Termination fees, in the event a planned merger or acquisition fails to consummate, is a fascinating topic that’s long been heavily litigated in Delaware courts where 52% of publicly held corporations are incorporated. Sometimes they are used to offset the time and resources involved in negotiations, and even add credibility to merger offers, and other times, they are used by corporations that put themselves up for sale to lure in an initial acquirer if it looks like an auction involving other bidders will soon follow.
The reason why I have yet to discuss break-up fees is because they almost never affect the medium-term thesis, yet alone the long-term thesis, for buying stock in a company.
Remember that Allergan-Pfizer merger that got abandoned a few weeks ago? The break-up fee in the merger agreement called for Pfizer to pay Allergan $400 million if the deal didn’t go through.
That’s nice, but it doesn’t really change the analysis of Allergan stock. Allergan makes $6 billion in profits per year giving people Botox injections, and carries $1 billion in cash and $42 billion in debt on the balance sheet. The decision to buy or not buy Allergan stock is almost in no way affected by the addition of $400 million in cash to the balance sheet.
For the first time in recent memory, Baker Hughes is actually receiving a break-up fee that is substantial enough to have some real implications on intrinsic value. After lawsuits from the Department of Justice and European regulators, Halliburton and Baker Hughes decided last evening to terminate their merger agreement that would have combined the #2 and #3 companies in the oilfield services field (Schlumberger is #1).
I’ve never been much of an oilfield services guy, because the business model is so feast or famine that I can never adequately predict what might happen to impair shareholders during a period of low oil prices like we’ve seen the past few years. Will there be shares issued at rock-bottom prices to cripple the future returns of antecedent shareholders? Will there be debt added at high interest rates that will greatly increase the cost of capital hurdle?
Considering that Berkshire Hathaway exists out there with 70 operating businesses and $55 billion in cash, it has never seemed necessary to make a judgment call about whether the risk-reward tradeoff for something like Schlumberger, Halliburton, or Baker Hughes is worth it. The long-term record at Halliburton is only 7.5% annual returns since 1972. Owning something with extreme earnings volatility may be worth it if the upside is superior returns over the long haul, but it has always seemed that Halliburton gave shareholders returns that lagged the S&P 500 while delivering earnings gains in a highly volatile way. I’ve never felt a need to go running into the arms of that.
Baker Hughes, on the other hand, appears to be receiving a gift that is effectively a get-out-of-jail-free card for this bust cycle in oil. After the stock hit a high of $81 per share in 2011, the profits of $1.1 billion-$1.7 billion turned into losses of $2 billion in 2015 and an estimated loss of $500 million this year.
But here is the crazy thing: Halliburton is going to now pay Baker Hughes a $3.5 billion break-up fee. That is a big deal.
On the Baker Hughes balance sheet, there is $4 billion in debt and $2.1 billion in cash. When oil is above $65 per barrel, the earnings power of the firm is somewhere around $3.5 billion. And by Wednesday, Baker Hughes stands to collect $3.5 billion in pure cash from Halliburton.
There are so many way you could characterize this payment. It could wipe out nearly all of the Baker Hughes debt. It will immediately give Baker Hughes $5.6 billion in cash against $4 billion in debt for a cash surplus balance sheet. It’s about two or three years worth of honest-to-God business operations showing up through an escrow account in less than 48 hours. By the end of this year, the toll of the oil bust will have been about $2.5 billion for Baker Hughes; it could lose another $1 billion throughout this cycle and still break-even (though you would have to subtract the undisclosed lawyer and advisory fees for the merger, time spent by the Board considering it, and the opportunity costs of Board decisions that were not made due to the pending merger to properly calculate this effect).
But aside from those parenthetical quibbles, this break-up fee is a big deal. This almost guarantees that Baker Hughes won’t have to engage in share dilution throughout this low oil business cycle (it had 438 million shares in 2013, and has 438 million shares now) nor will it have to borrow at punitive rates to stay afloat. Heck, it could even purchase $1 billion or $2 billion worth of distressed oil services assets to add to its base for when conditions improve.
At a price of $48 per share, the Baker Hughes investment thesis looks pretty intriguing for those contemplating a 3-5 year investment in the oil services sector. I’m not talented enough to tell you what exactly the new intrinsic value for Baker Hughes with this $3.5 billion cash infusion, but I can recognize material good news when it hits me in the face, and this is one of those rare times when a break-up fee substantially alters the total mix of information that you’d consider when contemplating an investment.
It seems to me that a lot of money gets made when you buy a surviving corporation during the upswing in the business cycle. That’s where the rapid capital gains come from. It would be great buying back stocks in 2009 and 2010. For a lot of intermediate skilled retail investors, the challenge is not figuring out whether a lot of money will be made on the upside, but figuring out which specific corporations within an industry will be the survivors (with the non-survivors being classified as the bankruptees and the firms that give shareholders so much dilution the practical effect is nearly equal to bankruptcy).
My view is that the oil industry now is akin to the bank stock sector in 2011. On an objective basis, the deals are still much better than most other things you’d find. But on a relative basis compared to the previous two years, the best deals have already passed you by. If I had to choose an oil stock right now, I’d pick Royal Dutch Shell at $52. The dividend is so high that it can self-fund other blue-chip investments all by itself, and it has the integrated business model that you can buy-and-hold the stock forever. Those types of stocks of generational holdings should always be favored over those that require an exit point unless the latter are substantially discounted compared to the former.
But Baker Hughes remains interesting because it just locked in survivor status. There won’t be punitive borrowing or share dilution at low prices unless we are on the precipice of a 3+ year downturn towards $20 and $30 oil. Heck, the Baker Hughes market cap is only $21 billion. This break-up fee will give them cash that is equivalent to 17% of the market cap. If the price of oil takes two to three years to recover, this break-up just ensured Baker Hughes shareholders that they will participate in a full recovery without having to share it with an opportunistic new shareholder class or bankers. It’s rare that a break-up fee deserves an article of its own, but a large infusion of cash during a cyclical bust is a great upshot for Baker Hughes shareholders.