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Halliburton & Baker Hughes – The Story Behind the Merger
by Vishnu Hariharan, CEO of BlueBook (Special Contributor to The Write Resume)
In this article we are going to run through the steps a financial analyst would take to evaluate a merger so that you have a roadmap to discuss with fluency the story behind a corporate transaction. For real-world application, we are going to analyze a recently announced deal and assess its economic, strategic and regulatory impact as well as the financial mechanics.
PART 1: Introduction
On 17 November 2014, Halliburton (NYSE: HAL), the world’s second largest oil services company and Baker Hughes (NYSE:BHI), the third largest announced an agreement for Halliburton to acquire all of Baker Hughes shares. The deal would be the largest corporate takeover by equity value in the global oil and gas industry since 2000, according to Dealogic.
Both companies serve the upstream (exploration & production) oil and gas industry throughout the lifecycle of the reservoir – from locating hydrocarbons and managing geological data, to drilling and formation evaluation, well construction and completion, and optimizing production through the life of the field.
The transaction is valued at $78.6 per Baker Hughes share, or $34.6 billion in equity value and $38.0 billion in enterprise value. As a combined entity, the enlarged company generated revenues of $51.8 billion in 2013 and employed over 136,000 staff in more than 80 countries.
Halliburton has for many years been looking for a deal to bring it closer to the size of Schlumberger, the world’s largest oil services group, and were previously in talks about a deal with Baker Hughes over 10 years ago. Schlumberger is valued at $105bn, compared with $37bn for Halliburton (as at 16 January 2015).
The merger creates a virtual duopoly as #4 rank by size, Weatherford International is significantly smaller with little to no overlap in many businesses. In evaluating any corporate transaction, whether the deal will deliver value to shareholders is the fundamental principle of sound corporate finance decision- making.
| Transaction Overview | |||||||
| Date Announced | 17-Nov-14 | ||||||
| Offer Price ($) | $78.6 per BHI share | ||||||
| Offer Premium (%) | 55% | ||||||
| Equity & Enterprise Value ($bn) | $34.6bn, $38.0bn | ||||||
| Ownership (%) | 63% Halliburton, 37% Baker Hughes | ||||||
| Financing | 76% Equity, 24% Cash | ||||||
| Status | Pending regulatory approvals | ||||||
PART 2: Why the merger
The combination with Baker Hughes would create a bellwether global oilfield services company and benefit stockholders, customers and other stakeholders of Baker Hughes and Halliburton. The stockholders of Baker Hughes would immediately receive a substantial premium for their shares – at $78.6 offer price for BHI shares, this is a 54% premium to the stock market price of BHI just prior to the offer announcement. BHI shareholders would also have the opportunity to participate in the potential growth of the combined company if they wished to retain their shares.
A merger of two companies may be achieved in one of two ways. The acquirer may negotiate with the management of the prospective acquired company, which is the preferred approach. If negotiations are not successful, the acquirer may make a tender offer directly to the stockholders of the targeted company. A tender offer represents a cash offer for the common shares held by stockholders. The offer is made at a premium above the current market price of the stock. In some cases, the tender may be shares in the acquiring company rather than cash. Minority shareholders are not required to tender their shares. Consequently, not all of the target firm’s stock is usually tendered. Usually an expiration date exists for the tender.
In this deal, the agreement on the stock and cash takeover followed weeks of sensitive talks between the two companies’ leaders, in which BHI complained it was being pressed into agreeing a deal too quickly, and HAL moved to prepare for a hostile bid.
Definition/Context: A merger is a business combination in which the acquiring firm absorbs a second firm, and the acquiring firm remains in business as a combination of the two merged firms. The acquiring firm usually maintains its name and identity. Should the transaction receive all necessary approvals, the combined company will maintain the Halliburton name and continue to be traded on the New York Stock Exchange under the ticker symbol HAL and will be headquartered in Houston, Texas.Generally, mergers are transacted when it is believed a combined company is capable of achieving opportunities that neither company could have realized as well – or as quickly – on their own.
Strategic rationale
For Halliburton, the proposed merger will create a more valuable entity that can more effectively compete with Schlumberger internationally and will remove a major competitor from the marketplace. The merger gives Halliburton a commanding position in North America and a #2 position internationally. The increased international scale will be key in helping the company narrow the operating margin gap with larger rival, Schlumberger, as it adds critical infrastructure.
One attraction of the deal is Baker Hughes’ capability in areas where Halliburton was relatively less strong, including production chemicals and pumps used to increase oil recovery from wells. Those operations have become increasingly important in the US shale oil boom, which has led to a surge in production as crude and other liquids are extracted from previously inaccessible reserves. A reduction in Halliburton’s capital intensity and an expected improvement in margins are estimated to lead to substantial free cash flow generation, which will further strengthen its solid balance sheet.
Synergies
The company predicts the combination would create annual cost synergies of nearly $2 billion.
Source: Halliburton Investor Presentation
How do we calculate synergy value? To calculate this figure requires the capital budgeting technique of discounted cash flow analysis. The difference between the cash flows of the combined firm and the sum of the cash flows of the separate firms is discounted at the appropriate rate, usually the cost of equity of the acquired firm. The components of the incremental cash flows are the incremental revenues, costs, taxes, and capital needs.
Where will synergies come from in the merger and can HAL justify the premium paid?
The two companies have justified the large takeover premium by saying they can achieve $2bn a year of savings by cutting costs by the end of 2017. This would encompass improving operational efficiencies to increase profitability margins, enhancing their research & development, and eliminating duplicate cost centres such as human resources. The combined entity should also benefit from revenue synergies such as leveraging complementary product offerings such as BHI’s artificial lift and pressure pumping division to serve Halliburton’s existing logistics network – offering an extended product set over its fixed asset base. The merger will also offer new and accelerated international market entry opportunities for BHI over organic stand-alone growth. Financial synergy may also result from the combination. The cost of capital for both firms may be decreased because the cost of issuing both debt and equity securities is lower for larger firms.
