2024-01-18 16:00:35 ET
Summary
- Energy security concerns and growing LNG demand should support Baker Hughes' core businesses, absent a deterioration in economic conditions.
- Baker Hughes' new energy initiatives could also provide meaningful upside if the company can meet internal targets.
- Baker Hughes' valuation is reasonable given the company's growth potential, but further progress towards margin targets is needed.
The past two years have been a perfect storm of events for Baker Hughes ( BKR ), with the war in Ukraine contributing to a surge in demand for LNG and high oil and gas prices spurring upstream activity. Despite this, the company's share price performance has been fairly tepid, due to an elevated initial valuation and growing doubts about the sustainability of current conditions.
Baker Hughes had expected oil markets to tighten in the latter part of 2023 due to producer discipline and solid demand growth. This has not proven to be the case, though, which may lead to underperformance relative to management expectations moving into 2024. Longer term, Baker Hughes wants to generate more revenue from new energy and the industrial sector, which along with structural LNG tailwinds, should support growth. This probably makes Baker Hughes reasonably valued at current levels, but the company still needs to demonstrate that margins can be sustained at higher levels.
IET
Baker Hughes' Industrial and Energy Technology business is to a large extent dependent on LNG, which should be a positive going forward. LNG markets remain tight, with demand currently around 400 MTPA and growing 2% annually. This is despite economic weakness in key markets like Europe and China. With estimated global nameplate capacity of 490 MTPA, effective utilization is over 90%. LNG demand is anticipated to expand 3% in 2024, with utilization remaining high. Longer term, Baker Hughes expects global LNG capacity to reach 800 MTPA by the end of 2030.
Since 2017, Baker Hughes has been selected for around 98% of the 204 MTPAs of LNG FIDs. With this capacity now starting to come online, Baker Hughes expects its liquefaction installed base to grow almost 50% by 2028.
Figure 1: LNG FIDs (source: Baker Hughes)
Figure 2: LNG Capacity (source: Baker Hughes)
There are risks to this rather rosy outlook, though. Natural gas is a relatively clean source of energy, which should result in it being used as a transition fuel. This scenario is not guaranteed, though, as environmentalists are pushing for elimination of all fossil fuels and nuclear. This is why nuclear has been replaced by coal in some cases, and why demand for natural gas hasn’t ramped faster.
Environmental groups are pressuring the Federal government to abandon fossil fuels, and as part of this, the DoE will now examine whether regulators should consider climate change when assessing proposed gas export projects. The Natural Gas Act requires the DoE to consider whether a project is in the public interest before granting export approval, but in the past, this has primarily been based on economics. Given the impact of the war in Ukraine on Europe, it is unlikely that environmental concerns will outweigh national security concerns in the near-term. Longer term, regulatory pressure on fossil fuels is likely to continue to mount.
Baker Hughes offers a range of services related to LNG, pipeline and gas storage, refining, petrochemical, distributed gas, flow and process control, nuclear, aviation and utilities. These services are based on the company's expertise in compression and power generation equipment and aftermarket services.
Gas Tech dominates IET revenue and is likely to continue growing on the back of LNG demand. In particular, Baker Hughes' growing installed base should lead to increased maintenance and service revenue in coming years.
The IET business' margins are not currently where Baker Hughes wants them, though. In response, Baker Hughes is reorganizing the business to try and lower costs.
Figure 3: IET Orders (source: Baker Hughes)
While Industrial Tech currently constitutes a minority of Baker Hughes' IET revenue, the company believes it has potential. Baker Hughes wants to develop its industrial portfolio into a suite of integrated solutions that support asset performance management and process optimization. If successful, this could result in more high margin recurring revenue streams.
Baker Hughes' Cordant platform is the starting point for this effort. Cordant is an integrated suite of solutions for asset performance management and process optimization. This includes machine learning capabilities based on Baker Hughes' partnership with C3.ai ( AI ).
