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Baker Hughes (NYSE:BHI) reported a negative operating profit for the fourth quarter of 2015, with particular weakness in North America. In international markets, the company's operating margins remained positive but showed a sharp sequential contraction.
Although weak financial results were not unexpected, given the commodity price environment, Baker Hughes continues to be unable to close the gap in operating margins to the industry's leaders, Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL).
As such, the stock is vulnerable to the risk of the merger with Halliburton failing to receive necessary regulatory approvals. In the event the deal is terminated, BHI's stock price will likely revert to trading at a discount to its larger peers. Moreover, the intrinsic discount may have expanded since the time of the proposed merger announcement. Such reversion implies a significant drop in the stock price, as illustrated by the deal spread graph shown further in this note.
The $3.5 billion breakup fee equates to ~$8 per share gain for Baker Hughes. However, it would be insufficient to offset the loss of the premium currently reflected in Baker Hughes' stock price - which would be lost if the merger agreement is terminated.
Margins Continue To Lag
The following slide from Schlumberger's presentation highlights the chronic margin underperformance by Baker Hughes relative to its two larger competitors, with sustained lag in international areas and widening lag in North America.
(Source: Schlumberger, December 2015)
In the fourth quarter, Baker Hughes' lag relative to the competitors in international markets widened sharply, highlighting that the company lacks critical mass in many geomarkets and is more vulnerable during the downturn.
The outlook for the current quarter is particularly grim as both activity levels and pricing are likely to be under pressure from the most recent collapse in oil prices.
Baker Hughes' Q4 2015 Margins Fall Into Negative Territory
The following table breaks down Baker Hughes' adjusted operating profit by area (please note that adjusted operating profit is a non-GAAP metric).
For the fourth quarter of 2015, adjusted operating profit fell to negative $40 million, down from positive $90 million in the preceding quarter. The decline was driven by a strong contraction in operating margins in international areas, whereas the operating loss in North America narrowed slightly as a result of business downsizing.
(Source: Baker Hughes, January 2016)
- North America. Revenue declined 17% compared to the prior quarter, driven not only by activity and price, but also by onshore pressure pumping share losses as the company attempted to avoid bidding for jobs at uneconomic price levels. While margins in this geographic segment remained flat as a result of cost-cutting measures, they are still insufficient to cover depreciation. I should note that among the three largest integrated oil service companies, Baker Hughes has the greatest exposure to the North American pressure pumping segment, which is the legacy of the BJ Services acquisition by Baker Hughes in 2010. The pressure pumping segment has been one of the hardest hit in the current downcycle and is characterized by severe excess capacity. While Baker Hughes has been investing into equipment renewals, the company's pressure pumping fleet remains generally older than some of its competitors' fleets, exacerbating the impact of the downturn. Baker Hughes commented that all of its product lines have been strongly impacted by the activity drop. However, its industry-leading artificial lift business and production chemicals business remained the most resilient. North America adjusted operating profit margin was (11.2%), unchanged from the prior quarter. The result for the quarter included costs of $34 million for liquidated damages and other costs related to sand supply contracts.
- Middle East/Asia Pacific. Fourth quarter revenue declined 3% sequentially, driven by lower activity in Southeast Asia and pricing pressures. Adjusted operating profit margin was 3.8%, compared to 9% for the prior quarter. The quarter included, among other things, additional charges in Iraq related to rationalizing operations in the country.
- Europe/Africa/Russia Caspian. Revenue in Europe/Africa/Russia Caspian decreased 9% sequentially, primarily due to reduced activity, including weather delays in the North Sea, and to pricing deterioration across most of the region. Adjusted operating profit margins were 6.6%, compared to 12.4% for the prior quarter.
- Latin America. Fourth quarter revenue for Latin America declined 3%, compared to the prior quarter. The sequential decrease in revenue was driven mainly by reduced activity in the Andean geomarket and Mexico as a result of customer budgetary constraints, partially offset by share gains in Argentina. Adjusted operating profit margin for Latin America in the fourth quarter was 3.5%, compared to 11.6% for the prior quarter. Foreign exchange losses, primarily in Argentina, and costs related to additional reserves for doubtful accounts negatively impacted margins sequentially by 600 bps, or approximately $25 million.
- Industrial Services. Revenue for Industrial Services decreased 16% sequentially, due primarily to the larger-than-usual seasonal activity decrease and project delays in the process and pipeline services business, and to reduced downstream chemical sales associated with lower refinery utilization and warmer weather.
- Merger-Related Costs. Adjusted net loss for the fourth quarter excludes, among other items, $91 million before-tax or $67 million after-tax ($0.15 per diluted share) costs for merger and other related costs.
Adjusted EBITDA for the fourth quarter of 2015 was $376 million, a decrease of $146 million or 28% sequentially and a decrease of $1.1 billion or 74% compared to the fourth quarter of 2014.
For the quarter, capital expenditures were $214 million. Capex was substantially below depreciation and amortization expense, which was $416 million for the fourth quarter.
Free cash flow for the quarter was $436 million. Excluding restructuring payments of $108 million, free cash flow would have been $544 million for the quarter. The strong cash flow reflected in significant part working capital "harvesting" related to the contraction in operating activity.
These run-rate financial metrics compare to the company's equity market capitalization and an enterprise value of ~$20 billion and ~$22 billion, respectively. It is also important to note that Baker Hughes has significant working capital that may continue to be a source of cash flow as customer activity contracts.
While Baker Hughes' business generated strong cash flow at the peak of the cycle, with a $4.4 billion in annualized EBITDA, it would clearly be a mistake to equate the result at the peak to the "through-the-cycle" average cash flow generation.
In this context, the current trading multiple of Enterprise Value/Peak EBITDA of ~5x is quite high, in my opinion, and reflects support of the pending merger with Halliburton.
It is also important to note that if an upcycle arrives, Baker Hughes will face significant cash flow requirements associated with the funding of its depleted working capital. Margins, on the other hand, may remain weak until capacity utilizations throughout the industry increase substantially from the current levels.
As a result, the recovery in free cash flow may take a substantial amount of time.
The Outcome Of The Merger Regulatory Review Remains Uncertain
In its latest merger-related filing, Baker Hughes disclosed an extension of the regulatory review deadline by the European Commission:
On Feb. 2, Halliburton and the European Commission reached an agreement under which the Commission will extend its Phase II review of the pending acquisition by 20 working days. Halliburton believes the extension will facilitate the Commission's review of a remedies package, which will be formally offered in the near future to address the Commission's concerns.
The disclosure appears to indicate that Halliburton will likely announce an additional asset divestiture package to address concerns by the U.S. and European regulators.
The disclosure is a positive development from the merger perspective. The deal spread contracted significantly in response to the disclosure, coming in below $10 per BHI share as of February 5, 2016.
(Source: Zeits Energy Analytics)
That being said, the cost to Halliburton of getting the deal approved is continuing to escalate, whereas the outcome of the regulatory review still remains uncertain.
Moreover, the downturn in oil inevitably puts the valuation and premium being paid by Halliburton in the transaction to a test. While Baker Hughes has several very strong product lines, such as the artificial lift, which would be strong additions to Halliburton's portfolio, Baker Hughes' overall profitability clearly lags Halliburton's, as indicated by the fourth quarter 2015 results. Turning Baker Hughes' financial performance around may prove to be a challenging task.
In the event the oil price trough persists, Halliburton's view on the value and strategic merits of the transaction may evolve, adding to the risk of the deal being terminated.
I would argue, therefore, that the assessment of the risks to the transaction needs to include near-term scenarios for commodity prices.
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