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.

Market forecasts as structural breaks….[Wonkish]

Not for everyone this post but important if you are involved in strategic planning. The above chart is from the latest Subsea 7 Q1 numbers. The problem I have with these charts is what statisticians call “structural breaks“. Basically if the underlying data has changed then you need to change your forecast methodology. As I have argued here and here (although it’s a general themse of this blog) I think there is sufficient evidence that large E&P companies are commissioning less offshore projects when they become economically viable in the past on NPV basis. I am not sure that all the forecast models reflect this.

This break in the historical patterns has really important forecasting implications because when you see whichever market forecast  it has made an assumption, whether formally through a regression model or on a project-by-project basis, that x number of projects will be commissioned at y price of oil (outside of short term data which logs actual approvals). If there has been a stuctural change in the demand side then y (commissioned offshore projects) will be lower, and on a lower trajectory to x (the oil price) permanently, than past cycles.

E&P companies are not perfectly rational. As the oil price gets to $60 there is no set programme that triggers a project. For sure the longer the price stays high it increases the probability of projects being commissioned but it is a probability and the time scale of has changed I would argue. I think it is why demand has surprised many on the downside because there has been a change in the forecast relationship between offshore projects and the spot price of oil.

 

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.

E&P versus offshore strategy plans… Not what you think?

Last week ExxonMobil released its analyst day presentation. It has a number of interesting things, but I wanted to highlight the fact that although it feels like E&P companies are back making real money, which they are, it may not feel like that to them. And as this article on Bloomberg makes clear investors in these companies want management to keep the lid on CapEx, which is one of the cash flows they really can control:

Exxon argues it has a formidable set of projects, pointing to such goodies as offshore Guyana discoveries, as well as the Permian basin. The problem is that investors have seen this story before, and quite recently, with the oil majors. And while Exxon’s reputation might once have enabled it to simply be trusted to deliver, that is no longer the case.

Here is a Bloomberg shot showing you what would have happened had you purchased 1000 ExxonMobil shares in 2013 and sold at the end of 2017 (about when plans were probably being agreed):

image.PNG

You were down fractionally in the share price and up overall marginally only after reinvesting dividends. So the Directors are probably not coming under massive pressure to throw more money at production when 4 years after the price slump the owners of the ExxonMobil are trading below their 2013 entry cost (or fund market value). This is very oversimplified, but I make the point only because it has become an article of faith amongst some in the offshore space that E&P companies are verging on the irrational by not increasing offshore project spend when it is far from clear they are, or that they face pressure to do so.

Which is why you end up with a slide like this from a company that has just made some huge offshore discoveries:

Disciplined value.png

ExxonMobil focuses on Brazil and Guyana in terms of offshore development. I think the larger E&P companies switching to larger developments only offshore continues to mark a real shift in the market because the smaller companies just don’t have access to the development funding they used to for smaller fields.

I thought this was interesting:

XOM Guyana.png

Versus shale:

XOM tight oit.png

ExxonMobil appears to be implying shale has a lower breakeven pricing at $35 to get to a great than 10% return? And as always productivity is increasing:

XOM productivity increase.png

The other thing that struck me about the presentation was just how many investment opportunities management have across the portfolio, and they are increasing CapEx across the forecast period from USD 24bn to USD 30bn, but it is clear that downstream and other activities are also important. Investors want growth but maybe some at lower volatility that a fluctuating oil price offers, and as this graph shows ExxonMobil will make money at USD 60 ppb oil, but not ridiculous amounts.

XOM Fundamental.png

Obviously XOM is a leveraged bet on the price of oil increasing. But at the moment the upstream managers probably feel they have a free option on the excess capacity in the offshore supply chain that means any rapid price increases can be met with shale and a slower commissioning pace of offshore fields. Also these larger discoveries allow greater flexibility to speed up infield developments at a lower cost and asset utilisation.

Bourbon Offshore recently released it’s Bourbon in Motion strategy which to my mind is one of the most honest assessments of the scale of the challenge facing offshore companies I have seen. I think Bourbon are well worth listening to because I cannot think of another company that has played the capital markets as well as they have in financing their operations. Here in 3 simple points is the problem every offshore company faces:

3 issues.png

And it was really nice to see it wasn’t followed by a slide which said “but we are doing lots of tendering”.

A little history is required: In 2008  Bourbon had €1.3bn in debt and was focusing almost exclusively offshore. The annual report for that year described the returns in the offshore business as “exceptional”, and like all good companies it took this as a price signal to invest and grow the business further. Bourbon did this, because as the financing market was so flush it could borrow a lot of money, by 2013 debt had increased by €1bn to reach €2.2bn and the Directors were so confident about the business they proposed a 34% increase in the dividend.

