Continued Strength in International and Offshore Markets Will Drive Baker Hughes' Long-Run Prospects

Analyst

Katherine Olexa

Baker Hughes represents one of the “big three” oilfield service firms, in league with industry heavyweights Schlumberger and Halliburton. It maintains sizable share in several end markets, including specialty chemicals and directional drilling, and it’s maintained the lead in specialty chemicals since at least 2008. The majority of Baker Hughes’ revenue comes from international (non-U.S.) markets, which tend to be less volatile, but challenges associated with the inherent cyclicality of oil and gas markets are ever-present. We expect demand for oil and gas will remain high over the next few years, presenting ample growth opportunities in Baker Hughes’ core market.

The firm nevertheless intends to diversify its business portfolio to hedge risks associated with declining oil demand over the long run. It’s investing heavily in industrial energy technologies, represented by its Industrial Energy Technology segment. The long-term goal is to establish a foothold in industrial asset management, characterized by long-term contracts (commonly spanning decades) that require aftermarket services, which tend to be very profitable.

Upstream end-markets historically represent about two thirds of Baker Hughes' annual revenue, but management aims to reduce that exposure to 40% while more than doubling its exposure to broader industrial end markets. A precise timeline for this transition is unclear, but we’re cautiously optimistic about Baker Hughes’ intentions to pivot. The industrial asset management industry appears conducive to excess value generation (several well-established players hold wide moats), and growth in the industry is, in our view, highly likely as process automation solutions and other efficiency-maximizing solutions are in high demand. Baker Hughes currently holds a 90% market share in turbomachinery for LNG refineries—a solid start, but it remains to be seen whether the firm can continue to win contracts in that niche and if it can successfully penetrate end markets beyond oil and gas applications.

Business Strategy & Outlook

We do not assign Baker Hughes a moat. The firm maintains some moaty business lines—we observe aspects of switching costs within its Industrial Energy Technology, or IET, segment—but these segment-level competitive advantages are insufficient to assign a moat to the firm as a whole. We use returns on invested capital, or ROIC, in excess of weighted average cost of capital as a quantitative measuring stick for whether or not a firm is likely to possess a moat. By our estimate, Baker Hughes’ ROIC will average 8.2% over the next five years, approximately in line with its 8.1% cost of capital.

Baker Hughes maintains two segments: oilfield services and equipment, or OFSE, and industrial energy technology, or IET, composed of the firm’s turbomachinery & processing solutions and digital solutions segments.

The OFSE segment does not exhibit moaty characteristics, in our view. Baker Hughes holds majority share in several of its oilfield service product lines, maintaining a strong lead in the artificial lift, specialty chemicals, and completion and equipment services end markets. The firm holds a solid second place—often behind Schlumberger—in several other categories, including directional drilling. Despite its strong presence in the service markets, Baker Hughes’ OFSE segment maintains operating margins in the midsingle digits, indicative of the highly competitive service market. Maintained technological differentiation is difficult to maintain, which challenges many firms’ abilities to command premium prices. A crowded market further exacerbates downward pricing pressure, as service providers continually cut prices to win contracts over competitors. We don’t see these factors abating over time, so we expect operating margins will average 13% over the next five years. This segment is also highly capital intensive, representing half the firm’s total assets and nearly two thirds of the firm’s total goodwill (after adjusting for past impairments).

About 20% of OFSE revenue involves subsea production systems, or SPS, a fairly sticky market characterized by strong demand for aftermarket services. Contractors also tend to favor incumbents, which benefits Baker Hughes for its existing installed base, however, TechnipFMC dominates the market, holding 50% of the global installed base of subsea trees. The segment also provides rig equipment, a market that has struggled in recent years as rampant inventory overcapacity continues to depress demand. We’re not optimistic about demand recovery, as customers rely on their substantial supplies of latent rigs to service their existing fleets. Even as the market’s inventory cannibalization dies down, efficiency gains continually reduce the number of rigs required in the first place.

