By The Valuentum Team
In May, Baker Hughes' (NYSE:BHI) merger with Halliburton (NYSE:HAL) was terminated by Halliburton. The firm called the deal off following increased resistance from regulators in the U.S. and Europe, and it now owes Baker Hughes a $3.5 billion breakup fee. This payment will primarily be used to help the company increase its financial flexibility as it intends to use it to repay ~$1 billion in debt and repurchase ~$1.5 billion in stock, as well as refinance its ~$2.5 billion credit facility that expires in September 2016. Though we like what the termination fees will do for Baker Hughes' financial health, a takeout may have been the best case scenario for shareholders, especially when considering management's lofty synergy target of an estimated $2 billion of annual cost savings.
Like many energy equipment companies, demand for Baker Hughes' products and services is highly cyclical and dependent on capital spending levels in the oil and gas industries, and its top line has been materially pressured as a result of the recent energy market weakness (revenue dropped 36% in 2015). We're not particularly fond of the firm's net debt position of ~$1.9 billion as of the end of the first quarter of 2016, but its credit rating remains in investment grade territory despite a recent downgrade from Moody's. Continued pressure on the spending patterns of its customers as a result of suppressed energy resource pricing will likely continue to threaten the company's financial health, but management expects the North American energy markets in which it operates to continue improving slightly. Stability in the U.S. rig count in the second half of 2016 should help results, as ~40% of its total revenue is generated in the U.S.
Despite management's expectations for an improved operating environment in the back half of 2016, ongoing cost reduction and cuts to capital spending will be necessary for Baker Hughes to remain free cash flow positive. Free cash flow generation has averaged just over $1 billion over the past three years (2013-2015), but meaningful reductions in investments in the business have the potential to weaken future growth opportunities (2015 capital spending was less than half of 2013 levels). A material and sustained rebound in energy resource pricing cannot come soon enough for Baker Hughes.
Baker Hughes' Investment Considerations
- Baker Hughes provides oilfield services and products. The firm also offers industrial products/services to the refining, process and pipeline industries. The company operates in 80 countries. It was founded in 1972 and is headquartered in Houston, Texas.
- Baker Hughes and Halliburton have abandoned their merger plans following opposition from U.S. and European regulators. Baker Hughes will receive a $3.5 billion breakup fee as a result, which the firm will use to buy back stock and repay debt.
- Baker Hughes is looking forward to solid growth in the U.S., Middle East, Asia Pacific, Africa, and Russia Caspian. The firm continues to take actions to improve Latin American profitability and make continued improvements in domestic pressure pumping. It plans to achieve $500 million in annualized savings from operational efficiencies by the end of 2016.
- The firm's business is driven by alternating periods of ample supply or shortage of oil and gas relative to demand. Worldwide economic growth is a long-term tailwind to continued hydrocarbon demand, however, providing ongoing support to Baker Hughes' operations.
- The company's revenue is dominated by North America, which accounts for ~40% of total revenue. Middle East/Asia Pacific and Europe/Africa/Russia account for ~20% of revenue, respectively. Technology and innovation are focus areas.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Baker Hughes' 3-year historical return on invested capital (without goodwill) is 9.8%, which is below the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of POOR.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Baker Hughes' free cash flow margin has averaged about 4.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Baker Hughes, cash flow from operations decreased about 43% from levels registered two years ago, while capital expenditures fell about 54% over the same time period.
We think Baker Hughes is worth $49 per share with a fair value range of $36-$62.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of -2.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -9.7%.
Our model reflects a 5-year projected average operating margin of 5.8%, which is below Baker Hughes' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 6% for the next 15 years and 3% in perpetuity. For Baker Hughes, we use a 9.9% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $49 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Baker Hughes. We think the firm is attractive below $36 per share (the green line), but quite expensive above $62 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Baker Hughes' fair value at this point in time to be about $49 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Baker Hughes' expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $64 per share in Year 3 represents our existing fair value per share of $49 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.