By Stephen Ellis
Baker Hughes' (BHI) North American and international results are likely to diverge in 2012. We cut our fair value estimate last month to reflect on our lower forecast for 2012 earnings in North America, thanks to costs associated with crews shifting to shale plays from dry gas plays, which we think will keep a lid on margins even as Baker Hughes resolves logistical issues with materials and proppant. However, our international thesis, led by both short-term and secular factors, continues to play out. Furthermore, Baker Hughes still has many opportunities to optimize its business model, as its high selling, general, and administrative expense ratio versus its peers shows. Baker Hughes is still transitioning from a product-based model to a geomarket-focused one, a process that took industry leader Schlumberger (NYSE:SLB) a decade. Technically, we believe Baker Hughes has essentially completed its organizational shift, as the country managers have been in place for a while. However, we still don't think the structure is optimized, and this is where continual refinements to the model in terms of cost savings will eventually show up. With the firm's very reasonable valuation, we think there is substantial upside as our thesis plays out.
North America Has Peaked for Now
North American margins are unlikely to rebound in 2012. In our eyes, challenges in passing along costs for materials and proppant shortages can be alleviated by the second half, but ongoing dry gas rig switching will continue to cause problems for oil services firms. Thus, margins are likely to remain below late 2011 levels.
Halliburton (NYSE:HAL) outlined several challenges during its fourth quarter. First, merger and acquisition costs had an impact of about 100 basis points for the quarter. Second, Halliburton's exposure to the more seasonal drilling areas such as the Rockies and the Bakken was a negative, as customers chose not to complete wells during the holidays. Third, the firm struggled with passing along vendor price increases to offset its own costs. Fourth, logistical and supply chain challenges, particularly with relocating crews and proppant supply, hurt results. As Halliburton relocates crews from basin to basin, the crew's existing productivity in the dry gas basin is disrupted, as the crew has to learn its new shale reservoir's producing characteristics. The shale plays also require the use of more expensive proppants and other materials, thanks to the step-up in services intensity, which again creates supply chain and other logistical challenges.
Baker Hughes faced similar logistical and supply chain challenges, but the margin impact was greater, with a decline of 360 basis points versus the adjusted 110-basis-point drop for Halliburton. We believe Baker Hughes was less prepared than Halliburton to deal with the crew and proppant difficulties. Baker Hughes indicated that it plans to invest in seven new facilities in 2012, which should help support its pumping fleet and store sand as well as other consumables. Baker Hughes highlighted its difficulties in getting sand to the well location from its storage centers, which is primarily a rail car and trucking fleet problem. In our eyes, Baker Hughes' planned facilities will alleviate the supply chain challenges for the second half of 2012, but continued crew transitions to shale plays from dry gas plays and the resulting productivity hit will weigh on North American margins. We forecast North American margins at 18.8% in 2012 versus 22.3% in the third quarter of 2011.
We do not think 2009, which saw margins collapse to break-even levels, is the appropriate comparison for today's North American services environment. This cycle will be different for several reasons. First, the decline in the natural gas rig count in the fourth quarter is part of an ongoing trend that has been in place since 2008. Second, the credit markets today are not in a state of panic, and leveraged exploration and production firms can still access the markets for capital. Third, international and national oil companies are involved in the U.S. shale plays to a greater extent, either through joint ventures or directly, which provides a large source of well-funded capital. Fourth, capital spending budgets for E&Ps are projected to increase about 9%-10% this year, thanks to healthy oil prices. Fifth, pressure pumping capacity is largely locked up under term contracts for the year. Schlumberger indicated that 80% of its current capacity is under contract for one year or more, 100% of Halliburton's existing capacity and planned additions for 2012 is already spoken for, and about 60%-65% of Baker Hughes' pressure pumping assets is under term contract. Granted, 2012 contracts could merely push the supply/demand imbalance and the resulting margin contraction out to 2013, but the delay gives the services firms time to lower their cost structure and redirect incremental capacity away from North American markets. Lastly, the development of the international shale plays is far enough along that the pressure pumping firms are sending more capacity overseas in 2012 than they did in 2011, which should help preserve the supply/demand balance in North America.
Overall, fourth-quarter results indicated that Baker Hughes is still undergoing growing pains as it seeks to optimize the BJ Services assets. Justice Department antitrust objections prevented Baker Hughes from fully integrating its U.S. operations until early September 2010, four months after the BJ Services deal closed. Furthermore, we believe BJ Services underinvested in its fleet in 2008-09 versus Schlumberger and Halliburton, so Baker Hughes needed to invest additional capital spending to catch up to its larger competitors. Ultimately, though, the combination of the two companies is a strategic win, given the importance of pumping in today's drilling environment, and there's no structural reason Baker Hughes cannot approach Halliburton's industry-leading margins in North America over time.
