2023-10-12 21:28:15 ET
Summary
- Baker Hughes shares have risen over 50% in the past year, driven by an up-cycle in upstream oil and gas investment and growth in LNG and clean energy businesses.
- The company's oil field services and equipment business and its industrial and energy technology unit are both experiencing strong growth.
- Baker Hughes has a strong backlog and is well-positioned for continued revenue growth, making it an attractive investment opportunity.
Shares of Baker Hughes ( BKR ) have been a tremendous performer over the past year, rising by over 50%. In addition to benefiting from an up-cycle in upstream oil & gas capital investment, BKR has high growth businesses tied to LNG (liquefied natural gas) and clean energy, providing a tailwind to results. With $1.80 in forward earnings power, BKR has a premium multiple of 19.5x, but this is warranted by its growth prospects, in my view.
Baker Hughes operates across two units. First, there is the legacy oil field services and equipment (OFSE) business, which generate about 60% of its revenue. The remaining 40% falls under its “Industrial & Energy Technology” unit, which primarily provides equipment and services for LNG facilities in addition to green energy efforts, like hydrogen and carbon capture. Currently, both businesses are enjoying strong growth, and I expect that to continue for the next 18-24 months, if not longer.
In the company’s second quarter , it earned $0.39 in adjusted EPS, more than tripling last year’s results, while revenue rose 25% to $6.3 billion. Thanks to these strong results, it generated a substantial $600 million in free cash flow. Management targets a 60-80% payout of free cash flow to investors via dividends and buybacks. In H1, it has bought back $99 million in stock, and in July , it raised its dividend to $0.20, up 11% from a year ago, a sign of confidence in its future prospects. In fact, alongside these results, management provided solid full year guidance for $24.8-$26 billion in revenue and $3.65-3.8 billion in EBITDA.
Drilling into each unit, I will first focus on OFSE, given it is the larger business. Baker’s oil field operations generate 28% of sales in North America, 37% Middle East 19% Europe/Africa, and 16% Latin America. 60% of revenue is onshore; 40% from offshore projects. Importantly, BKR is fairly evenly diversified across all stages of exploration activity, from well construction to completion and production. It generates revenue across the entire lifespan of the oil cap-ex cycle.
In the second quarter, revenue was up 20% to $3.9 billion and margins expanded 190bp to 16.4%, thanks to stronger pricing and the operating leverage embedded in its technology platform, which has fixed development cost and high incremental margins, similar to a software company. We have seen E&P firms gradually increase cap-ex since COVID as oil prices have risen and demand recovered. BKR has benefitted from this, growing revenue strongly and recapturing margin with a target of 20% margins, aided by cost rationalizations.
While revenue growth here should moderate, I am constructive on the outlook for oil & gas investment because global demand is continuing to increase. While renewable energy is clearly gaining share and a public policy focus, with the emerging world continuing to develop, the International Energy Agency expects global oil demand to keep rising, increasing by about 5% over the next five years.
The reality is that cap-ex activity has been relatively low relative to this demand, particularly overseas where BKR generates the vast majority of this unit’s business. As you can see below, international drilling activity has been rising, hence BKR’s revenue growth. However, it remains below pre-COVID levels. While this has been mitigated to a degree by higher well productivity, we will need to see capital investment continue to rise to grow production, providing more demand for Baker’s services.
Baker Hughes
We see ongoing momentum behind increased oil & gas investment. Exxon is investing another $12 billion in Guyana. Brazil has a $200 billion infrastructure plan with Petrobras ( PBR ) at its center. Competitor Schlumberger ( SLB ) sees $200 billion in potential deep-water projects. Meanwhile, the Saudis and Russia are curtailing supply to keep prices elevated. The past week has also been a sad reminder of the geopolitical risk underneath the oil market at all times, with Hamas’s attack on Israel. Combined with Russia’s war on Ukraine, there is a higher risk of unexpected outages rather than unexpected supply hitting the oil market. All of this is constructive for ongoing capital investment and demand for Baker’s oil field services.
