Prospects for oil services company Baker Hughes (BHI) are never really going to be divorced from the outlook for energy prices. However, the company has made great strides in operationally adjusting to flattish energy markets over the last year. Alongside companies such as Halliburton (HAL 0.34%) and General Electric's (GE -2.11%) energy segment, it's been forced to innovate to generate growth and develop its international business. The good news is that its plans are working.
Baker Hughes innovates
The following chart demonstrates the relationship between Baker Hughes and the U.S. Rotary rig count (data compiled by Baker Hughes).
US Rotary Rigs data by YCharts
The chart suggests that Baker Hughes' stock price will find it hard to grow given a fall in the U.S. rig count. So, is that all you need to know? Is Baker Hughes just a play on the rig count?
As ever with investing, it's not quite that simple. The truth is that things like energy prices, rig activity, and energy production are themselves correlated to the global economy. Therefore, Baker Hughes' prospects will be somewhat cyclically linked, but there are three reasons why it's able to outperform its industry.
Why Baker Hughes is outperforming
First, as discussed in a previous article, thanks partly to shale oil initiatives, U.S. oil production has gone up noticeably while oil prices have been relatively flat for the last two years. This has created a scenario whereby international rig counts are set to rise more than North American rig counts in 2014. For example, Baker Hughes is forecasting international rig counts to rise 9% in 2014 on average, while U.S. onshore rig counts are only forecast to rise by 4% to 1,830.
The good news is that Baker Hughes managed to grow its non-North American revenue by 12.5% in its first quarter, and this revenue is now generating 45.4% of its pre-tax profits vs. 41.8% last year. It's a similar story with Halliburton, whose eastern hemisphere operations generated 11% revenue growth, and operating income growth of 16% in its first quarter, compared to 5% and zero growth respectively for North America.
Second, Baker Hughes has focused its business on innovating to produce new technological solutions tailored to the growth markets within energy services, such as subsea, deepwater, and fracking. Moreover, on its recent first quarter conference call, management outlined that its new products would contribute positively to margins.
I think most significantly its [sic] the absorption of some of the new technologies whether it's AutoTrack Curve, whether it's the cemented FracPoint, whether it's FlexPump and Production Wave, these sell for significantly higher margins than the products that they are obsoleting.
It's a similar philosophy behind General Electric's recent moves to invest in areas like compressors for use in transporting gas from shale plays -- witness GE's $550 million purchase of Cameron's compression unit -- and subsea solutions. In fact, speaking on its recent conference call, GE's management outlined that it expects "stronger growth in Subsea and unconventional production" in the coming years.
The third reason is that its management expects to see an increasing intensity in wells, which should create additional demand for its technological solutions. In other words, even if the rig count is growing at a modest rate, Baker Hughes will be positioned to grow.
The bottom line
All told, Baker Hughes is positioned to grow more than its industry in 2014, and despite the U.S. onshore rig count only being forecast to increase by 4% in 2014, analysts have Baker Hughes growing revenue at an 8.6% rate for the next two years. Moreover, the measures it's taking are in line with what General Electric and Halliburton are doing with their operations.
With that said, the company still remains a directional play on movements in energy prices and rig activity, but if you are bullish on these aspects of the global economy then Baker Hughes could fit well in your portfolio.
