The Real Reason Halliburton Company Is Buying Baker Hughes Incorporated

Less than a month ago,Halliburton Company announced it was buying Baker Hughes Incorporated in a nearly $35 billion deal. The deal, which is merging the second and third largest oil field service companies in the world, is expected to put the new Halliburton in a better position to challenge Schlumberger Limited as the leader in the oil field service category. However, the real reason behind the deal isn't so much about challenging Schlumberger at the tops in terms of a higher revenue number, but instead, Halliburton is after a different number: Schlumberger's premium valuation.

The number Halliburton really wantsHalliburton's current CFO Mark McCollum recently spoke at an energy conference, where he laid out his company's rationale for the deal. He started things off by saying:

Clearly, he sees this deal driving better long-term returns for the company. That's important because of what those returns will represent to investors over the long term once the deal is completed and fully integrated. He went on to discuss what these returns should yield:

Here we get a glimpse of the number Halliburton is really after, and the real reason behind this deal. McCollum points out that the deal isn't about empire building, nor to just get bigger for the sake of being big. Instead, the company sees the deal as the key to closing the valuation gap between itself and Schlumberger, which we see in these charts.

HAL P/E Ratio (TTM) data by YCharts.

As both charts illustrate, Schlumberger has traditionally traded at a higher multiple to earnings than Halliburton. Sometimes the gap is rather wide, which, in Halliburton's view, is unfortunate because it thinks it should be the company that deserves a premium multiple, and it has the numbers to back that up.

Why Halliburton thinks it deserves this numberThe reason this really bothers Halliburton is because its returns have always been far better than those of Schlumberger. McCollum pointed this out:

We can see the returns that he's taking about in this next chart.

HAL Return on Equity (TTM) data by YCharts.

So, Halliburton's solution to closing the gap is to merge with Baker Hughes, as it believes that combining the two companies will deliver even better returns in the future. Those returns, when combined with greater scale, should earn the combined entity a multiple that's as good, if not better, than Schlumberger's.

Investor takeaway The key takeaway in all of this is that the combination isn't about building Halliburton's empire to rival the size of Schlumberger, but to seize Schlumberger's premium multiple. This is what McCollum is implying:

If the company succeeds in this plan, long-term investors will reap the rewards, as they'll own a piece of the best and highest-valued oil field service company in the world.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Halliburton. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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