OFSE
Baker Hughes expects the current upstream cycle to be more durable and less sensitive to commodity prices than previous cycles. I think there is truth to this, as many countries are now more focused on energy security than project economics. Consolidation and a focus on returns amongst shale producers should also make short-cycle supply more disciplined. These positives need to be weighed against the fact that modest upstream investments are still driving solid supply growth. Demand growth is also soft, and economic conditions generally appear to be deteriorating.
Figure 4: Upstream CapEx and Oil Demand (source: Baker Hughes)
OFSE performance continues to be robust, driven by activity in international markets. Baker Hughes expects solid upstream spending growth in 2024, led by international and offshore markets. This is a positive for Baker Hughes as a large portion of its revenue comes from the Middle East and Asia and its revenue base skews towards offshore.
Figure 5: Q3 2023 OFSE Revenue Growth by Geography (source: Baker Hughes)
Figure 6: Q3 2023 OFSE Revenue Growth by Product Line (source: Baker Hughes)
Baker Hughes is also trying to expand its digital business in OFSE. An example of this is the company's Leucipa production automation software. Leucipa aims to optimize operations across artificial lift, power, fluids handling, chemicals, field intelligence and field activity scheduling.
New Energy
Baker Hughes is trying to leverage its existing capabilities in areas like:
- Carbon capture and storage
- Hydrogen
- Clean power
- Geothermal
The company is aiming to expand new energy orders from 600-700 million USD in 2023 to 6-7 billion USD in 2030. This business has significant potential and should benefit from government support, but the technical and commercial viability of some of these technologies is still being established.
Baker Hughes has also made related investments in:
- Netpower - low emission gas fired power production
- Compact Carbon Capture - carbon capture
- Ekona - hydrogen
- SRI International - carbon capture
- Mosaic Materials - direct air capture platform
Financial Analysis
Baker Hughes' business continues to expand, with both the OFSE and IET segments performing well. OFSE revenue growth was 16% YoY in the third quarter and IET growth was 37%.
Figure 7: Baker Hughes Revenue (source: Created by author using data from Baker Hughes)
Fourth quarter revenue is expected to be 6.7-7.1 billion USD, representing roughly 17% growth YoY. Weaker oil prices could pressure the OFSE business in 2024, but the outlook for the IET segment looks positive absent serious macro weakness.
Table 1: Q4 2023 Revenue Guidance (source: Created by author using data from Baker Hughes)
Longer term, analysts expect solid revenue growth through 2030. Given likely growth in Baker Hughes' LNG business and potential new energy growth, these estimates appear achievable, with room for upside. Demand growth for oil and gas and government attitudes towards fossil fuels are risks, though.
Table 2: Analyst Revenue Estimates (source: Created by author using data from Seeking Alpha)
Baker Hughes' profitability continues to improve on the back of international growth within the OFSE segment. Margins are still well short of management's goals, though. Baker Hughes is targeting 20% EBITDA margins in OFSE by 2025 and in IET by 2026. All service companies and operators have higher margin targets though, and it is not clear how they will all sustainably achieve these targets. Free cash flow was 592 million USD in the third quarter, resulting in free cash flow conversion from adjusted EBITDA of 60%. Baker Hughes is targeting 45-50% free cash flow conversion in 2023.
Figure 8: Baker Hughes Operating Profit Margins (source: Created by author using data from Baker Hughes)
Conclusion
The outlook for Baker Hughes' stock really depends on where we are in the business and oil and gas investment cycles. Provided economic conditions remain stable and OPEC continues to support oil prices, Baker Hughes profits should increase on the back of both revenue growth and margin expansion.
Over the past 12 months, Baker Hughes' stock appears to have priced in a higher probability of economic weakness and / or an oversupply of oil. While I believe that this is reasonable, new energy and LNG related growth is likely underappreciated at this point in time, as investors are overly focused on the near-term demand environment.
Figure 9: Baker Hughes EV/S Multiple (source: Seeking Alpha)
For further details see:
Baker Hughes: LNG Winner