In 2013 and 2014, taking advantge of the exceptional sentiment in the market Bourbon sold, and then leased back, vessels worth €1.65bn to Standard Chartered and ICBC which also allowed them to write up the value of the rest of the fleet by €900m in value. It’s hard to overstate how good the timing of this transaction was, timed literally to perfection, as the vessel market peaked in value they got two banks to pay not only top dollar for the assets but lease them back at less than 11% per annum. I doubt if sold on the open market here these now commodity vessels would fetch a third of that.

I am not implying Bourbon knew this would happen, what I am saying is they worked out that perhaps this was as good as it was going to get in the industry and they should bank what they could and take some (more) money off the table for their shareholders. As a management team it made them look very smart.

So when Bourbon tell you things are grim I think it comes with a degree of credibility few can match. Particularly when backed by some solid data:

The worst crisis ever

Which we all know by now. As I have said here repeatedly understanding that CapEx expenditure is what drives utilisation at the margin, and therefore overall fleet profitability, is crucial. And the reason I used ExxonMobil above was to show that this CapEx number, which I call “The Demand Fairy”, is unlikely to miraculously change in the short-term.

Offshore will still be an important part of the energy mix, but the growth of shale, as the left hand graph below makes clear, is having a huge impact on vessel utilisation and therefore industry profitability:

Bourbon Offshore production.png

The region reserved for shale is an area 3 or 4 years ago most people investing in offshore would have believed their assets would be servicing. And when you rely on 75-80% utilisation just to break even that in effect changes the whole economics of the industry, because if it knocks even 10% utilisation back across the fleet everyone is struggling to break even on their assets.

The right hand graph shows the enormous drop in CapEx. The fact that more projects are being sanctioned but the spend is lower just highlights what company results are showing: the volume of work has increased slightly this year but the value being paid for it has not (or reduced in some cases). This is likely to be a structural feature of the industry going forward that previous margin levels will simply not recover.

Like everyone else Bourbon is making a play to drive down the cost of operation of its commodity assets and add more value to the value of its subsea assets through moving up the value chain. Across the industry an entire species of contractor that used to make a good living by supporting larger contractors now aims to do more projects directly with E&P companies. Bourbon, like others, will likely win some market share, but they will do this by competing on price and driving industry margins down overall. For Bourbon it will still feel like more revenue than running the vessel alone, and in the long run it maybe, but grow to big and the larger contractors will be unlikely to charter your vessels. That slow increase in the blue bar on the graph is a result of all this extra capacity coming to market on the contractor side and why good Bus Dev staff in the industry are still remarkably employable.

It’s a post for another day the problem for offshore demand in shallow water, where projects could be done by flexibles and a vessel-of-opportunity, is that the smaller companies who used to do these projects simply have no access to the capital markets. Capital markets prefer smaller projects to be shale-based now where the cash-flow cycle is shorter. Think of the last time an Ithaca Athena development was commissioned on the UKCS?

Obviously the E&P companies are doing better than the offshore supply chain, the point is that they are not doing so much better that things are likely to change immediately. Bourbon seems to realise the future may look a lot like the present on the demand side and adjusting its business model accordingly.

(Hat-tip: SE).

 

BOA and Volstad: End of a Norwegian era… More restructurings to come…

The best of men cannot suspend their fate: The good die early and the bad die late.

DANIEL DEFOE, Character of the late Dr. S. Annesley

Boa Offshore and Volstad Maritime are both involved in restructuring talks at the moment, both are bound by the same ties of market fate and financial commitments: excessive leverage, financial speculation, and a secular change in demand for the asset base that underpinned the bonds. On a wider scale these should be seen as examples of small Norwegian companies that rode an oil and credit wave that has now definitely ended and their place in the market will remain limited at best and in the Boa case is likely to be non-existent.

The excessive leverage isn’t simply a case of hindsight: again like the Bibby bonds these were depreciating assets backed by bonds that required no repayment during the life of the instrument. Capital assets that do not have to earn a return on their principal but rather rely on further refinancing are simply speculation by both parties to the transaction and are clearly indicative of a credit bubble. Such investments are what Minsky called Ponzi financing, it requires a suspension of belief from economic reality that such a situation can continue, and that interest payments can be met by constantly drawing on an increased capital value. In the offshore oil services world this wasn’t willfully disregardng the evidence but rather the industry belief that ever rising oil prices and demand side factors were immutable forces of nature. The failure to recognise that in the long-run this would cause some innovative firms to seek new solutions is one of the great enduring mental models that has led previous generations to believe fervently in ‘peak oil’.

