|Shares Out. (in M):||440||P/E||0.0x||0.0x|
|Market Cap (in M):||21,900||P/FCF||0.0x||0.0x|
|Net Debt (in M):||3,800||EBIT||0||0|
In a buoyant market, it is hard to find conservatively financed, strong businesses with stocks that have a chance of doubling over a few years. Baker Hughes is a possibility. The common stock traded at or above $90 in 2006-2008, today it is below $50. At the same time, invested capital has tripled, oil remains above $90, service intensive deep water drilling continues to grow, and the “shale revolution” has significantly increased the service content for wells domestically. After a period of disappointments both in its marketplace and some internal problems, Baker Hughes’ earnings appear ready to break-out.
Baker Hughes, Schlumberger, Halliburton, and Weatherford are the three and half world-wide diversified oil-field service companies at scale. Both Schlumberger and Halliburton have previously been written-up on VIC. The oil-field service industry provide a myriad of products that are purchased by E&P companies: geophysical analysis and seismic, drill bits, pressure pumping for cementing and fracturing, chemicals and drilling fluids , artificial lift, casings, wireline logging, equipment rentals, artificial lift (pumps), etc.
Instead of repeating the descriptions in the filings and the voluminous sell-side material that is readily available (JPM has data dumps on oil-field services and related), I’m going to provide one man’s simple view on how to think about the business and the stock, and why I find it interesting.
First, Baker Hughes competes in a world-wide oligopoly industry providing an essential service. E&P companies, including national oil companies, rely on the service company expertise for much of their drilling. Some aspects of what they sell appear largely commodity, some are highly technical. This is a rare example of where a technology-driven industry is still dominated by US-based firms.
Second, the oil-field services industry is cyclical. It is cyclical because the market price of the underlying commodity being produced is volatile and secondly, the service companies themselves over and under shoot on their capabilities and assets. The pricing power of oil field service companies swings with supply-demand dynamics, so margins are not stable.
Third, the industry appears to have greater volume potential than the past. “Volume” is both a measure of the number of projects, basically wells, but also the “content” that service companies need to provide for each well. As an example, a horizontal well in a shale formation can have 3x the revenue of a vertical well in a traditional reservoir. Another example is the technical requirements and cost of mistakes in deep water wells, (i.e. Macando) which in particular favor the largest service companies. This is partially a function of the declining reservoir quality world-wide.
Fourth, you make a lot of money on these stocks by calling the “turn” in the supply-demand driven pricing dynamics in the industry. Unfortunately, there is a lot of hot money that is playing this game, so if you are reading this, you probably will have a difficult time “beating the gun,” as Keynes would say. If you see it in the numbers (margin improvement, rig count, etc.), the stocks will already be up. Fortunately, “experts” in this game, including the managements of E&P companies who do this full-time, don’t usually look all that prescient either with the fullness of time, so maybe we aren’t too disadvantaged.
So why is Baker Hughes interesting?
First, it is conservatively financed, which for me is a requirement given the nature of the industry. There is $15B in invested capital, split roughly 50/50 between PP&E and working capital financed with $4B of net debt and the rest equity.
Second, Baker Hughes has underperformed its competitors and this provides opportunity for improvement. Baker Hughes’ margins compares unfavorably to Halliburton (Schlumberger appears to have permanently higher margins due to better eastern hemisphere share and their seismic business). For the last several years, Baker Hughes’ margins have been 4-5 points below Halliburton’s, even though their business mix is similar. Baker Hughes’ reputation also is #3 to Halliburton, partially due to recent business performance, which makes the Halliburton management and culture appear superior, and partially because red is a tougher color than blue and Halliburton has a cool employee ipad app for collections (Battle Red - Booyah!). In the last decade, however, Baker Hughes had the better reputation and Halliburton was the laggard. Baker Hughes management sounds driven to correct the current situation.
Third, the Baker Hughes business appears to have significantly grown its earnings power over the last decade, but the soft market hasn’t allowed that growth to appear in the earnings. Since 2006, Baker Hughes grew invested capital at a 14% CAGR, revenue at a 10% CAGR, and operating income negative 5%. Amazing. Halliburton did similarly but managed to grow earnings modestly. The managements appear to have overshot their market, but the underlying volume growth should be catching-up.
