Signal From Noise
Signal From Noise
- Baker Hughes ($BKR) is known to many investors primarily as an old-regime Energy company. However, it is likely the most diversified (in geography and technology) Oilfield Services company and one of the most exposed to renewable energy.
- The company has a growth driver in its Turbomachinery & Process Solutions which have multiple renewable energy applications. This is the highest margin segment in the business, and the firm has numerous credible paths to restoring industry-leading margins.
- The company has a stronger balance sheet than its large-cap peers. It will not have to prioritize reducing debt, giving it additional bandwidth to create shareholder value through a forward-looking strategy.
- The company’s close relationship with General Electric and its top-notch CEO gives us confidence that this firm will almost certainly be a part of the solution to the Energy transition rather than a part of the problem.
- Investor sentiment toward the Energy industry is still lukewarm at best. Still, we believe the Energy firms who are leaders in clean energy technology and ESG priorities deserve a higher terminal value than peers who do not.
At first, I was afraid, I was petrified,
Kept thinking I could never live without [oil] by my side,
But then I spent so many nights thinking how you did me wrong,
And I grew strong,
And I learned how to get along,
-Gloria Gaynor, “I Will Survive”
How did the dinosaurs die? The consensus of science has long agreed that the impact of the 6-mile-wide Chicxulub Asteroid near the Yucatan Peninsula was the catalyst that set into motion the extinction of three-quarters of all life on Earth, and most of the dinosaurs. The impact, which occurred roughly 66 million years ago, makes the largest hydrogen bomb ever built seem like a cherry bomb. Survival of the fittest (those most equipped to weather the subsequent harsh conditions, not the strongest) is a rule that also applies in the corporate and investing world. We think Baker-Hughes is an industry leader, but more importantly, a survivor. It may sound counter-intuitive, but the hordes of pigeons you see thriving are distant relatives of the T. Rex!
Most scientists think the global cooling by massive dust clouds was primarily responsible for the subsequent mass extinction outside the region devastated by the immediate impact. Still, other theories, including a global plague, also exist.
Human beings tend to take intellectual shortcuts to explain complicated events affected by many variables. These can be useful in many instances; they can also be devastating in the case of investing. We’d say one of the harmful shortcuts in an investing context would be: I should avoid Energy because the economy is moving away from carbon emissions.
If a third-grader is asked how the dinosaurs died, they will say because of an asteroid, of course. Suppose you ask an evolutionary biologist what happened to the dinosaurs. In that case, they might surprise you by explaining that some of the previous family members of the T-Rex (Theropods) most likely evolved to become the birds we see in our contemporary skies.
So, to say an asteroid wiped out the dinosaurs is partially accurate, but this convenient shortcut also obscures the complicated truth. There can now be little doubt that Energy has undoubtedly lost some of its luster to institutional investors because of the ESG asteroid and the threat of another, potentially species-ending trend of global climate change.
The Energy sector has taken a beating over the past few months as the heightening uncertainty associated with the Delta variant permeates through the economy. Concerns about demand, potentially increasing OPEC production, and a rising constellation of ESG considerations have given what used to be a stalwart in institutional portfolios a scarlet letter and cloud of uncertainty.
Compared to others, the shrinking relative size of the Energy sector has likewise contributed to a lack of institutional ownership, as the sector has become less critical to those tied to a benchmark. The entire Energy sector is less than half the market cap of Apple.
How Does Baker Hughes Measure Up to Peers In Corporate Fitness For Survival?
We understand that the carbon-emitting Energy sector is a late-stage industry, although we disagree with those who believe peak oil has already arrived. However, the most vocal environmentalists and most activist government agencies cannot re-make a carbonless energy system overnight.
For example, even if we could switch to all-electric vehicles tomorrow, the existing energy-generating infrastructure we possess would not be sufficient to support such a change. It will take decades, and recent developments have proven that the wiser management teams in the Energy industry have decided they’d rather have a seat at the table in fostering a responsible energy transition than to be what is being eaten at the table.
