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.

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.

North Sea DSV update… Has the Vard vessel been sold? Will IMR save the world?

We’re eyeball to eyeball, and I think the other fellow just blinked.”

Secretary of State Dean Rusk, during the Cuban Missile Crisis, 1962

It was a little windy (80-100 mph) up the mountain today as you can see from the photo… I thought it was a good metaphor for offshore at the moment anyway…

So in clearing out my emails I have now been told Technip have reached a deal with Vard on the 801. A price of ~$100m, but with no delivery risk and commissioning liability for Vard, has apparently been agreed. Technip is large enough for that to be a sensible risk to take as the Wellservicer needs to be replaced at some point. Unless ordered by SS7 or Technip I think this will be the last North Sea class DSV built without E&P company contract coverage for at least 10 years, maybe ever,  barring some unheard of change in the market. (This isn’t the place to get into why I don’t think any of the UDS vessels will end up North of the Med).

We are watching how an extremely illiquid and asset specific market clears in a huge market downturn. The interesting thing is that Technip and Subsea 7 seem to be making a renewed commitment to IMR having really lost focus during the construction boom, this graphic from Technip makes clear:

Technip Market Growth.png

If you are a smaller IMR contractor expect Technip to come up more often on tenders you are spending money on bidding. A near new DSV fleet fits this theme. It also shows you what sort of percentage/revenue increase on IMR a market leading company thinks it can get and how it is planning on taking market share. Smaller companies should be worried and anyone who publishes documents claiming they can grow organically at 50% in this market just isn’t serious.

I find the pricing of this asset fascinating: to Technip and Subea 7, taking a 25 year asset view it is an asset you could spend some real money on. One needs to replace the Wellservicer and the other the Pelican. But outside of those two companies the asset is almost unsellable at anything like it’s build cost. If you can’t operate that vessel in the North Sea (and it’s not even NORSOK) then it’s just an ROW DSV and you would be lucky to get $50-60m… and only then if you could find a bank to lend against it. So really they are just bidding against each other to take on the asset (not that I think Subsea 7 were)? How long do you make Vard sweat or risk seeing a really good vessel go to a competitor? Other vessels could also have been purchased from distress sellers e.g. How much better is the Vard vessel to the Toisa Pegasus (currently in lay-up)?

Both sides blinked at 100m if you ask me. More compromise than Mexican standoff.

The Seven Kestrel is arguably the best DSV in the world and as soon as construction work starts to pick-up SS7 will just ask the Koreans to build a replica (for less) if the need to relace the Pelican. And at that point that will be the last North Sea class DSV built for a very long time.

Both Technip and SS7 have some pretty new DSVs and both have an old (fully depreciated) one that operates when the market peaks… But as I wrote earlier the only realistic scenario for 2018 is for North Sea day rates to stay low for DSV work, and in this market making a trade off against a low capital cost to lose money on OpEx for a bargain purchase is getting ever harder to make? The lower than expected contract size for the Snorre Extension for Subsea 7 shows how low margins are for awarded work at the moment and how long it may take for day rates to recover. And if, as looks likely,  Boskalis and Bibby start a brutal price war to gain or keep market share, then dropping $100m on a vessel to go out at $100k a day (a cash loss amount in the North Sea) doesn’t seem that clever at the moment. Go back $10m a year for a few years on a DSV, easily possible in this market, and savings in CapEx were illusory.

Optimists point to graphs like this:

North SEa SAt MArket.png

But this ignored Boskalis taking the Nor vessels and Vard vessel replacing the Rockwater 1. [As a methodological point it is also worth noting that each movement on the vertical axis represents 3 DSV vessel years! showing you how easily the forecast could be out here]. It is also worth noting that if those Decom figures are wrong, and they look agressive, the market imbalance is illusory. No one in this market is going to force E&P companies to pay divers to remove mattresses etc off the seabed.. its just not going to happen. Just as importantly, a modest increase in day rates, which would see the DSV fleet operating at below economic cost, could curtail IRM or EPIC project demand as this graph seems to assume constant demand. There is a large amount of latent supply in the market that will come into the market as rates increase (which happened in 2014)… economic change happens at the margin… which is not reflected in a static graph like this.

Ultimately running vessels, even for companies the size of Subsea 7 and Technip, is a utilisation game as the fixed costs are so high that a small drop in utilisation and day rates /project margins can lead to a massive drop in profitability and cash losses. Shareholders would not welcome a cash call if it means they have overpaid for vessels and ultimately been diluted in a down market, and a North Sea class DSV is a very expensive vessel to have underutilised. I am always reminded mentally that Technip looked seriously at acquiring CGG not that long ago… in which case this would be a great bargain…

Let’s wait and see…I still have my doubts… but if the Vard 801 rocks up to the North Sea in April/May under Technip control for the North Sea summer my photo above will be a good reflection of economic conditions for North Sea DSV owners in 2018…