Baker Hughes: GE Shouldn't Mention It

(Bloomberg Gadfly) -- General Electric Co. is having a bad week. So, too, is its oily sidekick, Baker Hughes, a GE Company -- to use its full name.

Having "a GE Company" in your name, once a badge of honor, is more like financial antimatter these days. The industrial giant's curiously limp pledge of transformation, having slashed its dividend, wiped almost 6 percent off its stock on Tuesday, taking the two-day loss to 12.9 percent. So it's perhaps not surprising that Baker Hughes -- I'll dispense with the "a GE etc." from here --  got caught in the downdraft:

Baker Hughes: GE Shouldn't Mention It

Is such treatment really deserved?

Following its merger with GE's oil-and-gas business this summer, Baker Hughes is now 62.5 percent-owned by GE; the other 37.5 percent is the float that trades in the market. Under the terms of the merger, GE is blocked from selling its stake for two years without the approval of an independent board under a standstill agreement.

What seems to have spooked investors, at least initially, were comments made by GE's CEO, John Flannery, on Monday morning's call about the company evaluating its "exit options" for that stake. While pleased about progress on the merger, he's less enamored with commodity prices. Answering a question, Flannery emphasized GE's "optionality":

We own 62.5 percent of this company. We want to maximize the value of that for the shareholders of our company. Part of that's going to be how we deliver synergies, part of that's going to be how we share technology, and part of it might be, is there a different form or structure for the ownership of that asset?

It hardly need be said that this is not the most reassuring thing to hear from the CEO of your majority shareholder about a deal that closed only four months ago.

It's bad luck for Baker Hughes because it actually has some strong levers to pull at a time when nobody in the sector can rely on energy prices to do the job: Some of this week's sell-off reflects wobbling faith in the recent rally in crude oil, which is why Schlumberger Ltd. and Halliburton Co. are also down.

Chief among Baker Hughes's levers is its lack of leverage:

Baker Hughes: GE Shouldn't Mention It

That room to add debt allowed Baker Hughes to announce a $3 billion buyback last week. This shouldn't be a one-off, either. The company's pro-forma leverage ratio remains below 10 percent. And free cash flow over the next three years is forecast to be $5.44 billion, according to consensus forecasts compiled by Bloomberg, or almost 16 percent of Baker Hughes's current market capitalization. That is on par with Halliburton and higher than Schlumberger at just below 11 percent.

This ability to return cash should be attractive, given the apparent outbreak of value-over-volume thinking among energy investors. The problem is that those forecasts rest on Baker Hughes realizing its touted synergies from the merger.

In a normal situation, this would actually be another lever to pull to offset the vagaries of the oil price and the investment cycle. What it has trouble offsetting are the vagaries of GE's desire for "optionality."

The underlying industrial logic of matching up Baker Hughes's services with GE's equipment, software, relationships and financing remains intact. Ultimately, a full-suite services offering with an emphasis on all things digital represents the industry's future.

But the new Baker Hughes is also a unique mix of businesses in this sector and has higher exposure to markets such as liquefied natural gas and offshore drilling, which remain subdued in contrast to the Permian party powering Halliburton's results. And given that it resulted from a recent merger, it is also a work-in-progress.

The standstill agreement in the GE-Baker Hughes deal, therefore, serves an important purpose while the new Baker Hughes establishes credibility fully. And it is in GE's interest that this happens in order to reap the full value of the deal. That incentive, along with the agreement itself, offers investors some comfort that this week's troubles are unfortunate coincidences of guilt-by-association with GE and jitters in the oil market. On that basis, and given Baker Hughes's underlying strengths, the sell-off looks overdone.

Yet the fact that GE is choosing to cloud the picture this early into Baker Hughes's merger is an oddity investors can't ignore, not least because it creates a potential overhang in the stock.

Speaking at a UBS conference on Wednesday morning, Flannery reiterated GE's commitment to delivering its side of the merger. But he also reiterated his desire for "optionality" and noted that he "wasn't in the conference room" when the deal was thrashed out. The price of such ambiguity is a higher risk premium for Baker Hughes's stock (as it is for GE's).

For Baker Hughes, it would probably be worth just to ixnay the second half of its full name whenever possible from now on. Even more useful might be persuading Flannery and his fellow executives to simply not talk about the company at all.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

To contact the author of this story: Liam Denning in New York at ldenning1@bloomberg.net.

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