Musings: HAL/BHI Deal – Transformational Or Just Shifting Deckchairs?

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The recent agreement for Halliburton Companies (HAL-NYSE) to acquire Baker Hughes Corp. (BHI-NYSE), in what was reported at the time of the announcement of the deal as a $36 billion cash and stock transaction, sparked industry speculation as to the significance of the purchase for the global oilfield service industry. It is certainly a significant deal for the two companies, and was driven by Halliburton’s perceived need to gain increased global scale, as well as to fill out product lines in which the company was weak and needed greater heft to better fulfill the needs of its global customers, and potentially be better positioned to weather industry cycles. According to data from oilfield market research firm, Spears and Associates, the two companies have meaningful overlaps in at least 10 product lines. These overlaps create a challenge for Halliburton’s management in securing approval of the transaction from regulators both in the U.S. and other foreign jurisdictions where the companies operate. Besides seeking regulatory approvals, Halliburton still needs to convince its customers that: bigger will be better.

According to correspondence released by Baker Hughes as the negotiations were underway, the transaction was first proposed by Halliburton on October 13th, after both companies had released their third quarter 2014 financial results. Both managements commented to the investment community about their financial results and their respective views of future business activity in light of the then-recent fall in global oil prices. Halliburton’s Chairman and CEO Dave Lesar spoke optimistically about the downturn being of short duration, while Baker Hughes Chairman and CEO Martin Craighead was more guarded saying that the industry correction would last longer and provide greater business challenges. After the Dow Jones Newswire broke the story of the discussions in the early afternoon of Thursday, November 13th, Halliburton declined to comment while Baker Hughes acknowledged the talks but said it would have no further comment. Surprisingly, the price of the companies’ shares rose immediately after the news report and then continued to climb the following day, signifying that Wall Street believed the combination would be positive for both companies, although there had been no hint of the potential terms of the deal, which would impact the value of the deal for each company.

As the negotiations between the two managements and their advisors progressed on Friday, November 14th, the media was franticly sampling the views of Wall Street energy analysts and antitrust lawyers about the possible terms of a deal, whether the transaction made business sense, and the regulatory hurdles that it might have to overcome. About the time the ink was dry on these articles, news broke that the discussions had broken down over the purchase price (it appeared from the Baker Hughes letters and emails exchanged with Halliburton) and the terms of divestments. Almost immediately Halliburton notified Baker Hughes it was prepared to nominate a slate of directors to oppose the current Baker Hughes board of directors at the 2015 annual meeting. Prospects of a protracted proxy fight seemed clear absent a deal.

In the early morning hours of Monday, November 17th, came the announcement of the deal in which Halliburton would offer 1.12 shares and $19 in cash for each share of Baker Hughes, valuing the company at $78.62 a share, more than a 40% premium over where the stock had been trading. The transaction announcement also disclosed that Halliburton had identified businesses generating $7.5 billion in revenues that would be sold, and that the company and its advisors had already identified candidates to buy these businesses. Due to the antitrust hurdle and the perceived harm that would be done to Baker Hughes if the deal had to be abandoned, Halliburton agreed to pay Baker Hughes $3.5 billion. It subsequently was disclosed that Baker Hughes would pay Halliburton $1 billion if the deal failed to close due to various conditions. The transaction should close during the second half of 2015 after all regulatory approvals are secured.

As we pondered over the weekend following the announcement of the talks the prospect of a proxy fight in the spring, we were reminded of a similar management hardball negotiating episode during the creation of Baker Hughes. In early 1987, the energy business was still reeling from the first half of 1986’s oil price collapse engineered by Saudi Arabia. By the spring (May 18th) of 1987, the domestic active drilling rig count stood at 744 rigs after having fallen by 84% from the industry’s 1981 peak of 4,530 active rigs. Not only was demand for oilfield service at a low, but pricing discipline in the industry had been destroyed by the desperate actions of smaller, financially-weak competitors who were willing to discount their services and products merely to generate cash.

In the fall of 1986, Baker Oil Tools, as the company was then known, had approached the Hughes Tool Company with an offer to merge. A deal was struck. The problem was that the Reagan Justice Department announced it would sue to block the merger on antitrust grounds unless two divisions of Baker were sold. Justice demanded that Baker sell Reed Tool, its tri-cone drill bit manufacturing business, and Baker Lift, its manufacturer of downhole electric submersible pumps. Both businesses competed with Hughes, and the government believed that their combination would significantly reduce competition in the oilfield service industry.

