An In-Depth Q&A with Gustavo Grullon and Vikas Mittal

Interviewed by M. Yvonne Taylor

Conventional business wisdom states that mergers make business sense. Merging firms can cut costs by reducing redundancies and consolidating operations, expanding their scope and market share, and freeing up capital for further growth.

Last November, Halliburton and Baker Hughes, the second and third largest oilfield services firms in the world decided to merge. According to Halliburton, the deal, the biggest takeover of a U.S. energy company in three years, will consolidate operations, provide cost savings and align and expand their customer base. Halliburton’s CEO Dave Lesar has said that the merger could save the merged entity as much as $2 billion a year. And with lower oil prices and mounting pressures on margins, such a merger may make even more sense. But despite the many opportunities for business success, mergers are complicated and risky business.

Among their many offerings, both companies provide drilling and hydraulic fracturing services to a large customer base of oil and natural gas companies. Providing these services requires a combination of capabilities, such as technological innovation, operational support to customers, after-sales service and so forth. On the one hand, Baker Hughes has the innovative products and technological know-how to drill new wells and boost production in older wells. On the other, Halliburton is well-known for its capacity for efficient execution and logistics management.

But integrating these capabilities requires agreement and collaboration at all levels of both merging companies — from the highest levels of company leadership to front-line managers and employees. The sheer size of these two entities may also introduce additional complications because of the global footprint of the customer base of both companies and potential antitrust issues. In fact, the regulatory risks involved are so weighty that Halliburton offered Baker Hughes a $3.5 billion fee if the deal fails to go through due to failure to gain regulatory approval.



So what can research tell us?

Vikas Mittal, head of the Jones School’s Energy Initiative and J. Hugh Leidtke Professor of Marketing, and Professor of Finance Gustavo Grullon, sat down recently to discuss how their wideranging research on customer focus, efficiency of financial markets and strategic thinking can inform one of the most discussed merger stories in the energy industry.

Who benefits from value creation in a merger: target or acquiring firm?

Grullon: If you look at the empirical evidence, mergers, on average, do create value. The problem is that most of this value is captured by the target firm, not the acquiring firm. In many cases, especially during a large merger, the acquiring firm experiences negative stock returns around the announcement of the merger. Value is created by combining two firms, but most of it goes to the target firm.

[This can be seen in stock prices for both Halliburton and Baker Hughes, immediately following the merger announcement. On November 17, the day of the announcement, Halliburton’s stock price fell 11 percent to $49.23, their biggest decline since June 2010; Baker Hughes’ rose 31 percent more than its price three days prior. General market reaction to the merger news overall has been mixed.]

Grullon: Industry concentration is also a relevant issue during M&A transactions. My recent research shows that in industries with fewer rivals, acquiring firms tend to get better value from the deal. You see more value creation for acquirers in those cases where there is less competition in their product market. This evidence is particularly interesting because it suggests that market power considerations are becoming a key source of value during these corporate events. We also know from previous studies that when public firms buy private firms, usually the acquiring firms tend to do better in those transactions. One potential reason for this phenomenon is that public firms have more negotiating power in private transactions than in public ones. In addition to this, there is evidence that expected synergies are more likely to be realized in smaller deals than in bigger deals. Big deals are so complex that they usually end up destroying value.

How can value be created in a merger: efficiency focus or revenue-enhancement focus?

Mittal: Firms tread a delicate balance — you can save cash through a relentless focus on efficiency or generate cash by enhancing revenues from your customers. We found in our research that, post-merger, only firms that simultaneously create efficiencies and create revenue enhancement (through increased customer satisfaction) were the ones that increase value in the long run. In other words, achieving a dual focus — creating efficiencies and enhancing revenues through customer satisfaction — is what led to superior long-term value for merging firms.

Can a dual emphasis be achieved? Yes, but only with a relentless eye toward implementation. For example, take the case of the US Airways and American Airlines merger. It’s been almost a year but they are still working to integrate their reservation systems. They had eight hub airports; five from American and three from US Airways. And they’re still in the process of getting an agreement signed with the employees. So the big things that could have created any value from the customers’ point of view — good customer service because of happy employees or a good reservation system — haven’t materialized due to implementation issues.

