Consolidation In The Oil Services Industry

| About: Schlumberger Limited (SLB)
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A $34.6 billion deal between HAL and BHI finally ended as antitrust pressures broke the bond.

The merger looked to increase the competitiveness of the two firms against the leader in the oil services, SLB.

The aggressive M&A behavior shown by HAL and potential $3.5 billion break-up fee to be given to BHI could be an issue.

The mergers and acquisitions line is finally bustling with the news of two large oil services looking to give birth to a larger, more efficient firm that can thrive in a low price environment. Halliburton (NYSE:HAL) and Baker Hughes (BHI) have been in talks regarding a merger for a while now, a deal that could have significant implications for that particular industry.

The deal included an offer by Halliburton to buy out its rival for about $34.6 billion, as reported by DealBook. The collision course mapped out will help cut costs by almost $2 billion by meshing together the second- and third-rated operations in the country. By the terms of the deal, Halliburton would "pay 1.12 of its shares and $19 in cash for each Baker Hughes share ... valued at about $78.62 a share." In the end, Halliburton would own 64%, with Baker Hughes' leadership left with a 34% minority.

The proposal came as no surprise to investors who had begun to feel tension in the oil services industry, as low crude prices significantly reduced demand for new machinery and both firms' ability to compete with Schlumberger (NYSE:SLB), their largest competitor. A year and a half later, the merger looks to be in peril with antitrust officials flashing the red lights.

Source: Yahoo Finance

The reasons behind the deal are clear. Halliburton and Baker Hughes have failed to keep up with the impressive performance of their gargantuan rival. Schlumberger is almost twice their size, meaning that a merger would still leave the newly formed corporation in second place in the oil services industry. As far as revenue streams go, the comparison looks a lot favorable for the underdogs. Investors are actually paying less per dollar of revenue in choosing either HAL or BHI vs. SLB ($1.36 or $1.20, vs. $2.62, respectively).

The major advantage that SLB has over its two competitors is its margins, which are more than twice as big ($0.20 vs. $0.11 and $0.08). Because of its ability to keep costs low and operate efficiently, SLB has managed to maintain an earnings per share (EPS) well over $1. HAL and BHI, on the other hand, are operating at losses with the latter recording net income losses of almost $2 billion. For that reason, investors are noticing the potential of incredible earnings growth for SLB along with better oil prices. Their ability to run over $2 billion worth of profit bodes well for dividends, making them a safe bet for traders amid uncertainty.

Even though all three companies have seen their shares sold off since the beginning of the oil glut, SLB has seen the least loss out of the bunch. The chart above shows the securities' performances against the S&P 500 and their respective losses. Both HAL and BHI saw their shares sold off more than 45% of their girth, while the top oil services company did better by more than 10%.

Investors just preferred the large-cap stock, even though its price is twice as high. Its two competitors saw an opportunity to compete when their market and books prices dropped significantly. Halliburton, in particular, has been aggressively pursuing the venture offering to divest billions of dollars' worth of assets in order to satisfy the antitrust force's desire for a third competitor.

But despite the apparent rigor of the pursuit, its attempt to pass has been stymied by a lawsuit filed by the Department of Justice under antitrust laws. With the disappearance of a third competitor, the government argues that the oil services industry could experience problems with "collusion," an increased likelihood of "higher prices," and "less overall economic efficiency." With the firms already strapped for cash, fighting this judgment would prove to be an expensive path to take. So, yes, investors can look past the deal on to the repercussions. Upon the cancellation, Halliburton will be forced to pay a $3.5 billion break-up fee based on legal negotiations between the two companies, which will benefit Baker Hughes by adding to their cash reserves (as per the article linked to above).

So what does that mean for the oil services industry? It seems clear that most of the large-cap firms are currently shopping for cheap assets to add to their repertoire. With oil prices looking to rebound this year, firms like SLB, HAL, and BHI will be searching for ways to capitalize on the new demand for oil and gas machinery. BHI, with an incoming cash bonus of $3.5 billion, will be looking to bolster their financial position -- whether that's purchasing new assets, buying back stock, or increasing dividends.

The rigorous behavior shown by HAL puts them next in line for the proverbial M&A cashier as well. SLB's desire to shop around might be significantly smaller as their focus should be on pushing costs down and driving revenue up to solidify their financial position. The article linked to above suggested that Weatherford International (NYSE:WFT) and Franks International (NYSE:FI) could be possible targets for acquisitions. The purchase of either of these two large competitors would be the beginning of a large-scale consolidation in the oil services industry. The longer an environment of depressed oil prices subsists, the more likely and more robust the change will be.

Nevertheless, investors should look for some small- or mid-cap oil service firms with high book-to-market-value ratios. These stocks might get boosted by the prospect of purchase when the time comes. At the same time, look for low debt ratios. Companies that are in an ideal debt position will be able to negotiate a better market price for their assets than their debt-filled counterparts. For long-term security, though, SLB is an ideal choice in the oil services industry. HAL and BHI appear to be unable to steal away market share from this behemoth, and will struggle to do so unless they can find ways to maximize earnings potential by boosting their gross profit margins.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.