Key Takeaways
Oilfield services company valuations require careful consideration of where the company and industry stand in the cycle because current earnings, cash flow, market multiples, and asset values may not reflect sustainable operating conditions.
Under the income approach, appraisers may need extended forecasts, scenario analysis, and normalized assumptions for revenue, margins, capital expenditures, and working capital to develop a supportable view of mid-cycle cash flow and terminal value.
Market and asset-based approaches also require cyclical context, including thoughtful selection of comparable companies and earnings measures, evaluation of transaction timing, and recognition that equipment values can fluctuate materially with industry utilization and capacity.
The oilfield services (“OFS”) industry is among a number of highly cyclical industries that present significant challenges throughout the business appraisal process. This complexity matters not only to appraisers, but also to business owners, attorneys, CPAs, and other advisors who rely on valuations for transactions, financial reporting, tax compliance, ownership planning, and other purposes.
The three generally accepted approaches to business valuation - the income, market, and asset-based approaches - are no different for an OFS company than for a business in a less cyclical industry. Their application, however, can be considerably more complex.
Upstream capital spending, which responds to changing commodity prices, producer expectations, and broader economic and geopolitical conditions, heavily influences demand for OFS products and services and thereby the level of industry activity. Significant operating leverage can then magnify changes in activity levels into even larger swings in earnings and cash flow. As a result, current earnings may not be representative of ongoing earning capacity, observed market multiples may provide counterintuitive signals, and the relevance of underlying asset values may change over the course of the cycle.
The Income Approach: Developing Forecasts in a Cyclical Industry
The cyclical nature of the OFS industry creates several challenges in applying the income approach. Under the income approach, value is based on the present value of expected future cash flow.
While a single-period capitalization method may provide a reasonable indication of value for a business with relatively stable operations, a discounted cash flow (“DCF”) method will often provide a more reliable framework when valuing an OFS company.
Developing a Forecast That Reflects the Company’s Position in the Cycle
The first challenge is determining where the company stands in the industry cycle and how its operating results are expected to develop from that point. Strong recent performance may reflect an approaching peak rather than a sustainable level of activity, while depressed results during a downturn may understate the cash flow the company can generate as conditions recover.
Near term assumptions may be guided by exploration and production (“E&P”) capital budgets, rig and well counts, the company’s backlog, and other indicators relevant to its particular services. When assessing the company’s position in the cycle, the appraiser should also consider whether its operating results historically lead or lag changes in overall industry activity. Longer term assumptions generally focus on the timing and level of a return to mid-cycle conditions.
Because a conventional projection period may not capture that transition, the DCF forecast may need to extend beyond the period commonly used for a less cyclical business. If uncertainty regarding the timing or severity of the cycle is particularly significant, multiple scenarios may be appropriate. The objective is not to predict every future turn in the cycle, but to develop reasonable expectations based on information available as of the valuation date.
Determining Normalized Operating Performance and Cash Flow
The second challenge is determining the company’s normalized earning capacity. Historical results over a complete industry cycle provide an important reference point, but normalization should not be reduced to a mechanical average. Acquisitions, divestitures, changes in market share, entry into or withdrawal from particular basins, and changes in service mix may limit the relevance of earlier periods.
Revenue assumptions should reflect the factors that drive the particular OFS business, including activity levels, utilization, pricing, backlog, and the economics of the basins served. The degree of cyclicality also varies by service line. A provider of services necessary to maintain existing production may be less exposed to the cycle than one primarily serving drilling or completion activity.
Normalization must also extend beyond revenue and EBITDA. OFS companies frequently have significant operating leverage, and some expenses may not change proportionately with revenue. Fixed costs can produce substantial margin compression during a downturn, while competition for labor, materials, and equipment can constrain margins near the top of the cycle. Capital expenditures and working capital requirements may fluctuate with activity as well. Accordingly, the forecast may need to address internally consistent assumptions for each component of cash flow rather than normalizing EBITDA in isolation.
Establishing an Appropriate Terminal Value
The third challenge is developing a terminal value that reflects sustainable operating conditions. Because terminal value frequently represents a substantial portion of the overall DCF value indication, capitalizing a cash flow associated with a cyclical peak or trough can materially distort the valuation.
The terminal year should reflect a supportable mid-cycle level of revenue, profitability, capital expenditures, and working capital investment. Mid-cycle does not necessarily mean a simple historical average. Instead, it should reflect the company’s expected scale, service mix, competitive position, and exposure to future industry activity. Care must also be taken not to double count an expected recovery by beginning with normalized earnings while also applying growth rates that assume a rebound from depressed results.
The Market Approach: Interpreting Multiples in a Cyclical Industry
The market approach develops an indication of value from the pricing of publicly traded companies or transactions involving similar businesses.
For OFS companies, the challenge is generally not the absence of market data. The industry includes numerous public companies and has experienced significant acquisition activity. The greater challenge is determining whether the observed multiples and underlying financial measures provide a meaningful comparison to the subject company.
