November 24, 1998
Could Merger Mania Hit the Oil Patch Next?
By Paul R. La Monica
OIL SERVICES
IF ANYONE thought the M&A market was dead, they were thrown for a loop on Monday. A slew of deals in sectors ranging from banks and insurers to technology, retail and aerospace flew across the ticker. But one sector missed out on Merger Monday, and it might be the ripest for consolidation: the oil services sector.
Oil prices are still hovering at the anemic price of about $12 a barrel. There is little hope for further production cuts coming out of Wednesday's OPEC meeting in Vienna. Major oil exploration and production companies such as Mobil (MOB), Chevron (CHV) and Texaco (TX) have all said their capital spending budgets will likely be lower in 1999. Even the weather is not cooperating. So far November has been warmer than expected, increasing doubts that this winter will be cold enough to stimulate more demand for oil.
Can it get any worse? Even though some would argue that it can't, keep in mind that a lot of people have been saying that for months now. We unfortunately cannot plead innocence as we've incorrectly called the bottom as well. Companies were cheap back in June. Now they're even cheaper.
Dan Pickering, director of research for Simmons & Co., a firm that specializes in the oil industry, says that the longer the price of oil remains under $13 a barrel, the more likely it will be for companies to look at selling out. The oil services business is cyclical, so longer-term investors could conceivably reap huge rewards when oil prices do head back up. But this down cycle has now lasted for more than nine months. Some oil services companies may have no choice but to find partners before things get worse.
That's why we've decided to run the oil services merger screen. We came up with 10 oil services stocks that are still well off their 52-week highs, have a greater amount of debt than their peers and are expected to post woeful fourth-quarter results. One of the companies, Cliffs Drilling (CDG), agreed to be bought by R&B Falcon (FLC) in August. And Falcon, a SmartMoney pick from our Best Midyear Investments (July 1998) portfolio, actually came up on the list as well.
The drilling companies have been particularly hard hit. In addition to Cliffs and Falcon, two other drillers with a sizable presence in the Gulf of Mexico popped up on the screen, Global Marine (GLM) and Rowan (RDC). Pickering has done an analysis of how much more downside there could be for these and other drillers. The picture isn't pretty.
By calculating the replacement costs of the drillers' rigs and other assets, Pickering came up with downside prices of $8.20 a share for Falcon, $5.60 for Global Marine and $13.10 for Rowan. At current prices, Falcon could have 23% more downside and Global Marine could fall another 45%. But what's worse is that Rowan is trading below Pickering's downside target, which implies that the company is trading below its asset value. So it's clear that investors really are taking into account only one thing when looking at these companies: low oil prices.
What are the takeover chances for these companies? Matt Conlan, a Wall Street Journal All-Star analyst with Prudential Securities, thinks the oil drillers will merge with other drillers rather than being bought out by larger, more diversified oil services firms such as Schlumberger (SLB) or Halliburton (HAL). Conlan says any of the drillers could benefit from consolidation since cost cutting will be essential as big oil producers continue to scale back their drilling projects. "At the end of the day it doesn't matter if there's 10 companies left or eight companies. There's not enough demand to go around," Conlan says.
Lewis Kreps, an analyst with Dain Rauscher Wessels, says Rowan has maintained a pretty independent stance in the past so he's not sure if the company would want to sell. Global Marine has shown a willingness to build up its deep-water presence so it could look to either acquire a company with more deep-water capabilities or be acquired by one. Even though deep-water drillers like Diamond Offshore (DO) and Transocean Offshore (RIG) have seen their stock prices drop this year as well, they have not suffered earnings declines as great as shallow-water drillers like Rowan, Falcon and Global Marine. The deep-water business is more stable and less sensitive to crude prices but investors have punished these stocks nonetheless.
Conlan says that Diamond Offshore could make a good fit with Falcon, which is also trying to increase its deep-water presence. Others wonder if Diamond would be willing to take on the leverage necessary to complete the transaction. Falcon has one of the highest debt ratios in the industry, at about 63% of capital. And Pickering says Diamond is probably a more likely seller than buyer while Falcon has shown more of a desire to build by acquisition.
Even though analysts say consolidation on the drilling side is likely, the number of mergers among drillers has not kept up with the pace of deals on the equipment side. And there could be even more mergers among oil equipment companies. Baker Hughes (BHI), which is busy absorbing Western Atlas, also made our screen. But even though its stock is down more than 50% this year, it is still one of the larger players in the oil services business and analysts expect it to make more deals once it has integrated Western Atlas.
Some of the other smaller equipment companies that came up on the list could be appealing takeover candidates, however. Smith International (SII) was the subject of takeover rumors earlier this month. But Schlumberger, which was the name most often mentioned as an acquirer, has since said that it is not interested in any large acquisitions. Still, with Smith expected to post a 32% earnings decline this quarter, and a 38% earnings drop in the first quarter of 1999, you have to wonder if Smith isn't looking for someone else to acquire it. The company's debt load (more than 50%) doesn't help its chances of being able to remain independent.
Cashing in on a consolidation craze in the oil services business could make sense if you're looking to buy now. But if you've been holding these stocks for awhile, you might want to think about selling for tax purposes as the end of the year approaches. After all, even if, say, R&B Falcon decides to sell out, it is not going to be anywhere near its 52-week high of 36 1/2. But if you're an opportunist, there's a good chance for you to profit by picking the oil services companies that won't be around anymore by this time next year. Merger mania is back and it should hit the oil patch next.
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