It's Still Early Days for Overseas Expansion
The international outlook for Baker Hughes continues to be healthy, in line with our thesis. Baker Hughes outperformed internationally during the fourth quarter, as its international margin increased to 16% from 12% in the prior quarter, when we had only expected around a 15% margin. Peers and Baker Hughes have indicated that they can obtain healthy pricing on high-end services, while pricing tends to be more competitive for larger tenders using standard technology.
We expect key growth markets in 2012 will be Brazil, the Gulf of Mexico and other deep-water markets, and Iraq. All three markets are forecast to have higher levels of drilling activity, particularly around the Santos basin for Brazil. For the deep-water markets, we estimate there will be around 35 offshore rigs added to the rig fleet in 2012, all of which will require high-margin oil services work. The deep-water Gulf of Mexico is operating at roughly two-thirds of pre-Macondo levels, but we anticipate it will be at or exceeding pre-Macondo levels by the end of 2012. Halliburton's Gulf of Mexico revenue already exceeds its pre-Macondo levels. Baker Hughes continues to win work in the Gulf based on its differentiated technology, including providing electronic submersible pumps for the world's deepest subsea well. In Iraq, Baker Hughes is finalizing a 60-well, 4-rig award from Eni for work in the Zubair field. The firm said the security situation in the country is fairly stable, considering that U.S. forces are withdrawing, and it plans to add a rig a month. Overall, we think the strength in the international markets is directly playing to our thesis for Baker Hughes.
Are There More Savings to Come?
Baker Hughes' previous product-based organization structure was very inefficient. The firm routinely deployed multiple salespeople (one for each of its major product lines) per country. The end result was that there were multiple points of contact for national oil companies, which preferred Halliburton's and Schlumberger's geomarket-based model, in which there was a single point of contact per company. The geomarket approach also let Schlumberger and Halliburton offer a holistic all-in-one type solution for the oil services work, whereas Baker Hughes' model wasn't nearly as integrated.
Baker Hughes compounded its strategic error by being late to develop its international presence, and thus typically staffed its regional base with a much higher level of expatriates than its peers, leading to a higher cost structure. Schlumberger and Halliburton were able to build stronger relationships with key national oil companies, as the high levels of local employees was looked upon favorable by customers with nationalistic traits. Baker Hughes has made great strides in all of these areas over the past few years, but we believe it has some ways to go to match up to Schlumberger's and Halliburton's cost structures. For example, more than 90% of Halliburton's workforce across the globe is made up of local employees, with the only exceptions being a few countries in Africa and in the Middle East where there is a large amount of labor imported from Indian and Pakistan. However, with the reorganization and the recognition by top management of what needs to be done overseas to be more competitive, Baker Hughes has made progress. The firm took SG&A as a percentage of revenue to 5.6% in the fourth quarter of 2011 versus more than 12% in early 2009. We believe there is another 400 basis points of structural savings that can be achieved over time, as Baker Hughes seeks to match Schlumberger's and Halliburton's SG&A levels in the 1%-1.5% range.
Baker Hughes vs. Halliburton
We believe both Baker Hughes and Halliburton are quality plays for oil services, but Baker Hughes stands out to us for several reasons. Baker Hughes is not exposed to any Macondo-related liabilities, and all things equal, we'd prefer a company without significant exposure to Macondo. Also, we continue to believe there are opportunities to lower Baker Hughes' cost structure, particularly in SG&A, but also mix/price/volume improvements. In contrast, Halliburton is running like a well-oiled machine with best-in-class working capital metrics, and it already has significant exposure to pressure pumping, one of the most profitable portions of oil services. In addition, reorganization and cost-saving efforts have led to a much more competitive Baker Hughes, and we think the firm is well positioned to continue to excel over the next few years. In our view, the problem was never Baker Hughes' products; the organizational structure of the company was simply suboptimal with its product-based rather than geomarket-based approach. Thus, the firm has a long runway ahead of it, provided it can continue to execute on its goals.
Also, despite undergoing a significant reorganization and making a large acquisition over the past few years, Baker Hughes has generally held its own versus its peers. In North America, Baker Hughes has generally kept pace with Schlumberger and Weatherford (NYSE:WFT), as the group lost share to Halliburton. In Latin America and Europe, while Weatherford continues to chase unprofitable growth, Baker Hughes has maintained its share versus Halliburton and taken share compared with Schlumberger. Finally, in the Middle East, Baker Hughes has generally outperformed Schlumberger and Weatherford while matching up nicely against Halliburton, which has long held a position in leadership within the region. We believe that as Baker Hughes continues to optimize its organizational structure, it will continue to outperform Schlumberger and Weatherford (as measured by profitable growth) in most markets and perhaps take share from Halliburton.
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