The standard definition of Enterprise Value is the Market Value of a company’s Debt and Equity less cash. It is typically used to determine the offering price for a takeover. This is illustrated in the diagram:
Source: Street of Walls; Investment Banking Technical Training.
However, in exploration and production, Enterprise Value has an additional meaning: The market value of the entire Business minus the market value of the company’s individual Assets.
That is, the intrinsic value of the company as a capital steward. Frequently a company becomes a takeover target when an acquirer perceives they can manage the target’s assets better than the incumbent team, creating added shareholder value. The ability to sustain a higher intrinsic value relative to its assets depends on the company’s stewardship of capital. Is the current leadership team better able to exploit and grow the assets than a suitor? If the business generates returns that exceed its cost of capital it has a positive intrinsic or Enterprise Value as a business. The company may have a higher value than it would if the assets were sold off or managed by another leadership team. At least that could be argued to the shareholders. Conversely, a company that has failed to generate at least its cost of capital, if not an excess return, is vulnerable and the assets probably should be sold.
Another way to think about it is the concept of competitive advantage. Better capital stewards have a competitive advantage over their peers for a variety of reasons. They have access to growth capital on better terms, are more attractive to talented people, may have better access to desirable acreage and more favorable terms from service and supply providers. Morningstar refers to competitive advantage as “Moat”, a particularly apt and descriptive term. For medieval kings, a moat was a great way of defending against their notion of a takeover.
Few North American E&P companies have a moat in Morningstar’s view and those that do are characterized as narrow. But those that have a moat are typically those generating excess returns above their weighted average cost of capital. What differentiates the advantaged E&P companies from their peers?
Our research suggests there are three crucial components, that when aligned, virtually assure a company will have a positive intrinsic value, a wider moat and will endure as a sustainable enterprise.
Taken individually the three components may seem obvious. What gives them power to build Enterprise Value is Alignment. When all three pillars are aligned, a good outcome, i.e. achieving the organization’s goals is all but inevitable. Let’s examine them in order.
“Great vision without great people is irrelevant.”
-Jim Collins, Good to Great: Why Some Companies Make the Leap and Others Don’t
People comprise the first and primary pillar. It takes people, often ordinary people, striving to do great things that make high performing companies. They need to be the right people, with the right Talents, Knowledge, Skills and above all the right Attitudes. Consider the following expression:
A(T+K+S) => Performance
The sum of Talents, Knowledge and Skills are crucial to Performance. But Attitude is the multiplier. It can make the difference between thriving companies and those that merely survive. High performing companies do more than recruit and interview well. They seek to understand behavioral styles, values and thought processes of their best performers. They will certainly seek to replicate the attributes of their best performers. But they go beyond replication to find people who compliment, reinforce, challenge and contribute synergies to their team. They also provide training and development, lots of it.
They work very hard on Attitude. Attitudes are habits of thought that can be identified and reinforced, or changed and learned. Everyone comes to work every day with an attitude. It can be happy, enthusiastic and inquisitive, or not. Those that arrive on the first day of work usually have a very positive set of thought habits and views of the company and their future with it. Over time, positive attitudes can be eroded or reinforced. Early in my career I was told not to worry about attitude. “You can’t manage what you can’t measure and you can’t measure attitude”. Well experience and learning have proven otherwise. Attitudes can be measured and they are amenable to quality leadership.
"Would you tell me, please, which way I ought to go from here?"
"That depends a good deal on where you want to get to, said the Cat."
- Lewis Carroll, Alice in Wonderland
Strategy encompasses Vision, Mission and Objective. Grand eloquence is often mistaken for strategic intent. To be effective it must state what the business intends to do and explicitly exclude what it will not be. Lofty articulation of strategic intent that is not clear, concise and precise provides little in the way of guidance. Michael Porter, states “The essence of strategy is choosing what not to do”. Stating explicitly, and exclusively, what the company will pursue is the hallmark of good leadership.
A review of E&P company websites reveals that virtually all of them have a well written, eloquent strategy statement. But how many have an effective strategy? Two questions E&P companies should ask are:
1. What capabilities and resources do we have?
2. What plays match our capabilities and resources?
Limited resources require some choices need to be made. If the answers yield some matches, a semblance of a strategy begins to emerge. But just as important, the company is excluding the rest of the opportunities. It is choosing to focus, to be different and therefore excel above its peer group.