Selecting a Representative Earnings Measure
Current earnings multiples can provide counterintuitive signals for cyclical businesses. Near the top of the cycle, elevated earnings may produce an unusually low EV/EBITDA multiple, while depressed or negative earnings near the bottom can produce a high or nonmeaningful multiple. Accordingly, a low observed multiple does not necessarily indicate a low valuation, nor does a high multiple necessarily indicate the opposite.
The appraiser must determine whether current, trailing, forward, or normalized earnings provide the most meaningful basis for comparison. Whichever measure is selected should be applied consistently to the subject company and the guideline companies. When EBITDA is negative or particularly volatile, an EV/revenue multiple may provide an additional reference point for consideration. However, revenue multiples do not eliminate the underlying cyclicality and must be evaluated in light of differences in margins, capital intensity, and cash flow conversion.
Identifying Meaningfully Comparable Companies
The broad OFS designation encompasses businesses with substantially different operating and risk characteristics. A drilling contractor, pressure pumper, equipment manufacturer, and provider of services required to maintain existing production may all participate in the OFS industry while responding differently to changes in commodity prices and E&P spending.
Guideline company selection should therefore consider differences in service offerings, drilling versus production exposure, geographic concentration, fixed asset intensity, customer contract structure, and other relevant factors. Size and diversification are also important. Large integrated providers may offer services similar to those of a smaller subject company, but their scale, financial resources, geographic reach, and breadth of operations may result in substantially different risk and growth expectations. These differences cannot always be addressed reliably through a single adjustment to the observed multiple.
Evaluating Cycle Position and Transaction Circumstances
Even reasonably comparable companies may not occupy the same position in the cycle. One company may lead changes in industry activity while another lags, and the magnitude of their respective peaks and troughs may differ. The appraiser should therefore evaluate both the periods over which the multiples are measured and the operating trends underlying the multiples to determine how differences in cycle position may affect their relevance.
Transaction multiples require similar scrutiny because both the purchase price and the earnings denominator reflect conditions and expectations as of the transaction date. A transaction completed near the top of the cycle may produce an apparently low multiple because the acquired company’s EBITDA was temporarily elevated, even if the purchase price incorporated an expected decline in earnings. Conversely, a transaction near the bottom of the cycle may produce an unusually high multiple because current EBITDA was depressed while the buyer anticipated a recovery. The appraiser should therefore identify the transaction’s position in the industry cycle, determine whether the reported multiple is based on trailing, forward, or normalized earnings, and evaluate whether the market expectations at the transaction date are reasonably comparable to those existing as of the subject company’s valuation date.
The Asset-Based Approach: Valuing Assets in a Cyclical Industry
The asset-based approach develops an indication of value based on the market value of a company’s assets less the market value of its liabilities.
Although this approach may receive limited weight in valuing a profitable, asset-light service business, it can provide meaningful information for an OFS company that depends on a substantial fleet of specialized equipment.
Cyclicality affects not only the earnings these assets generate, but also their market values. Depreciated book value may bear little relationship to the equipment’s market value as of the valuation date. During an industry downturn, reduced utilization, excess capacity, and sales of idle equipment may place significant downward pressure on market values. Conversely, equipment shortages and high utilization during an expansion may increase demand and pricing. Technological changes can create additional obsolescence if older equipment no longer meets current operating requirements or customer preferences.
The appraiser may therefore need assistance from a qualified machinery and equipment appraiser. Relevant considerations include the equipment’s age, condition, utilization, remaining economic life, marketability, and technological relevance, as well as whether particular assets are necessary to ongoing operations or are idle, excess, or otherwise nonoperating.
The relevance of the asset-based approach may also change over the cycle. When current earnings are depressed, and forecasts are unusually uncertain, tangible asset value may provide an important reference point. It should not, however, automatically be treated as the value of the operating business or as a fixed floor. The same industry conditions that reduce earnings may also impair equipment values, and an owner intending to continue operating the business may reasonably expect to retain the assets and participate in the next recovery. The asset-based indication should therefore be reconciled with the company’s expected earning capacity, financial condition, and ability to operate through the downturn.
Cyclicality Requires Context
Valuing an OFS company does not require a different set of valuation approaches, but it does require applying those approaches with close attention to where the company and the industry stand in the cycle.
Current earnings, projected cash flow, market multiples, and equipment values can each provide misleading signals when viewed without that context. A credible conclusion therefore depends on distinguishing temporary cyclical effects from structural changes, developing internally consistent assumptions that reflect expected cyclical performance, and reconciling the indications produced by the income, market, and asset-based approaches.
For business owners, attorneys, CPAs, and other advisors, these complexities underscore the importance of engaging a valuation professional who understands both business valuation and the operating economics of the OFS industry. Mercer Capital has extensive experience valuing OFS companies and other energy-related businesses for transaction, tax, financial reporting, litigation, and ownership planning purposes.