Baker Hughes: Should You Reinvest The Special Dividend?
Summary
- In this article, I decided to look at the special dividend payed out by Baker Hughes, a GE Company.
- In particular, I ask the question of whether investors should reinvest it into the business or take the cash and find something else.
- Given my own investment approach, I would prefer to look elsewhere, but different types of investors could find reinvesting the distribution attractive.
Well, folks, the merger between Baker Hughes and the oil and gas segment of General Electric (GE) has, at long last, been completed. In the past, I wrote an article about the merger, when it was first announced, but since a great deal of time has passed and since the companies have provided some guidance as to what they believe the combined enterprise might look like, I figured it would be interesting for me to dig into the numbers and give my thoughts on what it all should mean for investors in the entity, which is called Baker Hughes, a GE Company (BHGE).
A look at the merger
Last year, shares of Baker Hughes took an initial tumble after news broke that the company would be combined with the oil and gas segment of General Electric. The transaction in question called for existing shareholders of Baker Hughes to own 37.5% of the combined entity, plus they would be entitled to a dividend with an aggregate value of $7 billion, payable in the form of a $17.50 per share distribution. General Electric would end up with the remaining 62.5% and, it seems, sold off its Water and Process Technologies business for $3.4 billion in cash to help facilitate the deal.
By combining both companies, the argument was that shareholders would see, by 2020, annual operating cost-savings worth $1.6 billion, which is certainly nothing to sneeze at. Not only consolidating dual positions but also through combining their size to generate economies of scale through other methods, it's a great way to create value. According to the latest press release on the matter, any shareholder who has not sold their units as of the close of business on July 3rd will have received the distribution of $17.50 per share on July 6th.
All combined, BHGE is quite a large company. In all, the firm has around 70,000 employees and operates across around 120 different nations. This set of operations, which will operate with four areas of expertise (Oilfield Services, Oilfield Equipment, Turbomachinery & Process Solutions, and Digital Solutions), will have a great deal of revenue. During 2016, the combined entity would have had sales of $22.74 billion, but it should be mentioned that both General Electric's oil and gas segment and Baker Hughes were very much negatively impacted by the energy downturn. To illustrate this, we need only consider that revenue in 2015 would have been $32.19 billion, while 2014's sales were a whopping $43.64 billion.
Should investors use their distributions to buy more?
If I were a shareholder of Baker Hughes, I would be wondering what I should do with my incoming check. With a share price at the close of business on July 3rd of $57.68, 30.3% of the company's stated market value represents cash that Baker Hughes' investors will receive. If you strip this out of the company's market cap of $24.54 billion, we arrive at a value placed on the business of Baker Hughes of $17.14 billion. That said, since the company's shareholders will own only 37.5% of BHGE, this means the market was valuing BHGE as a whole at $45.71 billion. It should be noted, however, that a decrease in market value has led to the post-distribution value of each share standing, as of the close of business on July 7th, was $37.91, which comes out to a market cap of $16.13 billion. This gives the entity as a whole a market cap of $43.01 billion.
In my article on the merger, I finalized my thoughts by saying whether you like the merger or not (from the perspective of being a Baker Hughes investor) will depend on your views regarding the energy market. If you are of the opinion that energy is headed higher, you would dislike the deal because you're not getting such a great return. On the other hand, if you are an energy pessimist, you should appreciate the deal to some degree. As for me, while I was and still am an energy bull, I didn't get too excited about the transaction.
Of course, my own work on the matter was based on a few different assumptions regarding what the combined business might look like on a historical basis. Since publication, management has actually provided projected EBITDA and free cash flow numbers for BHGE. In the image below, you can see what each of these metrics, as well as operating cash flow and operating income, should look like for this year, 2018, 2019, and 2020. Some of this improvement is certainly driven by estimated synergies forecasted by management, but a sizable amount can also probably be chalked up to the company improving since the energy market is showing signs of life once more.
*Taken from Baker Hughes
To illustrate the value proposition that comes with investing your distribution back into BHGE's shares and/or the value proposition that comes with investing cash in the company in general, I created the table below. In it, you can see, given the company's market cap and assuming that the EBITDA and cash flow metrics provided turn out to be accurate, how expensive shares currently are.
*Created by Author
Compared to 2017's projected EBITDA, shares of the company are going for a multiple of 10.8. Truth be told, I am not now, nor have I ever been, a fan of EBITDA, but what's undeniable is that, as the company's profitability improves, this number should improve alongside it. Its forward price/EBITDA ratio for 2020 stands at just 5.3, which is quite attractive. The big question, though, is what does this mean for the business?
If we assume that the market is at least somewhat rational and that the company's current trading multiple is a true fair value for the business, then this would imply upside of 22.5% per annum in the three-and-a-half years between now and the end of 2020. That said, even if you assume that part of BHGE's value today is based on the market realizing this quick improvement, knowing that this number will moderate, and if you apply a 50% discount to the upside because of it (basically demanding a lower multiple in the future than today when that future does arrive), then that's still upside of 12.7% per annum.
If, instead, you use free cash flow instead of EBITDA as the multiple, which I highly recommend, the multiple looks a lot higher at 20.5 times. That said, this also improves quite a bit over the next few years, falling to just 10.5 times free cash flow by the end of 2020. This represents upside of 21.1% per annum, while slicing the value to the upside in half since a company can't grow cash flow quickly forever, would result in upside potential of 11.8% per annum. Even this kind of growth is nice to see.
Takeaway
Based on the data provided, it seems to me as though BHGE is trading at quite a high multiple, which is a natural turnoff for value investors like myself. Some of this may be due to expected synergies, while the rest is probably attributable to the bullish energy recovery thesis. Irrespective of the cause, though, the market is applying a premium on the business today for what that cash flow may or may not look like in the future.
Investors buying in under these terms are also relying on the assumption that the market will continue to value BHGE at a high multiple going forward, but, as I demonstrated, even slower growth could justify attractive upside (conversely, a lower multiple but with high growth like what has been projected could give similar upside). In summary, my own take is that the kind of investor buying into BHGE should probably be those who are growth-oriented, especially those who have the view that the global energy market is on the mend. For value investors, even those bullish on energy, and/or for growth investors who are pessimistic regarding energy markets, you may want to look for other ways to invest your distribution or look other ways to invest cash you were considering for BHGE.
This article was written by
Daniel is an avid and active professional investor.
He runs Crude Value Insights, a value-oriented newsletter aimed at analyzing the cash flows and assessing the value of companies in the oil and gas space. His primary focus is on finding businesses that are trading at a significant discount to their intrinsic value by employing a combination of Benjamin Graham's investment philosophy and a contrarian approach to the market and the securities therein. Learn more.Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (9)
"With respect to the amount of the Special Dividend that is treated as a dividend for U.S. federal income tax purposes and paid to a former Baker Hughes stockholder who is a U.S. person, (i) if the U.S. person is not a corporation, such amount generally will be eligible for a reduced rate of taxation and (ii) if the U.S. person is a corporation, such amount generally will be eligible for the dividends-received deduction, in each case, if certain holding periods and other requirements are satisfied. Each such person should consult its tax advisors regarding the potential applicability of the statutory provisions regarding “extraordinary dividends” in light of its particular circumstances. "
