By Charlie Solnik, Ryan Tenerowicz (California Polytechnic University), and Steven Skomra (Georgetown University)
Report Head: Timur Kurbanov (New York University)
Oil & Gas Industry
The current state of the North and Latin American oil & natural gas industry is rather distressed. The months of March and April of 2020 saw crude oil prices plummet to lows below $20 per barrel driven by the combined effects of COVID-19 lockdowns and the decision by Saudi Arabia, Russia, and other OPEC based countries to not cut production volumes. This environment created an extreme case of oversupply in global oil markets worsening an already damaged situation as companies struggled with the impacts of coronavirus.
1.1 – New Competitive Environment
Looking back to the M&A landscape of 2019, deal count within the oil and gas industry has been declining along with the continuous fall of commodity prices. There were almost 400 global O&G transactions in 2019, which represented a substantial drop from 2018, despite deal value rising over 30% to $370 billion. This is indicative of the current trend shaping the industry in that large players continue to make deals in a wave of consolidation, but smaller companies have struggled to adapt to challenging market conditions since prices began falling in late 2018. In Q1 of 2020, there was $770 million worth of U.S. announced O&G deals, a 72.3% decline from the previous quarter. Surprisingly however, deal volumes increased in Q2 with $2.6 billion in newly announced deals within the U.S. That being said, this still ranks as the third lowest quarterly value since 2009. Companies within the sector have struggled to maintain financial stability and M&A activity as a result of lower prices. Additionally, unlike other industries, cash reserves among oil and gas companies were at low historical levels leading up to the events of 2020. In 2019, O&G companies’ average total cash on hand over total debt was at 25%, an 18% decline from 2018 levels. This has left little room for companies to justify a strategic rationale for current deal opportunities, with cash being better used to maintain current operations and stability.
While few deals are currently being made, recent transactions have come largely from upstream gas-producing assets. Although crude prices have risen from lows to back around $40 per barrel, the uncertainty around oil has limited the market for new deals. Instead, strong future prices are driving some demand for gas assets leading to a resurgence in gas-based M&A and total Q2 transactions. Overall, natural gas has increased its share of U.S. based oil and gas M&A volumes from 5% in 2019 to 30% YTD.
Given the improbability of a strong rally in oil prices in the near future, the little transaction activity there is in the industry is likely to remain concentrated in gas-based assets over the next 2-3 quarters.
1.2 – Situation in Latin America
In Latin America, the overall landscape remains similar to the situation in North America. Most activity in the region is concentrated between the countries of Mexico, Brazil, and Venezuela, which account for 75% of Latin American oil production. Mexico and Venezuela offer mostly onshore drilling, and companies operating there will be forced to endure the same conditions as elsewhere. However, the present situation provides an opportunity for further investment and transactions within Brazil. Brazil benefits from a large production base of high quality, low cost oil from the pre-salt located offshore. This will be beneficial for companies operating there due to the low breakeven costs associated with drilling. Currently 10 of the 14 pre-salt fields in the region under concession are operated by the state-owned company Petrobras. The remaining 4 fields are operated by other companies such as Shell, ExxonMobil, Repsol Sinopec, and others. This could lead to economic growth for the Brazilian economy as a result of Petrobras’ operations as well as other companies that will look to operate in the region in the future.
1.3 – Future Outlook
Looking at the future of oil and gas, North and Latin American based companies will be forced to undergo significant changes in order to survive a post-COVID environment. Given the uncertainty and speculation surrounding oil prices, it is likely that commodity prices of crude and natural gas could remain depressed for the foreseeable future. Companies will be forced to operate at lower margins unless they are able to evolve through improved efficiency and use of technology. As of now, 70% of O&G companies that are undergoing a significant business or technology transformation program may decide to put it on hold while they address liquidity issues. While companies certainly need to account for short-term stability, the importance of creating long-term efficiency through innovation must be balanced in the present. Whereas previously companies could plan for long-term pricing assumptions of $60 per barrel, moving forward companies will likely be forced to compete at prices in the $35 to $45 range. Additionally, the industry will experience further consolidation around large players as more companies file for bankruptcy. The larger players that have dominated M&A volumes over the past two years are likely to benefit from this landscape as a result of their ability to create economies of scale, whereas smaller companies will be more prone to distress.