Baker Hughes’ IET business reflects the firm’s intentions to gradually shift away from upstream oilfield services, targeting more midstream and downstream players as well as broader industrial end markets. In our view, the IET segment exhibits elements of switching costs thanks to its large installed base of capital-intensive, mission-critical equipment as well as long-term contract agreements and a risk-averse customer base that favors incumbent providers. Together, these factors create a formidable barrier to entry for would-be competitors. 

Our forecasts suggest both the segment’s operating profits will average in the high teens over the next five years, driven by favorable end market growth trends and increasing revenue from aftermarket services—currently about 60%—which tend to be more profitable. Baker Hughes holds a very large share of the turbomachinery market for LNG refineries (as high as 90% according to management) specifically, and as the OEM, Baker Hughes secures a very high likelihood of handling aftermarket services for those customers. The firm’s already-large installed base coupled with the long-term contracts (often exceeding 20 years) associated with these projects will help Baker Hughes protect its niche. This will be further enhanced by a highly risk averse customer base that favors contracting incumbent equipment and service providers rather than risk costly shutdowns from a competing but “unproven” provider. Although there are several moaty competitors in this space (including Emerson and Schneider Electric), each occupies its own niche for the most part, and a recent push toward improved operational efficiency and (sometimes mandated) carbon reduction initiatives imply abundant growth opportunities for industrial asset management, leaving plenty of room for numerous providers moving forward.

The IET segment also provides numerous process automation services, ranging from general monitoring and diagnostics all the way to maintenance prediction and more. We view the firm's inspection and condition monitoring services as avenues to strengthen the segment's moatiness. First, these products and services help Baker Hughes provide more holistic solutions to customers—also known as “balance of plant” solutions—creating a stickier customer base by deepening its integration within client operations. This will be particularly useful in greenfield projects, where Baker Hughes can secure a strong presence within a project right out of the gate. We see potential for strengthening services in brownfield projects, as well. Management indicates Baker Hughes’ LNG turbomachinery ensures 98% uptime, but disruptions from other providers’ equipment can still cause plantwide shutdowns costing hundreds of thousands of dollars per day. By expanding its ecosystem of integrated hardware and software products, Baker Hughes can increase its relative value proposition for customers through reduced operational downtime, potentially taking share from less reliable incumbents. We think this will be particularly effective in LNG projects, where Baker Hughes can lean on its strong brand reputation as an established oilfield services provider to increase its share.

Overall, Baker Hughes maintains its status as one of the “big three” oilfield service providers, and we’re optimistic about its recent focus on industrial asset management (given the sector’s apparent moatiness). Nevertheless, the firm maintains quite a few asset-intensive business lines that will continue to suppress ROICs for the foreseeable future, holding the firm in no-moat territory.

None

Economic Moat

Baker Hughes Co

Baker Hughes Co. is a holding company. The firm engages in the provision of oilfield products, services, and digital solutions. It operates through the following segments: Oilfield Services (OFS), Oilfield Equipment (OFE), Turbomachinery & Process Solutions (TPS) and Digital Solutions (DS). The OFS segment provides products and services for on and offshore operations across the lifecycle of a well, ranging from drilling, evaluation, completion, production, and intervention. The OFE segment provides a broad portfolio of products and services required to facilitate the safe and reliable flow of hydrocarbons from the subsea wellhead to the surface production facilities. The TPS segment provides equipment and related services for mechanical-drive, compression and power-generation applications. The DS segment provides operating technologies helping to improve the health, productivity, and safety of asset intensive industries and enable the Industrial Internet of Things. The company was founded in April 1987 and is headquartered in Houston, TX.

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Baker Hughes Co. is a holding company, which engages in the provision of oilfield products, services, and digital solutions. It operates through the Oilfield Services and Equipment (OFSE) and industrial and Energy Technology (IET) segments. The OFSE segment designs and manufactures products and provides services for onshore and offshore oilfield operations. The IET segment combines expertise, technologies, and services for industrial and energy customers including on and off-shore, LNG, pipeline and gas storage, refining, petrochemical, distributed gas, flow and process control, and industrial segments such as nuclear, aviation, automotive, marine, food and beverage, mining, cement and utilities. The company was founded in April 1987 and is headquartered in Houston, TX.

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