What about capital expenditures in mergers?
Carefully reducing them pays off.

Grullon: There is evidence that most of the synergies in M&A transactions come from the elimination of duplicate activities and reduction in capital expenditures. These types of synergies are extremely important in the oil and gas industry. So one way you could see a benefit from the Halliburton-Baker Hughes deal is through reduced capital expenditures, and that could have a huge impact on current cash flows. However, managers need to be careful because these decisions can have a significant impact on the long-run performance of the firm. While reducing capital expenditures can increase cash flows in the short-run, it could hurt the ability of the firm to grow in the future.

Mittal: That’s a good point. The reduction of capital expenditure must be done very carefully. When it’s reduced in more of a surgical manner, very strategically — not reducing capital expenditure just for the sake of reducing capital expenditure — there’s a lot of potential.

There’s a second piece coming into play for the HalliburtonBaker Hughes merger. With the downward pressure on the price of oil, many E&P companies are reducing their capital expenditures. In anticipation of weak 2015 commodity prices, ConocoPhillips has further reduced its expected 2015 capital expenditures to $11.5 billion from the $13.5 billion previously announced. Shell announced that it would cut spending by $15 billion over the next three years. BP announced a 20 percent cut in spending this year. Chevron intends to spend $35 billion in capital in 2015 versus the $40 billion it spent in 2014, a 20 percent cut. ExxonMobil intends to cut spending by 12 percent this year. And the list goes on.

And that can be a boon for companies like Halliburton. The E&P companies are not going to indiscriminately cut down any project. They are going to rank order the projects and cut down the low-grade projects and keep only the high-grade projects. A lot of these high-grade projects are by default very complicated. Because of the higher cost of executing these complicated projects, larger companies are going to look for more service from the oil field services companies. They are not just looking to buy a piece of equipment — rather, they are looking for a complete, bundled solution from a company. A company like Halliburton which can provide the entire suite of products, services, advice and assurance is more likely to get business.

Moreover, if companies can innovate and provide that complete solution are they also more likely to have pricing power. Only those companies that have pricing power and the scale to provide the entire array of solutions would have an advantage. If Baker Hughes and Halliburton can combine resources judiciously, they should be able to better capture value from customers, and they’d also have better pricing power now.

Are mergers detrimental to customers? Not necessarily, as they can stimulate innovation.

Grullon: So related to this issue of pricing power — there is another side of M&A transactions, which is antitrust issues. One obvious consequence of mergers in an industry is fewer firms in that industry. I’m currently working on a paper where we’re finding very strong evidence that competition has been declining over the last 15 years. For instance, today we have fewer public firms than we had in 1973.

Mittal: One way to think about this issue is as follows: a lot of literature shows smaller firms are more innovative than their larger rivals. If a wave of mergers leaves fewer smaller firms in an industry, you’re likely to see a decline in innovation. Even if you look at the oil and gas industry, particularly the unconventional industry, a lot of innovation — technological and process — came from smaller companies. With M&As, a strategic challenge confronting the oil-field services companies will be to keep innovating. If they are unable to innovate they will lose pricing power.

Grullon: Another way to look at this issue is as follows: larger companies have more resources to deploy into innovation. They can also sustain, over time, the erratic ebbs and flows of innovation success. Clearly, the scale of Google and Apple has enabled them to be more, not less innovative. The resource constraints in smaller firms do not allow them to have the same kind of innovation as big firms do. Today, because of the complexity involved in innovating, it's really hard to innovate at a smaller scale. You can't do innovation in a garage like Apple did decades ago. The complexity of the technology is changing so much it's really hard to do it with a small group of people. You need not only the resources, but also a team who can create more innovation.

I'm working on a paper that looks at the effect of competition on patents. If you look at the '80s and the early '90s, you'll see that most of the patents were created in competitive markets — now we are seeing the opposite, that most of the patents are created in concentrated markets where you have fewer players. And that may be driven by the fact that now you need more resources to innovate. And not only that, what we're seeing is that if a small firm creates innovation, these firms are likely to be acquired by large firms.

