Seeking Alpha

Baker Hughes: GE Acquisition Will Continue To Have Negative Effects Long Term

|
About: Baker Hughes, a GE company (BHGE), Includes: GE, HAL, NOV, SLB
by: Richard Durant
Summary

BHGE is overvalued relative to its peers due to its lower-volatility midstream and downstream offerings affording downside protection.

As oil & gas capital expenditure accelerates in coming years, BHGE will likely significantly underperform its peers due to its lower exposure to the upstream segment.

GE’s acquisition of Baker Hughes lacked business logic, and the poor handling of the integration will likely contribute to BHGE’s underperformance in coming years.

Baker Hughes, A GE Company (BHGE) is approximately fairly valued on an absolute basis, but relative to other major oilfield services and equipment companies is overvalued. BHGE’s presence across the oil and gas industry value chain greatly reduces the volatility of profit margins, which has protected the company somewhat during the downturn, but will cause it to underperform when capital expenditure expands. Additionally, there was no compelling business logic behind General Electric’s (GE) acquisition of Baker Hughes, and management and cultural issues are likely to contribute to the stock underperforming in the long run.

GE Acquisition

GE acquired Baker Hughes in 2017 on the basis that their combined product and service portfolio would create value by spanning the entire oil and gas value chain. At the time, GE argued that this would enable it to offer integrated services, which could be leveraged through GE’s digital capabilities and advanced manufacturing. In my opinion the upstream, midstream and downstream segments of the oil and gas industry are unrelated, and therefore, there is little strategic benefit to creating a “fullstream” portfolio.

Figure 1: Oil & Gas Value Chain and BHGE Offerings

(Source: Created by author)

Additionally, GE’s belief that it would add value to Baker Hughes through innovation, technology leadership and operations optimization is unfounded and is a result of GE overestimating its competence and lacking an understanding of the differences between the underlying businesses.

Figure 2: GE Rationale for Baker Hughes Acquisition

(Source: Created by author using data from GE)

While there is an increased push from operating companies for integrated service offerings to reduce costs and the complexity of their operations, there are likely only a handful of projects managed by national oil companies or integrated oil companies where there is any interest in integrating services across upstream, midstream and downstream.

Figure 3: Service Offering Comparison for Major Oilfield Service and Equipment Companies

(Source: McKinsey)

As Halliburton (HAL) and GE’s acquisition attempts occurred in similar time frames, it is informative to compare the structure, valuation and logic of each offer. GE and Halliburton’s offers had a remarkably similar structure and valuation, notably both offers were predominantly in the form of equity, thereby sharing the risk and potential reward of the deal.

Figure 4: GE and Halliburton Acquisition Offers for Baker Hughes

(Source: Created by author using data from GE and Halliburton)

Although I believe Halliburton’s attempt to acquire Baker Hughes was more compelling than GE’s from a strategic perspective, I do not think it made much sense either. While Halliburton would have benefited from Baker Hughes’s strong offerings in drill bits, production chemicals and artificial lift, the acquisition price was too high for just these assets. Across most other products and services, Halliburton has superior offerings to Baker Hughes, and it therefore appears Halliburton’s main objective was to increase its size and pricing power and reduce costs through the elimination of duplicated assets. It is no surprise then that Halliburton faced significant pushback from regulators and eventually decided the deal would be too difficult to complete.

this is a truly complementary combination with little overlap in terms of businesses and capabilities

Source: GE

GE estimated cost synergies from the acquisition of a similar magnitude to Halliburton, which is difficult to understand given that there was little overlap between GE and Baker Hughes and almost complete overlap between Halliburton and Baker Hughes. Given GE’s optimism, it is therefore no surprise that the company has been disappointed by the acquisition and began evaluating exit options soon after the process of integration began.

Figure 5: GE and Halliburton Estimated Acquisition Synergies

(Source: Created by author using data from GE and Halliburton)

Despite much of GE’s rhetoric around the acquisition being focused on the advantage of creating a “fullstream” portfolio and leveraging the company’s digital and advanced manufacturing capabilities, it forecasted minimal revenue synergies. While this may have been GE’s management being conservative in their estimates of benefits, I believe it reflects the fact there was little to be gained by combining GE Oil & Gas and Baker Hughes’s offerings. It appears the main motivator behind the acquisition was to increase the size of GE Oil & Gas, and the GE management team erroneously believed they could significantly cut costs by applying their expertise.

Figure 6: GE Estimated Acquisition Synergies

(Source: Created by author using data from GE)

In addition to the reasoning behind the acquisition being flawed, it appears the integration of the companies has been poorly executed, which will likely contribute to the erosion of value for shareholders in the long run. Despite Baker Hughes being the more economically important entity, the BHGE executive team and board are dominated by GE personnel who do not have the necessary expertise or experience to guide the combined company.

This issue was destined to cause problems, and reports from early in the integration phase indicated a significant clash of cultures and GE’s management practices alienating Baker Hughes employees, suppliers and customers. Issues highlighted have included:

  • Demanding cost reductions from suppliers and more favorable payment terms
  • Abruptly increasing service prices and changing contracts
  • Reduced focus on client relationships
  • Exodus of Baker Hughes executives

If the acquisition was going to be successful, the Baker Hughes management team and board should have had majority representation in the combined company.

Figure 7: GE Oil & Gas and Baker Hughes Integration Issues

(Source: Created by author using data from GE and Baker Hughes)

BHGE’s CEO, Lorenzo Simonelli, has a background in finance and management within GE, only relatively recently gaining exposure to the oil and gas industry. It is not clear he has the necessary skillset to guide the company given revenue is driven by upstream services and equipment. I believe Simonelli will add little value from a strategic perspective, and will likely focus on areas like capital allocation, cost cutting, payment terms and inventory turnover.

