It was a memorable phone call. A couple of months ago a classically trained financial engineer with money to invest in distressed oilfield services (OFS) companies called and asked, “Do you know of any quality oilfield equipment manufacturing companies in CCAA?” CCAA stands for Companies’ Creditor Arrangement Act defined on the PWC website as, “a Federal Act that allows financially troubled companies the opportunity to restructure their affairs”. In simple English a company in CCAA is broke, owes lenders and creditors it cannot pay $5 million or more, and may or may not survive.
My response was, “I don’t know of any companies that meet your criteria. It’s a contradiction in terms”. This is not to say that trying to buy formerly good businesses in a terrible market at a fraction of the former value is a bad idea. It just doesn’t work that way in what is fundamentally a people-based, not asset-based, business.
For over a year private equity (PE) firms, merchant banks and deep-pocketed investors have concluded this is great time to go bargain hunting in the financially crippled OFS industry. There is no question valuations of OFS companies are at a multi-year, if not generational low. Two new special purpose OFS recovery exploitation funds have been launched in Calgary alone in the past two months, both raising $50 million to $100 million to ride the oilpatch recovery on the way back up. There are lots of pools of capital ready to do even bigger deals should the opportunity arise.
The problem is OFS investing today is incredibly complicated compared to prior years. As recently as two years ago pretty well anybody and everybody was making money and had been for some time. Analyzing an investment opportunity was relatively straight-forward. Companies could produce multiple years of stable or growing revenue and predictable and possibly expanding cashflow. Virtually all businesses needed expansion capital. Based on several years of high oil prices and multiple forecasts of expanding oil and liquids production, past financial performance provided confidence for continued success.
Anybody in OFS with credible financials, steady customers (they were all steady customers prior to 2015), half a business plan and a commitment by management to hang around and run the place for a couple of years could sell their operation for 3 to 4 times EBITDA. High demand specialty services for extended reach horizontal drilling and completions such as new multi-stage packer assemblies could command even higher valuations. It was a great time to sell. Related: Oil Prices Could Spike As Analysts See Venezuela Losing 500,000 bpd
But as fate would prove, it was a terrible time to buy. Oil prices started to soften in July 2014 and by the OPEC meeting in November later that year the party was over. The entire upstream oil and gas industry began a downward cycle that only recently appears to have arrested itself and is gradually changing direction. The old saying goes when exploration and production (E&P) companies catch a cold OFS gets pneumonia. When E&P quits drilling operators build cash. When E&P quits drilling OFS starves.
Staying in business to participate in a recovery of any sort has been a challenge of monumental proportions for all OFS managers. Anybody with any meaningful amount of debt still has the lights on only thanks to the flexibility of their lenders. Many have had to inject cash to keep the company afloat. The working capital required to fire up equipment and hire back personnel is in short supply. OFS needs money. Investors have it. You’d think the market conditions for both sides doing some business would be ideal.
Unfortunately, they are not. There are several obstacles to OFS companies raising much-needed cash and investors writing cheques. Until they are understood and overcome there will be nowhere near as many deals done as there could or should be.
The first obstacle is that the recovery will be unfair and uneven. Not everybody in OFS is going to go back to work. Many assets classes, products and services will not be required. Demand is such that only the best, newest and most cost-effective equipment and services will work this year. Having the right customers is essential. Investors will have to know enough about how the oilpatch works to be able to look at OFS companies and understand where they fit into the supply chain and why some are attractive investments and others are not. Investors closest to the business with hands-on experience and extensive industry contacts will do better than others.
The second challenge is there will be no historical financial data from the prospective target companies that mean anything. That OFS made a lot of money in 2010 through 2014 is interesting but is of no value in the latter half of 2016 and beyond. That’s how much the business has changed. Financial performance in 2015 and YTD 2016 is of some use if the company managed to maintain a positive cash flow (at least on paper with costs lower than revenue) but the EBITDA generated will not justify the size of investment required to make a difference using traditional valuation models. Whatever deals are done will be based primarily on asset values and financial forecasts for a recovery that has yet to take place. This is going to require a bit more courage than classically trained financial analysts who have traditionally based investments on discounted future cash flows are accustomed to.
The third factor is equity investors will most likely be forced to pay down debt to get the company’s balance sheet and banking relationship back on side. Traditional PE investors prefer to inject equity then increase debt, not pay it down. Lots of opportunistic investors have phoned banks looking for bargains in their troubled loan portfolios but the objective of many has been to get control of the company through buying the debt at a steep discount, not bail out the lender. Historically, equity investors want to grow the company with their capital, not save it from insolvency. Related: NASA May Have Just Transformed Aviation With 100% Electric Plane
The last issue to be addressed is the current equity holders, the owners. When traditional valuation methods are employed (points two and three) the calculation will likely determine the equity value of the target is zero, possibly negative. For pure asset deals like equipment, real estate or inventory that’s fine, assuming the buyer has an operating entity, which can exploit these assets. But for most service companies the people are as important as the product or service. The good customer relationships essential to sustaining business and growth are with the team, not the trucks. So third-party investors wanting to turn a good company around are going to have to allow key personnel to participate in the upside whether traditional valuation mathematics justifies it or not.
In summary, to do a good deal in today’s OFS industry – a good operation with good people and good equipment that will be part of the recovery – investors must throw the PE operations manual in the garbage can and do things differently. They will invest off current financials showing little or no cash flow. They will pay down debt – ideally to zero – so their new partner can use all its free cash from operations for working capital, equipment repair and growth. And they must figure out how to carve off a meaningful piece of the future action for the owners and management team that is going to take the company from the current challenges to the Promised Land.
Equity investors are going to have to pay more than they want to for quality companies that will ride the recovery into the upstream oil and gas industry of the future, whatever that may be. As I told the inquiring investor some months ago, there are likely few if any quality companies in CCAA. It’s the nature of the beast. There may be bargain basement assets for those already in the business but that’s different story.
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But there are, however, numerous quality companies in need of capital to get back on the growth track. If investors can figure out to treat the owners with dignity (allowing them the chance to make their money back if things work out) many of these outfits would benefit mightily from the financial expertise investment professionals can provide. It could be a great partnership.
There are deals to be done, opportunities galore. But like everything in the current upstream oil and gas industry, things will be different.
By David Yager for Oilprice.com
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