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As The Merger Is About To Fail, Why Are Halliburton And Baker Hughes Trading Higher?
The U.S. Department of Justice finally filed the antitrust lawsuit to block Halliburton's (NYSE:HAL) proposed acquisition of Baker Hughes (BHI). The market's reaction may appear counter-intuitive: on the day of the announcement, the stocks closed 5.9% and 8.8% higher, respectively. Shares of Schlumberger (NYSE:SLB), on the other hand, underperformed the Oil and Gas sector, moving higher by only 0.7%.
What is driving investor enthusiasm with regard to Halliburton and Baker Hughes? At the end of the day, it might appear that both companies stand to suffer significant setbacks if the deal falls apart (which now appears to be a near certainty). Halliburton would be saddled with massive merger-related expenses that will amount to nearly $4 billion. Baker Hughes, on the other hand, would receive only a small consolation prize of $3.5 billion (with a dent of merger costs in it) instead of a much larger takeover premium. Most importantly, neither company would be able to benefit from the stronger margins that the consolidated competitive landscape would have awarded them in the event of the merger's success.
The simple explanation may be that the downside was fully discounted in the stocks' prices. The DoJ's response is effectively a catalyst for the companies to terminate the merger agreement and pursue their independent business plans, taking additional steps to bring their cost structures in line with the current and expected market conditions. The strong move in oil prices during the trading session, which drove the entire Oil and Gas sector strongly higher Wednesday, also should not be overlooked. That said, there appears to be some downside risk to both stocks after Wednesday's strong upward move.
Schlumberger's underperformance relative to the sector is understandable, on the other hand. The favorable competitive environment that Schlumberger has enjoyed thanks to the pending HAL/BHI combination will now end somewhat sooner than some investors might have hoped.
The DoJ Harshly Condemns The Merger Concept
In its complaint, the Department of Justice used strong language to characterize the proposed transaction as anticompetitive and harmful to the industry and consumers. The DoJ alleged that the transaction threatens to eliminate competition, raise prices and reduce innovation in the oilfield services industry. The DoJ argued that in the United States alone the transaction would eliminate important head-to-head competition in markets for 23 products or services used for on- and off-shore oil exploration and production.
(Source: The U.S. Department of Justice)
In response to DoJ's lawsuit, Halliburton and Baker Hughes issued a joint press release stating that they intend to vigorously contest the DoJ's effort to block their pending merger.
The companies believe that the DOJ has reached the wrong conclusion in its assessment of the transaction and that its action is counterproductive, especially in the context of the challenges the U.S. and global energy industry are currently experiencing.
The proposed merger of Halliburton and Baker Hughes is pro-competitive and will allow the companies' customers to benefit from a more flexible, innovative, and efficient oilfield services company. The transaction will provide customers with access to high quality and more efficient products and services, and an opportunity to reduce their cost per barrel of oil equivalent.
Early in the process, Halliburton proposed to the DOJ a divestiture package worth billions of dollars that will facilitate the entry of new competition in markets in which products and services are being divested. Both companies strongly believe that the proposed divestiture package, which was significantly enhanced, is more than sufficient to address the DOJ's specific competitive concerns.
The companies intend to demonstrate that the DOJ has underestimated the highly competitive nature of the oilfield services industry, the many benefits of the proposed combination, and the sufficiency of the divestitures. Once completed, the transaction will allow customers to operate more cost effectively, which is especially important now due to the state of the energy industry and oil and gas prices.
Halliburton and Baker Hughes look forward to a full, impartial judicial review of the pending transaction, including the sufficiency of the proposed divestitures.
Despite the belligerent tenor of the press release, Halliburton has a weak case, in my opinion. The claim that the proposed merger is "pro-competitive" raises eyebrows as well as questions with regard to Halliburton being serious in this matter. It should be noted that the U.S. regulatory review may be the least difficult of Halliburton's problems. If the transaction is failing to get regulatory approval in the U.S., one can only imagine the challenge of convincing the regulators in Brazil, Australia and E.U. that the combination is "pro-competitive." In contrast to the U.S., Deepwater is much more important in those markets and the "big three" oilfield service providers dominate the Deepwater market segment.
The situation is strongly complicated for Halliburton by the final deadline in the merger agreement. As permitted under the agreement, Halliburton and Baker Hughes have agreed to extend the time period to obtain regulatory approvals to April 30, 2016. Beyond April 30, 2016, either of the parties may terminate the merger agreement. While the two companies may also elect to continue to seek regulatory approvals beyond April 30, the transaction will be at a high risk of termination by Baker Hughes.
