Baker Hughes, A GE Company Stock Price as of Publication: $27 per share. 

It’s challenging to spot undervalued equities in this environment, however, it’s our job at Market OutPerformers to give our clients the recommendations that they won’t find elsewhere. At the beginning of the year, we recommended our readers to buy Fogo De Chao, a Brazilian steakhouse chain that operates mainly in the US. The stock was trading at $13 per share, our price target was around $17 per share. Last week, the company was acquired by Rhone Capital for $15.75 per share. Those who followed our recommendation made nearly 20% in only 40 days.

Okay, enough talking about our achievements. Let’s move to our next pick; Baker Hughes, a Ge company.

Baker Hughes is an oil and goods service provider for Energy and Production companies. The sector in NA is dominated by only three players; Schlumberger, Halliburton, and Baker Hughes. Schlumberger is the biggest among the group, and Baker Hughes is the smallest, but after its merger with GE Oil & Gas, it became at par with Halliburton in terms of revenues.

We believe that Baker Hughes offers tremendous upside at current levels as the company is trading at a lower multiple than its peers and is being unfairly priced by the market.

Multiples’ Discount to Peers And Top Line Improvement 

From a “price to tangible book value” front, Baker Hughes is trading at 2x tangible book value while Halliburton is trading at 7.5x.

On the EV to EBITDA front, Baker Hughes is trading at 14 times, which is lower than Halliburton’s multiple of 17 and Schlumberger’s multiple of 32. Baker Hughes had a 10.3% EBITDA margin (not including merger costs and impairments) which is obviously lower than Schlumberger’s 20% and also lower than Halliburton’s 14.3% figure.

However, it should be noted that Baker Hughes’ EBITDA margin should increase to between 16% and 17% once the promised 2018 synergies are taken into account (management reaffirmed its target on those synergies in the latest earnings call). If those synergies took place, Baker Hughes would have a higher EBITDA margin in 2018 than Halliburton while having an 18% lower EV to EBITDA multiple.

Note: Baker Hughes’ management is expecting $700 million in synergies this year and $400 million in synergies thereafter. So, the expected EBITDA margins in 2018 are not including any synergies from the other $400 million.

Bears may argue that BHGE deserves lower multiples due to its humble revenue growth compared to its peers. While BHGE lagged its competitors in 2017 on the top line growth level, we do not expect this situation to continue going forward. BHGE did not issue any guidance in its latest earnings call, however, we believe that things should get better for the company. For instance, while GE expected 2018 to be a flat year for Baker Hughes, the expectations, which were released in mid-2017, were under the assumption that oil prices would increase gradually to $60 per barrel by 2019. However, we are now in early 2018 and the oil price per barrel is already well above the $60 level. Such this level persists, some of the 20% of the revenue GE expected for 2019 should happen this fiscal year.

Another reason why we believe BHGE should have increasing revenues is its 2% rise in orders in 2017. While 2% sounds low, the fact that this number translates to a 78 million increase in orders is encouraging if we assume that the clients’ spending per order goes higher. Taking the better oil pricing environment into account, this is the likely case.

Moreover, Baker Hughes should benefit as its cousins, HAL and SLB, from a rising inventory of drilled but uncompleted wells. Over the last 2 years, companies adopted the habit of drilling wells without completing them, waiting for oil prices to go higher to take these wells online in a short period of time. With DUCs now at all-time high, accompanied by an increase in oil prices, many of those wells should go online which should translate to higher revenues for the three companies mentioned. The benefits of completing already drilled wells are enormous; for instance, Halliburton’s services sector got a 25% increase in revenues from completing already drilled wells. Baker Hughes didn’t have this benefit due to two reasons; its concentration on the Permian basin (Halliburton is more nationwide), and the company’s merger with GE which distracted management. We believe that Baker Hughes while being part of a much bigger and more profitable company, should benefit from GE’s huge expertise in the sector, which should make the company expand into other basins more aggressively.