Fourth, Baker Hughes appears cheap relative to a guess at normal earnings power. I estimate that Baker Hughes will have $26B in revenue in 2015 and 16% operating margins, slightly below what Halliburton and Baker Hughes managements say are “normal” ranges. This generates over $6 a share in EPS. Capitalized at 15x would return the stock to levels achieved in 2006-2008, when the company was much smaller and less well positioned in a growth industry.
If we are wrong on timing, and the market remains weak due to unfavorable supply-demand dynamics, the underyling earnings power will continue to grow with the increasing demand for their services. And supply will inevitably come out of the market, tightening pricing, but perhaps not on a timeframe we would want. The one way I think one could be impaired is if OPEC were to disintegrate, which I believe is unlikely.
|Entry||09/27/2013 12:23 PM|
What do you think is the potential for activist involvement in BHI? Seems like management / the company has significantly underperformed HAL/SLB.
|Subject||A couple questions|
|Entry||09/27/2013 02:06 PM|
Financing: I agree that the standard credit metrics (debt/cap, debt/EBITDA) look strong,
but they are rolling ~$1 billion of commercial paper to fund their domestic operations
since the $1 billion of cash they have is trapped overseas. They basically have no
cash in the U.S. It's probably a non-issue given the $2.5 billion size of their revolver and
A-1 commercial credit rating, but still something to watch.
Earnings power: I agree with your observations that service intensity is rising,
particularly in North America, but I am suspicious the earnings tailwind won't necessarily materialize.
Probably 1/4 of their consolidated revenue comes from the old BJ Services in North America. Pressure pumping
is an awful business and I don't see how it gets better unless natural gas prices take off.
There is lots of excess capacity. Completion efficiencies are constantly improving, so the industry
is "completing" itself out of a job, so to speak. There's no pricing power.
Some E&P companies are figuring out how to trade down from ceramic to sand proppant, and/or acquiring sand mining operations, thus denying service companies the opportunity to continue making gross margin dollars on a large portion of completed well costs.
Management/activism: I don't have a good read on the CEO. He has an operating background,
so that's nice. He's new enough that we probably have to give him a chance before activists
can step in and say, "you've had your turn. Now it's our turn." That said, the company seems
to have second class management compared with SLB.
Overall the discounted multiples on depressed earnings probably make this work, though maybe
it has less upside than you suggest.
|Subject||RE: A couple questions|
|Entry||09/27/2013 02:06 PM|
The subject of my post should have been "a couple comments", not "a couple questions"!
Anyway, thanks for posting.
|Subject||drew and snarfy|
|Entry||09/27/2013 02:57 PM|
good comments. drew, on activism, it isn't unthinkable and I agree with snarfy that it appears the challenges of today are not of Martin's making. I note, however, that the commodity price input and supply-demand cyclical nature of the business make it less attractive for an activist that wants to control as many variables as possible. Nor do I see some egregious mistake being made by management.
snarfy, i love the CP comment - thank you. I note that they could always repatriate the $1B off-shore and pay the tax. Since management believes North America will improve and does not require investment, they will generate significant cash flow domestically, so lack of domestic cash seems temporary, shrewd, and not a source of significant liquidity risk.
Pressure pumping is a much more commodity business. And E&P companies can keep their suppliers honest by vertically integrating (SWN did this in Fayetteville). But pressure pumping is cyclic and will eventually turn and the trend is clear for increasing E&P reliance on their service providers.
|Subject||RE: drew and snarfy|
|Entry||09/27/2013 04:15 PM|
You know what might really give BHI (and the others) a boost? If some real consolidation happened in pressure pumping. I doubt the Big 3 can do it since they still control 60% of the domestic market and the DOJ is looking at them, even if the inquiry is for something that doesn't stick.
However, Patterson has said they would look at acquiring somebody if the fleet equipment wasn't too dissimilar. Patterson uses all Cummins engines, for example, and would want to keep it that way.
I'm curious if you have any thoughts on who they could buy, or which pressure pumping companies would be logical mates for each other.
|Subject||RE: RE: RE: drew and snarfy|
|Entry||10/01/2013 09:23 AM|
Correct me if I'm wrong, but the current CEO was the COO. Which means that his fingerprints are all over BHI's current problems and the BJ acquisition (which was horribly integrated and dilegenced, at best)? BHI's margins, working capital and revenue growth all significantly lag large peers, and the others have bought back significant shares? Do you think this is fixable, or just reflects BHI's underlying products and people?