A Case Study For Students Of Corporate Governance
In the now very likely event that the deal falls apart, Halliburton's shareholders stand to pay a hefty price for a difficult-to-rationalize strategic initiative. In addition to the $3.5 billion anti-trust termination fee to be paid to Baker Hughes, Halliburton will have incurred massive merger-related expenses. Through December 31, 2015, merger-related costs had amounted to $325 million on a pre-tax basis. Significant additional costs are being accrued in 2016. The hidden costs of the disruption to Halliburton's organization and market opportunities lost due to management distraction are difficult to quantify but are certainly present.
The initial decision by Halliburton's management and Board to pursue the Baker Hughes combination is truly puzzling, as the deal's non-viability from a regulatory perspective appeared almost obvious from the outset.
It is worth noting that the Department of Justice characterized the proposed combination as "unprecedented" in term of its anti-competitive nature:
"This transaction is unprecedented in the breadth and scope of competitive overlaps and antitrust issues it presents," said Assistant Attorney General Bill Baer of the department's Antitrust Division.
The DoJ also commented on Halliburton's proposed remedy whereby the company offered to divest "a mix of assets extracted from certain business lines of the two companies" (DoJ's characterization):
…the proposed divestitures would not include full business units but rather would be limited to certain assets, with the merged firm holding onto important facilities, employees, contracts, intellectual property, and research and development resources that would put the buyer of those assets at a competitive disadvantage.
The proposed divestitures mostly would allow Halliburton to retain the more valuable assets from either company while selling less significant assets to a third party. …this divestiture would not replicate the substantial competition between the two rivals that exists today.
To anyone even remotely familiar with the competitive landscape of the global oil service industry the regulators' strong objection is probably not a big surprise. In this context, it is difficult to avoid some uncomfortable questions.
Wasn't it obvious from the outset that the proposed merger would run against DoJ's guidelines regarding market share concentration in horizontal mergers, in multiple product and service lines? Wasn't it obvious that the transaction would face similar objections in other key jurisdictions, including Australia, E.U. and Brazil? Wasn't it obvious that selective divestitures would not be a cure to the problem?
Apparently, the transaction's regulatory risks were obvious to Baker Hughes' Board. Baker Hughes initially resisted Halliburton's overtures and eventually demanded a massive antitrust termination fee as a condition to agreeing to the combination, essentially making the deal a "tails you win, heads you win" for its shareholders. In this context, was Halliburton's Board acting prudently when exposing its shareholders to a very large loss in the event of the deal's regulatory failure (which, one might argue, was a very high risk, if not a certainty, from the very beginning)? Furthermore, was it - and is it -appropriate for a major corporation to aggressively push the envelope as it relates to antitrust laws?
What was the role and opinion of Halliburton's advisors and lawyers with regard to the proposed transaction's compliance with antitrust laws? How high were the fees paid for the expert advice?
Finally, is there any confidence that Halliburton's shareholders will not be again exposed to miscalculated high-magnitude risks and potential massive losses in the future?
The Competitive Landscape
Among the "big three" integrated oilfield service providers - Schlumberger, Halliburton and Baker Hughes - Baker Hughes comes out as the biggest winner in the (highly probable) event that the deal falls apart. For Baker Hughes, the game has certainly been worth the candle. The large payoff - at the time when cash is a valuable commodity - would open multiple options for the company, which may include acquisitions at cycle-bottom prices, investments in research and development and more aggressive posture increasing footprint in the most sought-after markets. By the same token, Halliburton would see a large amount of opportunity-creating cash leave its balance sheet.
With its windfall profit, Baker Hughes would have a fighting chance of narrowing the competitive gap to the two market leaders, Schlumberger and Halliburton. Baker Hughes' lag is particularly noticeable in North America where the company's business mix is heavier weighted towards commoditized segments (one might recall the acquisition of BJ Services several years ago that increased Baker Hughes' presence in the pressure pumping segment but also created a legacy of low-margin assets).
(Source: Schlumberger, December 2015)
Overall, the integrated oilfield services segment may become modestly more competitive in the aftermath of the deal coming through, as Baker Hughes would become a stronger #3. That said, the big three integrated oilfield service providers would still remain strongly positioned to generate healthy profits through the cycle, particularly in international markets and with regard to large-scale projects and high-technology products. In those areas, the "big three" face little competition from smaller providers, as validly pointed out by regulators in the course of the Baker Hughes-Halliburton merger review.
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