Description

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. 

Catalyst