Brighter Future In the Services Segment

Another reason why we believe Baker Hughes’ best days are ahead is the company’s strong gross margins in the services sector. BHGE gets 42% of its sales from the services segment, that’s low compared to Halliburton’s 75% figure. If Baker Hughes get to focus more on growing its services market, the company can undercut Halliburton’s lead in this segment as BHGE reported a 22.5% gross margin there while Halliburton had only a 10.5% gross margin. This, accompanied by the company’s access to GE’s technology through the GE Store, should increase BHGE’s ability to undercut Halliburton on pricing and take some market share in the services segment.

In This Environment, Baker Hughes Is a Safer Bet Than Halliburton

We are mainly comparing Baker Hughes to Halliburton and not Schlumberger as the two companies are close in terms of profitability and revenue while far in valuation. We believe that Baker Hughes should trade at a premium to Halliburton due to the former being a much safer bet. For instance, Baker Hughes gets 75% of its revenues from countries outside the United States, while Halliburton gets 44% of its revenues from outside the US, and that includes a 10% from Venezuela alone. Baker Hughes did not disclose how much revenues it gets from the troubled country but definitely, it has a much lower rate than Halliburton. Our belief is backed by the fact that Venezuela owes Baker Hughes $266 million from accounts receivables (5% of the company’s AR) while it owes Halliburton a whopping $1.4 billion (28% of the company AR).

Also, the fact that Baker Hughes is not dependent on the shale sector is a huge relief for investors. The huge cyclicality of the US energy market made most companies burn billions of dollars even when oil prices were at $90 per barrel. Baker Hughes doesn’t have this risk as the company generated $3.8 billion in pre-tax profits (thanks to GE Oil and Gas for sure) in its foreign operations at the time when oil prices were trading between $30 and $50 per barrel. This strong foreign segment, in addition to BHGE’s strong presence in the Turbomachinery (37% of 2017 revenues) market where it supplies refineries and other downstream participants, should make BHGE investors less worried about the cyclicality of the upstream shale energy sector in the US and should be translated to a higher multiple for the stock.

The Funny Part

The market is funny sometimes. It gives priority to topline growth and market share while neglecting the real purpose of enterprises; the ability to generate free cash flow to shareholders. In the commodity sector it is best to take a whole commodity cycle and see how the company performed during that time (in our case, the oil commodity cycle is from 2010 to 2016); did it increase shareholders’ tangible book value through FCF generation or did it destroy value by focusing on the top line and forgetting about the bottom line?

By applying this kind of analysis on Baker Hughes (without including GE Oil & Gas) and Halliburton, we found that Baker Hughes generated $4.3 billion in free cash flows from 2010 to 2016 while Halliburton generated only $1.47 billion in FCF, that’s despite the fact that Halliburton had a much higher market cap than Baker Hughes at that time and still. In addition, Baker Hughes increased tangible book value for its shareholders from $6.66 billion in 2010 to $8.3 billion in 2016, a 24% increase. While Halliburton had its tangible book value decline from $9 billion in 2010 to $7 billion in 2016 which means that it destroyed 22% of shareholders’ value in the latest oil cycle.

So, investors should ask; do a company which created value and FCF generation to shareholders at the time when most companies were destroying value really deserve to trade at a discount on a price to TBV basis? What about the GE Oil and Gas segment? Shouldn’t a bigger footprint and the ability to access GE’s technology (one of the world’s best) through the GE Store be translated to higher multiples? What about stability, diversification, and non-cyclicality? What about the fact that Halliburton offered more than $30 billion to buy Baker Hughes alone (not including GE Oil & Gas), which is more than the combined current market cap of GE Oil & Gas and Baker Hughes now? We believe all these questions have an answer which is in BHGE’s favor; it deserves to trade at a premium to its closest competitor, Halliburton, not at a discount.

Buying “Baker Hughes, a GE Company” is not a risk-free investment. We believe that the stock would take a hit if management couldn’t meet its guided synergies as our bullish thesis is mainly based on getting the $700 million left in synergies, which should translate to a higher EBITDA margin.

As the stock is now trading at only 2x tangible book value, the lowest in the sector, we believe that BHGE’s downside is limited.

As a result, we rate BHGE stock as a “strong buy”.

Cautious Investing to All.