The other similarity is the type of vessels both Boa and Volstad have backed: no other asset class in offshore has been as overbuilt as the large OCV (~250t crane, 1000m2+ back deck etc). Potential new investors in Volstad should look at how illiquid the Boa Deep C and Boa Sub C are: bondholders are looking at a liquidity issue because these assets are in all reality unsellable at any price at the moment. When the Volstad vessel charters finish their maximum upside is surely capped to the amount bondholders in comparable assets are willing to accept to supply vessels to Helix-Canyon… and that is surely lower than their current charters? And that would assume Helix need as many vessels, a bold asumption looking at their utilisation record. In the old offshore such assets were rare and expensive… now not so much…

Part of the clue to the lack of sales in the OSV market is not just in the demand side of the market it also lies in the behaviour of banks. Have a look at DVB (my previous thoughts on the bank here), lending to offshore was running at c. USD 2-3bn per annum in 2010 to 2014:

DVB lending by segment 2010-2014.png

Welcome to the world of The New Offshore and closed loan books as the DVB investor presentation (2017) shows:

DVB New Transport Business 2017

That isn’t DVB specific this is a relfection of all banks in the market and a total withdrawal of asset financing. No matter what the relationship bankers tell you to all but the most exceptional cases the loan book is closed for offshore assets in all banks (apart from US focused companies with a US revenue base and a US bank). And no one pays close to historical value for such specialised assets if you cannot get a loan, but this has become a self-referential cycle that will be very hard to break, and in reality will only be done so as part of an overall consolidation play by a player with a realistic financing structure relative to the market risk.

Volstad Maritime may have a viable business going forward (i.e. strategy and execution capability) based solely on the Helix-Canyon charters, but liquidity is a different issue. The fate of the Bibby Topaz remains a major area of interest as the vessel is part of a three boat high-yeild bond and the owners of the bond have in effect an option to take full control of the Topaz. The bond has a corporate guarantee from Volstad Maritime AS that adds to the complications. OTC bonds are a grey area but rumours abound of Alchemy (the core M2 investor), other funds, and industrial players all having positions in the bond. Bibby Offshore may well be delaying their restructuring announcement until the position of Volstad Maritime and the Topaz is clear (although if they can make it to September without legally overtrading handing back an Olympic vessel is also likely an announcement time). A seperation of the Helix chartered vessels could be a viable option but only if the corporate Volstad corporate guarantee can be squared with the bond owners (who also own the m/v Tau on charter to DeepOcean but must surely been seen as effectively worthless, and the Geco Bluefin (in lay-up?)).

The Boa bondholders and banks seem to be repeating the same mistake the Harkand/Nor bondholders have consistently made: confusing a permanent impairment in asset values for a temporary market dislocation. In fact the Boa OCV bond term sheet contains the following nugget:

the aggregate current market value of the vessels according to information provided by the Group prior to the date of this Term Sheet is NOK 810,000,000

No sane individual believes that you could get USD 95.7m for the Boa Deep C and Boa Sub C at the moment:  2 vessels that have to enter lay-up because there is no work for them and assets that no bank that would lend against. There is a nice gap in the documentation here where the advisers to Boa state they have not undertaken due diligence of any information supplied. Everyone here wants to believe something everyone knows not to be true.

The structure calls for the seperation of the various asset classes into their individual vessel type exposures and is in effect a wait-and-pray strategy. Bondholders pay a “Newco” management company a fee to manage the vessels and provision is made for a further liquidity issue. I sound like a broken record here but the longer everyone keeps providing further liquidity the further any supplyside recovery becomes. The Sub C and Deep C are very nice vessels but two vessels does not an operator make in the current market, all this set-up does is support latent capacity, like the North Sea PSV market, that keeps everyone bidding at OpEx levels only. Hope is not a strategy.

I don’t have any magic answers here beyond investors accepting the economic reality of their position which they are under no obligation to do. The Boa bondholders, like the Harkand bondholders, and others, figure they have lost so much what harm can one last roll of the dice do I suspect? For those of you who have seen the movie ‘A Beautiful Mind’ you may recognise this as a problem that is a case of Nash Equilibrium:

a solution to a non-cooperative game where players, knowing the playing strategies of their opponents, have no incentive to change their strategy

It drove Nash to a nervous breakdown (literally) and I have no intention therefore of taking this any further.

The New Offshore: Liquidity, Strategy, Execution. Nothing else matters.