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Baker Hughes
Contestant #2, come on down!

by Jeff Fischer (TMFJeff@aol.com)

Alexandria, VA (Feb. 4, 1999) -- The second company on our list of oil and gas considerations is Baker Hughes Incorporated (NYSE: BHI).

Description: Similar to yesterday's company, Apache, Baker Hughes is headquartered in Houston, Texas. Unlike Apache, it isn't a pure play on oil and gas exploration and production. In 1909, Baker Hughes' founder developed the first oil well drill bit for use on rock and stone. The company quickly had a monopoly on the market and it still sells the bits today, but they're only a very small part of the company's business.

Baker Hughes focuses on three segments of the industry and it has a worldwide scope in each. They are 1) the oil field segment, 2) chemicals, and 3) process equipment. Baker Hughes doesn't only help companies locate oil and gas reserves. It provides drill bits, drilling fluids and other equipment used in the drilling process as well as in the completion and upkeep of oil and gas wells, and it sells waste material removal and separation systems for several industries, including mining and industrial, papermaking and municipal. And did we mention its chemical division? Yes, we did.

Last year, oil field operations accounted for 78% of revenue, chemicals for 11%, and process equipment about 10%.

In 1998, Baker Hughes acquired rival Western Atlas for $3.3 billion in hopes of maintaining pace with a quickly consolidating oil field services industry. The acquisition also increased Baker's lead in the seismic data market. Overall, Baker Hughes is not afraid to take chances with acquisitions or other initiatives. For example, the company was the first large well service company to reorganize itself in order to provide fully integrated services -- from planning and engineering, to coordination of efforts involved in drilling wells -- through to completion.

As one might imagine, low oil prices and the resulting lack of progress or growth in the industry has forced Baker Hughes to slash expenditures and cut costs dramatically, including lay offs. This year the company could cut its workforce by 18%, to 29,000. Baker Hughes is the third-largest oil field services company.

Financials: As Brian described, our overview of each company will hit only key elements first. (If a company makes it into round two or three, we'll dig much deeper.) In this round, we consider the following: How is the company valued by the market? How profitable are its chosen operations? (Baker Hughes focuses on the most profitable aspects of the industry, it says, but hold on: we'll see how it's going.) How does the company finance its operations? And what does management do with the money that it earns?

Valuation: At nearly $18 per share, Baker Hughes is valued at $5.97 billion. (This market value is found by multiplying shares outstanding by market price). The company recently had $24 million in cash and equivalents and $2.77 billion in long-term debt. At the end of the fourth quarter this puts long-term liabilities at 46.4% of capital. Not horrific, but far from ideal. Adding debt and cash to the numbers, the company has an enterprise value (which is market cap plus debt, minus cash; this equates to the price that a suitor would pay for the whole company) of over $8.7 billion, or 1.3 times sales.

The P/E is currently not very meaningful. However, Baker trades at 30 times '99 estimates of $0.60 per share, and 22.8 times the year 2000 guess of $0.80 per share. (The year 200 estimate hopes for oil prices of about $16 a barrel, up 30% from current levels.) If you remove charges, the stock is now at 17.4 times trailing earnings, so earnings are obviously expected to decline this year.

Profitability: On revenue of $6.3 billion in 1998, the company earned $1.05 per share, or approximately $343 million, before significant extraordinary charges. Including merger related and unusual expenses, Baker Hughes had an operating loss of $135 million in 1998.

Being long-term investors, we view our candidates' performance over history as being much more important than any one year, and of course we aren't overly concerned with unusual charges. Only when charges are unusual and related to an industry slowdown or the need to restructure due to weak results do we have a second thought: "For how long will these difficulties persist? etc." In the oil industry, merger and expense-cutting related charges are going to become more prevalent in the near future before diminishing. We have that in mind throughout this study.

Related to this, Baker Hughes announced at the beginning of this week that revenue in 1999 will probably decline significantly from 1998, and that it will slow or cease specific operations that otherwise incur high costs. The company had $1.3 billion in capital expenditures last year. It hopes to cut that to $600 million this year. While cost-cutting is smiled upon generally, slowing investment in one's own business is frowned upon if it indicates (as it does here) weak demand and weak expectations.

The company's net profit margin (net income divided by revenues) without charges was 5.4%, near the middle to high side of its normal range. The year before last, the net margin was 2.6%; the year before that, 5.8% -- so they do vary consistently. However, they're always below our hoped-for level of over 10%. High profit margins indicate a company with power in its industry (or that it's in a favorable industry, if the margins are sustainable).

Baker Hughes fails to appease us in our return on equity derivation, too, which is return on capital employed, or ROCE, as Brian described yesterday. After-tax operating earnings were $153 million this year after we back out unusual charges. Up against shareholder equity plus debt, this gives us a return on capital employed of below to 0.2%, even much lower than the 0.7% for Apache that we found yesterday. Meanwhile, on more common measures the company's return on equity was 3.7%, while return on assets and capital were both negative last year. The industry's average return on equity is over 15%, according to Hoover's, so Baker Hughes, though respected, is lagging considerably at 3.7%. One measure in which it shines: it has over $24 per share in assets; but deriving value from this fact assumes that you can unload the assets at a certain price.

Leverage: The long-term debt at Baker Hughes stands at 46% of capital, as we already discussed. We're looking for companies with little debt or only debt that is being used to put more high-margin returns (net earnings!) on shareholders' plates. We're not seeing that here. At least not now. Plus, $2.7 billion is a lot of debt for a company with $6 billion in annual sales with net margins of 2% to 5%. 'Nuff said.

Use of Cash Flow: Through all the heartache, the company should generate cash flow per share of $3.00 this year -- more than most companies achieve. With that, it pays a 2.70% dividend yield, and beyond that management is determined to lower debt. It will use any extra cash, we could imagine (and hope), to pay down debt. Especially because investing the cash back into the industry appears to be a losing proposition right now.

The Snapshot for Baker Hughes: Click here for all the goods.

Conclusion: The company might be the best oil field services company in the world in some Fools' opinions, but it fails to meet nearly any of the qualities that we look for in an investment.

So, what can we say but... Fool on!

[To discuss these columns, please visit the Drip Companies message board on the Web.]

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