Baker Hughes: A Smart Oil Play
We believe that Baker Hughes (BHI; recent price $82) is well positioned to benefit from a trend toward greater oil field activity in frontier regions around the globe, especially in the Eastern Hemisphere, and offers an attractive value proposition to oil and gas operators.
In our opinion, Baker Hughes has a strong technology focus in its product and service offerings, with one of the only product line-focused corporate organizations among its oil field services peers—we view this as an advantage as technology content becomes increasingly important. On a geographic basis, we view the company's exposure to the faster-growing Eastern Hemisphere as second only to that of chief rival Schlumberger (SLB), and thus consider Baker Hughes to have an excellent footprint for future success.
By our analysis, the company's investments in expanding its geographic reach and focusing on core technological strengths will enable it to generate significant earnings growth in years to come. Combined with our view of Baker Hughes' relatively inexpensive valuation, on a discounted cash flow basis and vs. peers, we believe the shares offer compelling value. Our recommendation on the stock is 5 STARS (strong buy).
Headquartered in Houston, Baker Hughes is an oil field services company with operations in more than 90 countries. As of November, 2007, it had a stock market capitalization of over $26 billion, ranking third among U.S.-based oil field services companies, behind only Schlumberger ($115 billion) and Halliburton (HAL; $34 billion), and ahead of Weatherford International (WFT; $21 billion).
As of Jan. 1, 2007, Baker Hughes had two reportable business segments: the drilling and evaluation segment (D&E: 52% of 2006 revenues, and 57% of 2006 segment operating income), and the completion and production segment (C&P: 48%, 43%).
The D&E segment combines results of four product lines typically involved in the drilling and evaluating of oil and natural gas wells. Those four product lines are Baker Hughes Drilling Fluids (fluid services), Hughes Christensen (drill bits), INTEQ (drilling and related services), and Baker Atlas (wireline services). (A wireline is a slender piece of metal, small in diameter, used to lower tools and valves into a well.)
The C&P segment combines results of three product lines typically involved in the completion of drilled wells and, later on, the production of oil and natural gas from those wells. These product lines are Baker Oil Tools (well completions), Baker Petrolite (chemicals), and Centrilift (artificial lift).
In April, 2006, Baker Hughes sold its 30% stake in seismic company WesternGeco to its former joint venture partner, Schlumberger, for $2.4 billion in cash. We view the divestiture as strategic in nature, enabling Baker Hughes to focus its energies on growth in its core oil field services businesses.
Year to date through Sept. 30, 2007, Baker Hughes has generated approximately 48% of its total oil field services revenues from the Eastern Hemisphere, which ranks second among the top four U.S.-based oil field services companies, behind only Schlumberger (56%), and ahead of both Halliburton (41%) and Weatherford (38%).
Based on continued high projections for oil and natural gas prices, and continued high levels of capital spending by exploration and production companies (E&Ps), we project the company will increase total revenues by approximately 16% in 2007, and an additional 16% in 2008. We see revenues from the D&E segment rising 17% in 2008, with operating margins in the high 20% range. For the C&P segment, we see revenues growing 15%, with operating margins in the mid-20% range.
Overall, we expect Baker Hughes to report earnings per share of $4.86 in 2007, and $6.28 in 2008.
It's become increasingly challenging for producers—integrated oil companies, independent E&Ps, and nationalized oil companies—to obtain sufficient supplies of crude oil and natural gas in order to keep pace with growing demand. Emerging markets such as India and China have joined the developed world in the demand for hydrocarbon resources, which continues to show resilience in the face of high prices. According to Global Insight, an independent economic forecasting firm, total demand for crude oil is expected to rise 1.9% in 2008, up from a projected 1.4% increase in 2007.
Meanwhile, on the supply side, producers are constrained by several factors. First, the decline rate for existing wells—the rate at which a producing well generates less output year after year—continues to deteriorate, especially in mature regions. Second, political unrest in key supply regions such as Nigeria, Russia, and the Middle East can make access to attractive reservoirs more difficult and/or expensive.
Third, with mature regions largely picked over, the biggest untapped reservoirs are likely in highly challenging terrain, such as the Arctic Ocean. It is estimated that nearly half of all undiscovered crude oil and natural gas resources now lie in deep water.
Projected prices for hydrocarbons underscore this struggle between supply and demand. Based on data from Global Insight, S&P projects crude oil prices averaging nearly $90 per barrel in the fourth quarter of 2007, and nearly $85 per barrel in 2008 and 2009. Similarly, natural gas prices are estimated to be nearly $7 per million BTU in the fourth quarter of 2007, more than $8 in 2008, and over $9 in 2009—all high by any historical comparison.
Oil field services companies, including Baker Hughes, enter the supply chain, broadly speaking, in two ways. First, they can help upstream producers gain access to reservoirs that otherwise would not be technologically attainable. Second, they can help those companies do a better job of recovering the resource base from existing wells, either by prolonging the life of the well or, perhaps, by recovering those resources in a more efficient manner, thus saving time and money.
Increasingly, more of the undiscovered resource base is held by nationalized oil companies (NOCs). By advent of the recent surge in commodity prices, NOCs often have ample access to capital, but lack the high-tech knowledge to extract such resources out of the ground. NOCs, such as those in West Africa, the Middle East, India, Russia, and the Caspian region—all part of the broader Eastern Hemisphere—make natural partners for oil field services companies, in our view, given the latter's ability to offer compelling value propositions with advanced oil field technology. Relatively speaking, we expect growth prospects from the Eastern Hemisphere to exceed those of the Western Hemisphere.
For relative valuation purposes, we estimate that Baker Hughes will generate return on invested capital of 28% in 2008, essentially in line with our estimated 27% for our group of oil field services companies under coverage. Thus, we believe a peer valuation is reasonable. At a 10.2X multiple to our estimated 2008 operating cash flow, Baker Hughes is trading at a 13% discount to the peer group average of 11.7X. Using a 13X multiple (in line with the 12.9X projected peer average) yields a value of $101 per share.
On an enterprise value to projected 2008 earnings before interest, taxes, depreciation, and
amortization (EBITDA) basis, Baker Hughes trades at a 7.1X multiple, about 16% below the 8.5X peer group average. Using an 11X multiple on projected 2008 EBITDA—in line with the projected peer average—yields a value of $123 per share.
Blending these relative valuation metrics with the intrinsic value of $114 per share yielded by our discounted cash-flow model results in a 12-month target price of $113 per share.
We believe that Baker Hughes' corporate governance practices are generally sound. Independent outside directors represent 11 of the 12 seats on the company's board, and board members are slated for reelection annually. The audit/ethics committee is comprised solely of such outside directors. All outside directors have a sizable equity component to their compensation, in the form of restricted stock. However, we note that the offices of chairman and chief executive officer are held by the same individual, Chad Deaton. S&&P takes the view that from a corporate governance perspective, it is preferable to separate these roles between two individuals.
Risks to our recommendation and target price, in our view, include events that would cause substantial declines in oil and gas D&E or C&P activity. Such risks might include significant reductions in long-term expectations for crude oil and natural gas prices, or an increase in political risk of oil field activity in frontier regions around the globe. Other risks include the aging of the existing labor pool of oil field engineers and an ability to supply, on a timely basis, a sufficient number of well-trained engineers to replace them as they retire.