Despite the scarlet letter this industry has attained amongst investors recently, it still regularly pulls off some of the most impressive technological feats accomplished by the human race. Like, life itself, corporations are not static, undynamic entities. They are adaptive, respond to changing environments, and have a great interest in self-preservation when faced with ruin.
If you chose to avoid late-stage industries, then you would have missed out on what has, up-to-date, been our column’s top-performing stock, Cleveland Cliffs ($CLF). This company proves that companies in late-stage industries that perfect corporate survivability, like having superior balance sheet health and lower debt costs, can really shine even in the twilight of their industry’s life cycle.
Baker Hughes is more capital-light and has much better credit than many of its’ Oilfield Services peers. The company spends between 3% and 5% on CAPEX compared to about 5-8% for other similar firms. This capital-light model helps offset some of the lower margins the company currently has in the legacy business of Oilfield Services compared to its large-cap peers.
The company’s higher balance sheet survivability is a direct competitive advantage that will likely lead to significant growth in FCF, which has already been building momentum. One of the macro-economic reasons we like the Energy sector, and Baker is certainly included, is that Energy companies are under-investing in both CAPEX and upstream discovery and production. When these two dynamics boomerang, $BKR looks set to benefit quite handsomely. $BKR also enjoys the most favorable analyst ratings of its large-cap peers.
While the last earnings report was a mixed bag in some ways, the company recently announcing a buyback program showed confidence on the part of a very informed management. We particularly like Lorenzo Simonelli as a manager because, in some ways, he is the perfect man (a seasoned and celebrated GE veteran) running a company whose future largely depends on the success of GE’s former Energy segment, which it acquired in 2017 after its proposed merger with Halliburton was struck down for anti-trust reasons.
Baker Hughes has more exposure to different types of renewable energy than most of its peers aside from Schlumberger, focusing on Carbon Capture and Hydrogen. We also put our ear to the ground in Houston from energy-industry insiders to get an anecdotal account of how the company is viewed within the wider industry. Despite having lower CAPEX, the company is perceived as having younger and more active engineers than many peers. It’s an engineer-forward company, and for some, it seems more like working at a cutting-edge tech firm much more than an old-regime Oil-Field Service play.
Baker-Hughes Is A “Theropod” of The Energy Sector
Even though the company still derives about half of its revenue from Oilfield Services, the second biggest segment is the Turbomachinery & Process Solutions. This forward-looking Energy segment produces the essential turbines that are needed to generate Energy, whether the source of it is clean or dirty. This is a business where quality really matters as well, and the legacy division of General Electric that is now $BKR’s second-biggest segment, is an industry leader in this vital technology for the coming energy transition and enjoys the prerequisite sterling brand reputation required for success in securing business.
In other words, the growthier-side of Baker’s business is a proven business with proven technology, not a pie in the sky. As the share of renewable energy grows, this business will benefit. The division produces compressors and turbines that are used in the necessary compression of hydrogen and other gasses in emerging clean energy processes. Hydrogen is the most abundant element in our universe and will likely be a major contender in the energy mix of the future. The digital solutions segment also has diverse clients in terms of end industries. The company also is involved in nuclear power and builds turbines for the largest nuclear power facility on Earth.
The company has several exciting partnerships with emerging leaders in the Clean Hydrogen space, including the Kingdom of Saudi Arabia, Air Products, and FiveT fund. Baker’s proficiency in Carbon Capture Utilization Storage (CCUS) is also impressive, and this proficiency leads to diversification across the Energy production and distribution stream. Another strength of Baker is that about 70% of revenue is international, making it very geographically diversified.
Like the Theropods had characteristics that made them better suited to than much of the competition and enabled them to transform and thrive, we believe that Baker Hughes is well-diversified, well managed, and also has a greater degree of flexibility in taking pro-active and forward-looking strategy than many of its more indebted and less diversified peers.
The diversity of segments and business likely gives the company greater revenue stability and exposes it to longer product cycles than most of the Energy industry. It is also the highest margin segment of the company, meaning the inevitable growth will likely continue the ongoing trend of margin expansion. It has a lower correlation to the price of oil than many of its peers. On top of this, the pent-up CAPEX and investment in upstream put positive secular pressure on the oil price. $BKR is exposed positively in the event of higher-than-consensus oil prices. Particularly since much of the Energy industry re-engineered its business for significantly lower prices than oil is currently trading at.
