Business activity practically ground to a halt after the knock effects of the coronavirus materialized in February. Shelter-in-place orders led to millions of Americans being stuck at home. Oil prices plummeted and Q2 GDP declined over 30%. Supply cuts from OPEC, Russia and certain U.S. oil drillers helped buoy oil prices. At around $40, oil may not be robust enough to spur further E&P. That could hurt Baker Hughes (BKR). The company reported Q2 revenue of $4.74 billion, down in the double-digit percentage range Q/Q.
Revenue from North America fell hard again this quarter. Baker Hughes, Halliburton (HAL) and Schlumberger (SLB) have dominated the North American land drilling market over the past few years. E&P in the region faced headwinds for much of 2019 and pricing power dissipated among oil services providers. Schlumberger and Halliburton have engaged in cost cuts to offset stagnant top line growth; Baker Hughes has recently stepped up cost containment efforts.
Short cycle businesses like Oilfield Services and Digital Solutions could be a proxy for North America land drilling. They reported a combined $2.9 billion in revenue, down 21% sequentially. They represented about 61% of total revenue, down from 65% in the prior-year period. However, the company is still highly-sensitive to results in the region.
Oilfield Services revenue was 23% Q/Q due to decreased activity in North America, primarily due to the declining rig count. The North America rig count fell 61% in Q1. It could continue to fall until oil prices rise. Lower economic activity caused by COVID-19 created headwinds for Digital Solutions.
Turbomachinery and Oilfield Equipment generated combined revenue of $1.9 billion, up 3% Q/Q. In Q1 Turbomachinery revenue was negatively impacted the disposition of certain business lines. This impact may have dissipated in Q2. Oilfield Equipment is highly-exposed to the subsea sector; at current oil prices, E&P in the sector is likely not economical. Oil prices may have to remain at $70 or above for an extended period to spur subsea E&P. This could be the company’s the worst-performing product line going forward.
Cost Containment Efforts
Sentiment for oil services name could be dependent upon the amount of cost takeouts they achieve. In Q1 the company incurred inventory impairments and separation charges of $1.5 billion. It incurred another $103 million in restructuring charges in Q2. Gross margin was 14%, practically flat with that of Q1, yet 400 basis points less than that of Q2 2019. Gross profit on a dollar basis was $678 million, down 10% Q/Q.
SG&A costs were $590 million, down 13% Q/Q. Cuts to SG&A helped offset some of the revenue fall off. EBITDA of $427 million fell 2% Q/Q. EBITDA margin of 9% was up 100 basis points versus Q1. Future cost takeouts could potentially buffer EBITDA:
As these challenges persist, we remain focused on identifying ways to right size the business and improve profitability across OFE. Overall, we are executing on the framework we laid out on our first quarter earnings call. We’re on track to hit our goals of rightsizing our business and generating positive free cash flow for 2020, and to achieve the 700 million in annualized cost savings by year end.
We continue to explore and identify further ways to make all of these savings structural in nature. We believe that the expanded use of remote operations and multi-skilling will drive greater productivity and affect change in service delivery capabilities, ensuring the health and safety of our employees during the pandemic and greatly reducing our resource needs and a longer term recovery.
Until the economy fully reopens, I believe oil prices will remain depressed. North America E&P could remain in the doldrums and new orders for subsea equipment could dry up. I expect more cost cuts from management in 2021.
Oil services firms must maintain liquidity to survive the stagnant economy, and Baker Hughes has lots of it. The company has $4.1 billion in cash and $4.9 billion in working capital, down from $5.2 billion in the year earlier period. As the business slowly retrenches, Baker Hughes should be able to monetize working capital. Free cash flow (“FCF”) through the first six months of the year was $106 million, down from -$185 million in the year earlier period. This came despite $602 million of capital expenditures through year-to-date 2020. I expect management to cut capital expenditures going forward. Baker Hughes must continue to squirrel away capital to support itself in case the downturn in the economy and oil markets lasts longer than expected.
BKR has an enterprise value of $19 billion. It trades at 7.6x last 12 months (“LTM”) EBITDA, which I deem appropriate given volatile oil markets. Its valuation could ebb and flow with broader markets, yet investors should remain focused on earnings fundamentals.
BKR could face headwinds until the economy reopens. Hold the stock.
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