Baker Hughes' (NYSE:BKR) stock price is likely to fall just as hard as its peers' shares if oil prices decline because of economic concerns. There's not a whole lot to be done about that; COVID-19 is a very real threat to oil demand that's already causing pain in the oil patch. However, there's a unique story at Baker Hughes today, and you need to understand what's going on before you make a final call.
So, forget about the most recent coronavirus scares for a second, and take the time to dig in a little deeper at Baker Hughes.
Putting it all together
Baker Hughes as it exists today is somewhat unique in the energy sector because it offers such a broad range of products and services. In fact, it covers the full spectrum of the energy business, from upstream (drilling) to midstream (pipeline) to downstream (chemicals and refining), leading to the idea of it being a "full stream" energy services company.
That's a cute name, one that's worth keeping in mind when you compare it to other industry players that are more focused. Diversification has notable benefits.
However, the company wasn't always this broadly diversified. The current business came about via the 2016 agreement with General Electric (NYSE:GE) that it would merge its energy services business with the old Baker Hughes. This was not a simple transaction, it actually involved GE buying Baker Hughes and then spinning off the combined energy business to shareholders. That resulted in GE owning around 63% of the new Baker Hughes, which was, at that time, known as Baker Hughes, a GE Company.
In late 2018, though, with General Electric still struggling to turn its business around, the industrial icon started to sell Baker Hughes shares. The reason was pretty simple to understand: GE needed cash to shore up its troubled balance sheet. By the end of that year, it had reduced its stake to just over 50%, but some at the time were concerned that the low price at which GE was willing to sell Baker Hughes stock hinted at desperation. Since then, GE has continued to reduce its stake below the 50% mark, effectively giving up control of the energy services company. Baker Hughes has now dropped the "a GE Company" from its name.
As of the fourth quarter of 2019, GE owned just about 37% of Baker Hughes. Remember that number.
Moving in the right direction
Throughout this complicated period, Baker Hughes has been working to integrate the combined GE and Baker Hughes energy businesses into one coherent whole. It wasn't so smooth at first, with the pair-up bleeding red ink early in the effort. However, things have improved materially since those days. Cost-cutting efforts and a move to focus on the best sectors and global markets have led to improving results.
To put some numbers on that, the company lost money in 2017 but was profitable in 2018 and 2019. Notably, its operating margin improved in each of those three years. The broader industry Baker Hughes serves is highly cyclical, and there's no way to get around that fact, but clearly, Baker Hughes has been doing something right. Its business covers a lot of ground, so not every division has been posting great results, but overall, the total picture appears to prove out the benefit of the broad diversification built into the company's offerings.
That said, Baker Hughes' largest unit, oilfield services (47% of the top line), ended 2019 on a weak note, with sequential sales falling 2%. Combine that with a 31% drop in sequential sales at the company's second largest segment, turbomachinery & process solutions (about 28% of sales), and the company's overall sales ended the year with an 11% sequential decline between the third and fourth quarters. Weak energy prices were likely the primary driver here, as end customers started to pull back because of low oil and natural gas prices.
That situation has only gotten worse in early 2020, with COVID-19 leading to a drop in energy demand in China. With the fear rampant that the new virus is starting to spread beyond the country of its origin (with material outbreaks elsewhere already making headlines), there's a good chance energy markets will remain moribund, or at least highly volatile, for some time. That's especially true if the virus leads to a global recession.
Still, Baker Hughes is likely to manage such a weak period in relative stride. Its balance sheet is reasonably strong, with financial debt to equity sitting at roughly 0.2 times and interest expenses covered by around 6 times. Its diversified business can handle some turbulence, even if the stock price remains under pressure because of weak energy market conditions.
However, this is where GE's 37% stake comes back into play. Although GE's financial situation has started to improve, it still wants to sell the rest of its ownership interest in Baker Hughes. Wall Street is well aware of this fact because Baker Hughes has been talking about it for some time. There's an agreement in place to make this happen in an orderly fashion but there's no set timeline. In fact, with GE's turnaround finally starting to gain traction and Baker Hughe's stock at depressed levels, GE could choose to hold on for better days. In other words, GE's 37% stake will remain a notable overhang on the stock price and there's no way to tell for how long.
Why buy Baker Hughes while the energy services industry is under pressure and more than a third of the total share count is going to hit the market? All of those shares will need to find buyers, and the end result of such a large sale is unlikely to be higher prices. In fact, a higher stock price really increases the likelihood that GE will try to opportunistically sell shares and end up squashing any rally that starts to take hold. That would likely lead the stock to lag behind peers in a recovery. Or, worse, GE could sell when prices are still weak, putting further downward pressure on Baker Hughes' stock price. If there were a more clear end date for General Electric's final sale, you could view this as an opportunity to buy Baker Hughes on the cheap. But without a clear way to know when GE will sell its last share, you could be waiting a very long time for this overhang to disappear and it could actually lead to more pain for investors before GE is finally out of the picture.
More than one issue to monitor
Baker Hughes isn't simply an energy services play; it's more complex than that. Yes, the ups and downs of the sector are important, as is the company's seemingly successful efforts to integrate the GE and Baker Hughes businesses. But overhanging it all is a massive block of stock that investors know is going to hit the market.
Until GE has sold a lot more stock, investors are probably best watching from the sidelines no matter what's going on within the company or the sector.