Perhaps the industry most largely impacted by the COVID-19 pandemic has been healthcare, which has been disrupted throughout the United States as coronavirus cases continue to rise. The global health crisis has forced all healthcare practices, from general hospitals to physician and specialty practices to drastically alter the manner in which they conduct their business as well as halting other forms of medical research. Like most industries, this has created a challenging environment for M&A activity in what had previously been an industry experiencing rapid consolidation. The future of healthcare M&A deals will be altered as a result of the changing practices and innovation that is being experienced across the industry.
2.1 – Previous Quarters Overview
Looking back to 2019, healthcare was among the most active sectors for mergers and acquisitions in the U.S., with deal-making hitting $533 billion over the year. This trend of consolidation can be attributed to several factors including high levels of dry powder among private equity firms and corporations, industry innovation and evolving forms of technology, and historically high levels of return on invested capital, among others. This environment, combined with the fact that healthcare typically proves to be a recession resistant sector, was driving M&A activity and company valuations within the industry higher throughout 2019 and into the first quarter of 2020.
Despite national lockdowns going into effect in the latter half of Q1 2020, M&A volumes within the sector remained relatively elevated with investment into the space increasing. There were 29 announced healthcare transactions in the first quarter of 2020, which is consistent with Q1 volumes from 2018 and 2019. Additionally, the average deal value increased 21% from Q4 2019 to $31.4 million that quarter.
Figure 2.1: Total Healthcare Deal Value (in $USD Bn.)
2.2 – The Current Situation
Looking at Q2 data, it is clear that deal volumes have fallen off from the levels reached in 2019, but the decline has been less dramatic than was initially predicted. Many expected that the effects of COVID-19 would prevent further consolidation as hospitals and other medical facilities shifted their focus to managing the crisis. This fear was upheld by the fact that hospital operating EBITDA margins had fallen 174% YOY in April. However, even given lower revenues and operating margins, there were still 14 new transactions announced in Q2.
2.3 – Future Outlook
The stability in healthcare M&A volumes is representative that consolidation within the industry is likely to continue and potentially increase post-COVID. Moving into Q3, we expect the number of deals to increase as shelter-in-place orders continue to be removed withstanding a resurgence in cases that would lead to another wave of national lockdowns. Additionally, there will be an increasing number of distressed and bankrupt medical facilities that will facilitate further deal-making. While the pandemic has led to short-term slowdowns in North American healthcare M&A, it may serve as a catalyst for more transactions over the coming quarters and years. Now more than ever, companies can utilize their advantages of scale and innovation to strengthen the rationale for future mergers and acquisitions. However, the pandemic will also bring about a transformation in healthcare operations. Looking to the future, the industry will be reshaped by an increased reliance on new forms of innovation and a normalization of telemedicine practices as companies will look to increase physician efficiency and reduce costs. The companies that are most capable of adapting to this landscape will benefit from future consolidation trends.
3.1 – Industry Decline
Like most other industries, the automotive industry has taken a pretty big hit during the COVID-19 pandemic. On the whole, there has been a large downward trend in sales volume with overall car sales being down 40% due to the pandemic. General Motors reports that for the first three months of the year, its sales were down by about 7 percent compared to the same period a year earlier. Nissan sales fell drastically, with a 30% year over year decline in sales. Since cars are typically considered a luxury good, it logically follows that with an overall economic decline, a similar decline in car sales would follow. Many of these car manufacturing companies have excess manufacturing capacity, and these unused factories have become deadweight liabilities. The decline in sales coupled with the excess manufacturing capacity may lead to an increase in the volume of factory sales as selling off unused factories will bolster on-hand cash as well as cut down on costs as these companies attempt to survive the pandemic.
3.2 – Positive Outlook for Car Manufacturers
Despite all the negative effects of COVID-19 on the automotive industry, a silver lining has appeared for electric car startups. The decline in overall sales volume is putting pressure on more established car manufacturers to push traditional SUVs on their customers, giving electric startups some time to establish themselves in the market before having to take on competitors head to head. SUVs provide carmakers with more profits, and the new low fuel prices make them the logical choice for leading products as carmakers now struggle to make ends meet. This newfound market space for electric car startups also provides an opportunity for Chinese investors, as industry-wide low valuations afford them the chance to get a foothold on North or Latin American soil via purchasing one of these comparatively smaller startup manufacturers.
