NEW YORK ( TheDeal) -- From a business perspective, it's hard to argue with the timing of Halliburton (HAL - Get Report) Chairman and CEO Dave Lesar's decision to make a play for oilfield services rival Baker Hughes (BHI).
With per-barrel prices in a slump, their customers -- the major energy producers -- have been shutting down wells and otherwise reducing capacity. As a result, Halliburton, Baker Hughes and other providers of rigs and drilling services to the producers have been making massive cutbacks themselves. Lesar knows the downturn won't last forever and with the merger is positioning Halliburton to be a more efficient company with a broader platform of services on which to ride the inevitable recovery.
The outcome of the merger review is important to the oilfield services arena generally. M&A in the sector has been fairly quiet because companies have been waiting on the divestitures Halliburton and Baker Hughes will need to make to gauge the valuations of their own assets.
In the first six months of this year, five mergers have been terminated due to lawsuits filed by the Department of Justice and the Federal Trade Commission or because of the regulators' threats to mount legal challenges. Deals dropped in the wake of court action are Sysco (SYY - Get Report) plan to acquire rival food services operator US Foods; National CineMedia's (NCMI - Get Report) proposed purchase of a competing provider of on-screen ads to movie houses, private-equity owned Screenvision LLC; and the proposed merger of medical sterilization providers Steris (STE - Get Report) and Synergy Healthcare. Mergers terminated after the regulators made it clear they were moving to take legal action against the transactions were Comcast's (CMCSA - Get Report) plan to acquire fellow cable operator and broadband provider Time Warner Cable (TWC) and the planned combination of semiconductor fabrication equipment makers Applied Materials (AMAT - Get Report) and Tokyo Electron.
Judging by the outcome of those deals, Halliburton's plans would seem to face long odds. Indeed, Baker Hughes demanded strong antitrust protections in case regulators blocked the deal, which would combine the No. 2 and No. 3 oilfield services providers. Their merger agreement called for Halliburton to commit to making divestitures of assets representing up to $7.5 billion in annual sales to resolve antitrust concerns and to pay a steep $3.5 billion reverse termination fee if regulators ultimately block the deal.
But there are factors playing in Halliburton's favor. The biggest is the downturn in the oil business that has created excess capacity among producers and companies that help them draw oil out of the ground. "The antitrust rules haven't changed but the context has," said Bruce McDonald, a partner in the energy practice at Jones Day.
"For the foreseeable future, demand for oilfield services will be down. There is a lot of capacity and so the combination of two existing players is less worrisome. They can't raise prices easily because others can come in and buy up the slack."
Despite his target's insistence on steep antitrust protections, Lesar has maintained since the deal was announced in November that competition issues could be addressed through selective divestitures and the DOJ opposition would not be a threat. Nothing so far seems to have shaken his confidence.
On July 10, the companies announced a timing agreement with the DOJ, giving the agency up to three months to continue reviewing the deal after they have certified substantial compliance with the DOJ's second request for information. Under the agreement, the companies will not close the merger until the later of either November 25, 2015 or 90 days after certifying substantial compliance. Under federal law, merging parties may consummate a merger 30 days after compliance is certified regardless of whether antitrust officials have signed off. It's common for companies to enter agreements giving regulators more time, however. Halliburton and Baker Hughes said they expect to certify substantial compliance with the second request by mid-summer.
The companies characterized the timing agreement as typical for a large, complex transaction because antitrust officials need additional time to review the companies' responses. The companies also said they continue to be in discussions with the DOJ, the European Commission and other competition authorities around the globe regarding the merger. As previously announced, Halliburton is currently seeking buyers for its Fixed Cutter and Roller Cone Drill Bits, Directional Drilling and Logging-While-Drilling/Measurement-While-Drilling businesses, which the company will sell to address antitrust concerns. In addition, it is offering to divest additional businesses that competition authorities may deem necessary to spin off. Halliburton stressed that to date there is no agreement with any competition authority regarding the adequacy of Halliburton's or any divestiture proposal.
