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Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component in deciding whether to invest or to remain invested in a company. There are many metrics involved in calculating profitability, but for this article, I will look at Baker Hughes Inc.'s (NYSE:BHI) earnings and earnings growth, profit margins, profitability ratios and cash flow.

Through the above-mentioned metrics, we will get an idea about the company's profitability over the past 5 years and a look at what to expect in the future.

By comparing this summary to other companies such as Schlumberger NV (NYSE:SLB) and Halliburton Company (NYSE:HAL), which are in the same sector, you will be able see which has been the most profitable.

All material is sourced from Morningstar, MSN Money and Baker Hughes webpage.

Earnings and Earnings Growth

1. Earnings = Sales x Profit Margin

  • 2010 - $14.414 billion x 5.63% = $812 million
  • 2011 - $19.831 billion x 8.77% = $1.739 billion
  • 2012 TTM - $21.403 billion x 6.59% = $1.411 billion

Baker Hughes earnings have increased over the past couple of years. The earnings have increased from $812 million in 2010 to $1.411 billion in 2012 TTM. This is a gain of 73.77%.

2. Five-year historical look at earnings growth

  • 2008 - $1.635 billion, 7.99% increase over 2007
  • 2009 - $421 million, 74.25% decrease
  • 2010 - $812 million, 92.87% increase
  • 2011 - $1.739 billion, 114.16% increase
  • 2012 TTM - $1.411 billion, 18.86% decrease

In looking at Baker Hughes earnings over the past five years, you can see how the economic crisis affected the company's earnings.

In 2009, Baker Hughes reported it's low in earnings compared to the last 5 years. The decrease in earnings was due to the global recession, as the demand for oil and natural gas weakened thus leading to a reduction in global drilling activity.

Over the past few years, as the economy and commodity prices have been strengthening, this has been reflective in the company's earnings. Since the low in 2009, the company's earnings have increased by 235.15%.

Profit Margins

3. Gross Profit = Total Sales - Cost of Sales

In analyzing a company, gross profit is very important because it indicates how efficiently management uses labor and supplies in the production process. More specifically, it can be used to calculate gross profit margin. Here are Baker Hughes gross profits for the past two years:

  • 2011 - $19.831 billion - $15.264 billion = $4.567 billion
  • 2012 TTM - $21.403 billion - $17.024 billion= $4.379 billion

4. Gross Profit Margin = Gross Income / Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

In reviewing Baker Hughes gross margin over the past five years, we can see that the company's gross margin has been declining. This decline has marked a 5-year low for the gross margin. The low for the gross margin was calculated in 2012 TTM at 20.46%. The 5-year high for the gross margin was calculated in 2008. The 2008 gross margin was calculated at 32.96%. The 2012 TTM gross profit margin of 20.46% is below the 5-year average of 24.46%.

  • 2008 - $3.910 billion / $11.864 billion = 32.96%
  • 2009 - $2.267 billion / $9.664 billion = 23.46%
  • 2010 - $3.230 billion / $14.414 billion = 22.41%
  • 2011 - $4.567 billion / $19.831 billion = 23.03%
  • 2012 TTM - $4.379 billion / $21.403 billion = 20.46%

As the gross margin is below the 5-year average, this implies that management has been less efficient in the company's distribution during the production process.

5. Operating income = Total Sales - Operating Expenses

The amount of profit realized from the operations of a business after taking out operating expenses - such as cost of goods sold (COGS) or wages - and depreciation. Operating income takes the gross income (revenue minus COGS) and subtracts other operating expenses, then removes depreciation. These operating expenses are costs that are incurred from operating activities and include things such as office supplies and heat and power.

  • 2011 - $2.600 billion
  • 2012 TTM - $2.264 billion

6. Operating Margin = Operating Income / Total Sales

Operating margin is a measure of the proportion of a company's revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

Compared to 2008, the operating margin has decreased. In 2008, the company reported an operating margin of 20.03%. In 2012 TTM, the company reported an operating margin of 10.58%. This indicates a sharp decline in the operating margin.

  • 2008 - $2.376 billion / $11.864 billion = 20.03%
  • 2009 - $732 million / $9.664 billion = 7.57%
  • 2010 - $1.417 billion / $14.414 billion = 9.83%
  • 2011 - $2.600 billion / $19.831 billion = 13.11%
  • 2012 TTM - $2.264 billion / $21.403 billion = 10.58%

When comparing the operating margin to 2009, you can see a recovery. This recovery implies that there has been an increase in the percentage of total sales left over after paying for variable costs of production such as wages and raw materials over the past 4 years.

7. Net Profit Margin = Net Income / Total Sales

The net profit margin is a ratio of profitability calculated as net income divided by revenue, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage of the net profit divided by the total sales. So a 20% profit margin means the company has a net income of $0.20 for each dollar of sales.

Over the past 4 years, Baker Hughes net profit margin has been increasing. The latest net profit margin of 6.59% is above the post crisis 4-year average of 6.34%.

  • 2008 - $1.635 billion / $11.864 billion = 13.78%
  • 2009 - $421 million / $9.664 billion = 4.37%
  • 2010 - $812 million / $14.414 billion = 5.63%
  • 2011 - $1.739 billion / $19.831 billion = 8.77%
  • 2012 TTM - $1.411 billion / $21.403 billion = 6.59%

As the 2012 TTM net profit margin of 6.59% is above the post crisis average of 6.34%, this implies that there has been a greater percentage of earnings that the company has been able to keep.

