Baker Hughes Cooks Up Some Investor Opportunity

After lagging its peers, the oil-service provider is attracting analyst interest.
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For once,

Baker Hughes'

(BHI)

sub-par returns may actually be a benefit.

The oil-services provider has long lagged its bigger peers when it comes to issues like return on equity. Now, however, Baker is on its way to improving those returns. And thanks to those past lousy returns, the stock trails competitors

Schlumberger

(SLB) - Get Report

and

Halliburton

(HAL) - Get Report

using at least one key measure: creating opportunity for investors.

"I'm recommending we purchase

shares," says Larry Shaw, vice president and equity analyst at Boston's

Loomis Sayles

, a Baker shareholder. Baker's earnings held up better than he expected during the recent downturn, Shaw says. He likes the fact that Baker, the smallest of the Big Three oil-service companies, is trading well below Schlumberger and Halliburton on a price-to-cash flow basis.

It's startling to hear that any oil-service company is viewed as a bargain these days. After all, the

Philadelphia Stock Exchange

oil-service index is up over 80% since early March. Baker has run to more than 35 from just under 18 on March 1, indicating the expected rebound has been priced into the stock. Nevertheless, the bullish thesis says that come fall, earnings estimates will head north as activity in the oil patch increases, fueling further gains. Already, Baker's earnings next year are expected to double, to 76 cents per share from this year's 36 cents, according to

First Call

.

Investors haven't always been bullish on Baker, for good reason. Throughout most of Baker's recent history, its returns on equity, a key profitability ratio and a measure of operating performance, fell short of expectations, as did revenue and profits. In fact, over the past 10 years, Baker's revenue growth has averaged 8.6% per year, compared with 10.2% for Schlumberger and 9.4% for Halliburton, according to

Salomon Smith Barney

. Salomon hasn't performed underwriting for Baker.

"Wall Street as a whole has been relatively disappointed by the returns generated by

Baker's businesses," says Wes Maat, who follows BHI at

Deutsche Banc Alex. Brown

. "In the mid-1990s, they lost market share and at times the company's overall cost structure was relatively high." He rates the company market perform, and his firm has not participated in equity underwriting for Baker.

But results from the most recent quarter suggest that Baker is improving its performance. Observers say Max Lukens, Baker's chairman, president and chief executive, has gotten the message that returns need to be lifted. Baker's second-quarter earnings and profit margins reflected the industry's lingering poor conditions, but margins from Baker's oil-field segments were better than expected. On Aug. 2, the company said operating earnings for the quarter totaled $18.3 million, or 6 cents per share, compared with $118 million, or 36 cents per share, in the year-ago period. Revenue dropped 27%, to $1.2 billion, from $1.7 billion in the year-ago period.

On its conference call, management reaffirmed its focus on tying executive compensation to improving returns. And while the third quarter will likely fall below the second quarter, improvements in several of Baker's key drilling-related areas will steadily boost earnings heading into 2000.

Baker's task now is to prove itself on a number of measures throughout an industry business cycle, says Shaw at Loomis Sayles.

"As Baker shows it can keep its profitability in the

anticipated upturn," he says, the multiple gap between Baker and its rivals may close.

Maat at Deutsche Banc also sees Baker as a bargain right now relative to its peers, but the reward for that discount will depend on how and whether the company comes through on its promises. Its "fate is in

its own hands, to a large degree," he says. He estimates that Baker can improve its total operating profit to the low-to-mid-teen levels, from its current level of under 10%.

Of course, there are risks to investing now in Baker -- and the group overall. For one thing, even though Baker's price-to-cash-flow ratio is lower than its peers, it's approaching the valuation it reached at its peak price in 1997, says Maat. Schlumberger and Halliburton also are at or above their 1997 peak multiples, he adds.

And on a price-to-earnings ratio basis, Baker looks pricey. It trades at 46 times 2000 earnings estimates, while Schlumberger is at 40 times and Halliburton is at 38 times.

Another risk is if oil company spending, tied to oil prices, doesn't ramp to match expectations, Maat says. Meanwhile, Baker and the rest of the industry will have to be careful not to cave to pressure from newly formed huge oil majors to tie up services on long-term, low-prices contracts, eroding margins.

Baker also still is wrestling with its capital-intensive seismic segment. Although Baker has produced on its promise to generate over $130 million in cost savings from its 1998 merger with

Western Atlas

, its

Western Geophysical

seismic contracting unit is expected to remain weak throughout this year, especially internationally. And as a Dallas-based analyst who declined to be named points out, when activity levels are high, seismic is extremely profitable. When overall activity is weak, seismic can be a big capital drag. He doesn't cover Baker.

On the conference call, Baker didn't elaborate on how much capital it was pumping into its seismic business. Industry spending on seismic surveys, which help oil companies pinpoint oil and gas deposits, will likely not pick up until oil-company budgets for 2000 are determined much later this year.

After years of underperformance, Baker still has a long way to go before it fully regains investor confidence. But as its profitability increases and cost-reduction measures kick in, its bigger rivals ultimately may be the ones playing catch-up.