The board and management of Hughes became concerned that if it voted to approve the merger before these businesses were sold, it would potentially be exposed to having to financially support these businesses during a long sale process. Hughes was also concerned that the sales might obligate it to license the buyers with Hughes technology, probably the greater concern. Both conditions were estimated to impact the value Hughes shareholders would have following the merger. Therefore, Hughes demanded that the consent decree agreed to between Baker and the Justice Department be changed to provide for the government’s prior approval of the sale of the domestic operations of Baker Lift to Trico Industries and the sale of Reed Tool, before Hughes shareholders would vote on the merger. Baker claimed it had numerous inquiries from parties interested in buying Reed Tool, but it had not agreed to final terms. In early March 1987, Hughes said that if the Justice Department merger conditions were changed by April 22nd, the last date the merger agreement remained valid, the merger could still be completed within the agreement’s proscribed time limit.

When Hughes’ objections to the Baker and Justice agreement became public and Hughes was forced to delay its shareholder vote at least three times, relations between the two companies grew testy. As Hughes became increasingly reluctant to complete the transaction, Jim Woods, Chairman and CEO of Baker called Jim Lesch, the Chairman and CEO of Hughes Tool, to arrange a private meeting between the two men. The meeting was scheduled for the board room at Hughes’ headquarters in the Texas Commerce Building in downtown Houston, as the company had recently relocated its executive management team from its Polk Avenue plant, the historical home of the company. Baker was headquartered in Southern California, although it had an executive office in Houston. As part of the merger agreement, the headquarters of the merged company would be located in Houston.

That afternoon, Mr. Lesch was surprised when his boardroom door opened and Mr. Woods walked in accompanied by another gentleman. Mr. Lesch knew immediately that Mr. Woods, a notoriously tough executive, was here to play hardball. The gentleman accompanying Mr. Woods was famous Houston lawyer Joe Jamail. For those unfamiliar with that name, Mr. Jamail was the attorney who represented the Liedtke brothers, long-time friends, and one of their companies, Pennzoil, in a suit against Texaco for tortuous interference in their agreement to buy Getty Oil Company. Mr. Jamail, a tough-nosed and aggressive Texas personal injury lawyer, known as the “King of Torts,” had outmaneuvered a team of high-priced New York City and prominent Houston lawyers and secured a $10.53 billion judgment against Texaco that ultimately forced the company to file for bankruptcy because it could not pay the judgment. The presence of Mr. Jamail convinced Mr. Lesch that Hughes had little choice but to complete the deal on Baker’s terms. Immediately after the merger was completed, the two targeted businesses were sold. Baker Lift was sold to Trico and Reed Tool to Camco, Inc.

One or two of the news stories about the Halliburton and Baker Hughes deal mentioned the founders of each company – R.C. Baker of Los Angeles, California and Earl Halliburton of Duncan, Oklahoma. One was an engineer/inventor of downhole oil tools while the other was an oilfield entrepreneur and problem-solver. Each of these gentlemen built successful companies and trained talented executives who took the respective companies on expansion and acquisition routes that ultimately led to them becoming the second and third largest global oilfield service companies. Each company has had an eventful and colorful history, marked by numerous acquisitions – some of which were equally as strategically important in the evolution of each firm as the current transaction is in creating a strong competitor to industry leader, Schlumberger Ltd. (SLB-NSYE).

As someone who lived through much of the evolution of Halliburton and Baker Hughes into major oilfield service companies due to their acquisitions since 1970, we see this deal as a natural response to the new demands on the oilfield service industry as a result of the shale revolution and the migration of the search for oil and gas into more remote and hostile corners of the world. The nature of the service industry’s customers is changing and the demands of their exploration and development efforts are different from only a few years ago. As many of the exploration and production companies are one-dimensional – shale, shallow water, deepwater, one-well international plays – their needs have become unique and more intense. On the other hand, the behemoths of the industry – the Independent Oil Companies and National Oil Companies – are increasingly developing barbell-shaped E&P strategies.

They will marry long-term, high return projects – deepwater or arctic E&P – with short-term output and cash flow generating efforts such as the shale plays. One strategy gives managements the opportunity to grow production quickly and to generate cash returns faster, helping to satisfy the demands of investors, while the other end of the barbell offers the prospect of finding and developing large reserve deposits providing high returns on investment but that require years of heavy investment before first oil, and cash returns are generated. While each E&P strategy will be different, they are similar in that each requires greater operational coordination and performance along with increased technology than the oilfield has traditionally delivered, putting more demands on oilfield service companies.

The Halliburton-Baker Hughes transaction likely signals the first stage of the next transition of the oilfield service business. These industry demands justify the hardball negotiating tactics engaged in by Halliburton just as they did for Baker Hughes in 1987. As experienced in almost every transition phase, it coincides with a new and lower oil and gas price environment. We anticipate that as we look back at the oilfield service industry from the perspective of being on the other side of the valley the industry is descending into, the structure of the industry will look meaningfully different than it does today.

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