Additionally, some auto-manufacturing companies such as Ford were able to catch a break from the effects of the virus with the adoption of the new USMCA trade agreement. US president, Donald Trump, had previously threatened to impose tariffs on automobiles going from Canada and Mexico to the US, which had the potential to drastically disrupt car manufacturing supply chains. While many in opposition of the USMCA claimed the burden of higher production costs resulting from the agreement would be too high, it is largely believed that Trump’s promise to not impose these tariffs will offset those production costs. Ford also managed to get lucky with the implementation of this agreement because in 2017, they pledged to build new facilities in Michigan and renovate old ones, so this new agreement that encourages US manufacturing will increase the value of those investments. Like with the declining car sales, the adoption of the USMCA gives auto manufacturers even more of an incentive to sell factories with excess capacity. This is largely due to a provision in the USMCA that requires car manufacturing workers to get paid at least $16 an hour. That means existing factories with excess capacity will cost even more to maintain, further encouraging auto manufacturers to sell unused factories.
Technology, Media & Communication
4.1– Winners & Losers in TMT
Typically, the technology industry is adaptive to changes in the economy, but as with most businesses there are winners and losers. The COVID-19 pandemic has increased the value of cloud-based companies as well as subscription-based services, while hurting others like communications companies. The performance of different technology sectors varied, with YTD performance of software up 25.22%, hardware up 13.35%, semiconductors up 5.05%, and communications equipment down -8.53%. What are the reasons behind this varied performance? The sectors outperforming are ones whose business models can already operate remotely, hence why cloud-based services and subscription services were able to maintain or even increase their business during the stay-at-home orders of the pandemic. The important question is what is going to happen to the industry when stay-at-home orders are removed, and people get back to in person work and school? Analysts estimate that there will be a -5.1% decrease in Q3 for the technology industry, but by Q4 we will see a 0.5% recovery, followed by strong growth for 2021. The top performers in the following quarters will be the companies producing interactive home entertainment, software applications, and semiconductor equipment.
Figure 2.2: Technology Sector: YTD Performance
The COVID-19 pandemic has accelerated the growth of some technology sub-sectors, slowed the growth of others, and has popularized a growing trend for employees to work remotely. Video-conferencing companies like Zoom have seen tremendous growth as a result of stay-at-home orders with the sector growth rate estimates increasing from 13.6% (pre-COVID-19) to around 30% up through 2023. Similarly, telecommunications companies like Verizon and AT&T reported an increase in the use of their wireless and broadband networks of 1000% and 400% respectively, citing companies, universities, and schools operating remotely as the driver. Conversely, hardware and semiconductor companies, although still seeing sector growth, have experienced supply chain difficulties due to the pandemic.
Supply chains disrupted by government work-from-home orders, and the quarantining of several cities in China who provide significant technology manufacturing, has made it difficult for hardware and semiconductor firms to meet their production needs. For example, Apple (NASDAQ: AAPL) announced it would delay the release of its new iPhone, citing issues with consumer demand and supply chain delays. Supply chains have since begun to recover, but it will take some time to fully rebuild back to their previous levels. Many large tech companies have been allowing some of their employees the option to work remotely since before the pandemic, however that notion has now gone mainstream. Considering that companies have found productivity is not hindered by working from home, and in fact has remained constant or even increased, technology companies are poised to allow their workforces the option to work remotely permanently. The tech companies who can successfully implement a fully remote workforce stand to gain value with reduced operating expenses (i.e. office rent, utilities, maintenance, etc.), and having access to a global talent group of potential employees.
4.2 – Space for Growth
M&A activity in the technology industry has slowed but could see an increase in the latter half of 2020. Historically, large tech companies have subscribed to the growth strategy of acquisitions with companies like Google, IBM, Facebook, Microsoft, and Oracle being the most active acquirers in the past decade. Since March 1, 2020, M&A activity in the technology sector declined by 30% compared to the same time last year. However, deal activity could pick back up in the latter half of 2020 as tech companies with large cash balances and/or access to liquidity look to buy out smaller firms at a discount. Besides growth-by-acquisition, tech companies have focused on research and development spending, not showing any signs slowing amidst the pandemic. R&D spending from the five large tech firms totaled $28 billion last quarter, up 15% from the same time last year.
4.3– Future Outlook
While the COVID-19 pandemic has significantly impacted the global economy, the technology industry in North America has remained relatively robust, with some subsectors like conferencing and telecommunications seeing unprecedented growth, while others like hardware and semiconductors have seen a decline due to supply chain disruption. Moving forward, the industry could see an uptick in M&A activity in the last half of 2020, with large tech firms looking to buy out smaller firms at a discount, and the industry outlook remains optimistic for 2021.