The above listed profitability margins are revealing that, the company has been showing weakness when compared to 2008 but has been gaining strength when compared to 2009. This is an indicator of how the financial crisis and the subsequent drop in energy prices have had an effect on the company's profitability.

Profitability Ratios

8. ROA - Return on Assets = Net Income / Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

When comparing Baker Hughes 2012 TTM ROA to its 2009 ROA, we can see the growth in the company's ROA. The current ROA of 5.72% is well above the 2009 ROA of 3.68%.

  • 2008 - $1.635 billion / $11.861 billion = 13.78%
  • 2009 - $421 million / $11.439 billion = 3.68%
  • 2010 - $812 million / $22.986 billion = 3.53%
  • 2011 - $1.739 billion / $24.847 billion = 7.00%
  • 2012 TTM - $1.411 billion / $26.756 billion = 5.27%

As the 2012 TTM ROA of 5.74% is above the 4-year post crisis average of 4.87%, this implies that management has had more of the ability to use the company's assets to generate earnings over the past 4 years.

9. ROE - Return on Equity = Net Income / Shareholders' Equity

As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.

  • 2008 - $1.635 billion / $6.807 billion = 24.02%
  • 2009 - $421 million / $7.284 billion = 5.78%
  • 2010 - $812 million / $14.100 billion = 5.82%
  • 2011 - $1.739 billion / $15.746 billion = 11.04%
  • 2012 TTM - $1.411 billion / $16.873 billion = 8.36%

Much like the ROA, the ROE has also revealed strength when compared to 2009. When comparing the 2009 ROE to the 2012 TTM ROE, we can see that the current percentage is much higher. The 2009 ROE of 5.78% is much lower than the current ROE of 8.36%. As the ROE has strengthened over the past four years, this reveals that there has been an increase in how much profit has been generated compared to the amount that shareholders have invested.

Cash Flows

10. Free Cash Flow = Operating Cash Flow - Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (NYSE:FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.

When reviewing the company's free cash flow, we can see that over the past five years, Baker Hughes free cash flow has been negative three times.

  • 2008 - $1.614 billion - $(1.303) billion = $311 million
  • 2009 - $1.239 billion - $(1.086) billion = $153 million
  • 2010 - $856 million - $1.491 billion = $(635) million
  • 2011 - $1.507 billion - $2.461 billion = $(954) million
  • 2012 TTM - $1.772 billion - $2.997 billion = $(1,225) billion

11. Cash Flow Margin = Cash Flow from Operating Activities / Total Sales

The higher the percentage, the more cash available from sales.

If a company is generating a negative cash flow, it shows up as a negative number in the numerator in the cash flow margin equation. This means that even as the company is generating sales revenue, it is losing money. The company will have to borrow money or raise money through investors in order to keep on operating.

As Baker Hughes cash flow margin is positive, it does not have to take the above measures to continue operating.

  • 2008 - $1.614 billion / $11.864 billion = 13.60%
  • 2009 - $1.239 billion / $9.664 billion = 12.82%
  • 2010 - $856 million / $14.414 billion = 5.94%
  • 2011 - $1.507 billion / $19.831 billion = 7.60%
  • 2012 TTM - $1.772 billion / $21.403 billion = 8.28%

Summary

In 2008, Baker Hughes reported strong earnings. The company reported earnings of $1.635 billion which was an increase of 7.99% over the previous year. When the economic crisis hit in late 2008 and into 2009, this had a huge impact on the company. This impact was reflective on the reported earnings. In 2009, Baker Hughes reported earnings of 421 million which was a decrease 74.25% over the previous year. Since 2009, as the economy and commodity prices have been increasing, this has been reflective in the company's earnings. Since the low in 2009, the company's earnings have increased by 235.15%.

The listed profitability margins are indicating weakness when compared to 2008, but are also indicating strength when compared to 2009. As energy prices are still not where they were in mid 2008, this has been reflected in the company's earnings.

When comparing the company's ROA and ROE to 2009, we can see that the percentages have increased significantly. The 2009 ROE of 5.78% is much lower than the current ROE of 8.36%. This is another indicator that the company is gaining strength when compared to 2009.

Over the past 5 years, Baker Hughes has posted negative cash in the past last 3 years. The company is generating positive cash but is using its cash to purchase assets. As the company is generating positive cash, this implies that the company does not have to borrow money or raise money through investors to keep operating.

Future Outlook

According to the Baker Hughes Outlook for Q4 2012 report, the company is expecting some headwinds in the near future. The report stated "North America revenue and profit margins are expected to be lower than previous expectations due to weaker than anticipated onshore activity and further price erosion within pressure pumping operations. As a result, North America operating profit before tax margin is now expected to be between 8.5% and 9.5% for the fourth quarter of 2012, as compared to 11.7% in the third quarter of 2012."

As a result of these headwinds some analysts lowering their outlook on the company. Recently Stern Agee downgraded their rating of Baker Hughes to Neutral.

Having states that Bloomberg Businessweek is expecting growth in revenues but a decline in margins for FY 2012 and 2013. Bloomberg Businessweek is expecting revenues to be at $21.1 billion for FY 2012 and $21.7 billion for FY 2013 and an EPS of $3.20 for FY 2012 and $3.18 for FY 2013. Even though this is a decline from the 2011 numbers, these numbers still show growth compared to 2009 and 2010.

For other articles on Baker Hughes please read: Baker Hughes: Inside The Numbers and Analyzing Baker Hughes' Debt And Risk

Source: Baker Hughes: Profitability Analysis