Baker Hughes (BHI)

Houston, Texas-based Baker Hughes, Inc. (BHI) is one of the largest oilfield services companies in the world, providing a range of services to the global oil and gas industry. In the recent past, the company re-organized its operations into two segments (down from seven previously): Drilling and Evaluation (contributed about 56% of the company's pre-tax operating earnings in 2007), and Completion and Production (44%). The new Drilling and Evaluation segment comprises these four divisions: Baker Atlas (wireline logging and data analysis), Baker Hughes Drilling Fluids, Hughes Christensen (leader in drill bits), and INTEQ (directional drilling services). The Completion and Production segment includes these divisions: Baker Oil Tools (a leader in completion, workover, and fishing technologies), Baker Petrolite (leader in oilfield chemicals), and Centrilift (leader in electric submersible pumps or ESPs). Approximately 42% of the company's total revenue in 2007 came from North America, while Latin America, Europe/Africa/CIS, and the Middle East/Asia-Pacific regions contributed 9%, 29%, and 20% of the total, respectively.

Our continued positive view of Baker Hughes reflects growing confidence in the company's ability to plug the historical performance gap with its large-cap oilfield service peers. The new management team has restructured the firm's operations and increased financial returns through efficiency gains and capital discipline. We believe that these measures have positioned the company to better capitalize on the current oilfield cycle. Growing appreciation of the company's solid market position (approximately of 70% of its revenue comes from products/services where it is in the top two market share holder) and international footprint (more than half of last year's revenue came from outside North America) will narrow its valuation discount to the peers.

Baker Hughes has almost completed its restructuring, which involved shifting focus from gaining market share to increasing returns and profitability. In the process, the company divested non-core assets and made significant investments in research and development (R&D). The company has also redeployed its assets from underperforming regions to more active markets and pared its workforce in underperforming markets. The payoff in R&D spending is becoming visible in results as a growing portion of the company's total revenue is generated by products that are less than three years old. The ratio of revenue contribution by new technologies is significantly higher in some divisions. In 2008, Baker Hughes will invest roughly $440 million in research and engineering, nearly 4% of its revenue, one of the highest in the oilfield service area. We expect that the company will continue to increase its spending on R&D and that the share of new technologies in the company's revenue stream will continue trending up over the next couple of years. New technologies usually command superior prices, which should help margin expansion going forward.

Margins are also expected to benefit from the company's new initiatives to manage costs and improve productivity and efficiency. In this context, the company is keeping a close watch on the North American cost structure over the next few quarters. We expect positive advancements from these initiatives. We believe that the company has opportunities to expand its margins as its product mix improves in the second half of 2008 and 2009, when a number of newbuild offshore rigs are scheduled for delivery. On the recent (second-quarter 2008) earnings call, management guided towards flattish margins (of around 23%) for the rest of the year, which in our view is on the conservative side. This is particularly so given the improving domestic drilling outlook. On the international front, Baker Hughes generates about 60% of its revenue from products/services geared towards the offshore market, of which the deepwater segment is the most lucrative slice. With about 85 new deepwater rigs expected to enter the market by the end of 2011, the operating outlook remains very favorable.

Baker Hughes' product-focused lineup of offerings differentiates it from its large-cap oilfield service peers, who have been major beneficiaries of the North American pressure pumping business. Baker Hughes had relatively weak North American pressure pumping exposure in the past. But the company is starting to see some positives in this space in a slowing market. Management has indicated a desire to increase its presence in the North American pressure pumping space through increased investment in Petrolite. The company has not been averse to plugging holes in its product line-up through bolt-on acquisitions. The recent acquisition of two reservoir consulting firms (Gaffney, Cline & Associates and GeoMechanics International) are steps in that direction essentially meant to broaden its portfolio of technologies and services. These two acquisitions are expected to strengthen Baker Hughes in two key areas in the reservoir and geo-science market and also in the integrated project management space.

Internationally, the major growth markets for the company remain Africa, Latin America, the former Soviet Union, the Middle East, and Asia. After a slow start in 2007, Baker Hughes' Russian business appears well placed for growth on the back of developing relationships with companies like Gazprom, Lukoil, Rosneft, and TNK-BP. Last year, Baker Hughes grew its Russian revenue by about 80%. The company is also well positioned in Brazil, where its revenue doubled last year. And with the recent contract award for handling roughly half of Petrobras' offshore activities, the outlook for this key growth market remains favorable. Additionally, Saudi Arabia has been a major success story for the company, where revenue has gone up from about $74 million in 2003 to about $481 million in 2007. The growth momentum in this region is poised to continue during the next few years. Mexico has also emerged as a focused area for the company, where it was recently awarded a $460 million offshore contract for servicing 15 wells. The first well is expected to spud in early November. Looking forward, Baker Hughes is targeting international growth in the low to mid-teens range, which appears to be on the conservative side.

Baker Hughes is in excellent financial health, with approximately $1.07 billion in cash (at the end of second-quarter 2008) and $1.62 billion in long-term debt (debt-to-capitalization ratio of 20%). The company remains committed to returning excess cash to shareholders through its regular dividend and share buybacks. It recently increased its quarterly dividend by 15% and authorized an additional $1 billion share buyback program to take its total buyback authorization to approximately $1.25 billion.

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