply chain is this is a market where it will be very hard to make money for a very long time, and in reality the glory days of 2012-2014 look extremely unlikely to return. The Oil and Gas UK report gives some important data in explaining why.

My holiday reading…

I’m off to Spain for some reading and beach time on Wednesday… Strangely prescient reading awaits …

If anyone wants a book recommendations one of favourite economic history books is The Wages of Destruction (but The Deluge is up there as well) and The Museum of Innocence is one of my favourite novels. I went to Turkey for the first time in 2001 and then everyone wanted dollars, then I went back four years later and everyone wanted €. The script looks written for a currency crisis here when the President asks the population to change $ into Lira as an act of patriotism, and so when I next go back to Turkey they may well be looking for Yuan if David Goldman is right.

The graph above just shows that Turkey isn’t going to stop buying Iranian oil. They will just barter for it and actually end up paying less in $ terms. Russia and China are getting a back door channel to the whole region the longer this keeps up.