Baker Hughes Still Playing Third Fiddle

By Stephen D. Simpson, CFA | July 22, 2013 AAA

You don't have to the biggest or the best to succeed in energy services, but you do have to execute on the opportunities in front of you. On that score, Baker Hughes (NYSE:BHI) still has work to do. Although the company is making some progress with its North American pressure pumping business and the Mideast continues to be a solid source of growth, there is still the risk of a one-two punch from softer margins and less E&P spending than expected. Baker Hughes is still undervalued today and arguably has more upside from better management execution, but it's tough to work up a lot of enthusiasm for the stock.

Q2 Results Miss The Mark
While there was a lot of talk of “beat and raise” from Baker Hughes on improving North American conditions, that's not what happened. Although management was optimistic about the prospects for significant margin improvement in the second half of the year, this quarter was not so strong.

Revenue rose 3% from the year-ago period and 5% from the first quarter on ongoing growth in the international business, and Baker Hughes did beat expectations here. North American revenue grew 3% sequentially despite some tough weather-related challenges, while international revenue was up 7% as strong growth in Russia, West Africa, and the Mideast offset a mid-single digit decline in Latin America.

On the margin side, the news wasn't nearly as good. Gross margin fell about three points from the year ago period and just slightly from the prior quarter. North American margins were weak on challenging weather in Canada and North Dakota, and Latin America was barely breakeven as the company couldn't reduce costs fast enough in the wake of less business from Petrobras (NYSE: PBR) and in Mexico's Chicontepec field. All told, operating income fell 27% and 2%, with North American operating income down 7% sequentially and international down 4%.

SEE: A Look At Corporate Profit Margins

Weather Won't Be Bad Forever, But Will The Market Rebound As Much As Hoped?
Baker Hughes does seem to be continuing to take share in North America, and the company has managed to move about 45% of its fracking fleet to 24-hour operations (with a target of 50% or more by year-end). Coupled with stabile-to-slightly better pricing across an array of services, that's positive. Even with that, though, Baker Hughes is well behind Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL) in terms of share and scale.

On the flip side, Baker Hughes' above-average exposure to Canada has bitten the company this year with a worse-than-normal stretch of weather. It's also well worth mentioning that the big recovery in the second half of the year may well not materialize. E&P companies are getting a great deal more careful with their spending and many may well choose to shore up their balance sheets in favor or reinvesting/redeploying capital to drilling.

Baker Hughes Needs To Get Better, But What About Bigger?
One of the challenges facing Baker Hughes is in better decision-making. Not unlike Weatherford (NYSE: WFT), Baker Hughes has made the mistake of pursuing a “growth at any cost” philosophy at various points. Latin America provides one example – while this is a credible and worthwhile region for energy services company, Baker Hughes over-committed resources, suffered from under-utilization, and now may well over-correct in response.

SEE: Oil And Gas Industry Primer

I do wonder, though, if Baker Hughes could still be a consolidator in the space. An acquisition of Weatherford would add scale in ares like wireline, tools, casing, and artificial lift and could create some longer-term synergy possibilities. I'm not predicting this (and I certainly have a vested interest in seeing Weatherford get an attractive buyout bid), but I wouldn't rule it out either.

The Bottom Line
Comparing the performance of Baker Hughes to Schlumberger, it's hard for me to get all that excited about these shares, even though they do seem undervalued. I suppose the most bullish case I can make for Baker Hughes is that there's more room for improvement here than with Schlumberger – if the market really picks up and/or if management decides to consolidate the industry further, they could have more to gain that a well-run rival like Schlumberger.

At a 6.5x EBITDA multiple, I think Baker Hughes is worth about $54 today. That's not a huge incentive to buy, but it does still make Baker Hughes an undervalued play on a better/improving energy market for investors looking to make that sort of trade.

Disclosure – As of this writing, the author owns shares of Weatherford.

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