The Outlook Begins to Improve (Gradually) for BHGE

The net income and EPS figures for the 2019 first quarter for Baker Hughes, a GE company, are confusing as presented.  The company reported net income (before income or loss allocated to the non-controlling interest, which is GE) of $71 million, compared with a loss of $19 million in 18Q1.

However, more than all of the 18Q1 net loss was allocated to GE.  Consequently, BHGE’s 19Q1 GAAP net income attributable to its common shareholders was $32 million or $0.06 per share, below the $70 million or $0.17 per share of net income reported for 18Q1.

While some of BHGE’s non-GAAP adjustments may be useful in projecting its future performance, they offer little help, in my opinion, in understanding its current performance.  A meaningful portion of the non-GAAP adjustments are merger, integration and restructuring costs, which presumably will go away over time.  So excluding them from projected performance, if they can be estimated with some precision, would provide a more accurate assessment of the company’s future earnings potential.  But it is not appropriate to exclude them from current performance, since they are actual costs incurred in the period and paid for (now or in the near future) in cash.

It is also not clear when and how quickly these costs will go away.  BHGE reported that it achieved $800 million in synergies related to the merger in 2018, $100 million ahead of plan.  It also anticipates that total cumulative synergies will increase to $1.2 billion in 2019 and then to $1.6 billion in 2020; but it has not (to my knowledge) disclosed the expected cost of achieving those synergies.  Restructuring costs allocated to its business segments totaled $304 million in 2018, about 10% below the 3-year average.  They were $62 million in 19Q1, down about 50% from the prior year.  It seems reasonable to assume that restructuring costs will be around $150 million in 2019, about half the 2018 total, but it also seems likely that they will continue in 2020 and beyond.

Besides the restructuring and merger costs, some key adjustments made by BHGE to arrive at the non-GAAP results are not fully explained.  It appears that most of the adjustments relate to a gain on the sale of a business and the impact of tax reform, but a significant portion of the adjustments are allocated to GE, the non-controlling interest.  A more complete explanation of these adjustments might be helpful in understanding BHGE’s current performance and forecasting its future results.

Background on the Merger.  GE acquired Baker Hughes in July 2017.  Baker Hughes held strong positions in key segments of the oilfield services business, especially onshore.  Its two main business segments were Drill and Evaluation (including drill bits, drilling services, wireline services and drilling and completion fluids) and Completion and Production (including completion systems, intelligent production systems, wellbore intervention, artificial lift, upstream chemicals and pressure pumping).

GE’s Oil & Gas business mostly produced equipment for the offshore and has been a leader in the construction of LNG production facilities for many years. Its primary competitive advantage comes from the application of gas turbine technology to oil & gas projects.  Over the 25 years or so that GE spent building its oil & gas business, it acquired companies that helped to expand its product portfolio in both core gas turbine applications and in related areas, such as artificial lift, which built upon GE’s expertise in turbines and motors, and trees and blowout preventers, which could be packaged with its turbines into turnkey systems for offshore drilling and production.

The acquisition of Baker Hughes broadened GE’s portfolio, creating a “fullstream” company whose products and services serve the upstream, midstream and downstream.  While its businesses now cover the oil & gas industry much more broadly, some of the legacy GE businesses serve other industries.  BHGE’s Turbomachinery and Process Solutions business, for example, produces rotating equipment for petrochemical and other industrial applications.  Its Digital Solutions business also competes in the power generation, aerospace and heavy and light industrial markets.

The merger was completed in the midst of an industry downturn.  Heightened competition during the integration period following the merger resulted in some loss of market share, especially in the legacy Baker Hughes businesses.  Consequently, a key focus of management is winning back share.

Although the industry has rebounded over the past couple of years, the recovery has been uneven.  The “short cycle” product lines, which include many of the legacy Baker Hughes businesses, have rebounded nicely over the past 12-15 months.  But the “long-cycle” businesses, which offer products and services for projects that have longer lead times and development periods, are still bouncing along the bottom.  Management sees a rebound coming in the offshore and LNG, but it is apparently still a year or more away.

Recent Financial Performance: 2018.  On a combined business basis, which combines the results of GE Oil & Gas and Baker Hughes as if the closing data of the merger was the first day of 2017, BHGE’s operating income improved from a loss of $409 million in 2017 to a profit of $701 million in 2018.  Revenues increased 10% to $23.9 million.  BHGE’s actual reported operating loss for 2017 was $284 million.

The improvement in operating income was due mostly to a $616 million decline in corporate and other costs (mostly inventory impairment, restructuring and merger-related charges), as well as a $493 million improvement in Oilfield Services (OFS) operating income.  The combined operating income of the three other segments (Oilfield Equipment (OFE), Turbomachinery & Process Solutions (TPS) and Digital Solutions (DS)) was flat.