PART 3: Deal details
There are several financing packages that buyers may use for mergers, such as common stock, preferred stock, convertible bonds, debt, cash, and warrants. A key factor in selecting the final package is its impact on current earnings per share (EPS).
Halliburton has elected to finance the transaction through cash and issuing new stock. Here are the steps:
- Based on its $78.62 offer price for each of BHI’s 440 million shares means HAL must finance a $34.6bn transaction.
- Financing $19 per BHI share in cash equates to $19 x 440m = $8.4bn cash
- HAL must fund the balance by issuing new shares: ($34.6bn – 8.4bn) $26,2bn / $53.23 (HAL share price) = 493m. This is the same as computing 1.12 exchange ratio x 440m BHI shares = 493m
- $26,241 in equity and $19 x 440m = $8.4bn in cash equates a financing split of 76% equity, 24% cash
- Total combined entity shares = 847m (HAL) + 493m (BHI) = 1,340m shares. Post-transaction share ownership is HAL: 63% BHI: 37%
| Deal Overview | Deal Financing | |||
| BHI Offer Price | 78.65 | % Equity | 75.8% | |
| Exchange ratio | 1.12 | Equity ($m) | 26,241 | |
| No. Shares (m) | 440 | HAL Price at Offer Date ($) | 53.23 | |
| Equity Value ($bn) | 34.6 | |||
| Net Debt ($m) | 3.4 | HAL + Exchange Rate (x1.12) | 59.62 | |
| EV ($bn) | 38.0 | Cash per Share ($) | 19.00 | |
| Offer Premia: | Offer price ($) | 78.62 | ||
| To initial offer (10 Oct ’14) | 40.70% | HAL Shares (m) | 847 | |
| To agreed offer (12 Nov ’14) | 54.30% | New HAL shares issued (m) | 493.0 | |
| Combined Shares (m) | 1,340 | |||
| 1 year | 36.30% | Ownership | ||
| 3 year | 34.50% | HAL | 63% | |
| 5 year | 25.90% | BHI | 37% |
HAL intends to fund the cash portion of the acquisition through a combination of cash on hand and debt financing. Applying the proposed 76/24% stock/cash split to the deal’s $34.6B equity value yields cash consideration of $8.4B. Assuming HAL uses ~$1B of cash on hand, this implies the remainder will be funded by newly issued debt.
“We expect that the acquisition will be accretive (increase) to Halliburton’s cash flow by the end of the first year after closing and to earnings per share by the end of the second year. We anticipate that the combined company will also generate significant free cash flow, allowing for the return of substantial capital to stockholders.” Dave Lesar, CEO of Halliburton.
PART 4: Transaction Risks
Oil price
With the continual drop in oil prices, this could lead customers to reduce their activity and would drive key end markets in the US into oversupply and result in a decline in earnings.
Executing on Strategy
If Baker Hughes fail to lift the utilization of its domestic pressure pumping fleet and/or gain share within the oil services markets outside of North America, then earnings growth could also be in jeopardy.
Anti-trust / Competition
The merger of HAL and BHI reduces the number of key players from 3 to 2 with a higher concentrated global industry for HAL and Schlumberger. As a result the transaction is subject antitrust regulation across multiple jurisdictions, including the U.S. Department of Justice (DoJ).
With Halliburton and Baker Hughes combined global market shares for some products and services exceeding 40 per cent, transaction success will come down to the US Department of Justice – how will it identify assets, and what will Halliburton end up having to divest. It is also expected that the European Commission (EC) will review the HAL-BHI deal given the significant market share these companies possess in the region.
In order to satisfy regulators, the company has suggested it is open to divesting both its vertical channels (products and services and horizontal (regional) to attain anti-trust clearance. HAL has noted it would divest up to $7.5 billion.
To provide guidelines as to what type of business combinations would and would not be challenged in antitrust actions, the Justice Department developed the Herfindahl-Hirshman index. This index is the sum of the squared market shares multiplied by 10,000 to eliminate the need for decimals. By squaring the market shares before adding them up, the index weights firms with high market shares more heavily. The value of the Herfindahl-Hirshman Index lies between 0 and 10,000. A value of 10,000 exists when a monopolist exists in the industry. A value of zero results when there are numerous infinitesimally small firms. See below for a numerical example:
| Industry Market Share | ||
| % Market Share | HHI | |
| Company A | 37% | 1369 |
| Company B | 24% | 576 |
| Company C | 20% | 400 |
| Company D | 12% | 144 |
| Company E | 6% | 36 |
| Combination of Company A and Company E | ||
| % Market Share | HHI | |
| Company A | 37% | |
| Company E | 6% | |
| 43% | 1849 | |
Concentration Thresholds
| Market Share Squared | Likelihood of Challenge |
| Less than 1,000 | Not Likely |
| 1,000 – 1,800 | Possible |
| Greater than 1,800 | Likely |
Summary
In this Halliburton-Baker Hughes merger story, we have assessed the deal rationale from a strategic, economic, financial and regulatory perspective to address the key issues that face the combined firm if they are to realize the value promised to the shareholders. For Halliburton management, they forecast earnings accretion in the second year and substantial annual synergies, which compensates for its high offer premium. For Baker Hughes shareholders, they stand to benefit from an immediate and large premium and an opportunity to be part of a stronger, more competitive organization in the midst of a sharply declining oil market. Whether regulatory hurdles are overcome remains to be seen which will be the focal point of 2015 for both companies and the oil & gas industry as a whole.