The nature of their divestiture proposals show that they are counting on being able to address the DOJ's worries by divesting specific product lines and rather than large business segments. Some observers had suggested early on that large segments -- such as Completion, which is the running of production tubing and other steps necessary to make a well ready for production, or Stimulation, which restores or enhances the productivity of a well -- might have to be pared off. Such large spinoffs would undercut the rationale for the merger. But Halliburton officials argued that within the broad categories are many sub-product lines and services associated with each manufacturing location that can be divested to address antitrust concerns.
McDonald said there is justification for Halliburton's contention because the major producers play the service providers off of each other when hiring providers to carry out a range of work, including such things as seismic testing, logging to clear a drilling area, handling drilling mud and finishing off well holes before extraction. "The producers will get the services they need from whomever has the right skill set in a geographic area as well as according to price," he said.
Paradoxically, the recently blocked Sysco-US Foods merger may play into Halliburton's favor. In the US Foods deal the FTC defined the market narrowly, finding that although there were many types of distributors to food service operations, the relevant market for that merger was broadline operators with national footprints. There was no divestiture package that could both preserve the rationale for the deal and prevent the handful of institutional customers that would be hurt by combining the two national broadliners.
In this case, however, Halliburton is willing to make a divestiture in any narrow product line that the DOJ feels will be hurt. "Different companies have different strengths and different strengths depending on if the producer is fracking or drilling on land, offshore, or deep offshore," McDonald observed.
Another recent merger approval indicating that Halliburton's approach might carry the day with regulators is the FTC's recent clearance of Zimmer Holdings' (ZMH) acquisition of rival joint replacement maker Biomet. The combination created the second-largest player in the market for treating muscle and orthopedic injuries behind Johnson & Johnson (JNJ) and reduced the number of significant players from five to four. The deal was approved after the FTC accepted the parties' offer to make targeted divestitures of Zimmer's Unicompartmental High Flex Knee system and Biomet's Discovery Elbow System and Cobalt bone cement assets.
The notion that Halliburton can pare off discreet business lines to DOJ's satisfaction is shared by TPH & Co. analyst Jeff Tillery. He noted in a report when the deal was announced last November that even in narrow product lines the companies' high market shares can be deceiving. For example, he pointed out that cementing services shows at first glance a high combined market share for the companies. But the real concentration in cementing is offshore, he said, whereas onshore is less of a problem.
"There are many other similar examples and as such, forced divestitures across entire product/service lines are less likely than specific niche products/services within the broad categories, which have high market concentrations," Tillery wrote.
After the parties reported the timing agreement July 10, Tillery told clients the announcement was a good sign for merger. "We see [Halliburton] as committed to do what's necessary to get it across the finish line," he wrote.
Tillery has suggested that the true threat to the merger is the difficulties Halliburton will face integrating the two sprawling and complex companies.
Jones Day's McDonald said for buyers of any divested Halliburton/Baker Hughes assets to be acceptable in the DOJ's eyes, they must have the market presence to go head-to-head with the new Halliburton as well as the top oil field services provider, Schlumberger (SLB - Get Report). "They have to be in the business and have the balance sheet to compete against the combined company and Schlumberger," he said.
The likely candidates, he predicted, are National Oilwell Varco, Weatherford International (WFT - Get Report), Siemens AG, and GE Oil & Gas. Any divested assets that can operate as standalone business could also be acquired by a PE buyer, he predicted.
McDonald doubted that the DOJ would accept Schlumberger as a buyer because there are few oilfield services that it doesn't provide already. "The DOJ will generally not want the biggest players to get bigger but wants the smaller ones better positioned to compete," he said.
Halliburton officials have stated that they are well on their way to finding buyers the DOJ will accept for the assets it has already designated for sale. "We are very pleased with the strong interest that's been expressed in the assets by potential buyers both within the energy industry as well as outside the industry, including a number of very capable financial sponsors," Halliburton Chief Integration Officer Mark McCollum said during the company's first-quarter earnings call.
When it comes to a final decision from the DOJ, the views of the major producers may be the deciding factor, McDonald said. Post-merger Schlumberger and the combined Halliburton/Baker Hughes will be the only oil field servicers that can provide a broad range of services. "If the DOJ thinks there is a sizable customer group that wants to buy a broad range of services from a single company, just as the FTC did with the Sysco deal, that creates great problems for this merger."