Seeking Alpha
Research analyst, valuentum
Profile| Send Message|
( followers)  

With Baker Hughes (NYSE:BHI) popping significantly since mid-July, we thought it important to share our perspective on the firm's valuation and whether we think it is a Value-Momentum stock.

Our Report on Baker Hughes

click to enlarge images

Investment Considerations

Investment Highlights

Baker Hughes' scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 11.7% during the past three years.

The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $35, we'd take a closer look at adding it to the market-beating portfolio of our Best Ideas Newsletter. At that time and on improving technicals, we'd consider it to be a Value-momentum stock.

Baker Hughes' cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about -2.5% during the past three years, much lower than the mid-single-digit
range we'd expect for cash cows. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 20.5%.

Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.

The firm experienced an operating cash flow CAGR of about -2.3% during the past 3 years. We expect its operating cash flow growth to be better than its peer median during the next five years.

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). 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 11.7%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of GOOD. 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 -2.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. 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 increased about 22% from levels registered two years ago, while capital expenditures expanded about 127% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Baker Hughes' shares are worth between $35.00 - $55.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $45 per share represents a price-to-earnings (P/E) ratio of about 11.3 times last year's earnings and an implied EV/EBITDA multiple of about 5.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 18.7%. Our model reflects a 5-year projected average operating margin of 12.4%, which is above Baker Hughes' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 5.8% for the next 15 years and 3% in perpetuity. For Baker Hughes, we use a 9.7% 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 $45 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 was 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 below, we show this probable range of fair values for Baker Hughes. We think the firm is attractive below $35 per share (the green line), but quite expensive above $55 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 $45 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below 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 $59 per share in Year 3 represents our existing fair value per share of $45 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.

Pro Forma Financial Statements

Disclosure: Rebecca Freese constructed the article. The opinions and analysis of the firms mentioned in this article reflect that of The Valuentum Team. We did not receive compensation from companies mentioned in this article, and we have no business relationship with any company whose stock is mentioned in this article.

Source: Is Baker Hughes A Value-Momentum Stock?