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It is only a mat­ter of time before oil and gas stocks stop mov­ing with the price of oil and start reflect­ing their under­ly­ing economics.

When this hap­pens, Baker Hughes (BHI – “very dan­ger­ous” rat­ing) will be among the stocks that fall the hardest.

The rea­son behind BHI’s immi­nent down­fall is the mis­lead­ing nature of its reported earn­ings. Per Fig­ure 1 below (click to enlarge images), BHI’s account­ing earn­ings have ben­e­fited sig­nif­i­cantly from the BJ Ser­vices acqui­si­tion that closed in late April 2010. How­ever, the eco­nom­ics, i.e. the result­ing cash flows, of the deal are not positive.

The math is sim­ple. BHI paid $6,897 mil­lion and assumed $2,348 mil­lion in lia­bil­i­ties (total cost of $9,245 mil­lion) to acquire BJ Ser­vices, which con­tributed ~$500 mil­lion in annu­al­ized unlev­ered earn­ings in 2010. This results in a return on invested cap­i­tal (ROIC) for the acqui­si­tion of 5.4%, which is lower than BHI’s cost of cap­i­tal (WACC) of 8.6%.

BHI over­paid for BJ Ser­vices, which dri­ves a decline in eco­nomic earn­ings of $295 mil­lion, despite the boost in GAAP earnings.

Fig­ure 1: Mis­lead­ing Earn­ings From “Accre­tive” Acquisition

Sources: New Con­structs, LLC and com­pany filings

One of the biggest mis­con­cep­tions in the invest­ing world is that the merit of an acqui­si­tion should be judged by whether or not it is “earn­ings accre­tive”. As shown above, the impact of an acqui­si­tion on a company’s account­ing earn­ings is not indica­tive of its eco­nomic value to shareholders.

From Credit Suisse First Boston, Fron­tiers of Finance, “Let’s Make a Deal”, Michael Mauboussin, page 7:

To illus­trate the point, we turn to the so-called ‘high-low fal­lacy.’ This sim­ple exer­cise shows the impact of com­bin­ing two ‘businesses’—one with a high price/earnings mul­ti­ple (P/E) and one with a low P/E—in a stock-for-stock deal. Assum­ing no acqui­si­tion pre­mium or syn­ergy between the oper­a­tions, it can be demon­strated that man­age­ment can either increase earnings—High buys Low—or increase the P/E—Low buys High.

Fig­ure 2 clearly demon­strates the sim­ple math behind how acqui­si­tions can be accre­tive with­out any con­sid­er­a­tion what­so­ever to the eco­nomic impact of a deal.

Fig­ure 2: The High-Low Fallacy

Sources: Credit Suisse First Boston, Fron­tiers of Finance, “Let’s Make a Deal”, Michael Mauboussin, page 7

The take-away for investors is: do not be fooled by the mis­lead­ing increase in BHI’s reported earn­ings. The eco­nom­ics of the busi­ness have taken a turn for the worse, and, even­tu­ally, the stock price will drop to reflect that decline.

In fact, the stock price decline could be rather severe given the unre­al­is­ti­cally high future cash flow expec­ta­tion reflected in its valuation.

To jus­tify its cur­rent price of ~$57.70, Baker Hughes would have to grow its after-tax cash flow (NOPAT) by over 20% com­pounded annu­ally for 12 years. Those are high expectations…not just the high level of growth but also the long dura­tion of expected growth.

With no future profit growth, the value of Baker Hughes’ stock is closer to $17 per share. Though I do not nec­es­sar­ily expect Baker Hughes will achieve no future profit growth, I think the no-growth value pro­vides impor­tant per­spec­tive on how much growth is priced into the stock and how much risk investors take by hold­ing it.

Fig­ure 3 sug­gests that investors in BHI’s stock could be in for some trou­ble if his­tory repeats itself. Over the last 13 years, BHI’s stock has quite closely tracked the company’s eco­nomic earn­ings. The stock is in for quite a cor­rec­tion if the cor­re­la­tion between mar­ket value and eco­nomic earn­ings returns — con­sis­tent with my analy­sis of future cash flow expectations.

Fig­ure 3: Stock Price Fol­lows Eco­nomic Earn­ings Not GAAP

Sources: New Con­structs, LLC and com­pany filings

Baker Hughes is one of September’s most dan­ger­ous stocks and gets my “very dan­ger­ous” risk/reward rat­ing. There is lots of down­side risk given the mis­lead­ing earn­ings while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price. More details on my rat­ing and a free report on BHI are here.

In a busi­ness where investors make money by buy­ing stocks with low expec­ta­tions rel­a­tive to their future poten­tial, BHI fits the pro­file of a great stock to short or sell.

I also rec­om­mend sell­ing the fol­low­ing ETFs because of their “dan­ger­ous” rat­ing and expo­sure to BHI.

  1. Energy Select Sec­tor SPDR (NYSEARCA:XLE)
  2. First Trust Energy AlphaDEX Fund (NYSEARCA:FXN)
  3. SPDR S&P Oil & Gas Equip & Ser­vice (NYSEARCA:XES)
  4. Rydex S&P Equal Weight Energy ETF (NYSEARCA:RYE)
  5. Pow­er­Shares Dynamic Oil Ser­vices (NYSEARCA:PXJ)
  6. iShares Dow Jones U.S. Oil Equip­ment & Ser­vices Index Fund (NYSEARCA:IEZ)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Sell Baker Hughes Before The Stock Goes Up In Fumes