Collins is also famous for his comment to “get the right people on the bus, the wrong people off the bus and the right people in the right seats, all of that before announcing where the bus is going”. The circularity can be confusing. How do you know what the right seats are before you know where the bus is going? There has to be some idea about what capabilities will be needed for the journey. After all, the people in a business are not passengers along for the ride; they are contributors.
The dilemma is resolved with leadership. All leaders come to a business with a vision, a mission and sense of how to get there. The great leaders know how to forge, refine and hone a vision by incorporating the wisdom of their people. Not only are the resulting vision, mission and strategy better for the multiple minds processing them, commitment is vastly increased. Without clear direction the effort to do great things can be wasted, unproductive or even toxic.
"Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat."
― Sun Tzu, The Art of War
Business Processes are the tangible reflection of a disciplined culture. While people breathe life into the strategic intent, even great people striving to do great things result in failure if their actions are not coordinated. The more complex the business, greater is the need for coherent processes.
E&P companies pursue multiple goals in achieving the objective of building shareholder value. The business is so complex it requires the loyalty of multiple stakeholders: Employees, contractors, regulators, communities, lenders and shareholders.
In fact, even adversaries such as environmental activists can be seen in this context. While they may never be allies, E&P companies that can be trusted to do the right thing most of the time, stand to gain a grudging respect; yes, even loyalty.
Any chance of success depends on the company’s goals and the game plan to achieve them. It is the starting point, the road map, but it is not sufficient. The means by which the strategic intent is to be realized are the Business Processes.
The practical means to achieving goals are operational mechanics the leaders initiate. But it is the people in the organization that define them in detail and refine them through practice, learning, revision and, frequently, work-arounds. If the processes are effective, the strategy has a reasonable chance of success.
It is a good idea for an organization to regularly review its processes. As the business environment changes, the processes could quickly become outdated. Ad Hoc adjustments often emerge over time and very soon an uncoordinated mess ensues. A regular formal review will identify where disconnects might have developed and suggest some process changes. Mapping the real (how we really do it) against the ideal (how we should do it) is also a source of creativity, stimulating new thinking on how to do business even better.
Success is not assured without the final element that binds people, strategy and process together, Alignment.
One expert, Larry Myler states that “65% of organizations have an agreed upon strategy, 14% of employees understand the organization’s strategy. Less than 10% of organizations successfully execute the strategy.”
One key seems to be communication. The message may get muddled as it filters down. It is not only what the message from the top is, it is how it is absorbed, processed and hopefully internalized by the people charged with execution. People may not be motivated by what they see, hear and sense. The connection between the strategy and their daily efforts may get lost or is never even perceived. A complex strategy is difficult to grasp at best. Even if it is understood, translating that into specific day-to-day actions could be even more of a challenge. Even senior leaders are buffeted by urgent events, sometimes knocking them off course.
But the essence is to ensure that good people executing streamlined business processes, focus on the critically few steps necessary to achieve strategic intent. Make it easy for people to do the right things that lead to success. Get essential. Author Greg McKeown in his book Essentialism advocates focusing on the essential few activities, sacrificing the trivial many. In designing business processes, keeping it simple, focusing on the essential few and shielding people from conflicting multiple priorities pays big dividends.
Structure plays a critical role. Do the multiple disciplines required of an E&P company synchronize with clear responsibilities, goals and yard sticks? Are hand-offs between team members seamless and effective? One red flag is the existence of archaic departmental structures. Silos can lead to a tight-hole mentality, killing cooperation, hindering strategy and creating process snarls. Many companies have formed strategic business units staffed with the required skill sets and access to centralized staff expertise.
Rewards go hand in glove with structure. Are people recognized and rewarded for advancing the strategy? Are the rewards true motivators? Do senior leadership and operating managers know what motivates individual team members? A one-size-fits-all bonus program may be more easily administered, but may be woefully ineffective and unnecessarily costly to fund. No two people have identical motivator sets. Financial rewards work for some, while varied or interesting assignments work better for others. It is vitally important in lean times to understand what works and what does not.
For E&P companies, the strategy track record is better than Myler’s general observation. Our research suggests that approximately 20% earn greater than their cost of capital. (There is another 8% that are very close, almost too close to call.) Excess return to capital demonstrates that all three pillars are aligned and the organization is exceeding the expectations of capital providers. They are more than good stewards of capital; they generate an excess return. This means the company is more than a holder of assets, it is creating positive Enterprise Value. Very clearly, these top companies have all three pillars aligned and are “hitting on all eight cylinders”. In a future article, we will take a close look at the North American E&P sector and illustrate in more detail how the three pillars work for individual companies.