Kevin Stevens
Kevin Stevens
What's Old is New Again

What's Old is New Again

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$12 billion. That’s the investment amount potentially earmarked for companies labeled ESG by the end of the year. For comparison, that’s more than the total amount invested into cleantech companies over the last 5 years.

A good part, if not the majority, of this capital, is flowing from firms active in the oil and gas sector. The reasons are obvious - no one wants to spend money getting oil out of the ground.

It’s way too early to know how these SPACs will play out for investors. But, if these firms are truly interested in joining the energy transition with an alternative to their current strategy in search of differentiated returns, there’s a different one they should be contemplating.

What’s old is new again

Industrial giants have long relied on growth and/or pivot through mergers and acquisitions not related to the core business.

The last qualifier is very important here. This strategy is not to acquire businesses that when combined with existing assets create operating efficiencies.

Instead, I'm suggesting a strategy like the one used by Roper and Danaher. Both of these industrial giants re-made their businesses over the last two decades via M&A but did so in very different ways.

Roper focused on adding asset-light, capital-efficient businesses to its portfolio. The goal was to create a flywheel where each dollar of growth drove returns for further acquisition of increasingly capital-efficient businesses.

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Danaher had the same strategy but deployed different tactics. They were one of the first industrial companies to master the lean manufacturing philosophy.

Instead of acquiring cash efficiency, they acquired companies where they could add margins by implementing their operational system. They went after solid assets with the same razor/razorblade model of their core businesses and executed with precision.

These acquisitions took Danaher from a company focused on siding and rubber to one focused on healthcare, dental supplies, and tools. If you look at it through this lens, any pivot to a new industry seems trivial.

Today, Danaher has a market cap near $115B and has spun out Fortive ($25B) and Enivsta ($5B).

How would this work in energy?

Rather than speculate which type of strategy would work (hard asset v. technology), the firms that could execute it, or the potential acquisition targets, we should focus on why now is the time to try something different to ensure future viability.

  1. The cost-of-capital spread between technology and energy is wide, arbitrage will be more difficult but the potential rewards are larger.
  2. The total market value of oil and gas has peaked. We may see the price per barrel come back, but the total volume will not return.
  3. The opportunity cost is low - even the best oil and gas companies will be capped on their returns over the next 20 years and margins will be captured by the biggest firms through consolidation.
  4. The worst-case scenarios are the same, assets that go to near zero if not operated correctly.

Danaher and Roper prove that tactics within this strategy can be different and still produce massively positive outcomes.

However, the businesses did have three commonalities that must be true here as well:

  1. A world-class CFO
  2. A repeatable operating philosophy
  3. Deal-terms that are simple and mandatory

Here are the 8 criteria that each potential acquisition target should meet regardless of post-acquisition tactics:

  • Non-cyclical business - oil and gas operators and investors have felt the pain of the boom and bust cycle for too long. Instead, focus on investing in stable, predictable assets like electricity or software.
  • Solid, but not exponential growth. We're looking for deals that are not splashy enough for most acquirers, likely in the range of 10-15% annually.
  • The gross margin to operating margin spread is wide. We want businesses that have room for improvement with capital investment and structure.
  • Small, niche assets regardless of a hardware or software strategy - sub $250M acquisition price. The acquisition can be a combination of debt and cash.
  • Lower asset intensity than E&P or midstream
  • Good business within niche parts of energy, excellent management
  • Assets that can be operated autonomously and will not be integrated. This lowers the risk of culture clash between, tech and/or renewables and oil+gas.
  • Prioritize top-line growth and align management incentives accordingly. The goal is to lock in talented teams for the long haul.

What would I do?

The strategy I would employ given this environment would be similar to Taleb’s barbell framework. I would seek out cash-flowing, non-cyclical assets that enable the acquisition of technological long-shots where my assets are the first and best customer.

For me, technology means software because it’s where I am most comfortable. But, it’s plausible a great oil and gas firm could continue operating a select few assets that are cash flow accretive while working on complex technologies like carbon capture.

Some of you reading this will undoubtedly think I’m completely crazy and this could never work. But, now is the time for oil and gas firms to take a chance and position themselves for the future.