Burgess COMMENTARY

Peter Burgess

Baker Hughes And GE: A Potential Mega-Deal In The Oil Service Space

Summary

• A merger of GE Oil & Gas and Baker Hughes could result in increased competition in the global Oilfield Services industry.

• The transaction would be transformational for Baker Hughes, significantly expanding the company’s business portfolio.

• The impact on value per Baker Hughes share is debatable, however, and would strongly depend on the exchange ratio in the deal.

• From GE’s perspective, the transaction could be a skillful solution to the strategic challenges the company’s oil & gas division has been facing.

Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the disclaimer at the end of this article.

On Thursday, October 27, after the market's close, The Wall Street Journal reported that GE (NYSE:GE) was in talks to buy Baker Hughes (NYSE:BHI). The report was corrected within few hours:

Note to readers: General Electric is in talks to merge its oil-and-gas business with Baker Hughes. An earlier version of this article reported that GE is in talks to buy Baker Hughes. After the Journal's report, GE said it is in discussions with Baker Hughes on potential partnerships but not an outright purchase.

Despite the initial inaccuracy, the report is quite important as it warns about a possible M&A mega-deal in the Oilfield Services sector. If materialized, the merger could lead to a significant change in the competitive landscape in Oilfield Services.

The Potential Transaction

In its corrected report, The Wall Street Journal provided the following statement from a GE spokeswoman:

'We are in discussion with Baker Hughes on potential partnerships… While nothing is concluded, none of these options include an outright purchase.'

The statement confirms that strategic discussions between the two companies are ongoing, but the effective acquirer in this potential transaction appears to be Baker Hughes, not GE.

Quoting 'people familiar with the matter,' The Wall Street Journal reported that GE had approached Baker Hughes about a deal that could 'dramatically reshape the industrial giant' and could be worth 'upward of $20 billion.' The article further suggested that GE may be trying to 'distance itself from the battered energy industry.' According to the report, the deal could be structured as a merger of GE's oil and gas business with Baker Hughes, with a subsequent spin-off of GE's pro forma interest in the combined entity. Such conceptual structure make sense, in my opinion.

Implications For GE

From GE's perspective, such hypothetical transaction is hardly a 'dramatic reshaping.' Based on the latest quarter results, the Oil & Gas segment accounted for just ~10.8% of GE's revenue and less than 8.2% of the company's operating profit. Therefore, in the grand scheme of things, a divestiture or spin-off of oil & gas would be a tactical portfolio management initiative for the company. Moreover, a case can be made that a merger of GE Oil & Gas into Baker Hughes with a subsequent tax-free spin-off would preserve the value in the business for the current GE shareholders and would give them spun-off shares or continue to participate in the investment via, arguably, a more competitive entity.

(Source: GE, October 2016)

Until recently, GE has been growing its oil & gas business, being generally viewed as a potential acquirer of additional product lines. However, GE has been cautious in embracing the Oil Service modus operandi and remained predominantly an equipment manufacturing company, falling short of becoming an integrated oilfield service provider.

It is worth noting that oil & gas has proven to be one of the most cyclical businesses in GE's portfolio. Moreover, given GE's significant exposure to deepwater rig equipment, subsea equipment and construction and LNG, the cycle in many of its product lines may take several years to turn. In this context, GE's thoughts with regard to exiting the business altogether are not particularly surprising.

Implications For Baker Hughes

In contrast to GE, the transaction, if it materializes, would be transformational for Baker Hughes, significantly increasing the company's capitalization and changing the complexion of its business portfolio.

Assuming the merger includes GE's entire oil & gas division, the transaction would expand the scope of Baker Hughes' business beyond the company's traditional Upstream focus, adding several Midstream and Downstream equipment manufacturing and service franchises.

(Source: GE, September 2016)

In the Upstream, the merger would increase Baker Hughes' exposure to late-cycle business lines, such as subsea equipment, deepwater rig equipment and natural gas liquefaction equipment and services. While each of these business lines in GE's portfolio is characterized by high quality strong technology suites, none has the same scale and scope as, for example, Cameron (recently acquired by Schlumberger (NYSE:SLB)) or National Oilwell Varco (NYSE:NOV) have in their respective markets. If Baker Hughes were to merge with GE Oil & Gas, it would be logical to expect that significant product line build out may be required on the base of the platform acquired from GE to compete effectively in the new segments. The extended downcycle may make such investments in the business problematic.

