We closed this position on March 21, 2012. A copy of the associated Position Update report is here.
It is only a matter of time before oil and gas stocks stop moving with the price of oil and start reflecting their underlying economics.
When this happens, Baker Hughes (BHI – “very dangerous” rating) will be among the stocks that fall the hardest.
The reason behind BHI’s imminent downfall is the misleading nature of its reported earnings. Per Figure 1 below, BHI’s accounting earnings have benefited significantly from the BJ Services acquisition that closed in late April 2010. However, the economics, i.e. the resulting cash flows, of the deal are not positive.
The math is simple. BHI paid $6,897 million and assumed $2,348 million in liabilities (total cost of $9,245 million) to acquire BJ Services, which contributed ~$500 million in annualized unlevered earnings in 2010. This results in a return on invested capital (ROIC) for the acquisition of 5.4%, much lower than BHI’s cost of capital (WACC) of 8.6%.
BHI overpaid for BJ Services, which drives a decline in economic earnings of $295 million, despite the boost in GAAP earnings.
Figure 1: Misleading Earnings From “Accretive” Acquisition
One of the biggest misconceptions in the investing world is that the merit of an acquisition should be judged by whether or not it is “earnings accretive”. As shown above, the impact of an acquisition on a company’s accounting earnings is not indicative of its economic value to shareholders.
“To illustrate the point, we turn to the so-called ‘high-low fallacy.’ This simple exercise shows the impact of combining two ‘businesses’—one with a high price/earnings multiple (P/E) and one with a low P/E—in a stock-for-stock deal. Assuming no acquisition premium or synergy between the operations, it can be demonstrated that management can either increase earnings—High buys Low—or increase the P/E—Low buys High.”
Figure 2 clearly demonstrates the simple math behind how acquisitions can be accretive without any consideration whatsoever to the economic impact of a deal.
Figure 2: The High-Low Fallacy
Sources: Credit Suisse First Boston, Frontiers of Finance, “Let’s Make a Deal”, Michael Mauboussin, page 7
The take-away for investors is: do not be fooled by the misleading increase in BHI’s reported earnings. The economics of the business have taken a turn for the worse, and, eventually, the stock price will drop to reflect that decline.
In fact, the stock price decline could be rather severe given the unrealistically high future cash flow expectation reflected in its valuation.
To justify its current price of ~$57.70, Baker Hughes would have to grow its after-tax cash flow (NOPAT) by over 20% compounded annually for 12 years. Those are high expectations…not just the high level of growth but also the long duration of expected growth.
With no future profit growth, the value of Baker Hughes’ stock is closer to $17 per share. Though I do not necessarily expect Baker Hughes will achieve no future profit growth, I think the no-growth value provides important perspective on how much growth is priced into the stock and how much risk investors take by holding it.
Figure 3 suggests that investors in BHI’s stock could be in for some trouble if history repeats itself. Over the last 13 years, BHI’s stock has quite closely tracked the company’s economic earnings. The stock is in for quite a correction if the correlation between market value and economic earnings returns – consistent with my analysis of future cash flow expectations.
Figure 3: Stock Price Follows Economic Earnings Not GAAP
Baker Hughes is one of September’s most dangerous stocks and gets my “very dangerous” risk/reward rating. There is lots of downside risk given the misleading earnings while there is little upside reward given the already-rich expectations embedded in the stock price. More details on my rating and a free report on BHI are here.
In a business where investors make money by buying stocks with low expectations relative to their future potential, BHI fits the profile of a great stock to short or sell.
I also recommend selling the following ETFs because of their “dangerous” rating and exposure to BHI.
- Energy Select Sector SPDR (XLE)
- First Trust Energy AlphaDEX Fund (FXN)
- SPDR S&P Oil & Gas Equip & Service (XES)
- Rydex S&P Equal Weight Energy ETF (RYE)
- PowerShares Dynamic Oil Services (PXJ)
- iShares Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ)
Disclosure: I receive no compensation to write about any specific stock, sector or theme.