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Baker Hughes (NYSE:BHI) and National-Oilwell Varco (NYSE:NOV) are currently rated around a "strong buy" on the Street. I find that this consensus is reasonable given improvements in demand, economies of scale, and gross margin expansion. Especially in the case of Baker Hughes, I believe that there exists little downside in opening a long position - staff increases, optimism in Brazil, and ramp up all point in the right direction.

From a multiples perspective, Baker Hughes remains the cheaper of the two, although it receives a more reserved rating by analysts. It trades at a respective 12.5x and 9.1x past and forward earnings, while offering a dividend yield of 1.2%. NOV, meanwhile, trades at a respective 16.7x and 12.5x past and forward earnings, while offering a dividend yield of only 0.7%. At the same time, NOV has gross margins that are roughly 1350 basis points higher than its competitor's at 35.9%

At the third quarter earnings call, Baker Hughes' CEO, Margin Craighead, noted strong performance:

This was a record revenue quarter for Baker Hughes, provides further confirmation that our transformation to a geomarket structure is paying dividends. Overall, we're pleased with the results and the growth of our major businesses. We still have some challenges and efficiencies to work through with the goal of further improving our overall margins next year to better reflect the value that our products and services provide the industry.

I'd like to start out by providing our listeners with an update on pricing.

Large international contract renewals continue to remain highly competitive. But when you put those contracts aside, prices are increasing, albeit slowly. It is our expectation that if commodity prices remain where they are and North America activity stays where it is, international pricing will continue to trend higher.

Despite pricing pressure, the firm is expanding, which will help to spread out costs and improve margins. Brazil is expected to have 8% growth in upstream spending next year, thereby creating the tone for top-line growth. The outlook on Marcellus and Utica is strong and the company is planning a 20% increase in staff for the former while ramping up in the latter. With that said, the firm faces considerable risks from executing on its earlier $5.5 acquisition of BJ Services.

Consensus estimates for Baker Hughes' EPS are that it will grow by 95.5% to $4.34 in 2011 and then by 28.6% and 17.6% more in the following two years. Assuming a multiple of 16x - well below peer levels - and a conservative 2012 EPS estimate of $5.47, the rough intrinsic value of the stock could be upwards of $87.52. Even if the multiple falls to 10x and 2012 EPS turns out to be 5.9% below the consensus at $5.25, there exists no downside by this calculation.

NOV similarly is undervalued. Since it first introduced its dividend two years ago, management has increased the offering twice. This is indicative of the company's strong financial positions. As demand for rig-building improves and exploration increases, the company is in a good position to generate free cash flow. Towards this end, PS&S margins have reached a new high of over 20% and the firm continues to reduces costs while maintaining a pricing advantage through market innovation. NOV is restructuring its offshore fleet and increasing global rig production to keep up with the demand. The company reported around $4B worth of orders in the third quarter, which was not incredibly unexpected, but nevertheless $1B more than last quarter.

Consensus estimates for its EPS are that it will grow by 14.4% to $4.68 in 2011 and then by 26.1% and 14.7% more in the following two years. Assuming a multiple of 17x and a conservative 2012 EPS estimate of $5.80, the rough intrinsic value of the stock is $98.60. This implies 34.3% upside and compares favorably to 10.7% downside. The downside calculation arises from an assumption that the multiple falls to 14x and 2012 EPS turns out to be flat. Accordingly, I remain bullish on both Baker Hughes and NOV, as I do for the overall oil & gas sector (see here and here).

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BHI, NOV over the next 72 hours.

Source: Bring On The Baker Hughes And NOV Bulls