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What is New Baker Hughes worth?

The service industry’s favourite target has finally found a new home— and gets a new financial outlook to boot

After anti-trust regulators torpedoed Halliburton's $38bn Baker Hughes takeover, Baker Hughes's management vowed the company would forge ahead on its own. But as the clear laggard among the service industry's big three-led by Schlumberger and Halliburton-a step change was needed if Baker Hughes was to keep up. A tie-up with General Electric's oil and gas business might do the job.

The new organisation-dubbed New Baker Hughes-will see the companies merge their operations and trade under the Baker Hughes handle.

GE shareholders will hold a 62.5% stake, while Baker Hughes's will own the remainder and receive a one-off sweetener dividend of $17.50 a share.

The companies' management were keen to tout the deal's strategic logic. Baker Hughes's onshore services and drilling expertise will be augmented by GE's focus on deep-water services, midstream equipment and the company's advanced data-analytics systems, they say. The increased size and broader scope of equipment and services housed under the same operation, they argue, will help them compete with Schlumberger and Halliburton. The companies also promise around $1.6bn in synergies by 2020.

The market wasn't convinced. As shareholders digested the details of the deal in the first few days after the announcement, Baker Hughes's share price fell about 10%. Part of this was because of a simultaneous drop in the oil price, but it was mostly driven by scepticism that New Baker Hughes would be better off than the old.

Cold hard numbers

Who's right? The key valuation metric for oilfield-service companies is the enterprise value-the sum of a company's market capitalisation, debt and preferred equity less cash and investments-to earnings before income tax, depreciation and amortisation (EV/Ebitda) multiple.

Beneath the jargon, that's a sort of grade the market gives companies-those with a better history of execution and better growth prospects typically trade at a higher multiple.

Schlumberger, the gold standard for large service companies, usually trades at a higher multiple than Halliburton and Baker Hughes. At the time of the deal, Schlumberger was trading at 11.2 times consensus 2018 Ebitda, compared to nine times for Halliburton, according to Raymond James, an investment firm. Baker Hughes sat between the two at 10.1x. The dip in Baker Hughes's share price indicates shareholders by and large see GE dragging this multiple lower-after a few days of post-deal trading the implied multiple had fallen to around 7.75x.

This may be a slight overcorrection but it is probably fair-at least looking out over the next two years. On its own, Baker Hughes is highly exposed to the vicissitudes of US shale, with its main business lines in drilling and completions. This has been a liability over the past two years or so as drilling activity collapsed. But as it has become clear that the shale industry will be on the leading edge of any industry recovery, the company's outlook has brightened. Owning stock in the company has been a proxy bet on a US drilling recovery in 2017 and 2018.

GE's business, by contrast, is heavily weighted towards deep water and other areas of the industry that will be much slower to recover.

The inclusion of these business lines in the New Baker Hughes dilutes the company's exposure to shale drilling just as it appears producers are getting ready to start spending again, while the offshore sector continues to struggle.

For that reason, New Baker Hughes's multiple may lag both Halliburton's and Schlumberger's for the next 18 months, or so.

Strong future

Longer term, however, the companies probably are stronger together, for many of the reasons management laid out. Combined, they'll be able to offer a uniquely wide array of services from the wellhead to the power plant-or "molecule to megawatt" as the PR gurus at GE put it. The broader portfolio will also make the company more resilient to downturns in particular sectors and let it in responding to market shifts.

In short, Baker Hughes is sacrificing short-term shale-linked growth for diversification and long-term stability. That should earn New Baker Hughes a consistently higher EV/Ebitda multiple, over the coming years, than Halliburton's narrower oilfield-service offering, though it will have a lot to prove to compete with Schlumberger.

For one, it's unclear how much value GE's digitisation offers. The industrial conglomerate's pitch to the oil industry has always been that it is bringing high tech-largely in the form of big data and analytics-to the oil patch.

The long-term value to Baker Hughes will depend on GE maintaining its tech edge over Schlumberger and Halliburton, even as those companies spend big to catch up. Analysts at Jefferies, an investment bank, point out that some of GE's early oil and gas acquisitions, like Vetco, Hydril and Wellstream, appeared to lose market share after GE bought them-though that doesn't necessarily mean returns on investment suffered.

What of the regulatory risk that felled Halliburton's attempted Baker Hughes purchase? The companies' portfolios are more complimentary, with far less overlap, than Halliburton and Baker Hughes's were.

So even at a time when mega mergers are getting extra scrutiny from anti-trust regulators, the chances of this deal collapsing are slim.

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