(Source: GE, September 2016)

While the combination would significantly expand the scope of Baker Hughes' portfolio, it would not necessarily add critical mass in individual product lines or geomarkets to improve the company's competitive position vis-à-vis the industry leaders Schlumberger (SLB) and Halliburton (NYSE:HAL). In addition, it is not obvious if investors will be pleased to see Baker Hughes' increased exposure to late-cycle businesses once the recovery in the oil and gas industry finally arrives.

In these regards, the merger would not be without strategic risk to Baker Hughes and the industrial logic of the hypothetical combination raises some questions. That said, the opportunity to acquire a business portfolio of such scale and quality as being offered by GE does not come along often.

Ultimately, the impact on Baker Hughes' stock will depend on the exchange ratio that will be agreed upon in the transaction. Arguably, Baker Hughes should have a greater bargaining power relative to GE, given Baker Hughes' broader customer access platform and greater leverage to the early phase of the global oil cycle. However, given that GE is prepared, as it appears, to surrender corporate control, GE may expect to be paid a premium for its premium-quality business portfolio.

The market reacted to the news last week with visible enthusiasm, sending Baker Hughes' stock 8% higher during the trading session last Friday. However, enthusiasm may be premature. A dilutive transaction is unlikely to be GE's concept for this deal. In the event Baker Hughes accepts an unfavorable exchange ratio to simply increase its scale, value per share may suffer.

Antitrust Review Considerations

In contrast to the common sense-bending Halliburton-Baker Hughes merger initiative, a transaction with GE does not raise big antitrust concerns, as the overlap between the two businesses is modest (the slide below). There is certainly a risk that some divestitures would be required. The artificial lift family of products would be the most vulnerable in this regard. However, the required divestitures will likely be moderate in the context of GE's entire oil and gas portfolio.

(Source: Schlumberger, September 2016)

Is A Takeover Of Baker Hughes By GE A Possibility?

Given the ongoing strategic discussions between the two companies, it is difficult not to ask oneself the question: is there a chance that these discussions will evolve into GE eventually making a bid for Baker Hughes? Indeed, a case can be made that GE is one of very few companies that has a business that would be compatible with Baker Hughes' portfolio and could pursue an acquisition of Baker Hughes without triggering major antitrust objections.

I would argue, however, that chances of such a development are slim to none. An acquisition of Baker Hughes by GE would in fact be 'transformational' for GE, in a disruptive way. The two companies have their own dominant business models that differ quite radically. The Oilfield Service business model is, first and foremost, that of an outsourced supply chain. While R&D and precision manufacturing are integral components of today's competitive formula in Oilfield Services, a large portion of this business is 'going wherever the customer goes' and, in the case of international integrated Oilfield Service companies, providing a wide scope of services, including those that are commoditized. This business model entails broad network of field offices, deeply entrenched customer relationships and extensive client support headcounts.

By contrast, GE's model has been traditionally centered on product development, R&D and precision manufacturing.

A case can be made that two business models can co-exist within the same entity. However, by acquiring Baker Hughes, GE would have to fully embrace the service model, with a starting position of a distant #3 in the global industry. As a result, GE would face the risk of becoming a conglomerate of two separately managed organizations.

These potential business model conflicts have been obvious from the outset of GE's expansion into oil & gas. During the upcycle in oil, the business was profitable and promising; few questions were probably asked. However, during the current severe downcycle, strategic choices - whether to invest more or exit - have probably come to the fore.

Implications For Competitors In The Oilfield Services Sector

The combination of GE Oil & Gas and Baker Hughes is unlikely to disrupt the industry's competitive landscape in the near term. In the longer term, however, Baker Hughes has a fighting chance of emerging as a more equal competitor to Schlumberger and Halliburton. The increased scale may provide Baker Hughes financial and organizational levers to gain critical mass in those geomarkets where the company currently lags relative to the two larger competitors. However, such market share gains may require that Baker Hughes be a more aggressive competitor than GE was, with negative implications for the industry's margins and competitors' market shares.

The impact will likely be the greatest on companies such as Weatherford (NYSE:WFT), National Oilwell Varco and FMC Technologies (NYSE:FTI) which will see a larger, more committed competitor than GE was in some of their key business lines. Moreover, Baker Hughes may use the business platforms acquired from GE to build out full product offerings, increasing completion.

The eventual outcome can be positive for customers in the Upstream sector, as Baker Hughes would be better position to break into the Schlumberger/Halliburton de facto duopoly in many international markets and product lines.

A detailed discussion of the global Oil & Gas industry fundamentals and commodity monitoring and outlook are provided on a regular basis for Zeits OIL ANALYTICS subscribers.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.