O&G - Merger Model and LBO Flashcards
- How is a merger model for a natural resource company different?
It’s not much different at all – the few differences that do exist:
- Commodity prices may be an important assumption in the model and in your sensitivity tables.
- The PP&E write-up may not be a simple percentage estimate (see next question).
- Synergies are calculated differently (see questions #4 and #5).
- You may have to adjust accounting standards if you have a successful efforts company buying a full cost company or vice versa.
- In a contribution analysis you will look at metrics such as NAV, Daily Production, and Proved Reserves.
- You can calculate natural resource-specific accretion / dilution metrics, such as NAV per Share, Production per Share, Proved Reserves per Share, and so on.
Overall, merger models are far less different for energy and mining companies than accounting, operating models, or valuation.
- Normally for the PP&E write-up in a merger or acquisition, we make a simple assumption such as 5% or 10% of the current PP&E book value. How might this be different for a natural resource company?
For natural resource companies you might look at the PV-10 value in their filings and use that as the fair market value instead.
Example: A company has done an internal NAV analysis and pegged the fair market value of their PP&E at $100 in the oil & gas supplemental section of their filings. On the balance sheet it’s currently listed at $50.
Rather than assuming a 5% or 10% write-up, we might just use that $100 value and therefore record a $50 write-up for this company in an M&A deal.
- What’s the flaw with making an assumption for revenue synergies in a merger model between 2 natural resource companies?
There are only 2 ways to boost revenue as a natural resource company: hope for higher prices or boost production.
Commodity prices are beyond the control of any single company, even giants like Exxon Mobil and BHP Billiton. So in a merger model you can’t say, “As a result of this acquisition, oil prices will magically rise to $100 per barrel!”
Production increases are more plausible, but you run into another problem: mines and oil/gas fields take years to develop and it’s impossible to flip on additional production instantly.
As a result, revenue synergies are rarely taken seriously for natural resource companies.
- Revenue synergies might be unrealistic, but what about expense synergies? Could you make assumptions for those?
Sure. You could look at all the standard ways to reduce expenses, from CapEx synergies to operating lease consolidation to headcount reduction.
Just remember that most expenses for natural resource companies are on a unit- of-production basis, so your assumptions need to reflect that. Rather than absolute dollar amounts, you should frame expense synergies in terms of $ per Mcfe, $ per BOE, or $ per ton.
- Can you explain what natural resource-specific accretion / dilution metrics are and why we might look at them in addition to the standard EPS accretion / dilution?
The 3 most common ones are NAV per Share, Daily Production per Share, and Proved Reserves per Share.
You calculate them as you would expect: take the buyer and seller’s Net Asset Values from the NAV models and add them together, make balance sheet adjustments (reflecting cash used and debt issued) and then divide by the new share count to get the new NAV per Share.
The others are even easier: just add the Daily Production and Proved Reserves from the buyer and seller and divide by the new share count post-transaction.
You look at them because EPS is not always a meaningful metric for natural resource companies due to non-cash charges, odd tax treatment, and so on – a deal that looks bad on an EPS basis might look much better if you think about it in terms of NAV per Share or other industry-specific metrics.
- What’s the downside of these natural resource-specific metrics? Are there cases where they would not be meaningful?
The downside is that these metrics may not always be meaningful: for 100% cash or 100% debt deals, for example, Daily Production per Share and Proved Reserves per Share will always be accretive because there are no new shares issued in the transaction.
NAV per Share is meaningful no matter the form of payment, but there you run into problems with companies calculating NAV slightly differently, using different commodity price assumptions, and so on.
- Do you think natural resource companies are good targets for leveraged buyouts? What are the advantages and disadvantages?
Generally oil & gas and mining companies are poor targets for LBOs, which explains why they’re rare in these industries.
They don’t have stable or predictable cash flows due to their dependency on commodity prices, they have a huge need for ongoing investment in the form of CapEx, and usually they have high debt loads already.
The other characteristics that PE firms look for such as a low-risk business profile, market conditions that depress stock prices, strong management teams, and opportunities for cost reduction are company-dependent but are often untrue.
Their only real advantage is that they do have hard asset bases that can be used as collateral, but even there you run into a problem: PP&E values on the balance sheet are linked to commodity prices, so the value of their assets could shift around significantly.
- When you’re creating an LBO model for a natural resource company do you use EBITDAX for the leverage ratios and other metrics?
No – remember that EBITDAX exists only to normalize accounting standards between successful efforts and full cost companies.
EBITDA is the standard used in leveraged finance and by anyone looking at the debt profile of a company, so it’s far more common in LBO models no matter what type of company you’re analyzing.
- How are the sensitivity tables for an LBO of a natural resource company different from those of a normal company?
Rather than looking at variables like revenue growth and EBITDA, you would look at commodity prices and how they impact the IRR.
You would also select a wider range for the exit multiples since the industry is extremely cyclical: 2x to 8x EBITDA might be too wide a range for a normal
company, but it’s not unreasonable for natural resource companies since you have no idea where the cycle will be when the PE firm exits.