Mittal: Great point. Industries have evolved to address these issues. I look at pharmaceuticals, which is an industry with many parallels with the oil and gas industry. That industry has evolved an eco-system where the smaller companies innovate, and large pharma typically buys out the small companies at the commercialization stage.

Really large companies like Google nurture innovation inside. So, Professor Grullon’s point about resources is well taken. Inside large companies with resources, you've got to create processes — whether they are based on incentive alignment or through company culture — to propel innovation.

In this industry, innovation is extremely important. The larger problem facing the industry is falling oil prices. The cost of extracting oil is higher than the price of oil. The only way to lower the cost of extracting oil is through innovation. Innovation, in the oil-field services industry has a twofold advantage. One is that innovation can allow you to lower your own fixed and variable costs. You make this investment today and innovation can allow you to lower your cost structure. And it also allows you to increase pricing power. But the fixed cost of innovating is high. The lead time to commercialize innovation is long. And there are enough safety concerns around every innovation, regulatory approvals, etc. that you really need an infrastructure to innovate and commercialize technology, assess their business and financial impact, and understand their strategic significance. You have to have people within the organization with commercial acumen and leadership potential who can take on this task. And that's how you can profit in the long run.

Oil and gas industry: Any predictions?

Grullon: We may actually see more M&A transactions because oil prices will drive a lot of consolidations. Cashstrapped companies are going to look for firms with more resources in order to survive. So now is going to be a good time for the big firms to buy the cash-strapped companies because they are going to have more power on the negotiation table.

Mittal: I agree completely. If you look back to the financial crisis faced by the U.S. in 2007-08, there was a wave of mergers — National City, Wachovia, Merrill Lynch — all marquee firms. However, they were relatively weak, and merged with rivals. Despite the shock, the financial services sector has emerged stronger today. In the long run, these types of shocks make any industry stronger. The oil and gas industry is no exception.

Grullon: Yes, because it drives innovation.

Mittal: It also clears out the weaker players.


Gustavo Grullon

Professor of Finance

Grullon currently teaches courses on mergers and acquisitions and on corporate financial policy. His research covers topics in empirical corporate finance and provides rational explanations to several documented anomalies in the asset-pricing literature, such as the tendency of investors to buy familiar stocks and the effect of managerial flexibility on firm value. His papers have been published in top academic journals and featured in the popular press. He received the Jones School’s Award for Scholarship Excellence in 2006. Grullon received his Ph.D. in finance from Cornell University.

Relevant Research
Grullon, Gustavo, Yelena Larkin, and Roni Michaely. “The Disappearance of Public Firms and the Changing Nature of U.S. Industries” working paper

Vikas Mittal

J. Hugh Liedtke Professor of Marketing
Head, Energy Initiative

Mittal’s varied experience designing integrated, experiential courses along with his superb, multidisciplinary research record provide the foundation for a strong, cross-functional energy initiative. His unique expertise and approach to teaching core content is embraced by leaders in the energy industry through courses designed for companies such as Shell, BP, National Oilwell Varco, Cameron and CB&I. In 2006, he was awarded the William F. O’Dell Award in recognition of his significant, long-term contributions to the theory, methodology and practice of marketing. He co-authored the new energy-focused SCOPE survey (see more on p. 8). Mittal received his Ph.D. from Temple University.

Relevant Research
Mittal, Vikas, and Wagner A. Kamakura. "Satisfaction, repurchase intent, and repurchase behavior: Investigating the moderating effect of customer characteristics." Journal of Marketing Research 38.1 (2001): 131-142.

Mittal, Vikas, Eugene W. Anderson, Akin Sayrak, and Pandu Tadikamalla. "Dual emphasis and the long-term financial impact of customer satisfaction." Marketing Science 24, no. 4 (2005): 544-555.

Swaminathan, Vanitha, Christopher Groening, Vikas Mittal, and Felipe Thomaz. "How achieving the dual goal of customer satisfaction and efficiency in mergers affects a firm’s long-term financial performance." Journal of Service Research 17, no. 2 (2014): 182-194.

This article is from the Spring 2015 issue of Jones Journal