OFS, which consists mostly of the shorter cycle, legacy Baker Hughes businesses, saw its revenues improve 12% to $11.6 million and its operating income more than doubled from $282 million to $785 million.  The business has benefited from the global increase in onshore oil & gas drilling and production that has accompanied the rebound in oil prices.  Orders for OFS were up 11% in 2018, suggesting that the improvement will continue.

As noted, 2018 operating income was flat on a combined basis for the three remaining businesses. Two of those segments, OFE and TPS, are long cycle businesses.  OFE has reported essentially breakeven results over the past two years and its revenues were flat in 2018.  TPS’s operating income declined 7% to $621 million in 2018, as its revenues slipped 4% to $6.0 billion.  DS, meanwhile, reported operating income of $389 million, up 22% in 2018, on only a 3% increase in revenues to $2.6 billion.

Despite the flat combined results for the three segments, order activity (on a combined business basis) suggests better performance in 2019.  OFE orders jumped 23% to $3.1 billion and TPS orders increased 12% to $6.6 billion in 2018.  DS orders declined 11% to $2.6 billion, driven mostly by the non-repeat of a large order from 2017.

BHGE’s free cash flow, which I define as the sum of cash flows from operating and investing activities, improved to $1.18 billion in 2018 from negative $4.9 billion in 2017.  (Excluding cash paid for acquisitions, free cash flow improved from negative $1.55 billion to positive $1.78 billion.)  The company paid an estimated $810 million in dividends during the year, including $495 million to GE, reduced its debt by $1.06 billion, paid $2.48 billion to repurchase shares, including $2.1 million for GE’s shares, and thus saw its cash balance decline from $7.0 billion to $3.3 billion.

Recent Financial Performance: 19Q1.  As with the full year results, the sharp improvement in 19Q1 operating income (from a loss of $41 million to income of $176 million) was driven mostly by a decline in inventory impairment and restructuring charges, which fell from $223 million to $62 million, and by a 25% jump in OFS segment profit.  Operating profit at BHGE’s other segments, OFE, TPS and DS, was essentially flat.

19Q1 revenues increased 4% to $5.62 billion, due entirely to an 11.5% increase in OFS revenues to $2.99 billion.  Orders increased 4.0% to $5.69 billion, as gains of 13.5% in OFS and 53.5% in OFE were partially offset by a 12.3% decline at TPS.

Free cash flow was negative $440 million in 19Q1.  $187 million was paid in dividends (including $95 million to GE), and $48 million was used to repay debt.  As a result, BHGE’s cash balance declined by $650 million to $3.3 billion.

Recent Trends and Outlook.  Overall, BHGE saw 19Q1 as a period of stabilization.  The price of oil rebounded 33% during the quarter, from near the December lows.  OPEC and Russian production cuts combined with continuing challenges in Valenzuela are serving to offset strong production growth from the U.S.; but BHGE anticipates that recent cuts in capital spending in the U.S. will reduce supply there over the medium term.

In the offshore, BHGE sees improvement ahead.  More projects are reaching final investment decision; but the lead times are long.  The company sees a more meaningful upturn coming in the 2020-2022 time frame.  That appears to be a view shared by other industry watchers.  For 2019, BHGE sees the demand for subsea trees (used to monitor and control the production of subsea wells), an indicator of overall subsea demand, remaining flat at about 300.

In LNG, where BHGE has been the clear market leader, concerns about oversupply are starting to recede a bit.   According to McKinsey, 41 billion cubic meters per annum (bcma) (or 30 million tons per annum (MTPA)) of LNG capacity were added in 2017 and 47 bcma (35 MTA) were expected to be added in 2018.  The consulting firm sees a total of 100 bcma (74 MTPA) of LNG capacity being added from 2017 to 2022. (If I have read the table and calculated correctly, one billion cubic meters of natural gas can be compressed into (or re-liquified from) 0.74 million tons of LNG.)

Yet, that 100 bcma forecast looks light, considering that the 16 million tonnes per annum Golden Pass project (which is being led by ExxonMobil and Qatar Petroleum) has achieved FID this year and another 46 MTPA of capacity in three projects (Venture Global’s Calcasieu Pass project, Tellurian’s Driftwood and Sempra’s Port Arthur) have been approved by FERC.  BHGE sees 100 MTPA of capacity being sanctioned in 2019 and it thinks that global LNG capacity could nearly double to 650 MTPA by 2030.   Consequently, after a lull, the LNG market may be entering another period of growth.

BHGE serves this market through its TPS business, which provides turnkey solutions (equipment and services) for the construction and operation of LNG plants.  It is looking to capitalize on the rebound in the LNG market, but is mindful of the need to maintains its leadership position by staying at least a step ahead of competitors.