This transaction is also exciting for employees of both companies. GE Oil & Gas and Baker Hughes are an exceptional cultural fit, sharing a commitment to exceeding customer expectations.

- Lorenzo Simonelli

Although GE’s cultural assessment indicated GE Oil & Gas and Baker Hughes would be a compatible fit, there have been reports of significant issues. GE’s assessment ignored the history and fundamentally different nature of the two companies, and with that context, it is easy to see why BHGE is having integration problems.

Figure 8: GE and Baker Hughes Integration Issues

(Source: Created by author using data from GE and Baker Hughes)

The primary beneficiaries of the acquisition appear to be the management teams of GE Oil & Gas and Baker Hughes. Former Baker Hughes CEO Martin Craighead was expected to receive a $41 million golden parachute, which was 40% higher than the $29 million expected payout if Halliburton had successfully acquired Baker Hughes.

Baker Hughes and GE Oil & Gas both have a history of making large acquisitions, and as a result, the combined entity has a large amount of goodwill on the balance sheet, which could be problematic long term. Schlumberger (SLB) and BHGE both have a relatively large amount of goodwill and low asset turnover, indicating they may have overpaid for past acquisitions. BHGE investors, in particular, should be prepared for the possibility of significant impairment of goodwill in coming years.

Table 1: Goodwill Comparison for Major Oilfield Service Companies

BHGE

SLB

HAL

Goodwill as % Assets

39.5

35.4

10.9

(Source: Created by author using data from Schlumberger, Halliburton and Baker Hughes)

BHGE

BHGE’s “fullstream” offering targets a diverse range of clients across upstream, midstream, downstream and industrial segments.

Table 2: BHGE Target Markets

Upstream

Midstream

Downstream

Industrial

  • Drilling
  • Evaluation
  • Completions and Production
  • Subsea
  • Liquefied Natural Gas (LNG)
  • Pipeline
  • Storage
  • Refining
  • Petrochemical and Fertilizer Processing
  • Power and Renewables
  • Controls and Sensing

(Source: Created by author using data from BHGE)

BHGE supports these client segments through its four divisions:

  • Oilfield services
  • Oilfield equipment
  • Turbomachinery and process solutions
  • Digital solutions

Table 3: BHGE Segments

Oilfield Services

Oilfield Equipment

Turbomachinery & Process Solutions

Digital Solutions

Global presence in well construction and production

Broad portfolio of subsea technology offerings and solutions

LNG and upstream production

Sensing and measurement technology and software

(Source: Created by author using data from BHGE)

Some of BHGE’s offerings are attractively positioned to benefit from longer-term trends, such as production chemicals and artificial lift, which should perform strongly in coming years as operating companies invest in maintaining production from mature fields. BHGE’s exposure to LNG is another positive part of the portfolio which is likely to perform strongly relative to other segments in the downstream market in coming years.

I believe BHGE is overestimating the potential of its digital solutions, as oil and gas companies are aware digital and data capabilities are a core competency, which is increasingly driving value creation, making them reluctant to outsource these activities. Equipment may be sourced from best-in-class vendors like BHGE, but oil companies will look to develop digital and data service competencies in-house.

One of Simonelli’s key goals of the acquisition was to reduce short-term volatility from equipment and service contracts using long-term contracts for the LNG and offshore industries. This can be clearly seen in the large difference in volatility of profit margins between the oilfield services and equipment divisions and the digital solutions and turbomachinery and process solutions divisions. Corporate diversification as a means of reducing risk is a long-discredited practice which is known to not create shareholder value.

Table 4: BHGE Segment Revenue and Volatility of Profit Margins

Segment

Revenue

Profit Margin Volatility

Oilfield Services

50.9%

14.1%

Oilfield Equipment

11.4%

11.9%

Digital Solutions

11.4%

1.4%

Turbomachinery and Process Solutions

26.3%

4.9%

(Source: Created by author using data from BHGE)

Baker Hughes has been an inferior company compared to its oilfield services and equipment peers for a long period of time, and I only expect the acquisition by GE to exacerbate this problem.

Table 5: Oilfield Service Financial Performance Comparison 2009-2016

BHI

HAL

SLB

NOV

Profit Margin

5.7

9.3

13.0

11.6

Asset Turnover

0.80

1.01

0.67

0.59

Return on Assets

3.9

9.3

8.4

7.2

Revenue Growth

6.2

7.5

7.9

-4.9

(Source: Created by author using data from company reports)

Relative Valuation

BHGE is currently one of the most highly valued oilfield services and equipment companies despite, in my opinion, facing a worse outlook.

Table 6: Multiples Comparison of Major Oilfield Service and Equipment Companies

P/E

P/B

EV/S

BHGE

70.7

0.70

1.46

SLB

24.3

1.75

1.79

HAL

13.2

1.32

1.14

NOV

-

1.05

1.25

TechnipFMC (FTI)

-

1.09

0.90

(Source: Created by author using data from Yahoo Finance)

Over the last 18 months, BHGE share price has outperformed its peers as a result of the downside protection afforded by its less-volatile digital solutions and turbomachinery and process solutions segments. In the event of a recovery in oilfield activity this will harm BHGE though, and investors should expect the company to significantly underperform its peers if and when prices recover.

Figure 9: Relative Stock Market Performance of BHGE / BHI

(Source: Created by author using data from Yahoo Finance)

I do not believe BHGE is overvalued at the moment given sentiment toward anything oil and gas-related is extremely negative, but if investors are bullish on the sector, I believe there are many better stocks than BHGE. Long term I expect BHGE to underperform its peers as a result of an inferior product and service portfolio, a management team lacking the necessary skillset to guide the company, turmoil from the acquisition and subsequent divestiture talks by GE.

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.