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03/27/17 10:00:06 AM



This week's Focus Stock of the Week is Baker Hughes (BHI 59) which carries CFRA's highest investment recommendation of 5-STARS, or Strong Buy. We view BHI as one of the leading oilfield service companies in our coverage universe, with a strong reputation for innovation, and about to embark on a transformative merger which we think bodes well for the future.

The oilfield services revenue stream depends on the level of upstream spending by producers. The sudden and dramatic plunge in crude oil prices, which started in late 2014, has finally begun to stabilize in the $50 per barrel range. Upstream spending fell about 32% in 2015, and another 40% in 2016, implying that 2016 spending levels were roughly 40 cents on the dollar compared to spending in 2014. As of March 2017, our universe of upstream companies looks to finally make a capex recovery, averaging about 16% higher spending planned in 2017. While qualitatively helpful, it still implies that 2017 upstream capex is merely approaching 50 cents on the dollar, relative to 2014 levels. In other words, we think higher spending is nice, but unlikely sufficient to lift all oil services firms out of the doldrums. The winners in oil services, in our view, need to demonstrate the ability to help customers either make meaningful cost reductions, and/or achieve higher levels of production than they could otherwise obtain elsewhere. Technology is likely to be a strong differentiator.

BHI has historically had a strong reputation for technology, in our view, but has occasionally fallen short on execution, perhaps a function of inadequate scale in a global business that frequently works in frontier regions. In late 2016, however, BHI agreed to merge with the oil and gas business of industrials giant General Electric. We think this follows suit from the 2015 Schlumberger - Cameron deal, where a strong oil services firm was married to a leading provider of oilfield capital equipment. The ability to integrate products and services expertise, in our view, should be attractive to clients that are willing to pay for new technology so long as it can prove its ability to reduce costs sufficiently elsewhere. Taking BHI's innovation expertise and aligning it with GE's scale and reputation for strong manufacturing execution should be a good fit.

Under the terms of the deal, BHI shareholders get a special dividend of $17.50 per share upon closing (likely in mid-2017), and own 37.5% of the combined company. GE anticipates that the pro-forma normalized run rate for EBITDA will be about $6.4 billion in 2018, and it sees synergy benefits of $13.7 billion following the deal. If we adopt GE's estimation that its oil and gas business merits an 11.8X multiple on projected 2018 EBITDA (which we think is reasonable for an oilfield capital equipment business), then the deal implies a $66 valuation for BHI completely absent of any synergies. Our 12-month target price of $70, which implies about 18% upside, assumes that the combined company achieves roughly one-third of the synergy benefits advertised, which we think is conservative. On a stand-alone basis, a $70 target price implies a forward valuation of 12.3X EBITDA, slightly below that of oilfield services rival Schlumberger.

For 2017, on a stand-alone basis, we see EPS of $0.47, rising to $1.90 in 2018. BHI's earnings power has historically peaked in the $4.20 per share range (in 2011 and again in 2014), and so in context, we see 2017 as a recovery year following two years of losses, with acceleration of earnings growth in 2018.

Investing in the energy services space brings risks, which can be substantial. Their customers are in the business of extracting crude oil and natural gas and selling them to the market, but prices for these commodities are notoriously volatile. In addition, oil services firms are exposed to potential regulatory or environmental restrictions (such as those related to fracking operations) and run the risk of unexpected accidents or damage from natural or man-made disasters.

CFRA's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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