Projections and Valuation.  Despite high single-digit order growth of around 9% for 2018 and 19Q1, the company’s guidance does not anticipate converting this into commensurate revenue growth in 19Q2.  Assuming that sales for OFE and TPS do pick up in the 2019 second half, however, BHGE could achieve revenue growth of 5% for all of 2019.  With that level of revenue growth, the realization of $400 million of additional synergies and the halving of restructuring and integration costs, I think that an increase in BHGE’s operating margin from 3.1% to 4.9% is achievable.

That would translate into 2019 EPS of $1.05, assuming a 22% tax rate, no loss on equity method investments and no help from other non-operating income.  (The current 2019 consensus estimate is, I believe, around $1.)

I am also assuming that GE will sell another 20% equity stake in BHGE in a public offering during the course of the year, but that should have little or no impact on earnings per share because the increase in shares outstanding should be offset by a corresponding decline in earnings attributable to the non-controlling interest.

In 2020, I believe that further (significant) improvement in EPS will depend upon BHGE achieving a higher rate of revenue growth.  The company can continue to show some improvement in operating profit from the achievement of additional synergies and reduction in restructuring costs, but it will not likely achieve a meaningful increase in operating margin without leveraging fixed costs through revenue growth.  According to my back-of-the-envelope projections, a 10% increase in revenues combined with an operating margin expansion from 5.0% to 6.0% would (all other things being equal) produce EPS of around $1.50, which is within the current range of analyst estimates.  

At the current price of $22.95, BHGE is trading 22 times my 2019 EPS estimate of $1.05 and 15 times by 2020 estimate of $1.50.  By comparison, its two largest peers (HAL and SLB) have an average 2019 P/E multiple of 22.5 and average 2020 P/E of 15.  BHGE is therefore trading in line with its peer group.

The average 2020 forward multiple for the peer group, which is below the corresponding multiple of 17.5 times as-reported earnings for the S&P 500, probably reflects some skepticism about whether the companies can achieve their forward estimates.

Consequently, if and when the market anticipates that BHGE will be able to achieve 2020 EPS of $1.50, and with the expectation that growth will continue beyond 2020, I believe that the stock would have upside to $30 (or higher) by the end of 2019.  At that time, a share price of $30 would translate into a one-year forward multiple of 20, which is below the current one-year forward multiple of 22.

GE’s Orderly Exit Plan.  In November, BHGE issued 92 million shares of its stock at a price of $23 before underwriting discounts.  Proceeds were paid to GE in exchange for a reduction in its equity stake in BHGE from 62.5% to 50.4%.  GE has said that it expects an orderly exit from its position, which suggests that the remaining 50.4% will be sold in one or more (probably at least two) public offerings over the next couple of years.  Under the current agreement, GE will retain at least one board seat at BHGE until its equity stake is reduced to below 20%.

In anticipation of its exit, BHGE and GE have executed a Master Agreement and a series of related agreements designed to clarify and formalize the future commercial and technological collaborations between the two companies so that BHGE can operate as an independent company.  A key aspect of the agreements is the ongoing use and development of turbine technology for which BHGE will continue to rely on GE.  BHGE also uses CT technology (from GE Healthcare); and as noted above, both its TPS and DS businesses serve customers outside the oil & gas business.

The Master Agreement Framework is proof that the companies will still rely upon each other to maintain product leadership in turbines and also to pursue growth in certain products and services outside of BHGE’s core oil & gas markets.  I believe therefore that rather than having GE exit its position entirely, both BHGE and GE would be well served to maintain a formal connection through GE’s continued ownership of a meaningful equity stake in BHGE and also through continued representation on its Board of Directors.  Selling its stake down to 20% would allow GE to keep one board seat.

Recent Trading Activity.  BHGE’s stock has been in a downtrend since peaking at $47.76 a little over one year ago.  From the beginning of October until right before Christmas, the stock lost 40% of its value.  It subsequently rebounded to a recent peak of $28.65 in mid-March, but has since given back a significant portion of those gains.

BHGE’s roller coaster ride is consistent with the trading activity in its broader peer group, which is measured by the Philadelphia Stock Exchange’s Oilfield Service Index ($OSX) plotted in gold behind BHGE in the chart below (which is provided courtesy of  BHGE’s stock has also slightly outperformed its two largest peers, HAL and SLB, since early 2018 as shown in the two bottom panels on the chart.

Thus, the gyrations in BHGE’s share price reflect broad investor sentiment toward the oilfield services sector.  While BHGE has upside if it is able to continue to grow its OFS business and especially if its long-cycle OFE and TPS businesses begin to rebound, its general fortunes in the near-term seem to be tied to the performance and outlook of the global oil & gas industry. Barring any supply shocks, the global oil & gas business should see gradual improvement, albeit with day-to-day variability as the industry adjusts to supply and demand fluctuations. Longer-term, the cuts in exploration activity in recent years will eventually lead to a supply shortage (and higher prices), if global demand continues to rise at its current pace.

May 8, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 975-0250

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