I would view the primary risk to this unit being a significant drop in commodity prices, most likely because of a recession that drives down global demand for oil, which in turn would reduce cap-ex spending. While this unit will always have exposure to oil prices, given the relative underinvestment in cap-ex in recent years, I view oil prices as likely to stay above $75-80 across most economic scenarios.
Turning to the IET business, growth here is even stronger. IET revenue was up 34% from last year to $2.4 billion, though margins were disappointingly down to 14.9% from 15.8%. Management blamed unfavorable mix shift for this and reiterated the attainability of 20% margins as the business continues to build scale. Margins remain something to watch, but one down quarter is not sufficient to derail the investment case.
As fast as revenue is rising, demand for Baker Hughes’s services is still eclipsing it. Baker booked $3.3 billion of orders in the quarter for a book to bill of 1.34x. It now has a $27 billion backlog, providing nearly two years of revenue visibility.
About 2/3 of this unit’s business comes from LNG facilities, providing equipment and services for the liquefication and compression of natural gas ship to ship overseas. With Europe pivoting away from piped Russian natural gas, and the global move away from coal, demand for LNG has never been higher. While Europe is leading the growth, Chinese demand continues to rise with Japan and Korea still key markets.
LNG capacity is expected to rise 25% by 2026 , according to the IEA, providing a significant tailwind for the IET’s units revenue growth. As these facilities continue to be built, I expect to see ongoing revenue growth here. It is this demand that is driving much of Baker Hughes’s backlog.
While LNG is the primary business line, IET also has exposure to emerging green technology, most notably hydrogen facilities, a natural extension of its leading LNG franchise as well as support for carbon capture. These units put Baker in the sweet spot for favorable government policy support. In fact, federal government will soon be providing $7 billion in funds for hydrogen facilities. Much of those funds will end up going to Baker as these hubs are built out.
Additionally, The Inflation Reduction Act increased carbon capture tax credits to $60 per ton from $35. Indeed, carbon capture technology is a major reason Exxon Mobil ( XOM ) is acquiring Denbury (DEN). Together, these renewable technology efforts will generative additive growth and provide long-term diversification away from fossil fuels. With a rising backlog thanks to strong order activity, before some of these grants have even been announced, IET is well positioned to maintain 20% revenue growth for several years, particularly as these mega-facilities take several years to complete, providing a long sight of cash flows.
The primary risk to this business would be Europe deciding to resume Russian natural gas purchases, reducing LNG needs, but this seems very unlikely. Similarly, if government support for renewables were to reverse, that would be a headwind, though with funds already allocated and set to be disbursed, this scenario also appears unlikely.
Assuming high single-digit revenue growth in oil field services and 25% revenue growth in IET, blended revenue growth is roughly 15% for Baker Hughes, alongside 100bp of margin accretion (or about ¼ of the company’s medium term target), in a year, BKR’s quarterly earnings power rises from $0.39 to ~$0.52, putting BKR well on pace to earn $1.80 in the next 12 months with an exit rate of ~$2.00/share in earnings power. This will enable continued dividend growth and modest buybacks.
Importantly, this will not be a one-year growth story. BKR services large, multiyear projects and has built an impressive backlog. Capital investment needs in the oil & gas sector are significant, and we are still in the opening innings of government support for hydron and carbon capture projects. With run-rate earnings rising by about 33% over the next year, even if just a portion of margin goals are achieved and topline growth likely to persist in the double digits for at least another 12 months after that, BKR is poised to generate 20% compounded annual earnings growth out at least three years.
With sustained earnings growth of 20%, I believe shares can comfortably support a 20x multiple, for a reason 3-year PEG (price/earnings to earnings growth ratio) of just 1.0x. That would suggest shares should be $40 today, or about14% higher. I would be a buyer of BKR.
For further details see:
Baker Hughes: High Growth Justifies A Premium Multiple