For those who are bullish on an economic recovery, Baker Hughes (BHI) and Schlumberger (SLB) are attractive targets. While both are rated near a "strong buy" on the Street, only Baker Hughes, however, in my view, offers attractive risk/reward. Even though the company struggled more than expected in the fourth quarter relative to its competitor, the fundamentals are showing further improvement.
From a multiples perspective, Baker Hughes is the cheaper of the two. It trades at a respective 11.8x and 8.6x past and forward earnings while Schlumberger trades at a respective 21.3x and 12.5x past and forward earnings. Baker Hughes has nearly 250 bps higher gross margins at 22.4% and is likely to improve margins more than its competitor given adjustments in infrastructure.
With that said, on the recent fourth quarter earnings call, Schlumberger's CEO, Paal Kibsgaard, noted a pleasant surprise in domestic performance:
"Our overall fourth quarter results showed solid sequential growth, driven by stronger activity for most of our service product lines and by stronger product sales for Completions, Artificial Lift, SIS and WesternGeco multi-client seismic.
In North America, we had a strong quarter with 6% sequential revenue growth and margins up 163 basis points. This was led by continued growth in the U.S. Gulf of Mexico, where market share momentum remained strong for our high-value technology offering and where operational performance was extremely solid. During the quarter, we moved a second wide-azimuth seismic fleet into the Gulf of Mexico, and we saw strong multi-client sales. In North America, revenue grew in line with rig count, while margins increased moderately, driven in part by internal efficiencies and active cost management."
The fourth quarter posted a 36% growth in the bottom-line, largely driven by higher crude prices, which compelled greater E&P by oil firms. EPS of $1.11 (excluding the impact of the Libya write-off) was roughly in-line with consensus. Average number of active rigs grew 68% to 37 in the Gulf. Revenue and cost synergies have yet to be fully unlocked following the Smith acquisition. And operations are holding out better than expected. Management, however, issued a conservative outlook on 2012 given macro uncertainty in Europe, especially with respect to the sovereign debt cries. International growth is forecast to slow and cost pressures are rising domestically.
Consensus estimates for Schlumberger's EPS forecast are that it will grow by 26.9% to $3.63 in 2011 and then by 33.6% and 23.1% more in the following two years. Assuming a multiple of 17.5x and a conservative 2012 EPS of $4.76, the rough intrinsic value of the stock is $83.30, implying 11.7% upside. Modeling a CAGR of 27.8% for EPS over the next three years and then discounting backwards by a WACC of 9% puts the company at roughly fair value.
Baker Hughes, on the other hand, merits its "strong buy" rating. The firm struggled in the fourth quarter in terms of margins due to challenges in keeping up with fracking demand. While Baker Hughes lacked the necessary materials to immediately service energy companies, infrastructure investments should avert the issue going forward more than what the market acknowledges. Spending on domestic franking is expected to rise by 19% in 2012. During the fourth quarter, earnings declined by 6.3% y-o-y. Ultimately, recent weakness sets the stage for an upcoming positive market reaction as fundamentals prove strong.
Consensus estimates for Baker Hughes' EPS forecast are that it will grow by 93.7% to $4.30 in 2011 and then by 27.7% and 18% more in the following two years. Assuming a multiple of 12x and a conservative 2012 EPS of $5.42, the rough intrinsic value of the stock is $65.04, implying 37.1% upside. Even if the multiple were to plummet to 9.5x and 2012 EPS turns out to be 8.9% below consensus, the stock would be fairly valued. Baker Hughes thus has plenty of upside and very little downside.