Buying Any Near Term Baker Hughes Dip Could Be Worth It

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Mar 19, 2015

Halliburton Co (HAL, Financial) has made a pending offer to acquire Baker Hughes Inc (BHI, Financial). Baker Hughes stockholders will receive 1.12 shares of HAL and $19 in cash for each share of BHI stock. The companies anticipate the merger to be complete in the second half of 2015. For the transaction to succeed, it must gain the approval of shareholders at each company and pass regulatory scrutiny. The latter consideration seems most concerning; however, terms appear likely to mitigate risk for investors in Baker Hughes.

Since per share figures are used for calculations, let’s review current data. Baker Hughes records state that 9.1 million shares were bought back at an average price of $65.75 during 2014. There are 436,000,000 weighted average diluted shares outstanding, as of the 3 months ended December 2014, higher than the 434,526,345 reported as outstanding on February 19th, 2015. There is an agreement not to repurchase any shares of common stock while the merger is pending. So, 436 million is the divisor used to asses any hypothetical fees paid by Halliburton to Baker Hughes.

If Halliburton shareholders do not approve the merger, then a $1.5 billion payment ($3.44 / share) is to be made to BHI. If BHI shareholders do not accept the deal, the company is responsible for $40 million in expenses, and in the event that an alternative deal surfaces and is not withdrawn at least 10 days prior to the Special Meeting held on March 27th, the fee to the company would be $1 billion. Lastly, if the deal fails because of antitrust considerations, then HAL pays BHI $3.5 billion ($8.02 / share).

Per its most recent results, Baker Hughes now has close to $18,730,000,000 in equity, or $42.96 in book value per share. In the event Halliburton investors vote down the merger, the figure could be close to $46.40. If the merger fails because of antitrust reasons, I calculate $50.98 / share in equity. There would of course be some bumps, perhaps including damage to customer relationships and technological issues that could make the figures used optimistic.

Goodwill and Intangibles, assets that disappear eventually, are worth 6.893 billion currently. However, as of December 31, 2014 no impairment has been found pursuant to annual testing. As shown in the lower half of the graphic below, over half of intangible assets are classified as Technology and carried customer relationships are worth 32.5%. Also, during 2014, the company amortized $101 million, or 11.4%.

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Pertaining to ongoing matters that could be relevant to Baker Hughes as a standalone entity, I note the following two risks as concerning:

  1. Demand for pressure pumping services could be reduced or eliminated by governmental regulation or a change in the law, such as proposed changes in laws surrounding hydraulic fracking.
  2. Control of oil and natural gas reserves by state-owned oil companies may impact the demand for services and create additional risks in our operations. e.g. Petrobras (PBR, Financial); revenue declined across most product lines in Brazil due to lower activity levels in 2014.

With energy prices in a steep decline, oilfield services firms are bound the feel the pinch. For reference, here is a valuation table that contains Sterne Agee’s price to earnings revisions (The BHI target is based on terms of the merger).

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While these figures may or may not prove accurate, Baker Hughes is likely to remain a profitable business. If there is in fact a high multiple during trough earnings, it could be the case that book value is a reason. Further, the company would likely be well capitalized toward the end of the downturn. Consequently, if the merger fails because of antitrust reasons, I would be surprised if shares of BHI trade at under $50. Yes, it would amount to over 20x 2016 consensus EPS estimates even if the industry difficulty is prolonged.

Assets of a profitable business probably would be undervalued if regulators block the deal. Caution may be warranted in consideration of a Petrobras implosion, or change in domestic government regulations. Overall, Baker Hughes appears to be well-positioned.