Reports of My Death Are Greatly Exaggerated
Baker is an excellent example of the Epicenter narrative coming to fruition. As the company re-wired the business, emphasizing maximum efficiency (possible destruction is always a good motivator), they have managed to grow EPS, despite the obvious revenue setbacks associated with the healthcare crisis and associated lockdowns. The company has optimistic forecasts for 2022 and 2023. More than just positive consensus forecasts, we buy into the company’s long-term strategy.
We see management as dedicated to continuing to drive down costs even if the healthcare situation improves. One of the best parts of this company is that its clean energy plays (which everyone in the industry will eventually have to have) are not show-me initiatives. They are robust products that are already integrated into clean energy supply chains, the demand for which seems almost certain to expand. Therefore, it can afford to divest from laggards in its legacy energy business and focus on areas where it enjoys a competitive or cost advantage and expand margin through the Energy side as well.
The stock is also well-owned by institutional investors. We believe their appetite will increase as the company continues to expand margins and produce significant free-cashflow. The company is well along its stated intention to evolve from an Oilfield Services company into a full-fledged Energy Technology company. It is actually well on its way, and you may be surprised to learn that Oilfield Equipment is only 10-15% of revenue.
The company’s main growth initiative, the TPS segment, generated almost a third of revenue but was actually over half of pre-tax operating margins. Does anyone think it might be a possibility that there will be additional tax incentives to adopt and promote clean energy technologies in the coming years? We’d say that is a solid bet. If the company ever gets the recognition it deserves for its industry-leading ESG stance; it may help its multiple shine a bit compared to peers lagging in that department. The company plans to be net-zero by 2050.
Risks And Where We Could Be Wrong
One immediate tactical risk to its share price is more technical than secular, but it still bears watching. General Electric owns over 20% of the company and will fully divest its stake in the near to medium term. Such a significant divestiture is bound to cause some price volatility. However, the company’s recently announced buyback initiatives may mitigate some of the adverse effects. On the other hand, if you are thinking of this company for a long-term hold (which we would suggest), then this weakness may provide good entry points or opportunities to reduce cost-basis. Like the Theropods, this company’s transformation won’t be overnight, but we believe the stock should benefit longer term. We believe it will soar.
Of course, as we all have just been painfully reminded, the Energy sector is one of the two highest beta sectors. It is very volatile. So, as my colleague, Tom Lee, once said of the Energy trade, only get into the kitchen if you can stand the heat! Excessive price volatility is often one of the costs of superior alpha. The Delta variant led to some nasty price action. This is a good reminder that despite its many strengths and financial safety and soundness, it is still very much at the mercy of healthcare developments.
Another risk that is always prevalent for any internationally inclined Energy company; the risk of doing business in volatile parts of the world. Sometimes the way business is done in those countries isn’t exactly congruent with Western Liberalism and our rules-based system. In 2007, for example, $BKR was fined $44 million for violating the Foreign Corrupt Practices Act (FCPA). So the risk of fines from similar activity and associated reputational damage is always on the radar screen, certainly more so than companies more heavily concentrated in the United States.
However, there is also a flip side to this international exposure. There is undoubtedly an outside possibility that the progressive wing of the Democratic party gains more political and legislative influence and dramatically reduces profitability through onerous or unreasonable regulation. Since $BKR is exposed to Energy in so many markets where regulating carbon emissions is probably at the bottom of the list, it seems relatively insulated from this threat compared to peers with an over-exposure to US markets.
The most considerable risk to our thesis materializing would probably be that the company’s investments in its greener growth initiatives don’t end up covering the cost of capital. The energy transition is nebulous, and no one in the world knows exactly how it will play out. Maybe a completely unknown technology becomes dominant that $BKR has no exposure to; this is always a possibility as well. The company is highly correlated to the price of oil but less so than many peers. Of course, negative price activity in oil can often be a negative for any Energy company. Still, as we discussed earlier in the article, the current supply/demand dynamics make us biased to the upside on the future price movement of the vital and controversial commodity.