Many studies or articles have been published during the last few years that claim E&P merger and acquisition transactions fail to create shareholder value. While many studies have shown this to be true, a recent study by the PricewaterhouseCoopers Transaction Services Group in Houston reveals this is not the case for transactions during the past two years, which have been a period of unprecedented rising commodity prices. The study shows that more than 50% of the deals completed during 1999-2000 were rewarded by the capital markets-and even more surprising, less than 10% destroyed shareholder value. The study was of more than 60 energy M&A transactions from the beginning of 1999 to midyear 2000. All of the deals are in excess of $20 million and involve acquirers that were public. Their targets consist of other public and private companies as well as large asset packages. Although most deals were upstream transactions, some midstream and integrated deals were included. Although not entirely scientific, the parameters that were set to measure whether the deal created value are as follows. The performance of the stock price of the buyer was tracked against its key benchmark index for at least six months before and after announcement of the deal. Usually this was the applicable Standard & Poor's Oil Index, but sometimes included the S&P Natural Gas Index, S&P Electric Power Index or the S&P Small-cap Oil & Gas Index. If the acquirer's stock outperformed its key index subsequent to the announcement by more than 5%, the deal created value. If the stock continued to track the index (plus or minus 5%) the deal was considered neutral. If the stock underperformed the index (by more than 5%) subsequent to the announcement, the deal destroyed value. While it is true that many factors affect a stock's movement, it certainly can be argued that in the first six months after the announcement, a merger or acquisition likely has the greatest effect. The study shows that 58% of the deals received a positive response, 35% were neutral and 7% had a negative effect on the acquirer's stock. What these results reveal is that, during a period of rising commodity prices, Wall Street rewarded growth, sometimes at any price. Perhaps most surprising was the low percentage of negative deals, which highlights that M&A transactions in this period were not a risky proposition from the market's perspective. In fact, during the past year Wall Street has rewarded growth in all industries with disproportionately higher multiples for companies delivering in excess of 20% growth. It would certainly appear that in the oil and gas industry, those companies that sat on the sidelines, refusing to get involved in the higher-priced M&A game, may have missed a temporary window to be rewarded a higher multiple. Of the deals that were rewarded positively in the marketplace, 37% involved companies that had been underperforming their benchmark index prior to announcement of the deal, and they proceeded to overperform the index subsequent to the announcement. For these companies, the right, high-impact deal, done at the right time, dramatically affected stock price, altering the Street's view of the company. Other characteristics The PricewaterhouseCoopers group examined other characteristics of the deals to determine what effect, if any, they had on market response. International element. From a geographic perspective, 87% could be characterized as domestic with 13% comprising international elements. It would appear the market still reacts with early skepticism to international energy deals. Acquirers would be advised to continue to price these types of transactions at appropriate discounts. Gas versus oil. With respect to the nature of the transaction, 80% could be characterized as upstream deals, with midstream and integrated deals making up the remainder. The upstream deals are 75% gas-weighted and 25% oil-weighted. Gassy deals were rewarded a higher percentage of the time by the market with 61% of these receiving a positive response, compared with 50% for oil-oriented deals. This is consistent with the recent excitement in the industry with respect to rising gas demand in North America, which has resulted in unprecedented price increases. Financing. Of course, how the deal was financed plays a significant role. In the study group, cash deals represent 63% of the transactions; the remainder are stock deals, or a mix of cash and stock. Clearly, excess cash resources were such that issuing additional shares, and risking dilution, simply was not necessary. The market appears to have responded more favorably to cash deals than stock deals. Acquirers are cautioned to continue to monitor their debt-to-cash flow ratio to ensure it remains under 2.5; experience has shown that outside that level, a risk exists that the market will perceive the company's balance sheet as too levered, postdeal. Takeover versus merger. As for the market's response to takeover, versus merger, the study treats a merger as any deal where the price was within 80% to 120% of the market cap of the acquirer. As expected, the market takes a much more wait-and-see attitude to mergers. While mergers are often sold as "synergy" deals, the market often perceives that it will simply take too long to realize the promised synergies. On the other hand, the takeover does not bring the same uncertainties. The key management team is known, hence the strategy going forward is also known. The market reacts more positively to the takeover as it removes uncertainty going forward. We know the markets don't like uncertainty. Outlook for 2001 The first quarter of 2001 has continued to be highlighted by ongoing consolidation. The super-independents continue to look for opportunities to grow through acquisitions rather than the drillbit. This trend will continue as oil-service costs continue to increase. In addition, the supermajors will continue to divest nonstrategic assets and focus their efforts on high-impact activities in the Gulf of Mexico, North Sea, West Africa and possibly in the Middle East. These divestitures should provide more opportunities for the independents. Also continuing will be the recent trend in which all independents examine merger scenarios as they attempt to achieve the operational scale and efficiency necessary to obtain the higher multiples accorded the larger companies. All of this M&A activity will result in a different industry structure than witnessed in the past two years. The supermajors will be fewer and will dominate; growing independents will need to reach considerable size to attract capital; small independents will need to grow very quickly. Being stuck in the middle is not an option. In Canada for example, the large independent has almost vanished, mostly due to acquisition by U.S. companies. However, it is critical that the industry resist the temptation to spend 2001 excess cash flow to grow at any price. Past history shows that favorable commodity prices don't last forever. Companies must invest in projects that generate returns on investment in excess of the cost of capital. This means continuing to utilize realistic long-term pricing scenarios when valuing deals or projects. Any cash flow in excess of that necessary to invest in quality projects or deals should be used to strengthen the balance sheet, either through debt repayments or stock buybacks. Deals will always be evaluated on the following criteria: Is it accretive to cash flow per share? Did the acquirer pay a reasonable price? Does the deal fit with the overall company strategy? Answering yes to these three questions will almost always result in an early positive market response. The key challenge is to build on that. Will the recent market downturn penalize those companies that were rewarded positively in the first six months? Only if they didn't move quickly to capitalize on the opportunities the deal provided. Wall Street has little patience, and even less for companies that don't quickly capitalize on perceived opportunities. This will be especially true if commodity prices turn downward; high prices can often cover up problems, especially an overpayment for lower-quality assets. Considering all the aspects of the study's results, the deal with the best chance of success in the past two years was a domestic, gas-levered all-cash takeover. M Rick Roberge is head of transaction services for PricewaterhouseCoopers, Global Energy & Utilities Group, in Houston.
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